RBNZ adds colour to a developing picture

Local market participants are thinking through the likely consequences of increased capital ratios for banks proposed by the Reserve Bank of New Zealand (RBNZ) at the end of 2018. In an exclusive interview with KangaNews, Geoff Bascand, the RBNZ’s Wellington-based deputy governor and general manager, financial stability, says any wider market consequences are a necessary step in ensuring the long-term stability of New Zealand’s financial system.

There was a sense that most of the post-financial-crisis capital regulation had been completed. What makes it necessary to increase bank capital requirements now and how long has this been in process?

It is important to review capital ratios from time to time and to consider whether they are where they should be in the scheme of our regulatory settings. Levels of capital need to be consistent with the risks as we understand them.

We started this process in 2016. It has been released in parts with various stages of consultation. The paper released at the end of 2018 was the culmination of that process.

Capital is a crucial part of the regulatory approach. We want to ensure it is there on a long-term basis, through the various economic and financial cycles. We didn’t set the review because we were worried about any particular current risk, but because we want to adjust the long-term setting and have it at a level where we are comfortable.

We can then use other instruments to adjust for short-term risks, such as macroprudential or loan-to-value-ratio policies. We haven’t been in a desperate rush to do it. We want to get it right.

You mention the “various stages of consultation” undergone in reaching this point. Can you give some more detail about this?

Each piece in this process has been open for consultation and we are open to consultation now on the proposed ratios and the package as a whole. This consultation process is open until the beginning of May.

We had substantial discussions on the principles of the review, the capital instruments and the risk-weighting modelling before we arrived at this point. It has been a process of discussions and dialogue.

The deadline for consultation was extended from March to May. Why was this decision made?

We had requests from some of the participants to have more time to consider their input and provide quality submissions. We are not in a rush and we want well-considered submissions, so we are providing more background information and extending the deadline to allow for this.

One of the main points of consternation around the proposals is that the level of capital required would be higher than most other jurisdictions in the world. What is the benefit for New Zealand in going further than many peers with these requirements?

Capital requirements need to be set to suit the jurisdiction where they are applied. The international standards are a minimum and the idea is that countries can set levels above these that are appropriate for them. We are trying to find the right risk tolerance for New Zealand and what level of bank-failure risk society is prepared to accept.

We do think the proposed level is at the high end – particularly for tier-one capital – but it is not too extraordinary. We wouldn’t be far out on our own and the proposal is also not that extraordinary if you look at total capital. Looking at composition, there are other jurisdictions – including Australia – that have, or are proposing to move to, very high total-capital ratios.

We acknowledge what we are proposing would represent a significant lift and is high by international standards. But ratios are going higher around the world. As you look at global benchmarks over time, New Zealand used to be at the conservative end. But we have slipped.

For example, the relative standing of the large New Zealand banks has declined over time within S&P Global Ratings’ risk-adjusted capital ratios. We think New Zealand is a risk-exposed, small economy that is vulnerable to shocks. The welfare costs of such a shock would be high, so we have put out for consultation that we think we should be towards the conservative end.

The consultation paper says banks should be able to raise the capital through retained earnings over five years, but we have heard doubts expressed about how plausibile this really is. Is the RBNZ prepared to offer any flexibility around the implementation timeframe?

This is something we are specifically consulting on. We are asking what stakeholders think of the proposals and the implementation. None of these are set in stone.

We are mindful that it is possibly going to be tougher for some of the smaller banks than it will be for the major banks in that timeframe. The sums are obviously bigger for the larger banks, but so are their profits and dividends.

We have looked at how feasible it is to meet the requirement either through earnings or funding markets and we appreciate feedback as to what the market considers is possible.

“We think New Zealand is a risk-exposed, small economy that is vulnerable to shocks. The welfare costs of a shock would be high, so we have put out for consultation that we think we should be towards the conservative end.”

Why is it necessary for the increment to be core, rather than additional, capital?

It has been a core principle from the very early consultations that the quality of the capital is important. We have a view that common equity has a lot more advantages for the resilience of the banking system.

Additional capital and tier-two instruments are only useful at the time of a bank being in severe distress. They mean some debt or equity holders would lose money rather than others, but they don’t make the bank safer.

There is some conjecture, among analysts and others, that banks may opt to meet the higher requirement by de-risking – in other words by tightening the supply of credit. Do you see this as a possibility?

We don’t think this will be the prime mechanism. The banks are very profitable, with rates of return on equity of 13-14 per cent. It would take a lot to drive this down to levels where the banks would prefer to pull out or shrink their businesses.

Of course we are interested in credit growth. And we agree there is the possibility that some banks will say the margin on some of their products or services is no longer what they would like and thus cut back. We look to the effects of competition.

As much as one bank might want to cut back in one segment, another might say it is worth growing into that market. Our proposal delivers a more level playing field and banks can be expected to re-examine opportunities.

If banks make the call that they can’t profitably lend quite as much as they were before, or sustain the rate of growth they had before, this is ultimately a reaction to the price of risk. The reality is that we are trying to manage risks, which sometimes means curbing rapid and excessive credit growth.

When increased capital requirements were introduced in Europe the European Banking Authority stipulated that regulators should introduce measures to ensure the supply of credit would remain. Would the RBNZ consider implementing anything similar?

It isn’t in the proposals. If it did become a real concern, or the consultation suggests this is very likely, we could think about how the capital is raised. It’s not something we think we’ll have to face – we’re looking to the competitive landscape to ensure this won’t happen. There will still be good business in lending in New Zealand.

Banks will need to put more equity in, but the counter to this is that they become safer. The reality is that if capital ratios are high on a world scale the banks are also safer on a world scale. Some of the credit rating agencies have acknowledged this. At this point, a bank’s target rate of return is arguably lower.

Most market participants are anticipating a more substantial increase in funding costs for the banks than the RBNZ estimates. If this is right, presumably banks will pass higher margins on to consumers. How well do you think the New Zealand economy can absorb a higher cost of credit?

We are clear in the paper that we think the increased cost of credit will be relatively small. The working estimateI have is around 40 basis points and some parts of the [RBNZ] building would have it a bit less, heading towards 25 basis points. There are a number of moving parts here – including how banks will respond and competitive effects. One commercial bank has come out with a similar estimate.

The impact we’re expecting is nowhere near some of the higher estimates. We did some work on this, but if we get more information we will update our estimate.

It does hinge a lot on how we assume banks will respond. The high estimates assume that all of this goes on mortgages even though banking mortgages are somewhere shy of 60 per cent of banks’ balance sheets.

They also assume no substitution of equity for debt funding, let alone a potential reduction in the cost of debt if investors are happier with the safety of the institutions.

We accept that there is uncertainty about the numbers, but we think the impact is far more likely to be at the low end of the estimates. We also accept that this will have some impact on the cost of lending. But the cost to borrowers will come at a gain to society of the reduced risk of the bad outcomes that can come from a banking crisis.

The main parameters framing these proposals are the maintenance of stability and efficiency in the banking system. Was any consideration given to competition?

Our primary objective is financial stability. We are mindful of the efficiency objective, in the sense of minimising the cost of regulation and also in wanting to have a competitive and dynamic market. We want it to continue to supply good services to borrowers and savers.

We think the proposal includes factors that are supportive of competition. We proposed dual reporting of internal-ratings based (IRB) models and standardised reporting to establish a more level playing field in setting capital requirements. We have proposed flooring for IRB models so they don’t have such an advantage over the standardised-model banks, which gives competitive support to the sector.

We accept there is merit in IRB models and the sophistication of risk modelling that comes with it, but it is a question of how much that should reduce risk weights. We think it is currently excessive. These changes should aid competition in that regard.

There is a bit of concern with mutual banks’ ability to raise capital. We are committed to looking at their available capital instruments because we don’t want them to be disadvantaged by our proposals.

“We think the increased cost of credit will be relatively small...The impact we’re expecting is nowhere near some of the higher estimates. We did some work on this, but if we get more information we will update our estimate.”

There was some optimism around the potential for the New Zealand securitisation market towards the end of last year, but it has been suggested that a revised capital regime could reduce major banks’ need or desire to issue securitisation. Can you give an update on the RBNZ’s securitisation plans and whether you think the asset class’s value will be affected by the capital proposals?

We are keen to proceed with the objectives and intent of those proposals. We are consulting on a revised set of proposals for the instrument – the residential-mortgage obligation – and the rules around it. We hope to make the final policy decisions on this before the middle of the year.

The implementation schedule is still under consideration. We are consulting with the banks on what they think they can cope with. We want confidence in the quality of the collateral we hold and to get the markets operating, but it is not imperative on time.

We are being flexible as to what investors and issuers could cope with and we are also talking to them about these capital instruments.

In Australia, increasing capital requirements on banks have seen market share of lending taken by nonbank financial institutions start to rise – to the extent that the local regulator has now taken on some oversight of the nonbank sector. Do you have any thoughts on how the lending landscape in New Zealand might change?

Having a vibrant, competitive financial system is a good thing. It is part of the competitive dynamic that some institutions can try to grow relative to others. What we want to ensure is that risks are appropriately managed when this growth happens.

There is a continuous watch over the nonbank sector and whether it is growing in any unexplained or extraordinary way. But we would also monitor and ensure risks are managed appropriately if it was a credit union or a small deposit-taking institution.

The environment is continuously changing and evolving with technology, so it is being closely monitored. But it isn’t of particular concern.

The proposed capital measures could have wider consequences for the New Zealand debt capital market including banks potentially having less need for wholesale debt funding and for regulatory liquid assets. To what extent are secondary or unintended consequences of the capital requirements a consideration for the RBNZ?

The primary focus is the resilience of the banks and having the quality capital we think facilitates that resilience. If this means they have less need for debt instruments, from our point of view, so be it.

We want healthy capital markets with a variety of instruments available. It should be said that nothing stops banks having additional funding if they want to grow – as long as they have the capital to meet requirements.