No free lunch for reduced risk - Nick Tuffley on the RBNZ capital review

The Reserve Bank has announced its final requirements for higher bank capital.  The increases in capital are aimed at improving NZ’s resilience to a financial crisis i.e. putting in place more insurance against a financial shock impacting on the economy.  That insurance will come with an insurance premium, most obviously in the form of higher than otherwise interest rates.

Bank capital is the safety cushion of the banking system, playing a crucial role in protecting bank depositors and other creditors from losses.  If a bank made loans that weren’t repaid, bank capital is there to absorb the first losses.  Bank depositors would only become exposed if any losses exceeded a bank’s capital holdings.  So the more capital a bank holds, the more protection there is for all the people providing funds to the bank.  The RBNZ’s new capital requirements are intended to ensure NZ banks can survive a 1-in-200 year crisis, a very high safety threshold.

The Reserve Bank’s (RBNZ’s) new capital requirements are for minimum total capital for the four major banks to be at least 18% of banks’ assets (e.g. lending), up from 10.5%. For the remaining smaller banks, it’s now 16%.  In dollar terms, this amounts to upwards of $20 billion for all locally incorporated banks.  The increase in capital will be phased in over 7 years from the start of July next year.  This is a longer timeframe than the originally-proposed 5 years, and will give banks and their customers more time to adjust to the changes.  Nevertheless, some of the key changes will impact the large banks (including ASB) early on.

Capital needs to earn a return, and that return needs to compensate the providers of capital for the risk they are taking through being first on the block to take losses.  Returns on capital are therefore much higher than for term deposits, for example, because shareholders are taking much more risk than depositors in putting money into banks.  So the greater the share of capital that is held by banks, the higher is their overall cost of obtaining funds to lend out to customers. 

The RBNZ’s new capital requirements will further reduce the risk of the sorts of calamities witnessed in countries such as the US, UK, Ireland and Spain during the financial crisis.  But the cost of this added insurance will be some combination of lower deposit rates and higher lending rates than would otherwise be the case.  Over the long term, credit supply is also likely to be a bit slower.

ASB’s economists estimate that the drag on the economy of higher interest rates and slower credit growth over the long term will be roughly 0.3% to 0.8% per annum.  So the reduced risk of a damaging financial crisis does come at the cost of an ongoing “insurance premium”.      

The impact is likely to be different across the various types of lending that banks do, as the RBNZ’s capital requirements depend on the perceived riskiness of each loan.  Capital requirements are low for home loans, particularly those for which the borrower has a high share of their own equity in the home.  In contrast, loans for commercial activities (small/medium enterprises, commercial, corporate and rural) require banks to hold substantially more capital.  The individual creditworthiness of loans matters too.

The new requirements will take time to digest, and ASB will work through what the changes will mean in practice for our customers.  It is also important to remember that the capital increases will be incremental, so the interest rate impacts for customers will occur gradually.

All up, over a period of time the NZ banking system will become even more resilient to the sorts of financial shocks that hit a number of countries during the Global Financial Crisis.  But there is no free lunch, and the reduced risk of a crisis comes at an ongoing economic cost to absorb the higher costs of putting in place the buttress of more bank capital.