Ideasroom

Why maximum headroom for banks matters now

After many years of extolling the virtues of high capital levels, why would the Reserve Bank now encourage banks to use capital, asks Victoria University of Wellington’s Martien Lubberink

The Reserve Bank of New Zealand (RBNZ) has taken exceptional measures to respond to the fallout from the Covid-19 pandemic. It has cut the Official Cash Rate and is now readying banks for negative rates. Governor Adrian Orr highlighted that the Monetary Policy Committee remains prepared to do “whatever it takes” to stimulate the economy.

One measure taken by the RBNZ, in particular, deserves more attention: it gave banks a clear go-ahead to use the capital they have stored for rough times.

Referred to as ‘headroom’, this is capital that banks hold over the required amount. One way to illustrate headroom is to see it as a spare wheel. We know that cars need four wheels, but many cars carry a spare. Headroom capital is like that spare wheel. Without it a bank runs the risk of losing its banking licence at the slightest sign of trouble. On the other hand, too much headroom may not make sense either - like having a full set of spare wheels. 

There is ample headroom in the New Zealand banking system, about $12 billion over a total capital requirement of about $34b, so would it matter if our well-capitalised banks started using it?

According to a recent study I completed it does. Financial markets do indeed care about this capital buffer. The study examined the ‘headroom’ of the largest 99 European banks over the years 2013-2019 and found that less headroom makes banks riskier. 

European banks were chosen because large banks are subject to higher capital requirements than smaller banks. They also have less headroom. The benefit of a sample with varying capital requirements and varying levels of headroom is that it makes clear whether headroom matters, or capital requirements, or both. The clear answer was the former is more important.

For example, the banks with the lowest headroom experienced the strongest share price drop during the first weeks of March 2019, when share markets worldwide took a deep dive. This result holds, even for banks that are well-capitalised or meet high capital requirements.

Bank supervisors in Europe realised the importance of headroom. In March of this year, they increased headroom and allowed banks to operate below capital requirements. Other bank supervisors encouraged the use of buffers, eg the Australian prudential supervisor and our Reserve Bank.

What this shows is that the RBNZ made a correct call by encouraging banks to use capital. This calms bank investors, who now know that the bank supervisor will be lenient once banks start reporting diminishing capital levels.

Unfortunately, there are no free lunches here. As a temporary measure, it makes sense to offer more headroom. But this should only be a temporary measure. 

At some point, banks need to start restoring their capital levels. Like the spare wheel in your car boot, you may have been encouraged to ride rough terrain and even use your spare wheel to get to your destination. Eventually you will have to replace all your tires, not just the punctured one. 

But here is the catch: unlike your local garage, which can do this all in a day’s time, restoring bank capital takes many years.

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