Banking study reveals familiar regulatory pitfalls

Roger Partridge
NZ Herald
23 May, 2024

When lightning strikes thrice, it is time to take notice.  The Commerce Commission is only partway through its latest market study – this time into personal banking services.  However, it is already evident that regulatory settings are impeding banks’ competitiveness.

It is a story we have heard before.  The Commission’s 2022 report on grocery competition revealed that a toxic combination of land use planning and consenting rules, combined with potential restrictions from foreign investment rules, creates barriers to entry for new competitors.

The Commission’s building supplies study commenced a year later.  It revealed another regulatory problem hindering competition.  Slow, costly, and uncertain processes for approving new and innovative products create barriers to entry for new materials, leading to less competition and higher costs.

Now, it is the turn of the banking industry to have the Commerce Commission expose the harmful regulatory settings that impede its efficiency.

Last week, the Commission’s consultation conference heard submissions on its banking industry study.  As has been widely reported, The Commission’s draft report painted a troubling picture of the Reserve Bank of New Zealand’s approach to prudential regulation.

The draft report makes several recommendations urging the RBNZ to change its practices.  The study suggests that many of the RBNZ’s rules, such as those related to capital requirements, risk weights, and access to funding, have inadvertently deterred competition.

The RBNZ has pushed back against the Commission’s findings.  However, its arguments are unlikely to deter the Commission from concluding that the RBNZ’s approach to prudential regulation is harming competition.

Submissions and commentary on last week’s conference zeroed in on an unsurprising target.  The RBNZ’s 2019 decision to significantly increase banks’ capital requirements was controversial at the time.  With the effects now being felt by banking customers, the policy was always going to come under scrutiny.

The RBNZ’s 2019 decision requires the big four Australian-owned banks – ANZ, ASB, BNZ and Westpac – progressively to raise the capital they hold from 10.5% of their loans to 18%.  Smaller banks will have to hold a minimum of 16% of capital.

In 2021, S&P Global described these requirements as “some of the toughest bank capital standards worldwide.” S&P predicted that “[m]eeting the high requirements [would] likely force New Zealand banks to cut riskier exposure, such as loans to smaller businesses, and require billions of dollars in extra funding.”

The consequences of the high capital ratios deterring lending are of concern enough.  But comparatively, high capital requirements have another important effect.

If banks in New Zealand are required to hold relatively more capital to support their lending activities than elsewhere in the world, they will need to earn relatively higher margins on their domestic loan books to meet their cost of capital.

Higher interest rate margins from higher bank capital requirements mean higher interest rates for borrowers, lower interest rates for depositors, or both.

It is not just bank customers who suffer.  So, too, does the economy as a whole.  When introducing its proposals to double banks’ capital requirements, the RBNZ acknowledged GDP might fall by as much as 0.3% a year.  Other commentators put the annual negative effects on GDP as high as 1%.

While no one would want an unstable financial system, the Reserve Bank’s proposals to double banks’ capital were met with a barrage of criticism.  Much of this, including from The New Zealand Initiative, focused on the absence of a rigorous cost-benefit analysis of the effects of the proposals.

Other critics pointed out that New Zealand’s banks had been subject to regular stress testing and had always come through with flying colours.  And they pointed to the lack of evidence to support the RBNZ’s desire to reduce the risk of bank failure to a one-in-200-year event.

The criticisms raised a crucial issue.  How much prudential regulation is too much?  The RBNZ’s approach was born of a single-minded focus on financial stability.  But financial stability is not an end in itself.  The purpose of banking regulation – indeed, of all regulation – should be to make the community better off than it otherwise would be.

That will only occur if a regulation’s benefits exceed the costs for those affected.  This is what economists call an ‘efficiency test.’ An outcome is not efficient if other arrangements would produce greater net benefits for the community.  

This question should be at the heart of the Commerce Commission’s market study into the banking industry.  And assuming the Commission answers it with a resounding endorsement of an economically efficient approach to regulatory standards, the outcome should have wider ramifications for Parliament.

That is because Parliament itself lost sight of the efficiency requirement when amending the Reserve Bank of New Zealand Act 1989 during the term of the last Government.  The resulting legislation – the Deposit Takers Act 2023 – provides a new framework for the prudential regulation of banks and other deposit takers.  However, the Act’s purpose statement does not even mention efficiency, let alone specify it as the ultimate goal of prudential regulation.

Rather than reducing the risk of regulatory overreach by the RBNZ, unless amended, the new framework will encourage it.

When Parliament first granted the Commerce Commission market studies powers in 2018, The New Zealand Initiative expressed reservations about whether the powers were needed.  We also questioned the absence of robust checks and balances on their use.

Yet, repeated market studies have shone a light in an unexpected direction.  From the grocery sector to building supplies and now personal banking, the inquiries have exposed how well-intentioned regulations can inadvertently harm competition, economic efficiency and overall welfare.

The Commerce Commission’s final report on retail banking should serve as a wake-up call for Parliament to address the RBNZ’s prudential regulatory excesses and prioritise efficiency in the new regulatory framework.

A balanced, efficient, prudential regulatory environment based on cost-benefit analysis will unlock the banking sector and other industries’ potential, promoting competition, innovation, and productivity.

By acting decisively, the Government can ensure that the lightning strikes of regulatory overreach do not continue to wreak havoc on New Zealand’s economy.

To read the article on the NZ Herald website, click here.

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