Big rule changes for banks expected on December 5

Thursday, 21 November 2019

Reserve Bank governor Adrian Orr is taking a strong stance against Aussie banks.

ANALYSIS: December 5 is expected to bring big rule changes to New Zealand's banks.

It has been a year since the Reserve Bank of New Zealand, proposed commercial banks hold more of their own money against the loans they make, that they might better withstand a monumental financial shock.

Over the last 12 months the consultation process has been controversial. The Reserve Bank solicited the views of the banking industry and other business users of financial services as well as the wider public. And contentiously, governor Adrian Orr used both public and personal channels to push the case for stronger rules and argue that the cost to the economy would be 'minimal'.

The banks and other observers, however, said the costs would be felt across the economy. Westpac estimated the proposal might add another $6000 a year to the average Auckland mortgage. Federated Farmers feared some of its members would be frozen out of borrowing altogether.

New Zealand big four Australian-owned banks say they are in 'wait-and-see' mode over proposed changes by the Reserve Bank.

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Over the winter, communication between Orr in particular, and the banks, and other players including academics, became so strained that Finance Minister Grant Robertson issued a statement asking for a 'mature debate.' Since then the war of words has quietened.

Reserve Bank of New Zealand governor Adrian Orr contentiously used both public and personal channels to push the case for stronger rules and argue that the cost to the economy would be 'minimal.'

When approached by Stuff for comment on their preparations for any changes, all four of the big Australian-owned banks said they were in 'wait-and-see' mode and declined to make wide-ranging comments. ANZ, Westpac, BNZ (owned by National Australia Bank) and ASB (owned by Commonwealth Bank) dominate the New Zealand market, responsible for some 86 per cent of bank lending.

But it is clear that even as they await next month's decision, the banks are already quietly weighing their options. And there is mounting evidence that tighter credit conditions – and perhaps even a credit crunch – will be among the consequences.

Credit already tightening

The Reserve Bank proposal is to increase large banks' total minimum capital requirements from the current 10.5 per cent to 18 per cent. For not 'systemically important' banks the number is 17 per cent. It is broadly agreed that the changes will cost the banks, including domestically-owned lenders, in the region of $20 billion in new capital.

Loans are risk weighted, and those that are riskier, typically including farm loans and loans to small and medium sized businesses, require the banks to keep in reserve a larger chunk of capital. The prospect of stricter rules may be constricting that lending already.

Economist Cameron Bagrie is among those who have called New Zealand banks 'sensationally profitable'.

In October, the Reserve Bank's bank survey of credit conditions told a story of tightening.

The survey of commercial banks showed that credit availability has contracted in the past six months and is now well below the last three-year average. Borrowing for dairy farmers has dropped the most precipitiously, to an index reading of -25.8, as opposed to -4.3 a year earlier.

But credit conditions have tightened much more broadly: across all agricultural loans and also for corporate and institutional as well as commercial property loans.

'Credit has contracted and it's going to contract a lot more,' Kiwibank chief economist Jarrod Kerr said.

The same survey shows that even as demand for agricultural loans is projected to pick up over the next six months, the likelihood that new demand will be met is bleak. The index reading is negative for loan availability in the next six months across all categories.

Banks cited: regulatory changes; bank's risk tolerance; bank's perception of risk; and, balance sheet constraints, as the key factors affecting the availability of credit.

'Those are all problems related to new bank capital regulations,' Kerr said.

While the Reserve Bank has proposed a phase-in period of five years for the new rules, there is a growing expectation that this time horizon will be pushed out to seven or even 10 years. Even so, Kerr said, it was difficult to see a situation whereby banks would delay repricing their lending.

'Credit has contracted and it's going to contract a lot more,' Kiwibank chief economist Jarrod Kerr says.

'Say the bank is making a loan today with a life of 10 years. And if we know that after five years we're going to have to hold an extra $100 of capital against that loan, then that's going to affect the loan pricing today. I'm definitely going to want to step up the capital over time, $20 this year, $20 next year, $20 the year after that. Mechanically, we'll look for ways to price that today.'

Approaching the final decision on new credit rules, this question hangs over the New Zealand economy: will unmet demand for loans weigh on vital sectors like agriculture? Kerr is reluctant to identify a credit crunch at this point but he doesn't like the direction of travel.

'Right sizing' the balance sheet

Earlier this month BNZ chief financial officer Peter MacGillivray told Interest.co.nz that one of the three likely ways for BNZ to meet new Reserve Bank rules was to 'right size' the balance sheet.

Paring back riskier lending is one way banks can alleviate pressure on their balance sheets. But there are others.

In September, in light of interest from foreign buyers, New Zealand's largest lender, ANZ, said it was not interested in selling its rural debt.

But an industry source said the bank was considering other ways of relieving pressure on its New Zealand balance sheet. One possibility is to make greater use of the parent bank through the New Zealand branch of the ANZ Banking Group.

Loans purchased by the group from ANZ New Zealand become the regulatory purview of Australia, where capital requirements will be lower if New Zealand's current proposal goes ahead.

ANZ spokesman Stefan Herrick declined to comment on whether ANZ NZ might make better use of the parent branch which conducts no direct business with customers in New Zealand. However, he confirmed that the group branch was established during the global financial crisis (GFC) and initially bought $10b of housing loans from ANZ NZ to provide funding for the New Zealand business at a time of disruption in the global funding markets.

ANZ NZ could sell some loans to its Australian parent to get around possbile tougher capital requirements.

He also said the branch holdings of housing loans have fallen over time and in recent years this has been due to changes in the Australian Prudential Regulatory Authority's (Apra) treatment of the ANZ Banking Group's activities.

David Tripe, professor of banking at Massey University, said there was a possibility that ANZ could use such a mechanism to move higher quality loans to the parent branch while leaving lower quality loans in New Zealand.

But he noted that he found no evidence of that when he looked at ANZ loans moved to the parent branch after the GFC.

He also expressed doubt that ANZ would find this an easy route to managing stricter regulation in New Zealand. 'I would be surprised if Apra allowed it,' he said.

Commonwealth Bank of Australia and Westpac also operate branches in New Zealand.

Where will the new capital come from?

Speaking after publishing interim financial results at the beginning of May, ANZ chief executive Shayne Elliott pointed out that 'all insurance policies come with a cost.' ANZ shareholders, he insisted, couldn't be expected to 'unfairly subsidise' the one proposed by the Reserve Bank.

ANZ chief executive Shayne Elliott says the bank's shareholders can not be expected to 'unfairly subsidise' the capital requirement changes proposed by the Reserve Bank.

ANZ has by far the largest banking operations in New Zealand, and estimates it will need between $6b and $8b in new capital once the new rules come in, if they remain as currently proposed.

Among the most obvious ways for ANZ and the other foreign-owned New Zealand subsidiaries to raise new capital is through the parent banks.

MacGillivray told Interest.co.nz that one way BNZ might meet the new rules was through a capital injection by National Australia Bank (NAB). Spokesman Sam Durbin said BNZ wasn't able to make any further comment at this stage, so close to the Reserve Bank's final decision. But observers agreed it was a likely avenue, despite the Australian bank's recent struggles.

'It's a difficult moment for the banks,' Eliza Wu, associate professor of finance at the University of Sydney Business School said.

She noted that the banks faced pinched profitability in the business broadly, as growth in the core Australian market was weak, and very low interest rates had squeezed the spread wherein banks typically make money: the difference between their lending rates to borrowers and the interest rates they pay depositors and others for funds.

In early November, Westpac became the second of the big four to pare its dividend to shareholders in the face of falling profit. In May, NAB cut its dividend to shareholders in order to shore up its capital position and compensate customers for wrongdoing identified in the Australian public inquiry into misconduct that concluded early this year.

Despite that, she said 'there is a market for the banks to raise capital through international investors'.

Massey University professor of banking David Tripe doubt that ANZ would be allowed to move New Zealand loans to it Australian parent to manage stricter regulation in New Zealand.

Capital raised in NZ

BNZ may also raise funds in New Zealand if the Reserve Bank loosens what it considers acceptable tier 1 capital. The current proposal raises the minimum tier 1 capital ratio to 16 per cent of risk weighted assets for the big banks, and largely limits it to ordinary shares and retained profits.

MacGillivary told Interest.co.nz a 'softening' by the Reserve Bank on what capital instruments count as tier 1 capital could see BNZ issue financial securities in its own name.

ANZ spokesman Stefan Herrick also said the impact of the Reserve bank's decision depends on factors including 'the instruments permitted to be used.' Beyond that, Herrick said that ANZ had 'already been retaining more of our profit in New Zealand this year to help meet any additional capital obligations, as well as investments in technology, risk compliance and customer service'.

Possible NZX listing

The question of a partial listing of shares by one or more of the Australian subsidiaries also remains a possibility.

ANZ and Westpac have, in previous decades, partially listed their New Zealand subsidiaries locally.

'The price was poorer than for the parent shares and the market was less liquid. I wouldn't say it was a success,' Tripe said.

For ANZ, however, a local listing might solve the regulatory squeeze it now appears to face, he said.

The Reserve Bank was proposing higher capital ratios just as Apra has promised new rules that demand the Australian banks limit their capital exposure to subsidiaries. Apra was now pressing ahead with a plan to reduce the maximum exposure banks could have to their subsidiaries to 25 per cent of total tier 1 capital, he said.

If the Reserve Bank's proposal went ahead in its current form, ANZ NZ was expected to account for well over that 25 per cent mark.

'That would prevent the parent from pumping additional capital into the NZ subsidiary,' Tripe said. 'So a float might solve that.'

Who pays in the end?

What remains to be seen is who will ultimately pay the extra cost of new capital: bank shareholders, or their customers in the form of lower interest on deposits and more expensive loans.

Independent observers like economist Cameron Bagrie have called New Zealand banks 'sensationally profitable'. With an after-tax return on equity for the big four in the region of 15 per cent.

But commentators like Wu point out that, 'how banks absorb new cost is a commercial decision' that depends on many moving parts, including competition and new entrants to the market. Pricing is not a story that will be told quickly, it will play out for years to come.