Economy

Why Orr prefers negative interest rates to QE

Reserve Bank Governor Adrian Orr thinks a negative official cash rate would be more effective at boosting the economy than the RBNZ creating money to buy bonds or other assets. He details the options for unconventional monetary policy in an interview with Bernard Hickey.

The Reserve Bank is more actively thinking about what it should do if the official cash rate gets to zero percent, including looking at options such as charging banks negative interest rates on their deposits with the central bank, buying bonds or other assets, and even creating and granting cash to every taxpayer or resident in a process known as 'helicopter money.' 

RBNZ governor Adrian Orr also suggested taxing cash holdings to encourage savers to either spend or invest to stimulate the economy.

Orr told me in an interview (transcript below) he hoped this week's twice-as-big-as-expected 50 basis point cut in the official cash rate would make it less likely the central bank's main monetary policy tool would make it down all the way to zero percent.

"Doing the 50 points cut was interesting: whilst you get closer to zero, you also shift the probability of going below zero further away," Orr said.

He said Reserve Bank research showed the interest rate lever was just as effective as ever, despite talk of diminishing returns and whether banks would pass on the cuts to borrowers.

"Looking at the effectiveness of interest rates, both at higher interest rate levels and the current low levels, the answer is they are as effective as ever, and, in fact, some of the research suggests it's even more effective at the low nominal interest rates," he said.

The effectiveness of interest rate changes, even into negative territory, made it preferable to other types of policies such as quantitative easing, which is where central banks invent money to buy Government bonds to force down longer term interest rates.

"I think there is confusion between the effectiveness of low nominal interest rates and the effectiveness of alternative types of easing structures. Without doubt some forms of non-interest-rate monetary policy easings are less effective than the interest rate structure. So whilst interest rates are low and positive they can be just as effective there as when they were high and positive, and they can be effective when they are negative. It's the other forms of quantitative easing that are less effective," he said.

The bank was however looking at all the options for these types of unorthodox or alternative ways of conducting monetary policy.

"We're doing work which is incredibly similar to almost every other central bank in the world outside of Venezuela, Zimbabwe, and Argentina. We're all in the same global waka," Orr said.

"We are all within some confidence interval of a zero interest rate. Some central banks are already south of that: you know, the European banks, Sweden, and Japan have been there for a long time. And life continues, and monetary policy remains as effective as it is - but you might have to use different tools. Probably the most effective and simplest one is having negative interest rates. Bizarre as that seems, it still operates the same around the shape of the yield curve, and it makes people either bring spending forward or delay spending," he said.

"It also makes people think much harder about alternative investments: so, it makes them think about putting their capital to work outside of just a bank deposit. And that is, again, another positive reason for monetary policy. It's not just about: can I save - should I save or spend; it's saving equals investment. How should I be saving? Should I be investing in real activities rather than just money in the bank?"

Orr pushed back at the suggestion negative interests had not worked in Japan and Europe, pointing to growth in real per capita GDP in Japan, where the population is falling and it has had deflation.

"What I will say is that negative interest rates can have a limit to how far they can go because people will start to say, 'hey, I'm not going to be paying money to have a deposit in the bank, I will just go and get cash and store it.' There is also the limit where they say: 'I'm going to actually look for alternative investments, and go and actually create some economic activity; look for the entrepreneur; look for the event; look for the equity market'. So, there are those engine rooms."

Quantitative Easing has 'sectoral impacts'

Orr was much more cautious when talking about quantitative easing, which has pushed up prices of bonds, stocks, property and other assets, but has not necessarily strengthened economies or helped those without assets.

"The other forms of quantitative easing are effective, but can have sectoral impacts. And this is why we have to be very careful about talking about where we're thinking: because, for example, a simple one is that we the central bank buy government debt, long-dated government debt, and turn it into short-dated debt. And, again, that's just changing the shape of the yield curve. And so the Crown balance sheets are saying the duration of the balance sheet has been shortened, and, again, it means that people will be more incentivised to spend rather than save: because you've shifted the yield curve.

"That's one form - a more high powered form would be: we would go out and buy assets outside of the Crown balance sheet. And that's been done, historically, both through the GFC [and] I always recall the most famous one was during the Asian financial crisis back in the 90s, when the Hong Kong Monetary Authority courageously stepped up. They were in a fixed exchange rate regime against the US dollar, and they just intervened by buying directly into the asset markets."

One problem for the Reserve Bank is there are not enough Government bonds to be able to buy bonds directly. He said the bank was looking at establishing markets for mortgage-backed securities during a quieter periods in markets, rather than in the heat of a crisis, as was the case when the Reserve Bank had to lend money to New Zealand's big four banks in late 2008 and early 2009 so they could roll over their 'hot' wholesale funding in the frozen New York and London markets.

"Basically, the bank had to step up overnight and buy a chunk of the mortgages off the banks and give them the cash, because they were in real trouble. We've said: well, let's make sure that this market exists and it's a normal part of our market so different types of instruments that we can purchase to put cash out is great. So, there's a mortgage backed; there's the government bonds, there's a lot of different types of things if you need to be creative."

Taxing cash?

"Another one, of course, is a simple one, is saying: well, let's remove the arbitrage between a negative interest rate and holding cash. Let's tax cash holdings, simple as that: we're back to monetary policy as usual; people are disincentivised to be holding large lumps of physical cash; they are having to think harder about putting money to work," Orr said.

Orr referred to proposals from Nobel Prize winning economist Ken Rogoff to reduce the use of large denomination bills such as the $100 to improve the potency of monetary policy near zero percent and remove a tool for money launderers and criminals.

Helicopter money?

I then asked Orr about the 'helicopter money' idea put forward by famed monetarist Milton Friedman in 1969 where cash could be thrown out of a helicopter for people to pick up and spend to stimulate the economy and fire up inflation again.

"This is where fiscal policy is being run by the monetary authority. And that is absolutely fine: because in a sense we're already doing that," he said.

"I mean, the Reserve Bank balance sheet is just part of the Crown balance sheet. It's just that operationally we are set up independently to achieve a particular goal with the instruments that we are. So we are thinking far more about cyclical behaviour, able to deploy capital much quicker than the traditional fiscal policy Treasury side, which is thinking about long-term intergenerational behaviours; leads; lags. So being able to do the helicopter kind of money concept would just simply be around being able to inject cash into the system whichever way we chose to use a 'helicopter'.

"That sounds quite exciting. But, you know, effectively, this is some type of voucher: 'here's your money, you've got x period to spend it, otherwise it's not useful anymore', and these types of ways of incentivising expenditure. Now, that is using the Crown balance sheet, just as we already use the Crown balance sheet: but it's just a different instrument. And so there's nothing mystical or magical about it, it's just a different instrument."

Orr said the Reserve Bank was working with Treasury on a follow-up to its May 2018 paper on 'Aspects of implementing unconventional monetary policy in New Zealand."

Below is the transcript of the full interview. I will be writing three more articles later today on this: one on banks and insurers behind on climate change pricing, one on fiscal policy flexibility and one on high bank profits.

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Adrian Orr August 9

Bernard Hickey: Can you talk us through that decision about 25 [basis points] versus 50? Because some people were surprised. What were the things you had to take into account?

Adrian Orr: The real message was that there was a consensus decision that interest rates had to be lower; the official cash rate. And we were also very confident that they had to be significantly lower from where they are - i.e. at least the 50 basis points. Our forward path for the projections are even slightly more than that when we were discussing it. And then it becomes a tactical decision: do we do 25 and signal more, or do we just get to work now?

We've spent a lot of time around, I suppose, regret analysis, and I spoke about - you know, in a year's time looking back, thinking 'well, I wish I had done what?' And I thought it's - I would far prefer - and the committee agreed - far prefer to have the quality problem of inflation expectations starting to rise and us having to start thinking about re-normalizing interest rates back to, you know, something far more positive than where they are now. And that would be, you know, it would be a wonderful place to have regret relative to the alternative: which would be where inflation expectations keep grinding down. We're just moving down with them. Our actual inflation rate remains below the midpoint of the target band and, you know, we end up in a similar place to what you're seeing in many other countries around the world.

Bernard Hickey:  Did you go 50 instead of 25 because your potency, if you like, with monetary policy is getting less and less the closer you get to zero?

Adrian Orr: No. No, and the potency isn't - I know people like to talk about that, but we've actually done a lot of work internally, and we'll be bringing this out into the sunlight over the next few months. But looking at the effectiveness of interest rates, both at higher of the the official cash rate; both at higher interest rate levels and the current low levels. And the answer is they are as effective as ever, and, in fact, some of the research suggests it's even more effective at the low nominal interest rates. We are people - and I know we're being challenged, you know, are we just pushing on a piece of string, and so on - and that is a global conversation that's happening. But I think there is confusion between the effectiveness of low nominal interest rates and the effectiveness of alternative types of easing structures. So, without doubt some forms of non-interest-rate monetary policy easings are less effective than the interest rate structure. So, you know, that is globally accepted. So whilst interest rates are low and positive they can be just as effective there as when they were high and positive and they can be effective when they are negative. It's the other forms of quantitative easing that are less effective.

Bernard Hickey : So do you think that, as you get closer to zero - because we're not far off now - you may find yourself flogging more of a very tired or even crippled horse?

Adrian Orr: I think you've just asked the same question but in a more colourful way, so I'll just answer back: no.

Bernard Hickey: Just thinking about the last rate cut - the 25 basis points in May - what did you find happened with that in terms of how much was passed on to mortgage buyers and small businesses and farmers?

Adrian Orr: We saw as much passed on as anticipated. So there's no real change in historical behaviour between the OCR and then lending rates. And I say historic - i.e. post the global financial crisis.

The interesting and positive thing that has happened to our banking system is that the banks are now more dependent on deposits for getting their money - households - rather than just borrowing through the wholesale markets.

And it creates a great competitive tension: one, it creates a safer banking system, because deposits are more sticky than borrowing 90 days on the wholesale market. But, two: it also means that a bigger proportion of the bank funding they actually have to win customers, and so they are more reluctant to be lowering the interest rate on - that they are providing depositors, whilst they are always more than happy to change the interest rate to lenders. And so, you know, it's acting as a nice balance.

But at the end of the day, bank margins are a competitive thing and, you know, if one bank's being a laggard then people will shift to other banks. And so we've got quite an illuminating diagram in our monetary policy statement that shows exactly this is happening: that the pass-through is occurring. It occurs in different places - it doesn't all happen on the floating rate; it happens in fixed rates; it happens in deposit rates. But, you know, the pass-through's there.

Bernard Hickey: As you get closer to zero, you have to think more about unconventional ways of doing monetary policy. What work is the Reserve Bank doing, and what sort of things could it look at?

Adrian Orr: Yeah, we're doing work which is incredibly similar to almost every other central bank in the world outside of Venezuela, Zimbabwe, and Argentina, I think. You know, so basically every central bank is - we're all in the same global waka. Global nominal interest rates are at a critical low level, and so we are all within some confidence interval of a zero interest rate. Some central banks are already south of that: you know, the European banks, Sweden, and Japan have been there for a long time. And life continues, and monetary policy remains as effective as it is - but you might have to use different tools.

Probably the most effective and simplest one is having negative interest rates - so, bizarre as that seems, it still operates the same difference around the shape of the yield curve, and it makes people either bring spending forward or delay spending: it's just zero - around negative sides. It also makes people think much harder about alternative investments: so, it makes them think about putting their capital to work outside of just a bank deposit. And that is, again, another positive reason for monetary policy. It's not just about: can I save - should I save or spend; it's saving equals investment. How should I be saving? Should I be investing in real activities rather than just money in the bank?

Bernard Hickey: This has been tried overseas: Japan and Germany and Switzerland. Did it work there? Negative interest rates?

Adrian Orr: Yes. Yes, it has. You know, that's - has it worked - because - you're asking a question are they still low and struggling economies? The answer is, in some places, yes. It's an interesting mindset. I mean, real per capita GDP in Japan has been positive. We always think about nominal GDP in a low nominal economy with a population that stable - a lot of misinterpretation of what's going on in those economies occurs.

What I will say is that negative interest rates can have a limit to how far they can go: because people will start to say, 'hey, I'm not going to be paying money to have a deposit in the bank, I will just go and get cash and store it.' And so there is some kind of limit where we people say: I'm going to go just back to the hard physical cash.

There is also the limit where they say: 'I'm not - I'm going to actually look for alternative investments, and go and actually, you know, create some economic activity; look for the entrepreneur; look for the event; look for the equity market'. So, there are those engine rooms.

I've talked about the negative interest rate - the other forms of quantitative easing are, you know, have - again, are effective but can have sectoral impacts. And this is why we have to be very careful about talking about where we're thinking: because, for example, a simple one is that we the central bank buy government debt, long-dated government debt, and turn it into short-dated debt. And, again, that's just changing the shape of the yield curve. And so the Crown balance sheets are saying the duration of the balance sheet has been shortened, and, again, it means that people will be more incentivised to spend rather than save: because you've shifted the yield curve.

That's one form. A more high powered form would be: we would go out and buy assets outside of the Crown balance sheet. And that's been done, historically, both through the GFC [and] I always recall the most famous one was during the Asian financial crisis back in the 90s, when the Hong Kong Monetary Authority courageously stepped up. They were in a fixed exchange rate regime against the US dollar, and they just intervened by buying directly into the asset markets.

So, you know, these are all different ways of achieving the same thing, but they can have different implications for relative asset prices. And so that's where we have to be very careful. A big one is around forward guidance, and what I have been explaining to people recently is that we've always provided forward guidance. It's called our projection, and we're one of the few central banks in the world that put out a forward interest rate path we think is consistent with keeping inflation near the midpoint. And, so, that is - that forward guidance is what a lot of other central banks are starting to think about doing: being more transparent about what they believe they have to do to achieve their targets. Getting away from word counting on the statement on the day or slight twists in the words - we're not hung up on that; we say, hey, here's our projection, now let's talk about what matters to us, rather than trying to signal through word count.

Bernard Hickey: One way to do that is in your forecast to have that forecast flat or to have it falling. I noticed that, in this MPS, it obviously it goes down - and then it goes up in a couple of years' time. Were you tempted to have a flat one, or even going down further?

Adrian Orr:  No. I mean, effectively, the framework; the forecasting framework, you know - all models are wrong, some are useful. We use that model to, first and foremost, create a consensus view around where we think the economy is and how we think it will evolve, and what we need to do to keep inflation near the midpoint and maximum sustainable employment. So the projection you see is over the first year and a half, two years as we're lowering interest rates, then the economic activity is picking up - we're driving the economy above its capacity; inflation pressures are building, it means we can start taking some of the stimulus out. So most projections that we'll see generally have some kind of shape to the forecast ahead. The important thing is we don't need to be slave to that projection horizon. You know, for example, this projection said we would be down - we would have the 50 basis points cut by early next year. And given that we were so confident that we needed to do it, and that risk analysis, we said: 'well, let's just go there now; let's get moving'.

Bernard Hickey: Just on the unconventional policy -you said one option would be to buy, potentially, government bonds: are there enough government bonds for you to buy in New Zealand?

Adrian Orr: It's relatively limited. You know, so, like - and there are other assets, though, as well. So, for example, you know, the mortgage backed security business we're looking at is establishing - that got established during the global financial crisis, and that is the wrong time to establish anything. Basically, the bank had to step up overnight and buy a chunk of the mortgages off the banks and give them the cash, because they were in real trouble. We've said: 'well, let's make sure that this market exists and it's a normal part of our market'. And so, those, you know - so, different types of instruments that we can purchase to put cash out is great. So, you know, there's mortgage backed; there's the government bonds; there's, you know, there's a lot of different types of things if you need to be creative.

Another one, of course, a simple one, is saying: 'well, let's remove the arbitrage between a negative interest rate and holding cash'. Let's tax cash holdings, simple as that: we're back to monetary policy as usual; people are disincentivised to be holding large lumps of physical cash; they are having to think harder about putting money to work. So, you know, it's - in fact, Ken Rogoff the Nobel prize winner is speaking very openly. He's written a couple of books on this and it's - you know, these are proper consideration during good times, rather than what we came out of during the GFC and thinking, wow, what are we going to do.

Bernard Hickey: What about the idea of helicopter money that Milton Friedman put out there: where the Reserve Bank simply grants a chunk of money to every citizen or taxpayer or resident?

Adrian Orr: Yeah, these are, you know it's - buying the government bonds isn't helicopter money; people get confused about that. But without doubt these are - you know, this is where I said, I call it, you know, fiscal policy being run by the monetary authority. And that is absolutely fine: because in a sense we're already doing that. I mean, the Reserve Bank balance sheet is just part of the Crown balance sheet. It's just that operationally we are set up independently to achieve a particular goal with the instruments that we are. So we are thinking far more about cyclical behaviour, able to deploy capital much quicker than the traditional fiscal policy Treasury side, which is thinking about long-term intergenerational behaviours; leads; lags. So - being able to do the helicopter kind of money concept would just simply be around being able to inject cash into the system whichever way he chose to use a helicopter. That sounds quite exciting. But, you know, effectively, this is some type of voucher: 'here's your money, you've got x period to spend it, otherwise it's not useful anymore', and these types of ways of incentivising expenditure. Now, that is using the Crown balance sheet, just as we already use the Crown balance sheet: but it's just a different instrument. And so there's nothing mystical or magical about it, it's just a different instrument.

Bernard Hickey: On the process of how the Reserve Bank is planning or thinking for it: are we seeing some sort of discussion paper, or some sort of policy consultation, or what?

Adrian Orr: Yes, so, we've put already on on the record - I think it was mid last year, mid-2018 there's a bulletin article there talking through the pros and cons; well, talking through actually just mechanics: what's happening globally, why are people thinking about these things, and what would be the state of the art for New Zealand? And, so, we're now drilling down on various aspects of those and saying: well, which would be most effective? How can we get ourselves the broadest toolset that is possible, and in what kind of criteria and priority would you be using these things? So, you know, it's fascinating, and in doing that absolutely we have to have the Treasury. It's an interesting challenge, because our legislation is also going through Parliament. So, you know, we might have a new board, and there's a lot of different things going on there.

It's open consultation, but we have to be not spooking horses - in two ways: one about, 'wow, this is really really different', or two: 'oh, so you are going to buy x asset but not y asset, so I'd better rush towards and hold x asset'. Because it's just not the case, you know: it's business as usual. Doing the 50 points cut - you know, interesting: whilst you get closer to zero, you also shift the probability of going below zero further away.

Bernard Hickey: Just looking at fiscal policy: around the world, some central bankers are saying: 'hey, we need some help here. We had to carry the load during the GFC'. What do you think about the Government doing more with fiscal policy to help you out as we get closer to zero?

Adrian Orr: I believe globally fiscal and, I suppose, real economic policy has been been too slow, and that's a global - there's a global infrastructure deficit. We always think about New Zealand; we get concerned about trying to drive around Tauranga or Auckland. Globally there's a huge fiscal deficit. Globally, there's a huge wall of capital looking for good infrastructure investment. Some of that capital is government balance sheets; most of it is actual private pension fund balance sheets. And if you could get that to work: if you could get through the political economy of having third party ownership as part of your infrastructure, you would unleash an enormous amount of capital into the world for roading; for climate change adjustment; for so much.

But at the moment, globally the general trend is infrastructure is government-only, and council or Crown, and you go away third party capital. So, really there's two parts to that conversation: yes, Government, the hurdle rate's never been lower globally, get on and do it. And also, yes, voting citizens of the world - get over yourselves around having third party capital in this - there's fear of, you know, ownership. The single biggest challenge I see globally, and I'm talking the US, it's the battles that go between states and provinces and counties and it's just - people are amazing at getting in the way of each other.

Bernard Hickey: One of the things the Government said is: we need to keep a strong balance sheet just in case things get bad, and we have this 20 percent net debt target range - or, a range now 15 to 25. You've been following bond markets for a long time, and what bond investors are thinking. How based in reality is that 20 percent net debt target? Are fund managers worried about it? Is our net debt a problem for us that we have to really, really worry about?

Adrian Orr: No. And I think this Government is aware of that, and has been talking about having a far more flexible band around that target. What we have to remember: the political economy of New Zealand was that fiscal responsibility was through the voting population of New Zealand defined as one variable called 'we will get net debt to 20 per cent of GDP'.

Why 20 percent of GDP? I don't know. There is no math behind that. There is no magical number. It is certainly a non-linear relationship - you can be absolutely fine according to global bond markets until you're not. But that is well north of a 20 per cent, net 20 per cent of GDP.

Having said that, having low government debt and a position and confidence to increase that as and when needed is such a great place to be. And so what we want to see, you know, is the confidence and ability to be flexible around that number. It is not an electric fence, and it should have never been perceived as an electric fence. It is not an electric fence, and it should have never been perceived as an electric fence.

Bernard Hickey: Just looking more broadly - the Reserve Bank's thinking a bit more about climate change and about the effects of its policies and, more broadly, on social policy and wellbeing. We've got a housing affordability problem, a climate change problem, and a productivity problem. How would you look to solve those in the very long term - not just with monetary policy, which you control - well, the Bank does - but there are other tools as well?

Adrian Orr: Yes. So, it's probably a little bit about where - um - first, just briefly with the Bank, I mean obviously you get your own shop in order and make sure that our own portfolio is being invested appropriately and we are helping to stimulate green bond markets and other activity.

The other part of our strong leverage is across the broader financial sector: to say, 'hey, banks, hey, insurance companies, have you got your act together? How are you knowing that you are appropriately pricing the risk that comes with climate change and appropriately incentivising relative prices to motivate behaviour?' At the moment, you know, what you don't want is suddenly overnight something is - a whole region is suddenly uninsurable, or suddenly overnight the bank has lent a whole lot of money to an industry that is a sunset industry and suddenly disappears. So it's about, you know, relative pricing, and risk pricing is a critical part of creating the transition to a low-carbon economy.

And so banks, rather than just talking about how clean and green they are, it's about how are they using their lending practice, and show us how they are pricing in climate change risk: rewarding and penalising, in that relative risk sense - because that's what prices do.

Likewise, the insurance companies: how are you thinking ahead and how are you incentivising? Sometimes, you see, it's almost like the final scene of Reservoir Dogs: you know, where you've got the council standing there holding the gun to the insurance; holding the gun to the person, and waiting for the first one to blink. You know - they have to work together, because councils can't just suddenly draw a blue line. We saw that with tsunami - you draw a blue line and you have to be one metre below the line and your house is now half the value of the one a metre above the line. You know, it's - these things are blunt - we want to be smooth transitioning through time.

On the broader side, without doubt: structural economic activity or policy has been pretty absent for a long time, globally. And so, a big part of it is around this infrastructure build; a big part of it around education and getting fit for what is a rapidly changing global environment. These are all things getting to the nub of productivity, and there is a lot of work and a lot of good ideas around, you know, structural change to productivity which are intergenerational. So: not rapidly picked up by any one current government globally. And so, you know, we've really enjoyed the benefits of China coming into the global economy; of relative prices coming down - but it's been masking an otherwise lower productivity world.

Bernard Hickey: You regulate the banks and the insurers. Have they done enough, or are they prepared enough, for climate change? Have they gone through their books and worked out the risks and priced them properly, or are they still - have got some work to do?

Adrian Orr: No, they haven't done enough. I mean, awareness is okay; awareness is better in some parts of the insurance sector than others, and insurance sector awareness is better than banking awareness. So we've got a reasonable level of awareness; there's no one who doubts the need to be thinking about it. The actions are slow. So, the actions in the banking sector are, you know, coming around. We need to get past what makes good marketing vs., you know, being seen to look good: being good to doing good. And shifting to the doing good will mean much more intensive consideration around relative pricing, relative risks, and making that transparent to people. As long as there's always one laggard who's going to charge less than the other, well, then we end up at the lowest common denominator. So  this is something I'd love to see the New Zealand Bankers Association truly champion. It is a collective challenge. Rather than - but - they've proved to not be very good at grabbing some of these challenges. So, climate change without doubt; the insurance sector is far more aware of it, because, you know, they have to get reinsurance and so the increase in storm variability, etc., has got their brains working. But, again, our insurance sector itself is pretty concentrated, and, you know, we were kind of reliant on one or two of the big people to act sensibly and talk. And we're seeing that starting to happen quite rapidly, which is fantastic.

Bernard Hickey: So you're probably not buying a house in Petone or Lyall Bay?

Adrian Orr: The wonderful thing about New Zealand is we always go straight into thinking about the foreshore problem. We are the ones who are least affected by the foreshore, because we can just step back where we've got a lot of coastline and we just shift inland 20 metres. It's the storms and the variability to weather which will be the biggest impact on New Zealand, for sure. Yes, there will be occasional disruptions - you know, you might say, hey, you've got 50 years here and beyond that you're not insured, or something, or however these things work out. But it's actually the broader storm issues and interruption to global trade coming from other areas. There's also the migration issues, you know, as parts of the world become absolutely uninhabitable. Gee, this place is gonna look good. What are we gonna do about that?

Bernard Hickey: And just, finally, on banking and insurance regulation, again. The banks have made grumpy noises about how, potentially, increased capital requirements is going to stop them from passing on rate cuts, or force them to increase their margins to make sure their shareholders do not receive a cent less than they have before. What's your view on where the fairer or the correct level of profitability should be, for the banks? Because yesterday, we had ASB announce 15 percent return on equity, and the banks averaging 14 to 15 percent. Who do you think is a bit right?

Adrian Orr: Well, without doubt, New Zealand banks are among the most profitable in the world. I think we're second highest in the world at the moment. So, you know, that's both something to be pleased with, in one sense. We want profitable banks. But it also opens up questions:why so profitable relative to others; in particular, parent banks?

Part of that profitability is because they've been very low cost, and we have seen that cost in part leading to significant gaps in operational capability. And so, this is what we've been talking about: you need to reinvest more back into your business to manage your operational risks and to have better concern for your customers through the long term. So, some of that reinvestment behaviour rather than raw dividends forever going out on a lower and lower cost basis. So, thinking about competition around customer satisfaction and long-term security and safety is a real issue. And so that says we need to reinvest more rather than pay dividends; and so that's something that could see, you know, expected return on capital decline.

The other part is that, you know, the Bank has a fundamental position that - the Reserve Bank - that banks are undercapitalised, relative to the idiosyncratic risks of New Zealand: i.e. the nature of the economy, and also the concentration of the banking system.

Bernard Hickey: Because they say this proposal [on increases to bank capital requirements] you've got is way higher than the rest of the world.

Adrian Orr: And the answer is: it's not. And we've gone at odds to be as transparent as possible: to show the work that we're doing - and it comes out that, again, across comparable countries, etc, with comparable risks, what we're asking for puts us back into the upper quartile. It doesn't put us into some kind of world-record level. And at the upper quartile level, as well, we think that we could get there with only about 20 to 30 basis points maximum increase in the bank margins. Why that? Because the expected return on capital - they are safer. So, the expected return for investing in a safer asset would be lower. And this is very much the case - you know, it is comical to believe that you can sustain 14 to 18 per cent returns on equity in a global economy where the US 10 year government bond yield at the moment is one point six per cent. So, that is a massive multiple of the risk free rate - not a risk free plus something. And, so, you know, I kind of tire only ever talking to the agents, i.e., the people who are running the banks, not the owners: the principals of the capital. Because the principals understand risk and return, but the bankers are incentivised for return.

Bernard Hickey: And the proposed increase in capital requirements, by my understanding, would only reduce those returns on equity to around ten to eleven percent?

Adrian Orr:  Our estimates. Yes. So, still double figure - much safer. I know from my previous life as CEO of the New Zealand Super Fund, if I could get a 10 percent, 11 per cent return on a low safe asset, I would be shipping it in; and I'd be shipping it in in part because I'm privatising the profits that are being made, and I know that some of the losses will be socialised with people outside of my portfolio.

So it's still an incredibly healthy situation, and it's a safer situation, and we don't end up in situations like the agricultural sector at the moment: where for 10 years banks have been over-lending, and now they're in the position where they are wanting to somehow withdraw or.. They need to be there in good times and bad; in good weather and bad weather. So they're learning how to be good citizens of New Zealand.

Bernard Hickey: Adrian, thank you very much.

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