17 Jul 2019

Adrian Orr is right to look at bank capital

Adrian Orr, Governor of the Reserve Bank of New Zealand, received some vocal criticism recently on the back of the Reserve Bank's proposal to increase Tier 1 capital held by the banks from 8.5 per cent to 16 per cent.

Some of the criticism has been reasonable, part of the normal process of testing the substance of the assumptions behind the proposal.  However, some of it has not.  Mr Orr has noted surprise at the level of "underlying venom" that he has felt during public discussion of the proposals, including people referencing the size of his waistline!

The leaders of our banks are universally opposed to this proposal.  The voice of the banking industry, the New Zealand Bankers Association, claims that the Reserve Bank's proposals to increase banks' regulatory capital requirements could cost households, businesses and the economy about $1.8 billion a year.  Westpac made headlines when it warned the Reserve Bank's plan could add $6,000 to the annual interest cost of an average Auckland mortgage. 

In our opinion, the actual outcome is harder to predict, and Mr Orr has correctly noted that that risk/return requirements of the banks’ shareholders might not be aligned with the requirements of the country when it comes to our systemically important financial institutions.  He said “the RBNZ's proposals to increase banks' capital come from the perspective of society's risk appetite, not banks' risk appetite”.

We would go one step further and argue that, while higher capital requirements might not be aligned with the risk appetite of our banks’ leaders, they may well be aligned with the interests of a long-term shareholder.

It has long been our opinion that the profit and capital numbers of banks are overstated.  The nature of a bank’s business makes estimating the profit in any one year very difficult. Fluctuations in the market value of a bank’s assets and liabilities makes an asset valuation approach tremendously complicated and volatile.  Cash based profit calculations, while potentially more stable over a period, can be equally misleading.  Cash profits can be inflated in the short-term by lending to lower quality borrowers at higher interest rates.  This looks fine while the interest is being paid but there might be little or no hope of seeing a return of the principal.  Some of New Zealand's finance company collapses are a good example of this.

So, a bank’s reported profit in any given period is just a best guess of its actual economic profit.  Accounting profit is generally a relatively good approximation, but it can be easily manipulated when calculations become complicated.  The risk is that when company executives are paid large bonuses based on profit numbers, they push the number as high as possible.  Note that there is nothing necessarily illegal or unethical about this behaviour, it is just basic human nature when incentives are poorly aligned. 

And banks regularly fail.  Perhaps the historic tendency for the banking industry to suffer repeated bank crises is due to the overstatement of profits.  This would also result in the overstatement of its capital, and the gradual erosion of its economic capital from overpayment of taxes, dividends and executive bonuses.  At some point this erosion would be so great that a bank would be forced to declare massive impairments and raise capital.  Because banks generally follow similar practices, weakened banks often suffer write-downs at a similar time, resulting in the type of systemic failure that can cause an economic crisis.  This is what the Reserve Bank is attempting to avoid.

Number of countries having a banking crisis in each year since 1800.

Source: Wikipedia, By DavidMCEddy - Own work, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=24677824

While the culture in New Zealand’s banks appears to be better than the culture exposed in Australia, there are poor incentive structures that could encourage this behaviour.  The recently departed ANZ CEO’s woes are a good example.  While our banks’ leaders might have sound economic reasons for their opposition to the Reserve Bank’s proposals, it is also highly likely that their remuneration will be negatively affected by this move.  How easily would you give up a large bonus to mitigate the risk of an event that might not even occur in your lifetime?

Our New Zealand banks are currently very profitable, and it is yet to be seen how they will respond to higher capital requirements.  Their biggest threat to Mr Orr has been that interest rates will rise materially as a result.  But this will only necessarily happen if bank culture remains focused on short-term profit, a culture that the regulators on both sides of the Tasman are trying very hard to change.  In our opinion, extinguishing this culture is far more important than regulating capital limits.  Unfortunately, this is also far more difficult to do.

Love them or loathe them, for now at least, we need our banks.  And we need them to be strong and safe.  This is by far the most important thing.