Do our banks need as much gold-plating as the Reserve Bank thinks?
Stress-testing banks has become de rigueur for central banks since the global financial crisis and New Zealand's banks have passed repeated tests over a number of years with flying colours.
In addition, these days New Zealand's major banks are required to conduct their own stress tests on a continuous basis and to share those results with the prudential supervisor, although the results aren’t made public.
The last time the central bank conducted such a test itself was in 2017 when it looked at the big four banks in conjunction with the Australian Prudential Regulation Authority (APRA) and the banks passed doomsday-type scenarios with ease and capital to spare.
The scenario the Reserve Bank used was indeed dire: house prices plummeted 35 percent, commercial property fared even worse with a 40 percent decline in values, unemployment shot up to 11 percent and the Fonterra payout to dairy farmers averaged $4.90 per kilo of milk solids for three years, below break-even for the average farmer.
On top of that, the regulator overlaid an industry-wide scandal relating to bad behaviour in mortgage lending, such as customers successfully suing the banks for poor lending practices and failure to abide by the Responsible Lending Code.
“Like previous stress tests, this exercise suggests the major New Zealand banks can, as a group, absorb large losses in a downturn while remaining solvent,” the Reserve Bank concluded at the time.
Of course, it added the proviso that no stress test can predict the actual impact of a severe downturn in real life.
But note that phrase “like previous stress tests.”
New Zealand’s big four banks, ASB Bank, Bank of New Zealand, ANZ Bank and Westpac, all owned by Australia’s big four banks, have passed many such severe tests with apparent effortlessness.
They were acknowledged as among the world’s strongest banks through the GFC.
To put the latest test’s scenario in a real-life context, New Zealand house prices fell about 15 percent after inflation, less than half the test scenario, through the GFC and the unemployment rate peaked at 6.7 percent.
The last time house prices in New Zealand fell anywhere near the magnitude of the test scenario was in the second half of the 1970s during the oil price shock. The price fall was about 40 percent in an economy which was arguably very different – rampant inflation, no floating currency and Robert Muldoon’s rule by fiat with price freezes and carless days, for example.
The last time New Zealand’s unemployment rate was above 11 percent was in 1991/92 following former finance minister Ruth Richardson’s catastrophic “Mother of all Budgets” but the house price fall later that decade was less than 3 percent.
As for a dairy downturn, the Reserve Bank ran a stress test in late 2015 to find out what would happen if the dairy payout fell to $3 a kilo of milk solids and remained under $5 until the 2019/20 season and that land prices fell 40 percent over that period.
The conclusion: “The banking system is robust to a severe dairy stress test,” the Reserve Bank concluded.
It’s against that backdrop that the Reserve Bank has suggested the big four banks should have to effectively double their tier 1 equity capital during the next five years.
That will mean the big four banks would need to increase their tier 1 capital by $12.8 billion and replace another $6.2 billion of preference shares because they will no longer count as tier 1 capital.
The central bank estimates the four banks could get there by retaining about 70 percent of their average $4.4 billion of annual earnings over the next five years.
Reserve Bank governor Adrian Orr and his predecessors had been foreshadowing the idea that the banks probably needed to hold more capital from as long ago as last year, so the market was well-prepared to expect a raising of capital requirements.
Nevertheless, the magnitude of what it thinks is necessary is shocking.
International ratings agencies aren’t given to hyperbole. Fitch described the Reserve Bank’s proposals as “radical,” “highly conservative relative to international peers,” and that they go "well beyond the international norm.”
Long-time banking journalist Tony Boyd wrote in the Australian Financial Review that the move will inevitably raise borrowing costs and that Orr risks forcing New Zealand companies to seek alternative sources of capital outside the banking systems, pushing people into the arms of less heavily regulated lenders.
Boyd says New Zealand doesn’t have a great record of protecting depositors in non-banks, pointing to the $6 billion of finance company losses.
APRA “already supervises the big four Australian banks, which all operate in New Zealand with group level capital requirements,” he says.
“Orr is clearly not satisfied with this oversight, even though APRA is well known for having capital requirements tougher than those in most Western countries and no depositor in Australia has lost money.”
However, another journalist writing in The Australian newspaper, Adam Creighton, described Orr’s move as “a breath of fresh air” that came “out of the blue.”
He was writing in the context of the endless scandals emanating from Australia’s royal commission into financial services.
Former Reserve Bank official Michael Reddell is concerned about the apparent lack of consultation with APRA ahead of the mid-December release of the proposals.
“It seems surprising to me that the Reserve Bank could propose something so radical without a genuine prior discussion with the regulator of the banks who dominate the New Zealand financial system,” Reddell wrote in his Croaking Cassandra blog.
The Reserve Bank estimates the Australian-owned banks account for about 88 percent of New Zealand’s banking system.
“Searching the Reserve Bank’s consultative document for references to APRA, it seemed telling that the bank referred a couple of times to the possibility of aligning with APRA standards around the idea – questionable – of introducing new capital requirements so far in excess of those APRA imposes,” Reddell said.
“There is a suggestion that the governor has a bit of chip on his shoulder about Australia and Australian banks. Whether that is true or not, if the indications of lack of prior consultation are correct, it isn’t good enough.”
Orr was National Bank’s chief economist in the 1990s and then Westpac’s chief economist between 2000 and 2003. He was the Reserve Bank’s deputy governor and head of financial stability, then chief executive of the New Zealand Superannuation Fund before taking the central bank’s top job in March last year.
Macquarie Equities has suggested that the new capital requirements are so onerous that it could lead to the Australian banks selling some or all their New Zealand subsidiaries – if that meant the banks became listed on NZX, many a New Zealander might think that would be a jolly good thing.
But a paper put out by the Federal Reserve Bank of Philadelphia last year suggests that one outcome of requiring banks to hold more capital would be “a much more concentrated loan market.”
It would mean “large banks grow larger, putting pressure on small banks to merge or close. As large banks’ market power increases, they extract higher profits by raising loan rates, which tighten credit and depresses the economy’s output.”
Clearly, New Zealand’s banking sector is already highly concentrated.
On the other hand, if the tier 1 capital requirement before 2007 had been 6 percent rather than its actual 4 percent minimum, “large US banks would have had enough capital to cover their losses at the peak of the 2008/09 crisis,” the paper says.
“That would have avoided a financial sector meltdown and the severely depressed economic activity and large-scale government intervention that followed.”
Still, it’s an awful long way from 6 percent to the 16 percent level our central bank is proposing.
The Reserve Bank’s consultation paper does make it clear that deciding optimum levels of bank capital is a balancing act.
“If banks in New Zealand fail, some of us might lose money and some of us might lose jobs,” it says in the non-technical summary. It notes the proposed changes might lead to higher borrowing costs and lower returns to bank shareholders.
“However, there would also be indirect costs on all of society that may be harder to see that would negatively impact the well-being of all New Zealanders. In the end we would all bear the cost of bank failures in one way or another,” it says.
“This is why we want to make the chances of this happening very small – so small that a banking crisis in New Zealand shouldn’t happen more than once in every two hundred years.”
But it's an open question as to whether the Reserve Bank has the balance right.
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