RBNZ Consults On Revised Capital Adequacy Changes

The Reserve Bank NZ, has issued a Consultation Paper: Review of the Capital Adequacy Framework for locally incorporated banks: calculation of risk weighted assets.

This is the third consultation document of the review. The first document provided an overview of the review. The second document considered the definition of capital, which is the numerator in the minimum regulatory capital ratio. This document is concerned with the denominator in the minimum capital ratio, which is effectively a measure of exposure to risk.

They highlight further issues with the internal calculation method, as well as recent changes from the Basel Committee.

There is international and New Zealand evidence that minimum capital requirements went down significantly after banks were permitted to use their internal models for parts of the capital calculation. There is also international evidence that internal model outcomes are inconsistent. Different banks often come up with similar rankings of risk but the absolute levels of risk are substantially different even for the same obligors. The evidence is clearest in the case for exposures to governments, banks, and large corporations, but there is also some evidence of problems in other portfolios such as residential mortgages and SME lending.

The Basel Committee had proposed to replace the IRB approach with the standardised approach for bank and large corporate exposures, and with a standardised or semi-standardised approach for all specialised lending to corporates. The finalised framework did not go this far – it continues to allow a more limited form of IRB modelling, the Foundation IRB (F-IRB) approach, for bank and large corporate exposures. The new framework does, as originally proposed, constrain the outputs of internal models and impose an overall floor – based on the risk assessed under the standardised approach – on the average risk weight, to prevent it from straying too far from a common level.

Specifically, there are currently significant differences between the two approaches. Banks with internal models have a significant capital advantage.

They table options for both internal and standard approaches, as below.

 

Reserve Bank NZ to ease LVR restrictions

The Reserve Bank NZ has announced a slight reduction in tight loan to value lending controls, in response to the slowing housing sector and Government policy.  The loan-to-value ratio (LVR) policy was first introduced in October 2013, with progressively tighter restrictions for investors introduced in November 2015 and October 2016.

New Zealand’s financial system remains sound and risks to the system have reduced over the past six months, Reserve Bank Governor Grant Spencer said today when releasing the Bank’s November Financial Stability Report.

“Momentum in the global economy has continued to build over the past six months, reducing near-term risks to financial stability. However, the New Zealand financial system remains exposed to international risks related to elevated asset prices and high levels of debt in a number of countries.

“Domestically, LVR policies have been in place since 2013 to address financial stability risks arising from rapid house price inflation and increasing household debt. These policies have helped improve banking system resilience by substantially reducing the share of high-LVR loans. Over the past six months, pressures in the housing market have continued to moderate due to the tightening of LVR restrictions in October 2016, a more general firming of bank lending standards and an increase in mortgage interest rates in early 2017.

If there was a major housing market correction or economic downturn, then this reduction in the share of lending at high LVRs is likely to mean that fewer housing loans would default, and overall bank losses would be lower. One way of quantifying this is to use data from recent stress tests to estimate how the change in banks’ portfolios would affect default and loss rates for a given downturn scenario. Based on the 2017 stress test scenario we estimate that banks would experience around 10 percent lower default rates and around 20 percent lower credit loss rates than they would have if LVR restrictions had not been applied .

In the media conference the bank said $54bn of new OO were written over the past year, but there is no data on the number of additional applications which may flow now. They expect some increase in new loans at higher LVR’s but as the banks use their own buffers the bank is not expecting a large rise, but it could benefit first time buyers. They called this an incremental change, and they will continue to review the LVR restrictions – there is no schedule to move to no restrictions.  This is also a reaction to Government policies which will cool the market. They expect property investors to remain on the “back foot”, with lower future price gains now observed.

“Housing market policies announced by the Government are also expected to have a dampening effect on the housing market.

“In light of these developments, the Reserve Bank is undertaking a modest easing of the LVR restrictions. From 1 January 2018, the LVR restrictions will require that:

  • No more than 15 percent (currently 10 percent) of each bank’s new mortgage lending to owner occupiers can be at LVRs of more than 80 percent.
  • No more than 5 percent of each bank’s new mortgage lending to residential property investors can be at LVRs of more than 65 percent (currently 60 percent).

“The Bank will monitor the impact of these changes and will only make further LVR adjustments if financial stability risks remain contained. A cautious approach will reduce the risk of resurgence in the housing market or deterioration in lending standards.

Deputy Governor Geoff Bascand said “Looking at the financial system more broadly, the banking system maintains adequate buffers over minimum capital requirements and appears to be performing its financial intermediation role efficiently. The recovery in dairy commodity prices since mid-2016 has supported farm profitability and has helped to reduce bank non-performing loans in the sector. Recent stress tests suggest that banks are well positioned to withstand a severe economic downturn and operational risk events.

“The Bank has released two consultation papers on the review of bank capital requirements and a third paper on the measurement and aggregation of bank risk will be released shortly. The aim of the capital review is to ensure a very high level of confidence in the solvency of the banking system while minimising complexity and compliance costs.

“The Bank has also completed a review of the bank directors’ attestation regime and is making good progress in implementing a new dashboard approach to quarterly bank disclosures. This is expected to go live next May,” Mr Bascand said.

Westpac capital requirements increased after breaching regulatory obligations

The Reserve Bank in New Zealand says that Westpac New Zealand Limited (Westpac) has had its minimum regulatory capital requirements increased after it failed to comply with regulatory obligations relating to its status as an internal models bank.

Internal models banks are accredited by the Reserve Bank to use approved risk models to calculate how much regulatory capital they need to hold. Westpac used a number of models that had not been approved by the Reserve Bank, and materially failed to meet requirements around model governance, processes and documentation.

“This is very disappointing. Operating as an internal models bank is a privilege that requires high standards and comes with considerable responsibilities. Westpac has not met our expectations in this regard,” Reserve Bank Deputy Governor and Head of Financial Stability Geoff Bascand said.

The Reserve Bank required Westpac to commission an independent report into its compliance with internal models regulatory requirements. The report found that Westpac:

  • currently operates 17 (out of 35) unapproved capital models;
  • has used 21 (out of 32) additional unapproved capital models since it was accredited as an internal models bank in 2008; and
  • failed to put in place the systems and controls an internal models bank is required to have under its conditions of registration.

The Reserve Bank has decided that Westpac’s conditions of registration should be amended to increase its minimum capital levels until the shortcomings and non-compliance identified in the independent report have been remedied.  Westpac’s minimum capital ratio requirements will be 6.5 percent for Common Equity Tier 1 capital, 8 percent for Tier 1 capital and 10 percent for Total capital, with the additional 2.5 percent capital conservation buffer applying.  Currently, for all other locally incorporated banks capital ratios are set at, respectively, 4.5 percent, 6 percent and 8 percent, plus the 2.5 percent buffer.

In addition, the Reserve Bank has accepted an undertaking by Westpac to maintain its total capital ratio above 15.1 percent until all existing issues have been resolved.  The Reserve Bank has given Westpac 18 months to satisfy the Reserve Bank that it has sufficiently addressed those issues or it risks losing accreditation to operate as an internal models bank.

“We believe the regulatory action is appropriate given the seriousness of Westpac’s non-compliance and the need to protect the integrity of the capital regime,” Mr Bascand said.

The Reserve Bank has taken into account that Westpac has not deliberately sought to reduce its regulatory capital. While there have been serious shortcomings and  non-compliance, it appears that Westpac has remained well above its required regulatory capital levels.

Westpac has confirmed that it does not dispute the findings of the independent report, that it is committed to remedying all the issues identified, and that it will maintain its total capital ratio above 15.1 percent.

RBNZ Holds Cash Rate At 1.75%

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent. They are projecting higher rates ahead.

Global economic growth continues to improve, although inflation and wage outcomes remain subdued.  Commodity prices are relatively stable.  Bond yields and credit spreads remain low and equity prices are near record levels.  Monetary policy remains easy in the advanced economies but is gradually becoming less stimulatory.

The exchange rate has eased since the August Statement and, if sustained, will increase tradables inflation and promote more balanced growth.

GDP in the June quarter grew broadly in line with expectations, following relative weakness in the previous two quarters.  Employment growth has been strong and GDP growth is projected to strengthen, with a weaker outlook for housing and construction offset by accommodative monetary policy, the continued high terms of trade, and increased fiscal stimulus.

The Bank has incorporated preliminary estimates of the impact of new government policies in four areas: new government spending; the KiwiBuild programme; tighter visa requirements; and increases in the minimum wage. The impact of these policies remains very uncertain.

House price inflation has moderated due to loan-to-value ratio restrictions, affordability constraints, reduced foreign demand, and a tightening in credit conditions.  Low house price inflation is expected to continue, reinforced by new government policies on housing.

Annual CPI inflation was 1.9 percent in September although underlying inflation remains subdued.  Non-tradables inflation is moderate but expected to increase gradually as capacity pressures increase.  Tradables inflation has increased due to the lower New Zealand dollar and higher oil prices, but is expected to soften in line with projected low global inflation.  Overall, CPI inflation is projected to remain near the midpoint of the target range and longer-term inflation expectations are well anchored at 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain and policy may need to adjust accordingly.

Banks Need To Grow Deposits In Line With Credit

The Reserve Bank New Zealand has published an Analytics Note entitled “Diving in the deep end of domestic deposits“.   They conclude that banks may need to limit credit growth unless they are able to grow retail deposits in line with credit growth.

Deposits are an important part of the New Zealand financial system. Deposits play a large role in funding bank lending – banks try to attract deposits in order to build up funds to lend out to borrowers. Over the past couple of years, lending has been growing faster than deposits, requiring banks to source funding from offshore wholesale funding markets. External funding can increase risks in the financial sector, as deposits are typically a more stable (“core”) source of funding than offshore wholesale funding.

This paper explores deposit growth in New Zealand in order to answer two questions:

1) What factors drive deposit growth in New Zealand, particularly in the past few years?

2) Can banks increase deposits by increasing interest rates?

We use two models to explore the dynamics of household deposits in New Zealand’s banking system in order to answer these questions. The first model uses bank-specific data from New Zealand’s four largest banks, while the second uses aggregate data for the entire banking system.

The paper highlights that the rate of domestic deposit growth has varied significantly since the Global Financial Crisis, and sharply slowed over 2016. We provide evidence that a range of supply and demand factors influence deposit growth, and that the recent slowing was largely driven by a reduction in supply (that is, households wanting to allocate less money to deposit products). We also find that banks increased their demand for deposits in late 2016 in an effort to close the gap between deposit growth and lending.

We also consider the degree to which banks are able to increase deposit growth materially by raising interest rates. We find that a 1 percentage point increase in the six-month deposit rate can increase the level of household deposits by about 1 percent after four quarters, and by 1.3 percent in the long-run.

As we find that deposits are not strongly responsive to interest rates, if banks wish to maintain robust funding profiles by not becoming too reliant on offshore wholesale funding, they may need moderate credit growth or use a combination of approaches to bring deposit growth in line with credit growth.

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

Does past inflation predict the future?

Interesting Analytical Note from the Reserve Bank New Zealand. They have recently changed their modelling of inflation, preferring to use past data rather than a two year prediction because despite low unemployment, inflation has remained lower than would be expected on the old method. This suggests monetary policy needs to be more stimulatory than expected .

Forecasts of non-tradables inflation have been produced using Phillips curves, where capacity pressure and inflation expectations have been the key drivers. The Bank had previously used the survey of 2-year ahead inflation expectations in its Phillips curve. However, from 2014 non-tradables inflation was weaker than the survey and estimates of capacity pressure suggested. Bank research indicated the weakness in non-tradables inflation may have been linked to low past inflation and its impact on pricing behaviour.

This note evaluates whether measures of past inflation could have been used to produce forecasts of inflation that would have been more accurate than using surveys of inflation expectations. It does this by comparing forecasts for annual non-tradables inflation one year ahead. Forecasts are produced using Phillips curves that incorporate measures of past inflation or surveys of inflation expectations, and other information available at the time of each Monetary Policy Statement (MPS). This empirical test aims to determine the approach that captures pricing behaviour best, highlighting which may be best for forecasting going forward.

The results show that forecasts constructed using measures of past inflation have been more accurate than using survey measures of inflation expectations, including the 2-year ahead survey measure previously used by the Bank. In addition, forecasts constructed using measures of past inflation would have been significantly more accurate than the Bank’s MPS forecasts since 2009, and only slightly worse than these forecasts before the global financial crisis (GFC). The consistency of forecasts using past-inflation measures reduces the concern that this approach is only accurate when inflation is low, and suggests it may be a reasonable approach to forecasting non-tradables inflation generally.

From late 2015, the Bank has assumed that past inflation has affected domestic price-setting behaviour more than previously. As a result, monetary policy has needed to be more stimulatory than would otherwise be the case. This price-setting behaviour is assumed to persist, and is consistent with subdued non-tradables inflation and low nominal wage inflation in 2017.

Figure 6 shows the average 1-year ahead forecast of non-tradables inflation for the measures of past inflation and surveys of inflation expectations. The range of forecasts produced by the models is currently large relative to history, perhaps reflecting differences between the surveys of inflation expectations and measures of past inflation. The two most accurate measures (shown by the red lines) suggest non-tradables inflation will be between 2.5 and 3 percent in 2018 – similar to the forecast in the August 2017 MPS and only a little higher than the latest outturn of 2.4 percent in the June quarter 2017.

Conclusion

Non-tradable inflation has been surprisingly weak since 2014. Phillips curves with the survey of 2-year ahead inflation expectations suggest non-tradables inflation should have risen by more than we have seen, given the level of the unemployment rate and the Bank’s estimates of the output gap. This note shows that using measures of past CPI inflation instead of surveyed inflation expectations would have produced more accurate forecasts of non-tradables inflation, although not all of the weakness in non-tradables inflation would have been predicted.

The Bank has adjusted its forecasting models to better capture the role of past inflation, moving away from using the survey of 2-year ahead inflation expectations to underpin its forecasts

The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

NZ Holds Official Cash Rate 1.75 percent

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has continued to improve in recent quarters. However, inflation and wage outcomes remain subdued across the advanced economies and challenges remain with on-going surplus capacity. Bond yields are low, credit spreads have narrowed and equity prices are near record levels.  Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has eased slightly since the August Statement.  A lower New Zealand dollar would help to increase tradables inflation and deliver more balanced growth.

GDP in the June quarter grew in line with expectations, following relative weakness in the previous two quarters.  While exports recovered, construction was weaker than expected.  Growth is projected to maintain its current pace going forward, supported by accommodative monetary policy, population growth, elevated terms of trade, and fiscal stimulus.

House price inflation continues to moderate due to loan-to-value ratio restrictions, affordability constraints, and a tightening in credit conditions. This moderation is expected to continue, although there remains a risk of resurgence in prices given population growth and resource constraints in the construction sector.

Annual CPI inflation eased in the June quarter, but remains within the target range. Headline inflation is likely to decline in coming quarters, reflecting volatility in tradables inflation.  Non-tradables inflation remains moderate but is expected to increase gradually as capacity pressure increases, bringing headline inflation to the midpoint of the target range over the medium term.  Longer-term inflation expectations remain well anchored at around two percent.

Monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly.

Central Bank Inflation Targetting

The Reserve Bank of New Zealand has published a Bulletin article on “An international comparison of inflation-targeting frameworks“. The article compares the inflation-targeting frameworks of 10 advanced economy central banks.

The Reserve Bank of New Zealand (‘RBNZ’) began targeting inflation as a mechanism to ensure price stability in 1988. The RBNZ’s inflation target framework was then formalised with the Reserve Bank of New Zealand Act (1989) and when the first Policy Targets Agreement (‘PTA’) was set in 1990. The Bank of Canada was the second central bank to target inflation, in order to achieve price stability, in 1991. Since then inflation targeting has become internationally regarded as a conventional monetary policy framework. Inflation-targeting frameworks have continued to evolve based on individual country experiences; consequently it is useful to periodically compare the formal and informal inflation-targeting frameworks across advanced economies and understand the key similarities and differences. A previous article by Wood and Reddell (2014) compared the goals for monetary policy across inflation-targeting countries by focusing on primary legislation. This article expands on that analysis by comparing the inflation-targeting frameworks, including informal frameworks, with actual practices.

This article compares the frameworks and practices of 10 advanced economies that employ either full or partial inflation targeting.  This includes six ‘fully fledged’ inflation-targeting central banks: Reserve Bank of New Zealand, the Bank of England (‘BoE’), Norges Bank, the Bank of Canada (‘BoC’), the Reserve Bank of Australia (‘RBA’), and Sveriges Riksbank (‘Riksbank’). These banks explicitly target inflation over a specified time frame in order to achieve price stability, have monetary policy independence, regularly announce monetary policy decisions, and are accountable for policy decisions. Several large central banks also use elements of inflation targeting without either explicitly announcing an inflation target, or they have other objectives alongside low and stable inflation. These are the European Central Bank (‘ECB’), the Swiss National Bank (‘SNB’), the United States Federal Reserve (‘Fed’), and the Bank of Japan (‘BoJ’). Given their importance to international monetary policy, we also assess their frameworks and practices.

The comparison covers five components of an inflation-targeting framework: inflation target definition, communication of monetary policy, secondary considerations5, assessment of the inflation-targeting performance, and framework reviews and revisions. The comparison reveals four key findings.

  1. Despite large differences across inflation-targeting frameworks, the central banks operate and communicate monetary policy similarly.
  2. The central banks pursue forward-looking inflation targets and produce reports that support ex ante and ex post performance
  3. The central banks take account of secondary considerations when setting monetary policy, but not all inflation-targeting frameworks detail how central banks should make these secondary considerations, particularly with regard to financial stability.
  4. Several countries have published reviews of and made revisions to their inflation-targeting frameworks. However, the revisions to the frameworks are not always based on recommendations from published reviews.

The most striking observation from the paper however is the fact that most of the central banks do not expect inflation to return to target any time soon.

This would imply lower interest rates for longer, despite asset price bubbles. This begs the question, is inflation targetting really good and effective policy?

New Factors Play Into Central Bank Forecasting

An external central banking expert has commended the New Zealand Reserve Bank’s forecasting and monetary policy decision -making processes. However, two areas are recommended for further analysis. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.

As part of good practice peer review, the Bank regularly commissions reviews by external experts of its forecasting and monetary policy decision-making processes.  It has modified its processes over the years in light of their findings.

Dr Philip Turner, former Deputy Head of the Monetary and Economic Department and a member of Senior Management of the Bank for International Settlements (BIS), was requested to attend the February 2017 forecasting round, report on his assessment of the process, and make recommendations where relevant.

Dr Turner comments that, in seeking to “avoid unnecessary instability in output, interest rates and the exchange rate”, the Bank’s mandate is realistic about what monetary policy can achieve.

“This mandate would not have been fulfilled in recent years, given the large shocks to international prices, by trying to keep the year-on-year inflation rate in New Zealand at close to 2 percent.  To have achieved this, interest rates would have had to move by more than they have in recent years, and this would have created the unnecessary instability in output and the exchange rate that the RBNZ is enjoined to avoid.”

Dr Turner says it was clear that the Bank’s Monetary Policy Committee, which advises the Governing Committee on the monetary policy decision, has in its sights key questions about what might be called the ‘new normal’ for monetary policy.

These include the lower natural or neutral rate of interest; the increased responsiveness of aggregate demand to any change in interest rates; and how macro-prudential policies will affect monetary policy.

He says that the Bank’s open working-level culture of challenging views or arguments in a constructive and professional way enables the Bank to avoid ‘policy blind spots’.

“The whole forecast round has been engineered to bring to bear a full range of economic analyses and to ensure an open and comprehensive debate.”

Dr Turner recommended further work on two topics.

“Both are on the radar screens of RBNZ economists. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.”

Dr Turner concludes: “Results over the past few years speak for themselves.  The RBNZ has helped steer its economy through several large external shocks.  Because it has done so without becoming trapped at a zero policy rate and without multiplying the size of its balance sheet by buying domestic assets, it has retained more room to pursue, if needed, a more expansionary monetary policy than is available at present to many central banks of other advanced economies.”

RBNZ Considers The Australian Connection

One really interesting observation from the recent IMF review of New Zealand’s financial system was the structural inter-dependency with financial services in Australia, not least because much of the banking footprint in NZ stems from Australian parent companies. Now the Reserve Bank in New Zealand has published its response. The Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The IMF recommends a number of steps to strengthen institutional arrangements, define responsibilities, and to clarify the objectives necessary to support the operational independence of New Zealand’s financial regulators. These recommendations cover prudential regulation and supervision, crisis management, and macro-prudential policy.

The IMF notes that the Reserve Bank, as a financial regulator, must have a suitable distance between itself and the executive branch of government. Independence is a necessary pre-condition for optimal policy and supervisory outcomes, albeit this needs to be supported by a robust framework that holds the Reserve Bank accountable to both government and the public.

Cooperation with Australian authorities

The IMF recommends strengthening collaboration and cooperation with the Australian authorities in order to recognise the important interdependencies between the two financial systems. The IMF recognise that there are already well-developed working relationships between the New Zealand authorities and their Australian counterparts.

This is reflected in on-going supervisory contact between the Reserve Bank and its counterpart in Australia, as well as through forums such as the Trans-Tasman Banking Council (TTBC) which is a body comprising various New Zealand and Australian agencies.

Reserve Bank response

The Reserve Bank has already begun the process of reviewing all the relevant findings and recommendations. The initial focus is on the extent to which greater alignment with international orthodoxy – as envisaged in most of the recommendations – might further contribute to the Reserve Bank’s statutory objectives tied to the promotion of a sound and efficient financial system.

The Reserve Bank continues to believe that its three-pillar framework, and an emphasis on self- and market discipline, has served New Zealand well. That said, there are a number of recommendations that, if adopted, may support financial system outcomes and the statutory purpose of the Reserve Bank.

In this regard the Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The Reserve Bank will work with the Treasury to consider those recommendations tied to the ‘institutional boundary’ question in order to preserve and enhance a suitable degree of operational autonomy.

More generally, the Reserve Bank will be closely examining those recommendations that taken together may enhance the three-pillar approach to regulation and supervision. Elements of this model could include more independent verification or validation of information provided by regulated institutions, and a greater use of thematic reviews.

Other elements of this enhanced BAU model could include more clearly articulated (and enforceable) policy requirements, a re-emphasis on conservative and simple regulatory settings, and a more systematic and consistent approach to disclosure in the insurance sector. The review of the bank attestation regime currently in progress is likely to provide some insights into the value of the attestation process, how it could be enhanced and possibly how it could be applied to other sectors the Reserve Bank supervises.

The Reserve Bank will provide quarterly reporting, along with other agencies, to the Minister on progress in implementing FSAP findings and recommendations via CoFR.