RBNZ allows AT1, extends implementation period for new capital requirements

On December 5, the Reserve Bank of New Zealand (RBNZ) revealed its final determination on new capital requirements for domestic banks. Banks will still have higher capital requirements but the regulator has elected to let them fund part of these with redeemable additional tier-one (AT1) instruments and is also granting a longer implementation period.

The RBNZ estimates these concessions will result in a smaller increase in lending rates than its initial proposals on capital would have produced.

The decision ends what has at times been an acrimonious consultation since the RBNZ released its proposals late in 2018. The crux of the new regime is an increase in the minimum required total capital ratio for domestic systemically important banks to 18 per cent of risk-weighted assets (RWA), from 10.5 per cent.

The RBNZ argued that this level of capital would protect the New Zealand financial system against all but a one-in-200-years banking crisis.

Marginal concessions

The regulator initially expected common-equity tier-one (CET1) capital to make up by far the largest component of the enhanced capital requirement, at 16 per cent for the major banks, alongside a 2 per cent buffer probably comprising tier-two securities. CET1 capital is the safest – and most costly – form of capital for banks to issue.

The RBNZ did not permit redeemable AT1 capital to count towards tier-one requirements in its initial proposals, as it believed that, in the event of a crisis, holders of AT1 securities could be paid out at the expense of depositors. The plan was for only non-redeemable AT1 capital to be eligible.

Feedback from banks, however, was that non-redeemable AT1 securities would not be palatable to equity or debt investors – and would be at least as costly to raise as ordinary share capital.

In its final decision, the RBNZ decided that redeemable AT1 securities would be eligible for up to 2.5 percent of the requirement. It states that the risks of including redeemable AT1 capital are still present but that these would be manageable amid the higher overall capital environment.

“We have amended our original proposals in a number of ways so we achieve a high level of resilience at lower potential cost, with a smoother transition path for all participants. Our analysis shows that the benefits of these changes will greatly outweigh the potential costs.”

The RBNZ has also extended the implementation period for the higher requirements to seven years from five. This takes into account feedback that extended implementation would mitigate the adverse economic impact of the higher capital requirements that most expect the banks to pass on to the wider economy.

Domestic banks that are not systemically important have been given relief, with their tier-one requirement reduced to 14 per cent from the initial proposal of 15 per cent. The RBNZ justifies the 2 per cent buffer for the major banks as adequate, given their relative importance to the New Zealand economy. The major banks account for nearly 90 per cent of local lending.

Cost effect

The RBNZ’s initial proposals estimated that the major banks would need to raise NZ$20 billion (US$13.1 billion) of tier-one capital to meet the requirements, including the replacement of ineligible tier-one capital. It suggested this would result in roughly a 32-basis-point increase in lending rates in the real economy.

Some market estimates of the overall cost of raising capital and the subsequent increase in lending rates have been substantially higher, bringing into question the effect the higher capital ratios might have on the broader New Zealand economy.

New Zealand’s major banks would have options for meeting the new requirements, including increasing lending rates, changing the composition of lending to less risky assets and reducing the return on equity to their parent banks in Australia. The RBNZ has stressed the banks’ capacity to focus on the latter; however, most market participants clearly expect all three to be in play.

The RBNZ’s modifications should go some way to placating concerns. The reserve bank states that the inclusion of redeemable AT1 capital and a longer implementation period will reduce the increase in lending rates to 20.5 basis points.

In a statement, RBNZ deputy governor Geoff Bascand says: “We have amended our original proposals in a number of ways so we achieve a high level of resilience at lower potential cost, with a smoother transition path for all participants. Our analysis shows that the benefits of these changes will greatly outweigh the potential costs.”

Immediate reaction from ANZ analysts suggests they still think the impact will be 30-60 basis points – and spread unevenly throughout the economy. ANZ suggests the overall impact on GDP will also be higher.

Cost-benefit analysis

From the beginning, the RBNZ has been unapologetic in its ambition to safeguard New Zealand depositors and taxpayers from a financial crisis. It reasoned that it would be left severely exposed should a severe crisis unfold, given offshore interests own nearly 90 per cent of its banking system.

Critics have pointed out that the owners of the New Zealand banks – Australia’s majors – are already some of the most capitalised financial institutions in the world. Furthermore, the Australian Prudential Regulation Authority requires the parent banks to hold capital against their subsidiaries.

This led many to suggest the levels of capital the RBNZ proposed were an unnecessary burden. The RBNZ, in its initial proposals, set out to ensure the “soundness and efficiency” of the financial system, but market sources have argued that efficiency was a clear secondary concern. In July, the soundness and efficiency mandate was discarded in favour of “financial stability”.

In the cost-benefit analysis the RBNZ released alongside its final decision, the reserve bank seeks to quantify the expected GDP and wealth-transfer effects, arriving at a net positive conclusion (see table).

In a statement, RBNZ governor Adrian Orr says: “Our decisions are not only about dollars and cents. More capital in the banking system better enables banks to weather economic volatility and maintain good, long-term customer outcomes.”

The cost-benefit analysis estimates the amount of capital the banks will be required to hold – sufficient to safeguard against a one-in-200-years crisis – will reduce the probability of such a crisis to 0.5 per cent from 1.8 per cent in the absence of any reforms.

Disintermediation potential

How far the final decision goes to satisfying the concerns of banks and other market commentators will probably become clear quickly, although the RBNZ acknowledges that some unquantifiable costs remain.

The possibility of constriction of credit to some areas of the economy – such as agriculture, private construction and SMEs – as a result of higher lending rates and lower risk appetite remains, even though the impact on lending rates could be lower.

The knock-on effect of this would be disintermediation, with the possibility that some lending moves away from the banks to nonbank lenders or other financial institutions. Disintermediation has the potential to push some corporate borrowers to look to other funding sources, such as debt capital markets or direct borrowing from fund managers.

Summary of quantified costs and benefits

*Numbers may not add up due to rounding
Source: Reserve Bank of New Zealand, 5 December 2019

The RBNZ states that while it will be vigilant in monitoring lending from less-regulated entities, disintermediation is not necessarily a negative development. The reserve bank states that reduced concentration of credit provision would be unlikely to occur rapidly and would probably be a positive development.