Why ‘gold plating’ our banking system is a good thing

The banks accuse the Reserve Bank of trying to 'gold plate' the system by requiring them to invest too much of their own capital. Bernard Hickey argues the regulator is right to plan for a one-in-200 year crisis and investors should accept slightly lower profitability.

It's understandable that big Australian fund managers and bank CEOs choked on their Nutrigrain last December when the Reserve Bank proposed they forgo $20 billion worth of dividends over the next five years for no obvious or immediate reason -- to them at least.

After all, they argued, the banking system was safe and stable and this 'gold plating' of the system was unnecessary, especially given financial markets are relatively calm and our banks have much more capital and more stable funding than they did during the Global Financial Crisis of 2008 and 2009.

Trust us, they said. We're much safer than before and we're nothing like those bad banks overseas, they said. And believe us, they said, if you make us hold more of the safest capital then it will cost you, not us.

ANZ New Zealand Chairman Sir John Key told the Reserve Bank GDP could be 20 percent lower in the very long term because banks would have to increase their interest margins to maintain their profitability levels. ANZ Group CEO Shayne Elliott said ANZ shareholders may choose to pull their capital out of New Zealand.

Westpac New Zealand suggested the higher capital requirements would increase interest margins by a full 100 basis points or 1 percentage point, which would increase the average Auckland mortgage cost by $6,000 a year.

Farmers pointed to the gathering clouds of higher interest margins over their land values, saying banks would punish them the most because dairy debt is seen by the Reserve Bank as the riskiest. Dairy Holdings, which has 50,000 cows and is Fonterra's largest supplier, warned of a perfect storm of higher mortgage costs and lower milk prices that could trigger a collapse in land values. 

In summary, the banks argued: Why are these pointy-headed bureaucrats in Wellington being such a bunch of nervous nellies and putting the export economy in the regions and house prices in the suburbs of Auckland at risk?

'Autarkic nitpickers'

Some commentators have been even more pointed. Geof Mortlock, a veteran adviser to the Reserve Bank, the Australian bank regulator, the IMF, the World Bank, KPMG, banks and insurers, wrote a stinging commentary in the Australian Financial Review to an enthusiastic audience. He accused the Reserve Bank of having "deliberately pursued an obsessively autarkic, nationalistic and excessively defensive approach towards regulation, supervision and bank resolution.

"It has, in effect, sought to draw a financial moat around NZ, and designed regulatory and resolution arrangements on the basis of a misplaced mistrust of how the Australian authorities would deal with a financial crisis affecting NZ," Mortlock thundered.

He can say goodbye to any consulting work from the Reserve Bank then...

But are the banks right?

Behavioural economists talk sometimes about a tendency to over-emphasise the most recent and most available information when making a decision, rather than the most relevant and useful information.

This is described as the 'availability heuristic' or the 'recency bias', whereby decisions use the most easily accessible and recent information to make a decision. The layperson would describe it by saying memories are sometimes short. In banking regulation terms, this is known as 'disaster myopia,' whereby decision-makers tend to downplay the chances and effects of a low probability, but high impact event such as a bank collapse.

Memories and attention spans are increasingly short in an age where most people get their 'news' from their Facebook news feeds and the latest dramas on The Kardashians or The Block are at least as well known as what happened to Northern Rock, Bear Stearns, Lehman Brothers, AIG and South Canterbury Finance over 2008 and 2009. That was 11 years ago. Some bankers in executive positions had yet to start their careers. All those executives have seen are falling interest rates and very strong bank profitability. 

Most voters and bank customers watching financial markets and economies now can only see record high stock markets, record high house prices, record low mortgage default rates, record low unemployment and house prices that hardly ever fall much. Paul Simon sang in his 1986 song 'You can call me Al' about his "short little span of attention," and that was before the internet, Twitter and smart phones. Some bankers and their supporters have pointed out there has never been a major bank collapse in New Zealand, so why is the Reserve Bank planning for one, and one that is so big it only happens once every 200 years? 

We are exceptional and this time is different

It is technically true that a major New Zealand bank has not collapsed, as the Reserve Bank's Dr Chris Hunt observed in this 2009 paper on the history of New Zealand's banking crises.

The Bank of New Zealand had to be bailed out twice by the Government, first in 1895 after the collapse of the 1870s land boom, and then in 1990 after collapse of an Australasian commercial property boom in the 1980s. But it did not fail in the Lehman Brothers sense. It was eventually bought and recapitalised by Australia's National Australia Bank to limit the taxpayers' exposure. 

Development Finance Corporation did fail in 1989 and it was then the 7th largest financial institution, but it was not technically a bank. The same goes for South Canterbury Finance, which failed in 2010 and forced a $1.7 billion payout of taxpayer money to depositors because it was included in the 2008 retail deposit guarantee scheme set up in the crucible of the Global Financial Crisis.

And this is where the banks' confidence in their arguments against higher capital requirements start to crumble.

What you haven't been told about the GFC

No one wants to say this out loud, and certainly not on any front page or in any other loud way.  And I can write this because I was there and remember not writing things for fear (rightly) of being accused of shouting "fire" in a crowded movie theatre. 

Our big four banks were in a precarious position at various points in late 2008 and 2009. They had borrowed most of the money they needed to back the loans they had made to New Zealanders buying each others' houses from the 'hot' 90-day bill money markets in New York and London through 2003 to 2008. By late 2008, New Zealand's banks were the most dependent in the world on these 'hot' wholesale money markets. That was all fine when the lending counter-party, typically an international bank, was happy to roll over these 90 day bills at ever lower interest rates.

But in late 2008 and 2009 those markets froze repeatedly. That meant banks like Bank of America or Royal Bank of Scotland demanded to be repaid at the end of the 90 day loan to the likes of ANZ NZ, BNZ, ASB and Westpac NZ. That meant they would have had to force borrowers to pay up immediately or refuse to pay back term deposits. It's what is known as a liquidity crisis and it's the dirty little secret of banking in a country with a fiat currency (i.e not backed by gold) and fractional reserve banking (where only a small proportion of bank lending is backed by bank shareholder equity).

If everyone turned up to ask for their bank deposits to be paid out immediately in cash, the bank would be broke because it does not have the cash (or gold) in its vaults and cannot force borrowers to repay their money quickly to do it. It's how banks operate. If you want to dig deeper into how banks essentially create money and are bombs waiting to go off, then read this seminal paper from the Bank of England. It will blow your mind in a monetary sort of way.

Banks often borrow for short terms in liquid markets and lend long in illiquid markets in the hope no one calls their bluff and doesn't turn up to demand their money back at the same time. It all works fine ... until everyone wants their money back at the same time. It's why banks are vulnerable to bank 'runs'.

These days we don't think much about queues of people out into the street trying to get their cash out of banks. But they used to happen quite regularly. There was one at Auckland Savings Bank in 1893, as Hunt documented,  and one at Countrywide Bank in 1985, as Michael Reddell documentedwhich involved word of mouth, one radio news item that "there was no truth to the rumour that Countrywide was in financial difficulty" and an unfortunate minor party press release. Remember, this was in the days before Facebook and Twitter. 

There could just as easily have been a run on a major bank in late 2008. At the time, I was working at and received many, many phone calls and emails in September, October and November of 2008 (when Lehman and AIG collapsed) from people asking me if they should pull their money out of one big four bank in particular, which shall remain nameless. I had no evidence of any particular issue and had no intention of yelling fire in a crowded theatre. I passed all of this information on to the Reserve Bank and left it at that. But that impressed upon me the fundamental instability of banks that have liquidity mismatches (i.e borrow short and lend long) and that rely on a highly leveraged approach to operating (i.e significantly less than 20 percent equity holdings).

What the Reserve Bank and Government had to do to save the banks

As a result of the fear of triggering bank runs or reducing confidence in the banking system, the Reserve Bank and the Government did not shout from the rooftops in late 2008 when they effectively rescued the banks. Bailout is too strong a word, but the actions they took and the promises they made with taxpayers' money effectively ensured there was not a bank run or a wholesale liquidity crisis.

The Reserve Bank helped the big four Australian banks avoid a cash crunch by lending them more than $7 billion over late 2008 and 2009 to make sure they could roll over their own short term loans from US and European banks. Our Government also provided a guarantee for $10.4 billion worth of wholesale bonds issued by the New Zealand arms of the big four Australian banks and, obviously, Kiwibank. And then there's the retail deposit guarantee that had to be formulated and put in place on the weekend of October 10 and 11, 2008, after Australian Prime Minister Kevin Rudd shocked many on this side of the Tasman by guaranteeing the Australian parents. New Zealand had no choice but effectively to put over $100 billion of taxpayer money behind those deposits at barely a moment's notice.

The Australian banks may have forgotten, but the Reserve Bank and both of the two most recent finance ministers have not. 

Enough for a big crisis

The Reserve Bank proposed New Zealand's banks have enough capital to deal with a one in 200 year crisis, similar to the timeframes used by insurers and other bank regulators. It calculated that the safest level possible before a significant hit to economic growth was around 16 percent. That's up from around 12 percent now. It would mean the banks would have to accept a return on equity of around 10-11 percent, which is down from 15-16 percent now.

Most savers are lucky to get 2-3 percent from their bank accounts, before withholding tax. Australian taxpayers say they take a bigger risk, but it's worth remembering they have an effective (and still free) government guarantee. 

The big four Australian banks have had almost the most profitable landscape in the world, as this Reserve Bank chart from the May Financial Stability Report showed.

The banks argue the regime proposed by the Reserve Bank would put us near the top of the pack when it comes to 'gold plating' our system.

But there's a reason for that. 

Our banking system is among the most concentrated in the world and the failure of one bank would have devastating effects on the economy. Anyone wondering what a Government bailout would do needs only look to Britain and America and Europe, where bailouts followed by austerity have so undermined the broad social contract for democracy that Donald Trump and Boris Johnson are now the respective leaders of the Anglo-American alliance.

Also, as this chart shows, the capital changes create a much more level playing field by removing the inbuilt advantage held by the big four banks of being able to choose their own capital levels under the Internal Models approach, which three of the four failed to abide by over the past five years. 

And let's not forget that the banks threatened to cut back rural lending after a 2012 increase in capital requirements, but did not. 

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