The dilemma came into focus following the RBNZ’s December 2019 final determination, based on findings from its capital review, to increase the minimum required total capital ratio domestic banks must maintain from the present level of 10.5 percent of risk-weighted assets (RWA).

For the four Australian-owned major banks in New Zealand, the ratio will increase to 18 per cent, and for other domestic banks it will climb to 16 per cent. Banks have until 2026 to meet the new requirements.

Listed banks have the option of supplementing equity capital with additional tier-one (AT1) instruments that can convert to equity under stressed scenarios. But the new capital requirement is particularly challenging for Southland Building Society (SBS) and the Co-operative Bank – New Zealand’s only mutual banks. The convertible structure is not available to mutual banks as new equity would likely change their ownership structure and thus mutual ownership.

“The capital adequacy framework currently limits mutual banks’ CET1 [common equity tier-one] capital to retained earnings,” the RBNZ confirms in the consultation paper. “In order to issue ordinary shares and raise CET1 capital, mutual banks would be required to demutualise.”

The RBNZ released its consultation paper following feedback received following its decision to increase the minimum capital ratio banks must maintain to protect against failures. It proposes the adoption of one of two types of AT1 capital instruments – roughly comparable to those available to mutual banks in Australia and the UK – or a doing-nothing option.

The paper addresses whether the RBNZ should amend its definition of CET1 capital to recognise a “bespoke” mutual capital instrument as regulatory capital. It proposes two options: a mutual equity instrument (MEI) resembling the Australian Prudential Regulatory Authority (APRA)’s mutual capital instrument (MCI), or a mutual equity tier-one (MET1) security that would be similar to the UK’s core capital deferred shares (CCDS).

Mutual banks and sector experts say that while the road to implementation of either proposed solution is long, mutuals will be eager to add a funding weapon that helps them compete in the tougher landscape.

Guy Lethbridge, Wellington-based partner at Russell McVeagh, says a bespoke solution for the sector would be welcome to resolve mutual banks’ inherently greater challenge in issuing AT1 capital. “There has certainly been interest in developing something like this and I think it will be favourably received by the mutuals,” he says.

Tim Loan, Invercargill-based chief financial officer at SBS Bank, tells KangaNews the bank has been corresponding with the RBNZ during the development of the new instrument proposals.

“We are very supportive of having an option for mutuals to raise CET1 capital in New Zealand, and we are supportive of the RBNZ proposals in principle,” he says. While it is premature to estimate the likely shape of the market for such an instrument, Loan continues, he envisions SBS would consider it as a retail-led instrument potentially augmented by participation from wholesale investors.

Given how small the New Zealand mutual sector is – it accounts for only 1.3 per cent of locally incorporated bank assets, according to the RBNZ – the practical effect of the reserve bank’s adoption of either instrument is likely to be limited, at least at first. But having new means of acquiring capital could increase these lenders’ ability to continue and compete under the new regulatory regime.

While Co-operative Bank treasurer Andrew Gray, based in Wellington, says the RBNZ’s proposal is not yet a priority for his bank because it is already well positioned under the new capital requirements, he says the sector appreciates the reserve bank’s efforts to offer more options and that the proposed instruments could be useful in the future.

The path to a new instrument is not straightforward, however. The RBNZ paper cites the regulator’s concern that any solution that introduces a “new class of ‘investor member’” would make a mutual bank inherently “less mutual”. Mutual banks would need a way to distribute profits to investor members without diluting existing members’ equity interests, which the reserve bank says would also limit growth.

According to Luke Ford, Auckland-based partner at Chapman Tripp, the RBNZ’s concerns about introducing a capital instrument for mutuals exemplify the challenge these banks are facing. While the reserve bank is striving to find a mutual capital instrument that solves all problems the absence of any such instrument is the biggest challenge of all.

“One of the concerns raised by the reserve bank is that introducing these elements may stunt long-term growth. But we have been dealing without these instruments for years and there are still only two mutual banks,” Ford tells KangaNews. “[The lack of access to additional capital] is perceived to be preventing mutuals from becoming big enough to really play as banks, and thus to be encouraging them to convert into a normal company to be able to compete.”

The RBNZ’s consultation leaves open the option not to introduce a mutual capital instrument at all. If it elects to act, however, it says it prefers the second of the two policy options under consideration: the MET1 that is structured similarly to the CCDS the Bank of England’s Prudential Regulatory Authority recognises as CET1 capital for mutuals structured as building societies.

Both proposed instruments would constitute unsecured investments in the mutual with no maturity date and no right to redeem. A MET1 would give an investor a claim that ranks junior to all other liabilities but equally with other investors and with the mutuals’ members.

The first option, a MEI with features similar to Australia’s MCI, would give investors a claim that ranks senior to members’ equity interest.

“Under the MEI, investors’ claim to surplus assets would not be proportionate to their capital contributed, nor would they have the most subordinate claim to the mutual bank’s assets,” the reserve bank explains. “We consider the MET1 instrument would more closely adhere to the core requirements for CET1 capital as investors would have the most subordinate claim on mutual banks’ assets, and their claim to surplus assets would be proportionate to their contributed capital.”

SBS’ Loan agrees that the MET1 option is preferable. “A number of UK building societies have been able successfully to issue capital under the UK framework, and their mutuals have a similar structure to those in New Zealand,” he says. “We therefore believe the UK framework is likely to be more appropriate here.”

Ford says either option would make for a plausible capital instrument that could theoretically fix the problem for mutuals. But he also thinks which option the reserve bank chooses will be less crucial than whether it chooses to change the regulations at all.

“I think there's a tendency to overcomplicate this,” Ford tells KangaNews. “These banks are having a difficult time scaling further, particularly as regulatory requirements increase. How they meet the new regulatory requirements is only going to become more of a live issue as they transition over the next six years.”

Part of the challenge is that it is an inherently difficult matter to create a “most subordinated” instrument when it is not possible to subordinate below existing members, Ford says. He adds: “But this is something the mutuals have been wanting for years, and I think [the RBNZ] will go ahead with it. The question is, what kind of scale can they achieve, and how much help is it going to be for them long-term?”

Market participants are realistic about the likely impact of a new instrument on capital markets. With only two mutual banks in operation, Lethbridge agrees the ultimate impact of any changes the RBNZ makes for mutuals will likely not have a huge impact on supply in New Zealand’s capital market.

“The mutual banks are small relative to other banks in New Zealand and there are likely to be limits on the amount of mutual equity interests that these entities can issue,” he says. “Any supply will be a small amount issued by small players. It might have a significant impact on the mutuals but not necessarily on capital markets.”

If the RBNZ proceeds with one of the proposed instruments, it would also likely take some time before a bank actually uses one. They note that mutual banks would have to change its constitution to allow use of either an MEI or MET1.

In Australia, enabling legislation for the MCI passed in early 2019, and by the end of that year several mutuals had changed their constitutions to allow use of the new instrument. However, the first MCI was not issued until 24 December 2020, when Australian Unity printed a A$120 million (US$90.1 million) MCI after what it said was a challenging marketing and investor education process.

None have been issued since despite Australia’s much larger mutual bank sector: there are more than 50 such organisations in Australia including at least 10 that are relatively familiar names in the public bond or securitisation markets.

However, New Zealand market users say the development of a new capital instrument could be a game changer for the two mutuals. Ford also notes that such an instrument could also become useful to New Zealand’s larger mutual nonbank deposit takers (NBDTs). This is a much larger sector, with 20 names on the RBNZ’s NBDT register as of November 2021.

The RBNZ electing to choose either of the options rather than doing nothing appears to be more crucial than the question of which instrument it selects. According to Ford, the main thing will be keeping things simple. “The more we can follow one of the two international precedents the better, so no-one has to spend time re-explaining things to investors. I always favour simplicity over something very complex”, he says – noting that the MEI is the simpler of the proposed options.

“It is a small market, particularly in this space,” Ford adds of the challenges involving implementation. “If we have our own novel and complex way of doing it and we have just two banks at the moment that will be trying to explain it to investors –that is going to take considerably longer.”

Lethbridge agrees that mutual banks will be keen for the RBNZ to add either capital instrument and that action is required for the sector to keep up with larger banks as higher capital requirements take effect.

“This is good news for mutuals because it potentially gives them another option,” he says. “There are some details to be worked through, and it may have limited impact on the capital markets given the size of mutuals. But it is an interesting development and it will be good to see where it goes.”

Ford believes the reserve bank will choose one of the options rather than preserving the status quo, saying the disadvantages inherent to the mutual structure have been an ongoing concern that is becoming more pressing.

“If it takes a considerable amount of time for this to come through, it effectively means we are unlikely to see many other banks coming up in the mutual sector in the foreseeable future,” Ford says. “Meanwhile, the two banks that are there will find it quite difficult to meet the regulatory requirements – it will continue to slow their growth.”