Few subjects are as dry as prudential regulation. As something that relates to banks, it is not the most obvious topic requiring our attention.
Then there are hurdles created by jargon. Tier 1 capital, Basel III, LVRs – the regulation of banks’ capital requirements has its own language. (And that is before bringing up the current governor’s insistence on likening the Reserve Bank to a Maori tree-god, something to make even the staunchest banking student’s eyes glaze over.)
Yet, scarcely any other policy-setting bears as directly on economic wellbeing than how the Reserve Bank governor regulates banks. The capital ratios have a domino effect on how much borrowers pay in interest, the availability of credit and how much depositors earn on their savings. The governor has his hands on levers that affect the fortunes and futures of us all. Even the finance minister appears to be at the governor’s mercy.
Such power requires extreme prudence. Yet the governor is proposing an enormous gamble. The Reserve Bank is consulting on proposals that will almost double banks’ Tier 1 capital requirements (in essence, the amount of share capital they hold).
The bank’s objective is to improve the soundness of the financial system and reduce the risk of bank failure to a one-in-200-year event. This despite our banks surviving the global financial crisis – and every stress test thrown at them by the central bank since. And despite the Reserve Bank having scarcely a jot of evidence for its one-in-200-year target.
The Reserve Bank itself acknowledges its proposals are likely to see mortgage lending rates rise and GDP fall (by as much as 0.3% a year). The net present value of the cost of the proposals to the economy has been calculated by one central banking expert at $30 billion.
Controversially, nowhere in the Reserve Bank’s consultation documents has the bank evaluated whether the expected benefits of its capital proposals will exceed the expected costs. Without the analysis, the Reserve Bank’s one-in-200-year target is no better than a stab in the dark.
The omission prompted a barrage of criticism following the bank’s release in December last year of the consultation documents supporting its proposals. Since then, the bank has done some back-filling, trying to buttress its arguments with further papers. The most recent, released on April 3, provides more analysis. But it does not purport to provide the missing cost-benefit analysis.
However, the bank has now said it will carry out a cost-benefit assessment for a regulatory impact statement. This puts the cart before the horse. Such a statement is needed to support proposed regulatory action once a decision has been made. But it is no good undertaking this analysis after the bank has decided what to do. An ex-post cost-benefit analysis will not help inform discussion about the advantages and disadvantages of the Reserve Bank’s proposals, nor of the likely winners and losers.
The likely losers
Those sectors most at risk from the Reserve Bank’s gamble are, nevertheless, becoming easier to identify as financial markets participants digest the implications.
The emerging picture is the bank has underestimated the impact of its proposals and that the costs to borrowers, lenders and the wider economy will be more extreme than the bank predicts. Some commentators have put the negative effects on GDP as high as 1% a year.
But, even if the Reserve Bank’s more optimistic predictions prove correct, it is clear some sectors will suffer more serious harm than the bank predicts for the economy.
Those most at risk are borrowers with proportionately higher capital requirements: high loan-to-value first-time house-buyers, rural borrowers and growth businesses. Depositors will also be harmed as bank deposit rates fall as a consequence of the Reserve Bank’s proposals.
In other words, first-home buyers, farmers, SMEs and depositors are the likely losers. And those not directly affected are at risk of bearing the cost of the bank’s proposals through a contraction in GDP.
Against this background, some sort of circuit breaker is needed. The Reserve Bank needs to be jolted from its current course.
There are a few ways this might happen.
First, court proceedings might be brought against the Reserve Bank. When setting banks’ capital requirements, the Reserve Bank is exercising statutory powers. It must be at least arguable that the bank’s refusal to undertake an ex ante cost-benefit analysis is unlawful.
Second, Finance Minister Grant Robertson could intervene. He is in the middle of Phase 2 of reviewing the Reserve Bank of New Zealand Act. That review is evaluating the Reserve Bank’s governance and decision-making arrangements.
The minister could informally request the governor to defer any decision on his capital proposals until after Phase 2 of the review has concluded.
Phase 2 is almost certain to see a strengthening of the Reserve Bank’s governance arrangements. A deferral would allow the governor’s bank capital gamble to be subjected to some independent oversight.
Alternatively, the finance minister could intervene in a more formal way. The minister has power under the act to direct the governor to consider government policy in exercising his prudential regulatory powers.
The minister could exercise this power to require a proper cost-benefit analysis from the bank or to specify a more conventional risk appetite than the governor’s one-in-200-year whim.
Either way, an intervention is needed, and preferably before the governor’s gambling problem harms us all.
Roger Partridge is chairman of the New Zealand Initiative.