Reserve Bank’s $20 billion insurance policy

The Reserve Bank has proposed sweeping changes to the rules around the amount of capital banks are required to hold, saying the changes could eat up 70 percent of profits over the next five years. 

New Zealand’s banks are currently less capitalised than those overseas. Observers say the changes would bring regulations here into line with an international trend for banks to hold more capital, but that the cost is likely to be passed on in the form of higher rates for businesses and mortgagees. 

Deputy Governor Geoff Bascand said on Friday that the proposals would see banks’ capital levels increase “materially”. 

“We are proposing to almost double the required amount of high quality capital that banks will have to hold,” he said. 

Because many banks already exceed minimum capital requirements, Bascand estimates most banks will have to increase their capital by around 40 to 60 percent. The cost could be roughly 70 percent of their profits over the next five years.

That would equate to roughly $20 billion, based on current levels of bank profitability. 

Economist Cameron Bagrie, who was formerly chief economist at ANZ, the largest bank operating in New Zealand, said bank shareholders were unlikely to want to bear the full brunt of the rule change themselves, and the cost would manifest itself in higher interest rates. 

“If you want to make the system safer and more resilient, that’s not a bad thing but someone bears the cost,” Bagrie said. 

The question then becomes whether the costs come in the form of lower profits and higher margins.

The Reserve Bank expects the cost will likely be a mixture of the two, and Bagrie agrees.

“Bank returns in New Zealand are incredibly strong so the shareholder can afford to take a bit on the chin,” he said. 

“But there is no way banks are going to let profits fall by 70 percent,” he said. 

“This will be a green light for them talking about increasing margins,” he said.

Capital requirements 

Banks get their money in two ways. Their owners, or shareholders, and people they borrow money from, which includes both depositors and other banks.

The money a bank has from its owners is called its capital, and banks are required by law to hold a minimum amount of capital relative to the amount of lending they do, and the risk level of that lending.

The higher this ratio, the safer the bank. 

If loans go bad, a bank will eat into its capital and eventually the money of its depositors. If a bank has more capital, it can afford to absorb bigger shocks. Central banks around the world have spent much of the 10 years since the financial crisis requiring banks in their countries to hold more capital. 

Documents released by the Reserve Bank say most banks get funding from borrowing, usually around 90 percent, with just 10 percent coming from their owners. The Reserve Bank’s proposals will see the percentage of funding coming from owners increase. 

David Tripe, head of economics at Massey University told Newsroom that capital levels at New Zealand banks had fallen behind relative to international banks.

“Capital levels have been falling behind a little bit,” Tripe said.

“That doesn’t mean to say banks are under capitalised, they all have capital which is significantly in excess of the required minimum,” he said. 

He said it was difficult to put a number on the proper amount of capital to hold.

“There is in general no harm to increasing banks’ capital to some extent,” he said. 

But Tripe added there were a variety of views on what the appropriate level of capital should be. 

The cost 

While banks are currently highly profitable, parts of the industry are also massively competitive. 

The most competitive part of the sector is in mortgage lending to homeowners, where banks fiercely adjust rates in relation to one another. 

Competition mortgage lending means they could look to pass the cost on to other lending, like lending to businesses or farmers.

“It’s a lot easier for the banking sector to slip margin increases into the corporate world: commercial, farmers that sort of stuff. You see a lot more competitive pressure in the housing market,” Bagrie said. 

These increases could make themselves felt through higher prices as businesses pass on the cost to consumers.

Banks have until March 22, 2019 to respond, and once a final proposals are promulgated they will be phased in over five years. 

There are other implications for competition. KiwiBank told Newsroom it would be less impacted by the changes because of the way it calculates its capital. A spokesperson said the proposals would level the playingfield between KiwiBank and its Australian-owned competitors.

The New Zealand Bankers Association told Newsroom the industry was well capitalised.

“Capital buffers are essential to the strength of the banking system. New Zealand’s banks are currently very well capitalised and among the most stable and secure in the world. Reserve Bank stress tests show banks can withstand a 40 percent fall in house prices,” said NZBA acting chief executive Antony Buick-Constable.

He said that “too large a buffer limits banks’ ability to innovate and enhance customer outcomes,” but added the industry would work with the Reserve Bank during the consultation.

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