The Reserve Bank of New Zealand’s (RBNZ) proposed new capital requirements: Does the cost outweigh the benefits?

Clive Smith

Russell Investments

In late 2018 the RBNZ proposed implementing some of the most conservative capital requirements globally for the NZ banking system. Ironically these proposed changes may not end up materially improving the stability of the NZ banking system despite the potential for material costs to be imposed on the local economy.

Proposed changes to capital requirements

The Reserve Bank of New Zealand (RBNZ) is proposing to increase the capital requirements for New Zealand (NZ) banks with the objective of not only making the system safer but also reducing the contingent liability faced by the government. To this end the RBNZ wants NZ banks to hold sufficient capital to reduce the probability of a crisis to a 1 in 200 year event. To achieve this, not only is the level of tier 1 capital being raised to 16% for systemically important banks, but the methodology for calculating risk weightings (referred to in Figure 1 as ‘changes to IRB framework’) is also being made more conservative.

Figure 1

Should these proposals be implemented then NZ banks which are deemed to be systemically important will need to raise a further 4.4% of tier 1 capital. Under this proposed framework the NZ regulator would be adopting what is arguably amongst the most conservative capital requirements in the world.

RBNZ adopts a more conservative approach than the RBA

Whether such conservatism results in a materially safer banking system is debatable given that most of the NZ banks are subsidiaries of the major Australian banks. For this reason it is worth noting that the RBNZ has adopted a materially more conservative approach than the Australian Prudential Regulatory Authority (APRA) intends to apply to the Australian parent banks. APRA has placed greater reliance on tier 2 capital, to raise capital requirements, the RBNZ has focussed exclusively on tier 1 capital. The reason for this really comes down to a philosophical difference in views between the two regulators. APRA aims to provide flexibility to deal with capital on a ‘going concern’ as well as a ‘gone concern’ basis; i.e. having a capital structure in place which provides protection when a bank is under stress as well as once it has failed. To provide the different levels of protection there is a greater focus on tier 2 capital which can only be used once a bank ceases to be a ‘going concern; i.e. post a trigger event.

By contrast the RBNZ is more focussed on capital which can be used while the bank is still in a ‘going concern’ situation; i.e. avoiding the potential for a bank to reach the point of failure in the first place. Given the difference in philosophies the RBNZ has decided not to use tier 2 capital to boost the capital requirements of NZ banks assuming that this ‘sort of contingent debt … will not be triggered in time to provide going concern capital’. One approach is not necessarily better than the other but it is important to highlight that, where domestic and offshore banking systems are closely interlinked, the impact of both approaches need to be considered.

The impact to funding costs for NZ economy

Debate over the desirability of higher capital requirements would of course be uncontroversial if there was no cost associated with their application. In the absence of costs, more conservative domestic capital requirements would simply represent a ‘win-win’ outcome as the lower risk of a crisis would provide an unequivocal benefit to the economy. Unfortunately, it is not a costless decision even for the NZ market where the systemically important banks are subsidiaries of Australian banks. Higher capital requirements increase the effective cost of funding loans and in the absence of a change in pricing dynamics puts downward pressure on the profitability of banks. In quantifying this impact the RBNZ has estimated that the higher capital requirements may increase bank funding costs by 30-60 bps p.a. 1

What proportion of this increase in funding costs is passed on to borrowers will depend on how banks use a combination of higher lending rates and/or lower deposit rates to rebuild profitability. Without altering the pricing of loans and/or deposits, the banks may ration credit by focussing on more profitable business. Either way it would appear unlikely that the higher funding costs associated with the proposed capital requirements will be possible without some cost to the NZ economy.

Does the RBNZ proposal strengthen the NZ banking system?

While the economy may be impacted by the increase in capital requirements there may not actually be a commensurate reduction in bank risk. The key benefit of additional capital within a bank is that it provides an increased buffer against losses on loans associated with a deterioration in the domestic economic cycle. So in isolation it is reasonable to assume that bank risk declines and indeed, the RBNZ changes may result in the ratings agencies upgrading the standalone ranks assigned to NZ banks. Unfortunately, such a comparison overlooks the key point that most bank crises are not caused by a deterioration in the domestic economic cycle but rather by a deterioration in liquidity conditions arising from a loss in confidence; i.e. disruption to the ability of the bank to attract funding for its loan book. Being subsidiaries of Australian banks resilience to a liquidity related event is only as good as the parent bank’s ability to stand by its implicit guarantee and ensure liquidity to its subsidiary. Ultimately the fate of NZ subsidiary banks will be closely intertwined with that of the Australian parents. Given such a close interlinkage it raises material question-marks over whether the adoption of a materially more conservative capital regime than that existing in Australia really provides any advantage to the underlying resilience of the NZ banking system.

While the RBNZ proposals are currently just that and may therefore evolve over time, there is the potential that, as they stand, they may impose a significant economic cost on NZ without materially improving the resilience of the country’s banking system. Ultimately the stability of the banking system in NZ is inextricably linked to that of their Australian based parent banks. With such an interlinkage of systemic risk the adoption of more conservative capital requirements than those applied in Australia is less likely to materially improve financial stability within NZ. In this case increasing the potential for the costs associated with such conservatism to materially outweigh the practical benefits.

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Clive Smith
Senior Portfolio Manager
Russell Investments

Clive Smith is a senior portfolio manager for Russell Investments and a senior member of the firm’s Alternatives research group. Based in the Sydney office, responsibilities include researching Australian and global fixed income and property...

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