The New Zealand Reserve Bank has announced a review on Bank Capital.
They plan to release a high level Issues Paper in April, outlining the areas of the capital framework that the Reserve Bank intends to examine, followed by more detailed consultation papers. They will be seeking stakeholders’ views in three broad areas: what sorts of capital instruments should qualify (the numerator); how risk exposures should be measured (the denominator); and the minimum capital ratios and buffers.
The Issues Paper will request stakeholders’ initial views on the areas we intend to cover and issues that might warrant particular attention. Further consultation documents with options for changes to the framework and recommended policy positions will be targeted for the third quarter. They plan to conclude the Review by the first quarter of 2018.
The Purpose of the Review
The aim of the Capital Review is to identify the most appropriate regulatory framework for setting capital requirements for New Zealand banks. Consistent with the Reserve Bank’s legislative purposes, minimum capital requirements should promote the maintenance of a sound and efficient financial system. In broad terms, higher levels of capital will improve the soundness of the financial system as the likelihood of bank failures is reduced and the potential impact of credit cycles is moderated.
However, the capital regime may reduce the efficiency of financial intermediation if ratios are pushed too high or standards are made overly complex. Capital is a more expensive form of funding for the banks and so higher capital ratios can potentially increase the overall cost of funding the system as well as improving its soundness.
Our aim is to agree a capital regime that ensures a very high level of confidence in the solvency of the banking system, while avoiding unnecessary economic inefficiency.
In pursuing this objective, the Capital Review will look at the three key components of the regulatory capital regime:
- The definition of eligible capital instruments
- The measurement of risk, in particular the risk weights attached to credit exposures
- The minimum capital ratios and buffers
These three factors are interdependent and the links between them must be carefully considered. The calibration of the capital ratios needs to be set in the context of the risk weights applying to exposures as well as the capacity of eligible capital instruments to absorb losses. Also, the role of capital buffers versus hard minimum requirements needs to be considered.
The Capital Review will examine how well the Reserve Bank’s current framework operates and consider potential improvements. The Reserve Bank will consult the banks and the public on its findings and on any proposed changes to the capital framework.
Outcomes of the Review will be heavily influenced by the international regulatory context, the risk characteristics of the New Zealand system and the Reserve Bank’s regulatory approach.
New Zealand domestic context
The Capital Review will assess how our future capital framework might be shaped by domestic considerations. These relate to New Zealand’s risk profile, the shape of our financial system and also our regulatory approach.
New Zealand’s exports are concentrated in a small number of commodity-based sectors which can be subject to considerable price volatility. Bank exposures to commodity export industries are a key risk in the domestic system. Residential mortgage exposures are also a major source of risk given the system’s heavy exposure to housing and the capacity for house prices to become very stretched – as at present.
New Zealand is a net debtor country, having run current account deficits continuously over the past 40 years. About half of the country’s gross external debt is issued by the New Zealand banking system which then on-lends to businesses and households. This reliance on external funding is an important vulnerability of the New Zealand system, as starkly demonstrated during the GFC. While liquidity buffers must be the first line of defence against funding market disruptions, a strongly capitalised system also helps to mitigate the risk of reduced market access.
New Zealand’s financial system is less diversified relative to peer countries. Financial intermediation is concentrated in a few large institutions and capital markets play a relatively minor role.
Rating agency risk assessments of the large New Zealand banks is heavily influenced by expectations of support from the Australian parent banks. Under the S&P regime, this factor lifts the ratings of the large New Zealand banks by an average of 4 notches from BBB+ on a standalone basis, to AA- , the rating applied to the Australian parents. While the implicit support of the parent banks is valuable for the New Zealand system, it is also a vulnerability. For example, in recent times the Australian parent banks have been on negative outlook and, separately, APRA has placed restrictions on the ability of the parent banks to give credit support to their international subsidiaries. Should implicit parental support be eroded, it is important that our banks be seen as strong on a standalone basis in order to maintain their international standing.
The Capital Review will draw on the emerging international literature on optimal capital and include an assessment of optimal capital that takes account of New Zealand-specific characteristics. The final calibration of capital requirements will also take account of the results and insights from bank stress-testing and other analytical work we are undertaking in support of the Capital Review.
