Higher capital better for banking
system and NZ
Notes from an address delivered to Business NZ CEO Forum in Auckland
On 30 November 2018
By Adrian Orr, Governor
The Reserve Bank is tasked with ensuring the banking system is both sound and efficient.
To achieve our task we have a range of tools (see Table 1). The most important tool in our
kit is ensuring banks hold sufficient capital (equity) to be able to absorb unanticipated
events. The level of capital reflects the bank owners' commitment - or skin in the game - to
ensure they can operate in all business conditions, bringing public confidence.
Given its importance, we have been undertaking a review of the optimal level of capital for
the New Zealand system. We conclude that more capital is better. We are sharing our work
with the banking sector and public, and 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.
What have we done in practice?
"system" to
The Reserve Bank needs to ensure there is sufficient capital in the banking
match the public's -
"risk tolerance". This is because it is the New Zealand public both
current and future citizens - who would bear the social brunt of a banking mess
risk tolerance will be less than bank owners' risk
We know one thing for sure, the public's
tolerance. How do we know this? Surely the more capital a bank has the safer it is and the
don't banks hold as much capital as they can?
more it can lend. Why
First, there is cost associated with holding capital, being what the capital could earn if it was
invested elsewhere. Second, bank owners can earn a greater return on their investment by
using less of their own money and borrowing more - leverage. And, the most a bank owner
can lose is their capital. The wider public loses a lot more (see Figure 2).
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 stylised diagram in Figure 3 highlights where we have got to. Our assessment is that
we can improve the soundness of the New Zealand banking system with additional capital
with no trade-off to efficiency.
In making this assessment, our recent work makes the explicit assumption that New Zealand
is not prepared to tolerate a system-wide banking crisis more than once every 200 years.
We have calibrated our 'sweet spot' thinking about economic 'output' and
financial stability
benefits.
How did we arrive at this position?
Current levels of capital are based on international standards, and are not optimal for any
one country. The standards are also a minimum. There is a clear expectation that individual
tailor the standards to their financial system's needs.
countries
Banks also hold more capital than their regulatory minimums, to achieve a credit rating to do
The ratings agencies are fallible however, given they operate with as much 'art' as
business.
'science'.
-
Bank failures also happen more often and be more devastating than bank owners and
-
credit ratings agencies tend to remember. The costs are spread across the public and
through time.
- 'parents' are subject
Many large banks are foreign owned especially in New Zealand. Their
to capital requirements in their home and host country. This creates continuous tension as
to who gets the lion's share of capital and failure management support. 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.
-
A word of caution. Output or GDP are glib proxies for economic wellbeing the end goal of
our economic policy purpose. When confronted with widespread unemployment, falling
wages, collapsing house prices, and many other manifestations of a banking crisis,
wellbeing is threatened. Much recent literature suggests a loss of confidence is one cause
of societal ills such as poor mental and physical health, and a loss of social cohesion. If we
believe we can tolerate bank system failures more frequently than once-every-200 years,
then this must be an explicit decision made with full understanding of the consequences.
Table 1: The Reserve Bank's tool kit
Time
RBNZ tools Self Market Regulatory Permanent Event
varying
Institutional Governance
rules
Risk management
Attestations
Licensing & NZ
incorporation
Outsourcing
Transparency Disclosure
Financial Minimum capital
requirements requirements/solvency
standards
Conservation & counter
cyclical buffers
Sectoral Capital
Requirements
Core Funding Ratio
Loan to value
restrictions
Funding & Liquidity standards
liquidity
Collateral standards /
RMOs
LoLR
Foreign exchange
intervention
Infrastructure FMI rules and powers
Monitoring Financial Stability
Report
Stress testing
Supervision &
engagement
Thematic reviews
Enforcement Investigations
Directions
Monetary OCR
policy
Crisis OBR
management
Statutory management
Figure 2: The cost of recent bank failures on society
Fiscal cost as % of banking system assets
Uruguay (2002)
Korea (1997)
Greece
Finland (1991)
Czech (1996)
Japan (1997)
Iceland
Ireland
Netherlands
Slovenia
Sweden (1991)
UK
Norway (1991)
USA
Belgium
Austria
Spain
Denmark
Germany
France
Luxembourg
Italy
Source: IMF (2013) Systemic Banking Crisis Database
Portugal
0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0
% of banking system assets
'sweet spot'
Figure 3: The capital-output