Peter Lyons: Reserve Bank starts to show some mongrel

Reserve Bank of NZ Governor Adrian Orr.

While the raft of changes this government has proposed has dominated media headlines, another proposed change has largely crept under the radar. Yet the magnitude of its effect could be huge. It is being driven by one of the most traditionally conservative actors in our economic landscape. It's a very bold brave move.

Just before Christmas, the Reserve bank quietly announced that it was proposing a large increase in the capital requirements for banks in New Zealand. The amount proposed is in the order of $20 billion. It's a whopper of a change, both in amount and philosophy.

What this means is that bank owners will need to have "more skin in the game" if they want their banks to lend money in New Zealand. The Reserve bank is finally playing hardball with the banks in New Zealand.

Banking has always been a murky business, little understood by most people. The term "bank" is derived from the Italian term for bench. Moneylenders in medieval Italy used to sit on park benches to conduct their business.

Nowadays they sit in comfortable offices behind computer screens in high-rise glass towers to conduct their business. Their core business is essentially the creation of credit to gain interest.

This credit makes up the vast bulk of our money supply. The banks create most of the money in modern economies through their lending practices. Actual notes and coins make up a very small percentage of modern money.

Money lending had a bad name in the biblical verses. It was not entirely undeserved.

Modern banks have continued that tradition. Banks in New Zealand prefer to lend for mortgage finance for the purchase of residential property. Prior to the 1980s, they were tightly controlled in their lending practices.

My father used to recall going cap in hand to the bank manager to request a housing loan. Nowadays they, or their agents, come after you. The rules restricting bank lending were removed in the 1980s as part of the free market reforms. The magic and discipline of competitive market forces was meant to ensure banks were disciplined in their lending.

The Reserve Bank, which regulates the banks, adopted a largely "hands off" approach.

Ironically Milton Friedman, the father of free market monetarism, was very dubious of unfettered banking.

The result has been a spectacular surge in house prices over the past few decades as the banks went on a lending rampage. At the same time, debt levels have skyrocketed.

Kiwis have been indoctrinated with the belief that they can't go wrong investing in houses. But they have been left with the uneasy feeling that while their houses have gone up in value, their incomes are largely stagnating and their cost of living is rising. Their debt levels are sometimes horrendous. Something isn't quite right.

The Reserve bank's latest move is very bold. What they are effectively doing is requiring bank shareholders to put more money into their banks. If the New Zealand housing market tips over, as is occurring in Australia, this means the bank shareholders are carrying more of the risk.

Otherwise if things turn ugly, mum and dad depositors could lose money. Their deposits in the banks are not guaranteed. They are unsecured lenders.

But the government is unlikely to let that happen as shown in 2008 when they hastily introduced a guarantee on bank deposits to prevent a panic. That means the New Zealand taxpayer is left to pick up the tab if the banks have got their lending horribly wrong.

This move by the Reserve bank is very bold given its history of belief in the discipline of competitive markets for banking. The banks will lobby intensely to prevent it, or reduce it, because it will have a large impact on their profits and the dividends paid to their owners. Banking in New Zealand is very profitable.

The banks would prefer that the risks they take in their lending are largely carried by depositors or the New Zealand taxpayer.

Let's hope the Reserve bank sticks to its guns. It will be subject to intense pressure and lobbying. There will be all sorts of dire predictions by the banks and their various economic salespeople. Never underestimate the power of vested interests.

Peter Lyons teaches at Saint Peter's College in Epsom and has written several economics texts.