The price of safety: Reserve Bank capital plans could put handbrake on the economy

Friday, 18 January 2019

The so-called 'big four' Australian owned banks could have to collectively raise more than $20 billion to comply with the Reserve Bank rules if proposed increases in capital requirements come into force. Although the Reserve Bank claims this would have only a 'minor' impact on customers, commentators warn the move could push up the price of mortgages and make credit harder to obtain, especially for small businesses.

A plan to strengthen banks against massive future financial storms could push up mortgage rates, lower asset prices and slow economic growth, analysts warn.

Although the impact of proposed changes is uncertain and some time away, early predictions are that Reserve Bank proposals could add anywhere from 40 to 125 basis points to the interest rate charged on mortgages for all New Zealand customers.

All else being equal, this would increase the interest repayments on every $100,000 of debt by between $400 and $1250 a year.

Deposit rates, which sunk in the wake of the Global Financial Crisis, could drop even lower.

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Reserve Bank governor Adrian Orr had been public that the central bank had formed a view that the large New Zealand banks needed to hold more capital, however proposals released shortly before Christmas - which could force the banks to raise more than $20 billion from shareholders - surprised financial markets.

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The predictions fly in the face of the central bank's hopes that customers would face little impact.

A 'material' increase

As Wellington prepared for Christmas, the Reserve Bank revealed it was proposing a hefty hike in the amount of capital which the four Australian banks which dominate the sector must hold.

In simple terms, the shareholders of the retail banks are being asked to inject more cash, so as to have 'more skin in the game'.

As well as getting money from depositors, banks need to hold a certain amount of money in reserve to protect it in the event that some customers default on their loans.

Raising more capital means when the next major recession hits, the banks will be better braced to withstand the troubles.

Although governor Adrian Orr had been public with the Reserve Bank's view that the retail banks would need to hold more capital, the market gulped at the numbers in the consultation paper, sending bank shares lower.

Using new measurements, the Reserve Bank has proposed increasing tier-1 capital from around 11.5 per cent now, to 16 per cent.

ANZ estimates that the four banks will need to raise $22 billion, including replacing around $6b in existing financial products which will no longer be treated as bank capital, as well as maintaining a 'buffer' above legal minimums.

Finance Minister Grant Robertson is refusing to comment on the proposals, on the basis that the Reserve Bank is independent.

Smaller New Zealand owned banks such as Kiwibank would also likely have to increase capital, but the figures are much smaller.

While the Reserve Bank has said shareholders need to take the brunt of the increase, with only a 'minor' impact on borrowers, the market is increasingly dismissive of the claim.

On Thursday, Australian analysts for global investment bank UBS claimed the move could see the interest rates on mortgages rise by more than 100 basis points.

A number of participants have expressed surprise at the scale of the proposal, prompting questions that the Reserve Bank has dropped something of a hopeful first bid, to make a lower increase sound more reasonable.

The move could be complicated by the fact that the Reserve Bank's Australian equivalent, the Australian Prudential Regulation Authority (APRA) has rules around how much capital the Australian banks can hold overseas.

Banks in New Zealand are unclear how much additional capital will need to be raised, and how much could be shifted from across the Tasman, which would have an influence on the impact of the proposal on customers.

A capital crisis?

The Reserve Bank has not responded to a request for an interview, beyond asking what topics might be covered.

Finance Minister, Grant Robertson declined to comment, on the basis that the Reserve Bank is independent and the proposals are being consulted on.

Geoff Bascand, deputy governor and head of financial stability at the Reserve Bank, said in a statement that proposals to strengthen bank balance sheets would require a 'material' increase in capital, but would have only a minor impact on customers. The Reserve Bank has given no detail about what would constitute a 'minor' increase and commentators are warning the changes could increase the cost of borrowing and make capital more difficult to obtain. This would ultimately lower asset prices and could slow economic growth.

National finance spokeswoman Amy Adams said the proposals from the Reserve Bank came as something of a 'bolt from the blue' in terms of the amount needing to be increased.

'We all understand, of course, that bank stability is an incredibly important part of our economic system,' Adams said.

'But equally, as I understand it, our banks have some of the highest capital provisions in the world and we have a very stable system.'

Adams said the scale of the proposals raised the question 'what is the problem that they're trying to solve' which she would put to central bank officials.

'The scale is significant,' Adams said.

'At that level of magnitude it almost sounds like the RB thinks there's some sort of crisis in capital adequacy, and I just haven't seen anything to suggest that's the case.'

'Owners should bear greater share of risk'

Although the Reserve Bank holds around 10 press conferences a year, with senior staff giving a large number of speeches, the bank opted to simply drop the plans on its website on December 14, a fortnight after the release of the financial stability report.

'Bank crises happen more often than many people care to remember, and the economic and social costs of bank failures can be very high and persistent. These proposals are designed to make bank failures less frequent. With these changes we estimate the banking system will be resilient to shocks that might occur only once every two hundred years,' deputy governor Geoff Bascand said.

On the one hand, the bank's announcement was highly dramatic, designed to protect us against almost cataclysmic events, by adding up to 60 per cent to the capital individual banks may need to hold, representing 70 per cent of the industry's profitability over a five year transition period.

'The proposal would see banks' capital levels increase materially,' the Reserve Bank said. 'We are proposing to almost double the required amount of high quality capital that banks will have to hold.'

But the statement was also rose tinted. Bascand claimed that everyday customers would see little in the way of higher prices.

'Borrowing costs may increase a little, and bank shareholders may earn a lower return on their investment,' Bascand said.

'We believe these impacts will be more than offset by having a safer banking system for all New Zealanders.'

Will shareholders demand a return?

National Party finance spokeswoman Amy Adams said she was of the understanding that the New Zealand banks were well capitalised in comparison to overseas peers, so it was unclear what problems the Reserve Bank was trying to fix in proposing significantly higher capital provisions.

The degree to which bank shareholders will accept lower returns cannot be known by Bascand or anyone else.

UBS analysts Jonathan Mott and Rachel Finn said raising equity was expensive as accordingly the banks would demand returns on it.

If they demanded a return of slightly more than the cost of the added capital, mortgage rates would rise by around 80 basis points.

Demanding a rate of return on the new capital equivalent to current bank profitability, mortgage rates would rise by 125 basis points.

'We believe the [Reserve Bank's] endeavours to strengthen the banks could come at a significant cost to the NZ economy as they appear to be materially underestimating the likely mortgage repricing,' UBS said.

'We see these proposals as expensive and unnecessary.'

The comments were more strident and political than is usual in mainstream financial commentary on this side of the Tasman.

Arguably, Mott and Finn buried the lede of their argument, that if the Reserve Bank was to proceed with the plans 'it may be the final catalyst for dividend cuts' across the Australian banking sector, which has faced unprecedented criticism in their own country in 2018.

ANZ chief economist Sharon Zollner said it was important for banks to hold sufficient capital, but like insurance, there was a cost to holding more.

In New Zealand the commentary has been comparatively muted so far. Banks are ultimately likely to say they oppose the degree of increase.

In early 2017, the New Zealand Bankers Association commissioned a report by PwC which found the New Zealand banks were well capitalised compared to international peers.

'New Zealand's banks are currently very well capitalised and among the most stable and secure in the world. Reserve Bank stress tests show banks can withstand a 40 per cent fall in house prices,' the NZBA said in a statement.

However several observers are warning that the impact of the changes could also include a cut in credit availability, lowering asset prices and slowing economic growth.

One economist said the plans may need to be contingent on economic conditions, as raising capital at a time of falling confidence or slowing growth could help tip an economic into recession.

On Tuesday, Westpac predicting that borrowing rates were more likely to climb by around 40-50 basis points.

'Higher capital requirements will lead to upward pressure on bank lending rates and downward pressure on bank deposit rates,' Westpac chief economist Dominick Stephens said on Tuesday, adding that the proposals would put 'downward pressure on asset prices and [economic] growth'.

Stephens said the Reserve Bank could 'soften the impact' by having a lower than otherwise OCR.

Back in December, economists at ANZ said deciding what levels of capital were appropriate involved trade-offs, with too little capital leaving banks exposed to insolvency, which could precipitate a financial crisis.

'But … holding more capital is not without costs – like any form of insurance,' ANZ's Liz Kendall and Sharon Zollner wrote.

'Too-high capital requirements would weigh unnecessarily on both the cost and availability of credit, which is the oil in the macroeconomic engine … [The] economic impact of the proposed changes could be significant.'

ANZ's comments came a day after the bank said it believed that the OCR, the benchmark interest rate set by the Reserve Bank, would eventually be cut from the current 1.75 per cent, to a fresh all time low of 1 per cent, partly because of the impact of the Reserve Bank's changes to bank capital requirements.

Cameron Bagrie, managing director of Bagrie Economics and former ANZ chief economist, said the capital levels being proposed by the Reserve Bank were surprisingly high.

But Bagrie said estimates that lending rates could increase by 100 basis points were based on an assumption 'that consumers and businesses pay, and shareholders don't take a bit of a haircut'.

As well as the OCR being lower than it would otherwise be, Bagrie predicted the cost of the increased capital would be shared, perhaps evenly, between customers and shareholders.

'Shareholders should expect a lower return,' Bagrie said.

'At the end of the day, profits in the banking sector in New Zealand are not just high, they're hellishly high.'