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OPINION: The elephant in RBNZ's bank capital room

Wednesday 9th October 2019

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The most surprising thing about the Reserve Bank's proposed new bank capital rules remains that nobody has attempted to explain why we shouldn't believe the results of the RBNZ's own stress-testing of the major banks.

One would think that if RBNZ was planning to force the big four banks to near double their minimum equity as proposed, it would first have to demonstrate why current equity levels are inadequate.

RBNZ governor Adrian Orr came closest to it early this year in responding to a BusinessDesk story examining public stress test results in light of RBNZ's bank capital proposals.

“We emphasise in our public articles that stress testing results should not be read at face value,” Orr said in a letter.

“Both the significant modelling uncertainties, and the fact that the banks know how/when the stress situation ends, limits the value of stress tests,” Orr said.

Such caveats would always apply to any kind of economic modelling, but that doesn't stop economists – or the RBNZ – doing their darndest to try to make sense of the economy through such models.

Everybody knows reality will never precisely match the models, but they at least provide an idea of what might happen, and where the vulnerabilities might lie.

The puzzling thing about the RBNZ's last comprehensive stress test, conducted in 2017, is why its results are supposed to be so unbelievable as to require a doubling of bank capital.

The central bank "kitchen-sinked" that test, throwing every dire circumstance imaginable into the mix.

All four major banks, which account for about 88 percent of New Zealand's banking system, sailed through that test.

One of the independent experts who reviewed the RBNZ proposals, James Cummings of Macquarie University, notes that "the capital ratios of major banks decreased to around 125 basis points above minimum requirements" as a result of that stress test.

In other words, none of the four came even close to eating into their statutorily required capital, and even had a reasonably healthy margin to spare.

To recap, these were the dire circumstances the banks were required to model: house prices plummeting 35 percent, commercial property faring even worse with a 40 percent decline in values, unemployment shooting up to 11 percent and the Fonterra payout to dairy farmers averaging $4.90 per kilo of milk solids, below break-even for the average farmer.

On top of that, the regulator overlaid an industry-wide scandal relating to bad behaviour in mortgage lending, such as customers successfully suing the banks for poor lending practices and failure to abide by the Responsible Lending Code.

“Like previous stress tests, this exercise suggests the major New Zealand banks can, as a group, absorb large losses in a downturn while remaining solvent,” the Reserve Bank concluded at the time.

Of course, it added the proviso that no stress test can predict the actual impact of a severe downturn.

But note that phrase “like previous stress tests.” New Zealand’s big four banks, ASB, Bank of New Zealand, ANZ, and Westpac, all owned by Australia’s big four banks, have passed many tests, all comprehensively with capital to spare.

They were acknowledged as among the world’s strongest banks through the GFC, although Orr is now rubbishing that fact, and effectively trying to rewrite history.

The notion that the Australian banks "sailed" through the GFC and saved New Zealand's economy "is just wrong. They didn't sail through. They were last cab off the rank. They were 100 percent government guaranteed. New Zealand had about a $120 billion underwrite for the banks," Orr told Radio New Zealand.

He didn't mention that the banks paid insurance premiums for that guarantee, which was forced on the New Zealand government by the Australian government.

And the truth is the local banks didn't have a capital problem then. They had a liquidity problem.

That was because credit markets around the world seized up almost completely for a time and, back then, the big four banks had borrowed short in wholesale markets to lend long on mortgages and other loans in the mistaken belief that global financial markets would always remain liquid.

Orr says the RBNZ had to buy $8 billion of bank assets "overnight, almost blind" to provide bank liquidity and savagely cut interest rates. "They sailed through because everyone else was paddling like mad," Orr said.

The RBNZ has long since dealt with the liquidity question, forcing the banks to lengthen the tenure of their wholesale borrowing from offshore, which has fallen to about 22 percent of funding from about 35 percent when the GFC hit, and to rely more heavily on domestic deposits.

It's also worth remembering that the minimum tier one capital requirement for banks pre-GFC was just 4 percent of risk-weighted assets. The minimum is now 8.5 percent and the RBNZ is proposing to raise that to 16 percent for the four major banks and 15 percent for the smaller banks.

It's also worth comparing the conditions the 2017 stress test modelled to what actually happened in NZ during the GFC: house prices fell about 15 percent, less than half the test scenario, and then recovered rapidly.

The unemployment rate peaked at 6.7 percent – although it did rise above 11 percent in 1991/92 following former finance minister Ruth Richardson’s catastrophic “Mother of all Budgets.”

And the Fonterra farmgate milk price fell from $7.59 a kilo of milk solids in 2007/08 to $4.75 the following year, but had recovered to $6.10 by 2009/10.

It did fall as low as $3.90 a kilo in the 2015/16 season – the average farmer needed about $5 a kilo to break even back then.

In fact, RBNZ ran a stress test in late 2015 to find out what would happen if the dairy payout fell to $3 a kilo of milk solids in 2015/16, remained under $5 until the 2019/20 season, and land prices fell 40 percent over that period.

The conclusion: “The banking system is robust to a severe dairy stress test,” the Reserve Bank said then.

So, are RBNZ's bank capital proposals a solution in search of a problem?


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