Kiwis show the way on regulation

And the award for the best public policy decision of 2018 goes to: the Reserve Bank of New Zealand.

And the award for the best public policy decision of 2018 goes to: the Reserve Bank of New Zealand. To be fair, I can’t say I’m across every such decision everywhere, but the unexpected announcement in Wellington earlier this month that banks would bear more of the costs of their risk-taking, rather than benighted taxpayers, was surely the best decision south of the equator for some time.

It was a breath of fresh air in a year the royal commission has illustrated how ineffective — or less politely, captured — our own regulators have been. And it stands out among a series of backdowns and timid proposals by financial regulators since the crisis.

Out of the blue, the New Zealand central bank said it would lift the Tier I minimum capital ratio for banks to at least 15 per cent of risk-weighted assets, from 10.5 per cent, equivalent to diverting 70 per cent of the sector’s profits over the five-year phase-in period into shoring up the financial system’s resilience.

For all the sturm und drang about tough requirements this side of the Tasman, equity as a share of bank total (unweighted) assets has inched up a meagre 4.5 per cent to about 5.5 per cent since 2010, far short of the level logic and evidence dictate to be prudent, which, on this measure, is thought to be closer to 10 per cent.

The RBNZ said: “The literature suggests that up to relatively high levels of capital, the benefits of increasing capital are expected to outweigh the costs,” the RBNZ said. “In this case, it makes sense to target higher capital, because doing so increases stability and expected output (as the likelihood of banking crises fall),” it added.

The share prices of the big four Australian banks, whose subsidiaries make up 88 per cent of NZ’s banking system assets, fell afterwards. More equity means less recourse to cheap deposits, which are backed by the government free of charge. What was temporarily bad for shareholders, though, was good for New Zealand taxpayers, whose chance of enduring a financial crisis, and contributing to any bailout, fell.

The contrast to Australia is stark. When our banking regulator makes rules, bank share prices tend to rise.

Recently, APRA wound back from 4 per cent to 3.5 per cent a proposed minimum ratio for equity as a share of total assets, and gave banks until 2022, to comply. It’s hard to see how that’s tough.

“Sir Humphrey, why are we extending the banks’ deadline for a requirement they already satisfy and making it even laxer at the same time?” “Minister, it’s all terribly complicated; basically we don’t want to hurt growth,” Sir Humphrey replies, trotting out the same vague, unproved slogan beloved of the financial sector whenever higher capital requirements are brought up.

Never mind the extraordinary bouts of growth in history — in the late 19th century and post-World War II eras, for instance — occurred against a backdrop of a far less leveraged financial system.

“A one percentage point increase in a banking system’s Tier 1 capital ratio from current levels may lead to a six basis point increase in the price of bank credit,” the RBNZ said. Two things to note here: “may’’ and “six’’.

It’s debatable higher equity increases interest rates by any more than a tiny amount, if at all.

A comprehensive 2016 study by the Bank for International Settlements, looking at 105 banks in 14 countries including Australia, found: “The tension between … unlocking bank lending and ensuring the soundness of individual banks is more apparent than real”.

Said BIS chief economist Hyun song Shin: “Higher bank capital is associated with greater lending (because of) the lower funding costs associated with better capitalised banks.’’

It’s been a depressing decade for anyone tracking regulatory changes since the financial crisis.

Alongside a massive increase in regulatory complexity has been practically no change in structure.

We’ve ended up with countercyclical and conservation buffers, D-SIBs, G-SIBs, various tiers of capital — naturally, each with its own highly complex requirements — suites of new “liquidity’’ and “stable funding’’ ratios.

It’s been nirvana for regulators and the compliance sector. But it’s harmful, serving only to obfuscate reality and make work for lawyers, bankers and regulators, as Mervyn King, a great enough economist not to be captured, rightly concluded in his most recent book.

Lifting capital isn’t all the RBNZ proposed.

“We are open to discussing whether Tier 2 should continue to play a role,” the RBNZ said in its announcement, correctly implying that Tier 2 capital (which isn’t actually capital at all, being rather contingent loans and “convertible debt’’) is a bit of a joke.

Banks love it because in a genuine crisis it’s likely governments would come to the rescue far before investors bore any losses.

And as if a government would convert any Tier 2 debt into equity if it meant losses for, say, a superannuation.

Meanwhile, APRA released a plan to increase big banks’ minimum capital ratios by 4 or 5 percentage points by 2023 — but made up of Tier 2 capital. It’s a wonder it bothered, really.

Third, RBNZ questioned the so-called “internal ratings-based approach” for calculating minimum capital. Introduced as part of the failed Basel II regulations in the mid-2000s, this approach allows banks to decide how risky their assets are based on their own experience.

“Where there are multiple methods for determining capital requirements, outcomes should not vary unduly between methods. In essence, there should be as level a playing field as much as possible,” the RBNZ said.

That’s code for scrapping the internal method, because banks would opt for DIY minimums only if they thought it would permit higher leverage.

It remains a mystery why in the face of strong evidence that the economy would be better off with a less leveraged financial system, bank regulators, RBNZ excepting, have been so reluctant to act.

British banking inquiry author John Vickers last month said: “A gulf this wide between official opinion and academic opinion on a truly fundamental economic policy question is extraordinary.’’

It’s true, higher equity, to the extent it did lift funding costs, would force banks to cut costs to maintain their rates of return.

Perhaps short-term bonuses might have to be dumped, spending on consultants or advertising reined in.

Perhaps, in National Australia Bank’s case, there’d be only $55m to spend on executive travel rather than the $110m that’s currently the subject of a NSW policy investigation.

This explains why regulators face significant pressure not to rock the boat.