Orr says Reserve Bank is looking for a 'sweet spot' for bank capital

Friday 30th November 2018

Reserve Bank governor Adrian Orr says the central bank thinks there’s a sweet spot in which it can require banks to hold more capital “with no trade-off to efficiency.”

Orr has already warned banks a number of times that the central bank’s current review of bank capital requirements is going to require them to hold more capital.

The Reserve Bank plans to release its final consultation paper on the matter in mid-December.

Orr told a Business NZ forum in Auckland that central bank officials “expect to hear one side of the story loud and clear, that capital costs banks. We need to hear a broader perspective than that to best reflect New Zealand’s risk appetite.”

Currently, New Zealand banks have to hold at least 8 percent of their risk-weighted assets as capital and a 2.5 percent buffer but all New Zealand banks significantly exceed that minimum.

Orr said that’s because banks aim to achieve a high credit rating. “The ratings agencies are fallible however, given they operate with as much ‘art’ as ‘science.’”

Bank owners would like to operate with as little capital as possible so they can maximise their returns.

But the most bank owners can lose is their invested capital if their bank fails, while the wider public loses much more, Orr said.

“Hence, we need to impose capital standards on banks that matches the public’s risk tolerance. We have been reassessing the capital level in the banking sector that minimises the cost to society of a bank failure while ensuring the banking system remains profitable.”

The Reserve Bank has made an explicit assumption that New Zealand is not prepared to tolerate a system-wide banking crisis more than once every 200 years.

The last time a bank was at risk of collapse in New Zealand was in 1990 when the government had to bail out Bank of New Zealand to the tune of $380 million. BNZ was sold to National Australia Bank two years later.

“We have calibrated our ‘sweet spot’ thinking about economic output and financial stability benefits.”

Unlike many other countries, particularly Australia, New Zealand doesn’t have any system of guaranteeing bank customers’ deposits.

In the event of a bank failure, the Reserve Bank is supposed to operate what’s called Open Bank Resolution, which would involve using some or all of customers’ deposits to shore up a collapsing bank.

Many observers have noted that this would be politically untenable for any government. The temporary deposit insurance New Zealand’s government put in place during the GFC suggests that view is correct.

Orr noted many of New Zealand’s banks are foreign-owned – the four largest banks are owned by Australia’s four largest banks – and that “it would be naïve to expect a foreign taxpayer to bail out a domestic banking crisis.

“Hence, New Zealand needs to assess its own risk-tolerance and decide who pays to clean up any mess and the scale of that mess.”

Currently, the big four Australian-owned banks have a distinct advantage over their New Zealand-owned rivals in that they are allowed to use their own internal models to decide how risky their lending is.

Orr didn’t mention that in his speech, although in July he said the Reserve Bank had made an in-principle decision that the “big four” banks will have to report their capital positions using both their own internal models and the standardised models the other banks are forced to use.

On Wednesday, deputy governor Geoff Bascand said the Reserve Bank will allow the “big four” banks, ANZ ASB, Bank of New Zealand and Westpac, to continue using their own internal ratings-based models to calculate how much capital they need.

However, the central bank does plan to limit the advantage that gives them over the other banks. The way the Australian-owned banks have used their internal models has “become excessive” relative to actual risks, Bascand said.

The “big four” are responsible for more than 86 percent of bank lending in New Zealand.

(BusinessDesk)

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