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RBNZ urged to take a wider, non-plumbing view of banks

The Reserve Bank focuses too little on the incentives driving bankers, ignores the implied government guarantee that banks benefit from and takes too much of a "plumbing view" of banking, says an American banking professor employed by the central bank to assess its controversial bank capital-holding proposals.

The New Zealand central bank also devotes too little attention to how capital regulations might influence the allocation of credit or the degree to which non-banks will be able to fill any gaps in the provision of credit, Professor Ross Levine from the University of California, Berkeley, argues in a paper that is otherwise generally complimentary about the Reserve Bank's proposals to increase the amount of capital banks have to hold. The RBNZ's work is "first-rate analytically," he says.

He is one of three international experts engaged to critique the proposals, which include lifting the minimum amount of capital the big four banks have to hold from 8.5 percent of risk-weighted capital to 16 percent and to 15 percent for the smaller banks.

"The RBNZ takes a plumbing view of banks; money flows into banks in the form of equity, deposits and debt and flows out to households and firms in the form of loans," Levine says in his paper.

"Besides influencing the amount of credit flowing through the banking system – as stressed by the RBNZ - capital requirements might alter the incentives of bankers and hence how they allocate credit across households and firms," he says.

If decisions within banks are made by those with "more skin in the game" as a result of the higher capital requirements, "this could lead to a reallocation of credit to more prudent endeavours."

If, on the other hand, decisions are made by executives who are compensated with option-type contracts tied to the bank's return on equity, higher capital requirements "might induce executives to reallocate the flow of capital to different, higher-risk ends."

Separately from the bank capital review, the RBNZ and the Financial Markets Authority have conducted a conduct and culture review of financial institutions. The government has also promised legislation that will deal with incentives and remuneration design, among other matters.

Levine takes the view that depositors and debt-holders expect governments will bail them out if banks fail and so, in that way, governments subsidise banks. Banks can then borrow less expensively, hold less equity and take greater risks than if that implied guarantee did not exist.

"While RBNZ might believe that it does not insure bank liability holders, it did insure some of them when the last crisis hit," he notes.

New Zealand is the only OECD country without an explicit government guarantee of bank deposits and the government is currently considering whether to provide such a guarantee as part of the second stage of its review of the Reserve Bank Act.

"This means that government policies – or expectations of policies – tilt the financial system in favour of banks and away from other providers of financial services," Levine says.

So the higher bank capital requirements might allow non-bank financial service providers to emerge.

Since the collapse between May 2006 and 2012 of around 67 finance companies, the role of non-banks in New Zealand's economy has shrunk to negligible proportions. The most prominent survivor is ANZ Bank-owned UDC Finance.

Non-bank institutions had been unregulated and it was only once the collapses began that the Reserve Bank gained regulatory oversight of them.

Levine recommends the RBNZ should "consider the degree to which there are legal, regulatory and policy impediments to the emergence and operation of non-bank forms of household and firm finance," saying the comparatively high profits New Zealand banks make suggests there are barriers to competition.

He also reminds the RBNZ that New Zealand is a small, open economy and that "the global banking system is grossly distorted by the enormous subsidies that governments provide to banks in the form of implicit and explicit guarantees" but that the RBNZ decisions can only have an impact on New Zealand banks.

Levine also suggests the RBNZ should be "more discerning" in its use of international studies.

He also questions whether proposed counter-cyclical capital buffers – CCBs - will work as the central bank expects.

"The background paper that the RBNZ pointed me to argues that: 'To be effective, a positive CCB must be implemented at least one year before risks crystallise.'”

“Is there any evidence of such prescience on the part of bank regulators?" he asks. "Is there any evidence that central bankers implement monetary policy at least one year before financial system risks emerge?"

Such buffers could be used at the wrong time, or not used at the right time, or even abused for political purposes, Levine says.

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