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RBNZ plucks bank capital numbers out of the air: Reddell

Tuesday 22nd January 2019

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The Reserve Bank is discrediting its own evidence and plucking numbers out of the air in justifying its proposed bank capital requirements, former Reserve Bank official Michael Reddell says.

The central bank’s stress tests of the major banks published in late 2014 “were very stringent, using an increase in the unemployment rate larger than any seen in any floating exchange rate country in at least 30 years,” Reddell says in his Croaking Cassandra blog.

For that scenario, the Reserve Bank assumed a sharp slowdown in China’s economy triggered a double-dip recession with real GDP declining about 4 percent and the unemployment rate peaking at more than 13 percent.

The scenario had house prices falling 40 percent nationally and even more in Auckland and a 40 percent fall in agricultural land prices and a 33 percent fall in commodity prices.

“It is right that stress tests are stringent – the point is to test whether the system is robust to pretty extreme shocks – but these ones certainly were. And yet not a single one of the big banks lost money in a single year,” Reddell says.

None of the banks even had to raise new capital under that scenario.

Reddell was still working for the Reserve Bank when that study was published – he was made redundant in April 2015 – and says he was among the central bank’s sceptics about the stress test results.

“I vividly recall a seminar in which various sceptics – me included – pushed and prodded, unconvinced that the results could possibly be as good as they appeared to be. But, various iterations later, the broad picture of the results stood up to scrutiny.”

The Reserve Bank is proposing that the big four banks will have to lift their tier 1 capital, or equity, to a minimum of 16 percent of risk-weighted assets during the next five years from the current 6 percent minimum. All four of the big banks already hold significantly more capital than the current minimum.

The central bank published its proposals on Dec. 14 and submissions close on March 29.

Bank economists have warned the proposed increases are so large that they risk slowing growth. Last week, UBS said the extra funds banks would need to hold could add between 0.8 and 1.25 percentage points to home mortgage rates.

The most recent stress test published in 2017 featured a slightly less dire scenario in which house prices fell 35 percent, commercial and rural property prices fell 40 percent, unemployment peaked at 11 percent and the Fonterra milk payout to farmers was below the average farmer’s break-even point.

“If this test was less demanding regarding the fall in house prices, it not only explicitly assumes huge losses in asset values across the full range of types of collateral banks take in their lending, but also imposed material increases in funding costs …. and required banks to keep on growing their lending through a savage recession,” Reddell says.

“Overall, the test is likely to materially overstate the potential loan losses in an economic downturn of this sort because large dairy losses and large housing/commercial losses are highly unlikely to occur at the same time.”

That’s because in any serious adverse economic shock, both interest rates and the exchange rate are likely to fall – typically, a long way. That would act as a huge buffer to the dairy payout, even if global dairy prices fall a long way in an international recession.

“Again, no bank made losses and no bank fell below the minimum capital requirements,” Reddell says.

And then there’s the last big actual stress test, the GFC.

“Going into that recession, the Reserve Bank had been becoming increasingly uneasy about bank balance sheets,” he says.

“The 2008/09 recession was pretty severe and quite a bit of poor-quality lending was revealed – especially in the dairy sector. And yet, of course, the banking system came through that shock substantially unscathed.”

New Zealand house prices fell about 15 percent after inflation through the GFC and the unemployment rate peaked at 6.7 percent.

“You’d have thought the Reserve Bank couldn’t have it both ways. Sure, the most recent stress test results are now two years old but they’ve spent the last few years telling us that they are pretty comfortable with lending standards – especially after imposing their LVR (loan-to-valuation ratio) controls,” Reddell says.

“There is no credible story they can tell – and they haven’t even tried – as to how robust balance sheets in 2017 are now such as to make it imperative – using the coercive power of the state – for banks to have much higher capital ratios again.”

The Reserve Bank has repeatedly cited evidence from the United States, Spain and Ireland during the 2008/09 crisis “to imply that there is something wrong with the stress test results, rather than drawing the more obvious conclusion that they say something good about the health of the New Zealand and Australian banking systems,” Reddell says.

While Reserve Bank governor Adrian Orr has stressed the inherent limitations of stress tests, Reddell says that’s one reason to be as transparent as possible about the tests so that users can evaluate for themselves how demanding the central bank has been. He would like to see the Reserve Bank publish the results for each of the four major banks, for example.

Despite the repeated stress test results, the Reserve Bank has proposed capital requirements that "despite pages and pages of the document – are really just plucked out of the air.”

(BusinessDesk)



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