Reserve Bank's '$20 billion' decision on bank capital may flow through to mortgage rates

Wednesday, 4 December 2019

The Reserve Bank has a big call to make about the price of bank safety.

The Reserve Bank is expected to ask the big four Australian-owned banks to pour billions of dollars more of their own money into their businesses on Thursday.

The amount of extra capital ASB, ANZ, BNZ and Westpac and smaller banks will need to find, or transfer from Australia, could be as high as $20b over five years.

That is based on previous consultation documents published by the Reserve Bank.

The Reserve Bank is expected to largely stick to its guns for a big capital increase in its final ruling, but perhaps with some compromise.

* ANZ warns RBNZ capital proposals will push banks towards housing

The Australian-owned banks have proved solid over the decades, but some argue that is because they not yet been truly tested in a crisis.

* Big rule changes for banks expected on December 5**

The changes will be designed to make it less likely a bank will fall over in a future financial crisis.

But there is likely to be some short-term pain in the form of higher interest rates on loans, which means less lending, and/or lower interest on savings such as term deposits.

Why are bank capital rules changing?

Reserve Bank governor Adrian Orr appears confident that the benefits of raising bank capital ratios will outweigh the cost.

In short, because of the 'Global Financial Crisis' that started in 2007.

The Reserve Bank, along with many other central banks around the world, has concluded that the impact of bank failures can be worse and longer-lived than previously thought.

Individuals and institutions can usually muddle their way through the normal ups and downs of economic cycles, the thinking goes.

But when banks become stressed and stop being able to lend, as some overseas banks did during the GFC, then the impact – including on people's mental health and well-being – can be more profound.

Shouldn't Australian regulators ensure the Australian-owned banks don't fall over?

The Australian Prudential Regulation Authority (APRA) does have rules that cover the amount of capital that the Australian banks need to maintain, both for their operations in Australia and for their banking groups as a whole, including their New Zealand subsidiaries.

It is also tightening those requirements.

The Australian banking system has been regarded as pretty solid over the years, certainly compared to jurisdictions where bank failures have been more common, such as the United States.

But there is still a nagging concern that their New Zealand subsidiaries could be hung out to dry in a really serious crisis.

So what is the proposed solution?

Thursday will show whether the Reserve Bank will compromise on proposals which could force banks find an extra $20 billion.

The Reserve Bank plans to increase the amount of capital that New Zealand-registered banks including ANZ, ASB, BNZ and Westpac need to hold.

Banks build capital by selling shares in their businesses through equity raisings, and by retaining a portion of the profits they make in the course of their business.

But when they lend money, only about 10 per cent of the money they lend comes from such sources.

The bulk of the money they lend is in turn 'borrowed' from deposits that customers make with the bank.

Requiring banks to hold more capital means they can sustain more losses from bad loans in a downturn while remaining solvent and not putting people's deposits at risk.

How much capital does the Reserve Bank think banks should have?

That will be revealed on Thursday.

Not all loans are as risky as each other, so the Reserve Bank will express the new capital requirements in terms of a percentage of their 'risk weighted assets' (RWA).

During consultations, it has suggested the 'big four' banks should normally have a 'tier one' capital ratio of at least 16 per cent (relative to their RWA), while smaller banks that are less critical to the economy should maintain 15 per cent tier-one capital backing.

During a 'downturn' as declared by the Reserve Bank – for example in the wake of an event such as the GFC – all banks would be able to reduce those capital ratios by up to 1.5 percentage points.

ANZ says new rules could cost the economy $3b a year indefinitely, and much more during the 'transition stage'

The whole point of higher capital, after all, is to provide a buffer to enable banks to trade through such crises without stopping lending or putting deposits at risk.

Tier-one capital is the most unencumbered type of capital; the kind of capital that banks can most easily lose while still staying in business.

What would happen if a bank breached the capital requirements?

It would face escalating interventions from the Reserve Bank, until at some point the Reserve Bank might step in and put a bank under statutory management.

The latter is what a bank failure really amounts to.

Under the draft proposals, if a bank's tier-one capital ratio fell below a proposed 6 per cent statutory minimum it would be 'game over', but in practice the alarm bells would be screaming well before that point was reached.

What capital ratios do the banks need to have now?

They need to have a 10.5 per cent tier-one ratio, including a 2.5 percentage point 'conservation buffer'.

But the big four banks are maintaining higher ratios than that, averaging 13.4 per cent.

That is in part to ensure they stay on the right side of ratings agencies.

The fact existing capital ratios are influenced by ratings agencies arguably supports the Reserve Bank's thesis that its own statutory requirements are currently on the low side.

So how many more billions would the banks need to put in?

About $20b, if the Reserve Bank sticks to its previous thinking.

Increasing the big four banks' tier-one capital requirement from 13.4 per cent to 16 per cent would mean they would need to come up with about $13b of additional capital.

That figure takes into account the fact that Reserve Bank is also proposing to change the way it calculates banks' RWAs.

Smaller banks would need to find about $1b to meet their new capital ratio requirement.

But the Reserve Bank has separately proposed changing the definition of what would count as 'capital' for the purpose of the new rules, including limiting the amounts and types of funding from perpetual preference shares that could count towards the 16 per cent tier-one figure.

Those changes could add about another $6b to the sum to get to the total of $20b – though if the Reserve Bank does compromise, it could conceivably be on matters such as that capital definition.

ANZ has argued banks would need an extra buffer even beyond the 16 per cent ratio, so the amount of extra capital they would need to find could be even higher, and perhaps as high as $24b.

Where would they get the capital?

The Reserve Bank has 'helpfully' suggested that the big four New Zealand banks could get the capital by cutting their dividends by 70 per cent over five years.

That would mean lower pay-outs to shareholders.

One way the banks could find extra capital would be to cut the interest they pay to savers, another would be to up interest rates on loans.

Alternatively, the banks' Australian owners could raise capital through rights issues, or transfer capital to New Zealand from their Australian operations.

But the banks have suggested they would be more likely to react by raising interest rates on loans and/or cutting interest rates on deposits, so they made more profit from their operations to build up the required extra capital.

In all likelihood, their responses might involve some mix of all of the above.

How would Australian regulators react to banks simply moving capital across the Tasman?

Not too well, it seems.

APRA has issued an edict called APS222 that would in effect limit the ability of the big four banks to home more than 10 per cent of the tier-one capital that counts towards their Australian capital-ratio targets within their New Zealand subsidiaries – without requiring them to also further increase their capital in Australia.

Some of the Australian banks might be able to partially meet tougher Reserve Bank rules by moving some capital from Australia to New Zealand, but APRA's policy change appears intended to ensure that couldn't be a big part of any of their solutions.

How have the banks reacted to the Reserve Bank's thinking?

Not warmly.

The country's biggest bank, ANZ, said in a May submission signed by chairman Sir John Key that the proposed changes were unnecessary and the knock-on costs would be felt most by farmers, other businesses and savers.

The impacts of the proposed new regime could include a permanent $3b a year drop in GDP and up to a $9b annual hit in the first 10 years it has suggested.

Should I be worried about interest rates on mortgages and other loans going up?

Maybe, a bit.

$20b would be a big number, and there are legitimate concerns interest rate 'spreads' – the difference between the average interest rate that banks pay depositors and charge borrowers – would increase.

That is despite all the Reserve Bank's talk of banks forgoing dividends and the probability of some degree of compromise emerging on Thursday.

There have been some suggestions mortgage rates could rise 1 per cent, and counter-claims that is scaremongering.

It would be fair to suspect that many of the forecasts about the scale of the impact of the bank capital review on interest and deposit rates will have been tainted by a degree of lobbying and self-interest – but that is not to say they are all hot air.

After all, the review is fundamentally about taking a hit on the chin now, to avoid the risk of kick in the guts down the track.