New capital requirements proposed for banks by the Reserve Bank of New Zealand (RBNZ) are likely to have consequences well beyond the banking sector. Economics in the lending market could be set for change, which may in turn reshape the dynamics of corporate bond issuance in New Zealand.
Matt Zaunmayr Senior Staff Writer KANGANEWS
With little obvious sign of the RBNZ changing its tune on capital, the local debt market is pondering the funding consequences while waiting to see the shape of the puzzle pieces as they fall into place.
The RBNZ released its proposal to increase bank capital requirements late in 2018 and conjecture over what the consequences might be for markets and the wider economy have followed. The proposal would increase the ratio of common equity tier-one (CET1) capital required by New Zealand’s major banks to 16 per cent from 8.5 per cent. It would also change the calculation of risk-weighted assets for the major banks to a standardised, rather than an internal-ratings-based, approach.
A raft of potential implications from the proposals have been floated by market commentators. Most are convinced the RBNZ’s prediction of only a modest increase in banks’ cost of funds is an undershoot of the likely reality, and that any resultant costs will likely be shifted to borrowers through higher interest rates rather than absorbed by the banks in lower return on equity (ROE).
Banks could even meet the increased requirements and protect ROE by restricting lending to sectors offering marginal profitability, such as agricultural businesses and privately held construction companies.
A disruption in credit availability would be a concern for the broader economy but could also provide a supply boost to other funding markets. Market users have been expecting international banks to increase their activity in New Zealand for some time and some of these lenders are now reportedly pursuing market share. Boutique funding options, such as direct lending from fund managers, could also experience a competitiveness boost.
At the margin, it is possible that issuance in public debt capital markets may become more attractive to borrowers facing more expensive or constrained bank credit. How well set up the local capital market is to accommodate new types of issuance is an open question, though.
Feedback on the RBNZ’s consultation paper is now closed and the final shape of the proposals is expected to be announced in November 2019. The outcomes for New Zealand’s corporate-funding landscape will depend on the RBNZ’s final decision. But many in the market are already thinking about the prospective effects, opportunities and decisions that may lie ahead.
The RBNZ made its capital proposals in response to the risk of a banking system which is vulnerable to international market conditions and is also owned in large majority by offshore interests. High household and farm leverage clearly pose a risk to New Zealand’s economy and the RBNZ wants to ensure the country’s taxpayers are properly insured.
Vicky Hyde-Smith, Wellington-based head of fixed income New Zealand at AMP Capital, says New Zealand bank capital has risen in line with the global post-crisis trends and in general terms it was also predictable that the RBNZ would favour a more conservative stance on capital relative to Australian regulations.
“While it is not surprising the RBNZ has indirectly increased the total capital requirement following the similar APRA [Australian Prudential Regulation Authority] proposal late last year, the exclusive use of core equity does give a sense of gold plating New Zealand banks relative to global peers,” Hyde-Smith adds.
If the RBNZ proposals go through – and most market participants seem to think modification or compromise from the reserve bank will be limited at best – there will clearly be consequences across markets and the economy. The RBNZ wants banks to have more skin in the game, but the consensus view is that lenders will attempt to spread the cost as far as possible.
The year so far has been something of a phony war. The banks for their part do not appear to be pre-emptively raising their CET1 ratios. In fact, according to the RBNZ three of the big-four’s CET1 ratios in New Zealand actually fell in the first quarter of 2019 (see chart 1).
Borrowers from large corporates to mortgage holders will be waiting to see how higher capital requirements work their way through the banking system. The RBNZ itself has pointed out the major banks’ ROE in New Zealand has been very high – typically around 14 per cent – for a long time. Its view seems to be that the banks can stand a profitability hit and will not need radically to increase the cost or reduce the availability of lending.
There is some support for this view – including in a June report from S&P Global Ratings (see box). But most New Zealand market users believe it is somewhat naïve to think the banks will simply absorb a higher cost of capital without attempting to preserve ROE through higher lending costs or pulling back from less profitable areas. The question is who will be affected and by how much.
A different view on RBNZ capital impost
S&P Global Ratings (S&P) published a report, on 26 June, positing that the Reserve Bank of New Zealand (RBNZ)’s proposed increase to bank-capital requirements will have minimal effect on the availability of credit in New Zealand, based on capital requirements stipulated by Australian Prudential Regulation Authority (APRA).
Sharad Jain, Melbourne-based director, financial institutions ratings at S&P, tells KangaNews that because the New Zealand subsidiaries only have one shareholder – an Australian major bank – for which the impact is likely minimal, there should be no justification for wholesale scale-back of lending activity in New Zealand.
The RBNZ suggests the major banks will need to raise NZ$12.8 billion (US$8.4 billion) of common equity tier-one (CET1) capital to meet the requirements. The major banks themselves estimate the requirement to be NZ$18-22 billion.
The ultimate cost to the Australian parent banks has been a subject of debate. Some believe the parents will inevitably mitigate any cost impost and lower return on equity by scaling back lending to marginal sectors in New Zealand.
New Zealand’s top-tier borrowers expect to be reasonably well insulated from any consequences arising from the implementation of higher capital requirements as they tend to be less reliant on funding from domestic banks.
Competition from international banks in the New Zealand lending market was ramping up well before the RBNZ floated its capital proposals. Many local corporate borrowers in New Zealand confirm that the number of banks pitching for business has increased in recent years and continues to do so.
Stewart Reynolds, head of strategy, planning and performance at Auckland Airport, tells KangaNews new entrants have been pricing aggressively and are open to longer tenors, bringing good diversity to the market.
But increased competition can also bring risk. Mark Woodward, Auckland-based general manager, treasury funding at Fonterra Co-operative Group, explains that five banks have historically provided the vast majority of lending to the agricultural sector, offering stability and support through cyclical and structural challenges.
“Having more bank supply could actually cause instability in the agricultural sector as it is possible not all banks will be prepared to stick with it through cyclical and structural shocks – they may simply leave the New Zealand market,” Woodward warns.
Reynolds, meanwhile, acknowledges that it is important to be aware of the risk that some banks might depart from the market just when funding conditions are hardest. But he also says the incoming banks have clearly stated their long-term commitment to the New Zealand market.
It is easier for New Zealand’s top-tier corporates, which are unlikely to lose their traditional bank funding sources anyway, to be relaxed on the diversity of their loan books. The reliability of a long-term commitment may be far more relevant for sectors facing a potential squeeze from their traditional lending sources.
Top-tier corporate borrowers also have access to public debt capital markets, in some cases offshore as well as in New Zealand. Issuers tend to scale their funding diversification to need and therefore most treasurers say they are relatively relaxed about the cost of the major-bank component.
For instance, Auckland Airport has a large capital requirement, of around NZ$500 million (US$330 million) per year over the medium term. Its chief financial officer, Phil Neutze, says it has “a more sanguine view of the bank-capital proposals than most corporates and residential borrowers”.
The airport sources a low proportion of its total debt portfolio from New Zealand banks, Neutze continues, while its pricing in the domestic capital market is based off bank swap rates. “If banks push up lending margins to improve ROE on higher capital, we would expect the RBNZ to respond by lowering the cash rate to maintain economy-wide interest rates. Otherwise consumer-price-index inflation would tank.”
Neutze argues that total portfolio borrowing costs for an issuer like Auckland Airport may actually decrease as banks will have stronger balance sheets and thus interbank lending risk will ease, leading to a potential fall in interbank swap rates. With term deposit rates also likely to fall as banks try to maintain ROE, domestic bonds could become relatively more attractive.
Other treasurers challenge the idea that higher bank-loan costs would necessarily support more bond-market supply. Louise Tong, Wellington-based chair of Institute of Finance Professionals New Zealand and head of capital markets and tax at Contact Energy, says the cost of accessing capital markets could also rise in a higher bank-capital environment, thanks to increases to associated hedging costs and bridging facilities. She continues: “Furthermore, domestic bond credit spreads may widen and there could be a negative effect on bond liquidity if bank trading books are forced to hold much higher levels of capital.”
Flexibility is a consideration as well as cost. If corporates are more inclined to borrow from debt capital markets, Tong says, they will lose the ability to draw down, repay, increase or cancel limits, extend or shorten tenor and efficiently to establish new facilities at low cost.
“Having bank facilities enables us to access the attractive funding available in the commercial-paper market, which requires standby lines,” Tong continues. “Removing this source of capital from our funding base would affect our ability to run a flexible and efficient funding portfolio.”
New Zealand’s established borrowers believe they will have at least some insulation from any bank funding pressures that may arise. But there is broad acknowledgement that not all borrowers have this luxury.
The DCM context
New Zealand’s corporate bond market enjoyed a record year in 2018 (see chart 2). Deal flow has not been quite as strong in 2019 so far, as falling yields have made the asset class less attractive for institutional and retail investors.
At face value, the New Zealand market should be humming along. The current year is solid for redemptions (see chart 3), while the broadening of the institutional market from KiwiSaver contributions means there is plenty of cash in the market to put to work. The redemption stack is heavily weighted to the high-grade space, however. The falling-yield environment is creating challenges for those that might want to issue, meanwhile, as investors struggle to find value.
Companies in more marginal and riskier sectors such as agriculture, private construction and SMEs are likely to be among the worst off should the major banks decide to scale back lending in New Zealand. International banks may be able to step into some of the more challenged sectors, even where borrowing entities are smaller. Accessing debt capital markets could also be on the cards for some new borrowers. Many of the companies that may face funding pressure have historically either not been big enough or have not considered capital-markets access, but some believe the opportunity set could increase.
Mat Carter, Auckland-based director, debt capital markets and syndicate at Westpac Banking Corporation New Zealand Branch (Westpac), says it is inevitable that a wider range of issuers will explore debt capital markets if bank funding gets more expensive. “Bank debt is a flexible means of funding. However, the relative-value proposition and the value of diversity may become more compelling for new and existing issuers going forward.”
Scale would be the main barrier to entry. Shaun Roberts, head of debt capital markets at Forsyth Barr in Wellington, tells KangaNews the typical starting size for New Zealand bond issuance has historically been NZ$75-100 million and smaller corporates would have to consider the proportion of their debt book they want to devote to a single bond deal.
There is some precedent for small-sized unrated issuance. For instance, NZX printed a NZ$40 million, 15-year unrated deal in May 2018. Whether or not there would be a natural home for a significant increase in supply of this type of debt is a significant unknown, though. The answer would likely come down to the extent to which bank credit provision tightens. The bottom line is that bond investors will only be persuaded to look at smaller, riskier and less liquid transactions if the price is right.
Grasping how big the segment of potential issuers in New Zealand might be is difficult, but intermediaries and investors are confident that it has potential. Jason Green, director, debt capital markets at ANZ in Wellington, says: “There are certainly some corporates in New Zealand that have yet to issue which could, using a proven unrated bond market to diversify funding sources.”
David Austin, director and head of institutional sales New Zealand at Westpac, believes the buy side would be supportive of new names should they come given the growth of funds under management in New Zealand and investor appetite for name diversification.
The scale of funds under management relative to local supply has been an ongoing challenge for New Zealand investors needing to put their money to work domestically. But the institutional market is not necessarily yearning for a big uptick in high-yield issuance at this stage.
Fergus McDonald, head of bonds and currency at Nikko Asset Management in Auckland, tells KangaNews: “Fund managers in New Zealand are becoming larger but the ability to have a diversified portfolio is still limited. On the other hand, there is significant reputational and credit risk in going down the ratings spectrum.”
Potential issuers may also find that they are entering a market that is not quite as conducive as it was 12 months ago (see box). Brad Peel, previously Auckland-based director, DCM origination at Commonwealth Bank says: “Some new corporates could get a rating and come to market, but this would be happening at a time when yields are collapsing. If issuers have not already been looking at this option now may not be the right time to start.”
The state of the market is of course transient. But it is relevant, because New Zealand market sources say time may be of the essence for borrowers that are inclined to consider public debt issuance.
“Once the proposals are finalised it is likely that the banks will move quickly to implement the necessary changes. Any issuer thinking about the possibility of funding in debt capital markets would need to be aware of this,” says David McLeish, head of fixed income at Fisher Funds Management in Auckland.
There are also risks in a wider range of issuers being tempted towards public debt issuance. Most would likely be at the lower end of the credit spectrum, and while New Zealand’s retail debt market is strong it has been burned in the past. Whether it is wise to be enticing retail investors – of varying degrees of sophistication – to buy what would likely be more complex and riskier securities is an open question.
Funding for SMEs and other less obviously capital-markets-relevant sectors represents one of the major friction points that could result from the RBNZ’s capital proposals. New debt funding options could have a role to play.
The private debt market has gained momentum in Australia and while it is still a niche sector there is a comparison point with New Zealand. Constant growth of funds under management in Australia’s superannuation sector has led to the establishment of direct-lending infrastructure from superannuation funds and the emergence of boutique funds and fund managers.
The KiwiSaver regime is newer, voluntary and has a lower minimum contribution than Australian superannuation. But it is still generating a constant and significant inflow of funds which need to be put to work. Peel estimates that the system brings NZ$1.5-2 billion into the fixed-income market each year.
However, the impetus for New Zealand fund managers to look at direct lending appears to be nascent at best. McLeish tells KangaNews there would likely be opportunities in this space but the infrastructure and resources required are extensive.
However, not all the assets that may be relinquished by the banking system would be appropriate for fund managers. Mark Brown, head of fixed-interest portfolio management at Harbour Asset Management in Wellington, says it is unlikely fund managers would have interest in direct lending to dairy farms.
A more specialised approach to debt investing may be more time-intensive. But in the longer term some market participants believe it could also give New Zealand’s growing and yield-starved fund managers opportunities they can become comfortable with.
The market appears to be open to innovation to solve issues that result from narrow supply and the challenges faced by areas – such as infrastructure development and borrowers squeezed by banking-sector change – that need additional funding.
At a roundtable hosted by BNZ and KangaNews in September last year, Murray Jones, director, markets at BNZ in Wellington, argued that KiwiSaver growth will be a game changer for the local market. “There is a lot there telling me the NZ$95 billion we already have invested in debt domestically will continue to grow. But it is not so clear that recent issuance patterns will support this growth…. I think we are at an inflection point that will provide opportunities for issuers.”
But Stephens says: “The benefit for bank senior bondholders might be positive but it is likely to be vanishingly small. Interest rates on New Zealand bank paper reflect the fact that they are subsidiaries of the Australian major banks, with only a small premium paid. If the New Zealand subsidiary becomes safer this premium may fall, but it will likely be very marginal.”
There is a potential positive consequence for the New Zealand domestic credit market. If higher capital requirements force up the cost of corporate lending, as many in the market believe they will, Stephens says it is possible that some additional corporate borrowers may look to finance through direct debt issuance.
Smyth agrees that there is some potential for capital-market growth from increased bank regulation. He cites the disintermediation that has occurred in Europe over the last 10 years in which he says bank regulation has played a part.
“It would likely take some time to play out, but if the cost of accessing credit becomes higher one implication could be that some larger names, which would typically borrow from banks, may look to borrow in their own name if the cost is advantageous,” Smyth tells KangaNews.
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