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What is the position of New Zealand’s big banks?

As another banking crisis looms in Europe, what is the position of New Zealand’s big banks? Are they too big to fail and how safe is your money?

By Stephen Keys

New Zealand’s big trading banks are extraordinarily privileged private sector businesses owned predominantly by foreign shareholders. As publicly traded corporations they exist at the end of the day to extract the maximum amount of profit for their shareholders. Nothing wrong with that in a capitalist economy. Where they differ however from other businesses is their perceived systemic importance, their political connections and the degree of financial leverage they can get away with.

They constitute a protected oligopoly, some would argue they are parasites on the economy and body politic, extracting rent in the form of interest from credit they have created. The big New Zealand and Australian banks are among the most profitable in the world because of their dominant position in their respective marketplaces and fight behind the scenes to protect their position.

They are now so large in proportion to the New Zealand economy, far larger than the US banks are to their home economy, that they have not only made themselves both too big to fail but also potentially too big to bailout. The moral hazard is enormous. In the advent of another serious crisis the “parasites” could very well kill the host.

How safe is your money and the finances of the Government in these circumstances and what are the options open to the New Zealand Government and Reserve Bank to address these issues.

In 2008, at the depth of the aptly named Global Financial Crisis, a major source of New Zealand bank system funding froze as banks worldwide looked suspiciously at each other unsure who was solvent and who was on the verge of bankruptcy. Reluctantly forced into following the lead of their peers overseas, the New Zealand Government and Reserve Bank stepped in to provide both retail deposit and wholesale guarantees and a huge line of credit to prevent the very real risk of a run on the New Zealand banks and to stop them falling into first an illiquid and then an insolvent position.

The banks argue that this was a rare event and that like their Australian parents they were in a far stronger position than their European and US counter parts because they had not been involved in their high risk lending and proprietary trading activity prior to the crisis. New Zealand’s banks may very well be more “vanilla” than many of their foreign counterparts but the real issue is deeper than that. As things stand our banks have thin cash reserves, enough to cover themselves for day to day transactions but woefully inadequate for big protracted market fluctuations like the Global Financial Crisis.

They are able to do this because executives and directors have no “skin in the game” apart from “performance” based share options and bonuses, and an implicit, sometimes explicit guarantee from the taxpayer via the Government that they won’t be subjected to the same market forces that every other business is because of their systemic importance to the economy. Act Party leader, former Reserve Bank Governor and ANZ Director Don Brash admits “The problem is that too many bank directors and bank managers have traded on that belief, and will continue to trade on that belief.”

Admittedly this is not all one way. Governments and the population in general like a buoyant credit system. Lots of easy money means a rising housing market, increased consumer spending and lower levels of business failure. Everyone feels great. The politicians pat themselves on the back knowing the voters are more likely to look kindly on them come the next election, and home and business owners congratulate themselves on their rising net worth.

But the often used party analogy of former Federal Reserve Governor William McChesney Martin is very apt. At some point the adult has to step in and “take away the punch bowl” and everyone has to go home with a hangover of some description. Credit is debt, and too much of it will result not just in a hangover but possible alcoholic poisoning. Ask the Irish, the Argentinians or the Greeks.

Unfortunately the banks themselves are unlikely to be that adult. As Reserve Bank Governor Alan Bollard pointed out in his observations of the GFC in his book Crisis, “In self-interest, banks may encourage New Zealanders to take on more debt than is good for them individually or deliver more external liability than is good for the country.”

If your business is making as much profit as possible from the interest and fees accrued from debt; you know there is an implicit guarantee that the government won’t let you fail and your salary and bonuses are linked to lending and profit growth; wouldn’t you encourage your customers to take out as much debt as they could possibly afford?

Don Brash commenting on bank executive prudence says, “Self regulation works provided the people doing the self regulation have their proverbial's on the line. If they’ve got nothing to lose they’ll gamble with your money if they can. So you have to be in a position where you lose your shirt, you get absolutely thrashed…. If you think there is no downside in taking any position you eliminate any caution or prudence.”

The current banking system has to be seen in the context of the rise of neo-liberal economic policy in the early eighties, Rogernomics included, and the concurrent liberalisation of financial regulations around the world. Banks and global capital were the primary beneficiaries of this. Technological advances, especially computerised trading have accelerated and exacerbated the process. Currencies, bonds, shares, commodities such as oil and milk powder and even debt itself have become tradable poker chips in a global casino economy.

The rules may be rigged in favour of the connected bigger players but no one has any real control of it. The entire system runs on little more than confidence. As Don Brash reminds us on the Y2K scare, “The banks are a peculiar case where they can be bought down not by a technical fault but by a fear of a technical fault. Lose confidence and even the most solvent bank can fail.”

Even the Bankers Association, the lobby group for the banking industry admits the “…balance can be upset if customers lose confidence in the bank. In this event, little will be deposited with it and substantial amounts will be withdrawn, possibly resulting in the ultimate failure of the bank. Therefore, the role the banks play in providing the link between the needs of borrowers and the economy’s need for liquid transactions balances is, as with the payments system, primarily dependent on the public having confidence in the banks.”

David Tripe, Head of Massey University’s Banking Studies Department adds “You have to be extraordinarily careful about trying to warn people. No you don’t want to forewarn people…all you do is give them an opportunity to run on the bank and then those who get the information first get the advantage and those who get the information second lose out. It’s so easy for people to say something the wrong way, have it misconstrued and create problems in the financial markets. It does run very much on confidence.”

The traditional neo-liberal argument has been that for every trade there is a counter party, for every loser there’s a winner. Money just gets shuffled from one pair of “weak” and “inefficient” hands to “stronger” more “efficient” hands – economic Darwinism, creative destruction whatever you want to call it. Nice theory but when the brown stuff starts hitting the fan the big connected guys, like banks, start squealing much louder and in more important ears than everybody else.

Not only that but money starts disappearing from the system rather than being redistributed. Counter parties renege, bankruptcies rise and banks and other financial institutions become illiquid, unable to borrow themselves and to pay out panicking depositors. They can become insolvent as their liabilities, especially bad debts and falling asset prices their remaining good loans are based on overwhelm their balance sheet.

The banks that looked so solid and wealthy in good times, able to operate and generate large profits because of tiny reserves, now cry to the Government and Reserve Bank for assistance, screaming financial Armageddon and systemic collapse. The champions of deregulation and the free market in boom times suddenly want support to protect them from the same market place. Thousands of small, medium and even large business’s fail because they are not “too big”, because they don’t have the ear of the important people in Wellington.

The fear mongering works – it may even be valid - banks have been allowed to become so large, interconnected and systemic. The Reserve Bank and/or the Government steps in to guarantee them in the hope things will come right, or bails them out with loans, moving the liabilities from the bank, their executives and board, to the taxpayer. Banks fail because they do not provision themselves adequately for major downturns. The reason: it allows them to make bigger profits, distribute larger dividends to their shareholders and reward their executives bigger bonuses. Executives and boards know an implicit government guarantee offers no personal risk to themselves apart from reputational. There is also an incentive for politicians to “extend and pretend” or “kick the can down the road”. No one wants to be in charge when everything goes pear shaped.

It is commonly believed by many of us that banks solicit deposits first and then lend out using those deposits as reserves. In reality, as the New Zealand Bankers Association itself points out, “cash balances in bank vaults no longer act as a constraint on bank lending in the way they might have up until the latter part of the 20th century….since 1985, New Zealand Banks have not had any specific reserve requirements applied to their deposit liabilities. This means that, in theory, banks could keep on creating credit and expanding their loan portfolios indefinitely.”

Of course they don’t but the system is self-regulated. If there are no fixed cash reserve requirements the only cash a bank needs to hold is enough in its Reserve Bank account to settle day to day transactions with other banks, though even here it is able to borrow from other banks to make up shortfalls. “Therefore, a prudent bank will only create credit in proportion to the amount of its cash and other liquid reserves”

The key word here is prudent. The banking system in New Zealand is almost completely dependent on the “prudence” of bank executives and boards. But how does this equate with a corporate responsibility to maximise profit and executive remuneration based on profit generation? The simple answer is it doesn’t. As events in the US and now Europe show, big bank executives will push risk to its maximum knowing full well they are regarded as too big to fail.

When the banking system was deregulated in the mid 1980’s the theory was this. Remove most regulations on the banks but also make it clear that they would not be supported by the taxpayer in the advent of failure. The market would provide the required restraint and discipline by punishing poor performance. New Zealand governments since then, at least until the wholesale and retail deposit guarantee scheme of 2008, have not guaranteed banks or their depositors. The expectation of the public is that they will do due diligence on their bank much as they would do on a finance company or any other type of financial product, read its financial disclosure statements and make their own risk assessments.

How many Kiwis realise this and even those who do, how many have the skill or inclination to do so? Can they actually rely on the figures? David Tripe points out “If you look at a bank’s balance sheet you will find a whole lot of figures there…what you don’t know is whether all those assets are really good….This bank looks all right on the surface but it’s very difficult to judge what the real position of a bank is…That can be very problematic”

So we have a banking system where banks are expected to act prudently in their own interest and depositors are expected to do financial analysis of the banks disclosure documents. Both of these expectations are unrealistic. David Tripe notes “the disclosure regime is just not working, simply because the information is not clear or understood”

In a sense we have the worst of all worlds since the 2008 financial crisis, a no man’s land of hashed together policies that are far from black and white. The Reserve Bank is the regulator of New Zealand’s banking system and has always believed that banks should not be guaranteed or bailed out. But because of the financial interconnectedness of the global financial markets and the ease of moving money electronically across borders, Ireland’s guarantee to its banks in 2008 caused a wave of government guarantees around the world, including Australia and New Zealand, as governments worried about capital flight from unguaranteed to guaranteed jurisdictions. How many Kiwis would have actually moved their money isn’t clear but it created a number of problems. When push came to shove the theory of letting markets determine outcomes was dropped like a hot potatoe. It was determined that New Zealand was too small to not go with the international momentum towards taxpayer support for the financial system.

But it was very inequitable. Billions of dollars had been lost by depositors in finance companies prior to late 2008. Those people would have been dismayed to see remaining finance companies included along with banks in the new deposit guarantee scheme. It also created massive moral hazard issues. It is arguable that the big banks did very well out of the guarantee scheme. Money flowed from alternative investments to the safety of the big banks who are now even more dominant in the marketplace than before and in addition it seemed clear that given a similar set of circumstances, whatever Reserve Bank policy, the government of the day would step in and guarantee the trading banks. When the panic button got hit during a crisis all prior intentions were shown to be little more than a paper tiger, over ruled by politicians. Bill English has recently said that the National government supports the Open Bank Resolution (OBR) but ratings agencies may think otherwise. Don Brash feels that New Zealand’s sovereign credit rating is several grades lower than it should be because the ratings agencies see a risk of the government taking on the banking systems debts as per Ireland.

But are the big trading banks really too big to fail? Financial journalist Bernard Hickey thinks so. “Yes our banks are too big to fail. At the moment the Reserve Bank is putting in place a policy that they could fail (OBR) but we haven’t had that tested. The question is are they vulnerable to failure? Well any bank is when there is a run. Our banks have the extra vulnerability in that they rely on hot money markets overseas.”

Outspoken Australian economist Steve Keen, author of the critique of neo classical economics, Debunking Economics, adds a different perspective. “Moral hazard is a major contributor to crisis. Problem is people think the financial sector is essential, but far from essential it’s a parasite. When lending for speculative ends it’s a destructive force in the economy. Every time you rescue it they’ll go back to the same behaviour.”

David Tripe feels the too big to fail perception is one fostered by the banks. “They are actually trying to present themselves as too big to fail but in fact what would happen in the case of failure is that the authorities, the Reserve Bank, in essence need to try and sell them. That’s the sort of process that needs to happen.”

Alan Bollard admitted himself that the banks got through the GFC on luck as much as anything else. “We had no bank collapses, no big government bailouts, no nasty scars. But we have no cause to be smug: it was not by our cleverness that we survived.”

It is important here to differentiate between a liquidity problem - lack of cash for normal transactions; and a solvency problem - lack of cash and shareholder capital, declining asset values and rising loan defaults where liabilities outweigh assets on the balance sheet.

There was no suggestion that New Zealand’s banks were insolvent during the crisis but it wouldn’t take an unlikely set of circumstances to create this situation. As Steve Keen says of the Australian parent banks, “When you’ve got banks effectively geared something in the order of 30:1 it doesn’t take a large downturn to create problems with solvency.”

The Reserve Bank here has identified the problem and is working towards lessening the risk by requiring the banks here to hold higher levels of liquid capital, not cash but assets like bonds and securities that can be quickly converted to cash and also by requiring banks to lessen their reliance on overseas loans, especially the short term 90 day loans that may not be able to be rolled over in a crisis. At the moment about 30% of bank borrowings are sourced from overseas.

The banks respond that they have been stress tested for all these scenarios but not everyone believes them. They are as much about maintaining confidence and allowing politicians to offer soothing words as anything. Steve Keen again; “The stress tests are a joke. The basic problem with them is the way they’re set up – they’re effectively linear….what they don’t look at is where x% change in one area causes an x squared change in the system….negative feedback….so the impact is always worse than the stress tests say it’s going to be.”

David Tripe concurs. “One of the things about stress tests is that often when you look at them they generate results that aren’t particularly alarming. The question I actually start to ask myself is whether they’re actually subjecting banks to the right stress and whether they’re measuring the right stresses. I wouldn’t get too enthused about the reliability of some of those stress tests. To a significant degree I’m with Steve Keen on this.”

The events playing out in Europe at the moment with their banks and the 2008 bailout of the US banking system, all of which had been stress tested, are not confidence inspiring. The Franco/Belgium giant Dexia has only just needed a bailout after comfortably passing stress tests less than 3 months ago.

Nor is the outlook for China promising in the short term. The economy we are so dependent on, directly and via our reliance on the Australian economy (they are our number one and two trading partners) is increasingly looking like a property Ponzi scheme underpinned by unsustainable lending and corruption. Hedge fund manager Jim Chanos has described China as “Dubai times a thousand” and almost no one believes China can maintain its present rates of growth.

Australian house prices too are showing signs of declining and unemployment is on the rise. The New Zealand Government has just had its rating downgraded by Moodys and Standard & Poors and a potential further downgrade is possible for the banks themselves. The European sovereign debt and banking crisis is threatening another round of the GFC and frozen lending markets. Any one of these by itself would not be fatal but these are the linear stress test results Steve Keen is talking about.

So it is not difficult to foresee falling trade with China and Australia causing greater unemployment, causing rising defaults on mortgages, causing falling house prices, lowering bank asset values, restricting lending and prompting further rating downgrades. If this occurs at the same time as interbank lending freezes and the New Zealand dollar plummets and New Zealand banks and their Australian parents cannot roll over their foreign borrowings, all the banks will be in trouble. This perfect storm is far from an unlikely scenario. Bernard Hickey muses “I don’t think you’d have just a slump in housing. You’d have a rise in unemployment, you’d have potential for a rise in interest rates and inflation, a combination of different things that makes it difficult for banks. Just imagine if you had a synchronised downturn in both the NZ and Australian housing markets, that would put those big banks under a lot of stress.” The Prime Minister may be sanguine about any of these occurring but they are all very real threats and each of them could feedback and precipitate or exacerbate the other.

In such a scenario the banks will claim these are exceptional circumstances. They can hardly claim they are unforeseen. The question is do taxpayers stump up guarantees or cash injections to save them as private businesses along with their management or are they put into statutory management or receivership; deposits partially frozen but the payments system maintained intact; management and boards fired and shareholders wiped out, and the bank’s assets sold. Alternatively does the Government nationalise the bank, reorganise it and sell it as a going concern at a later date as the Swedish did during a banking crisis in the 1990’s.

The bank executives will claim systemic importance and push for taxpayer loans or guarantees but as Steve Keen says, and US and European banks have demonstrated, bank executives display remarkable hubris and return to old behaviour as soon as possible. Should taxpayers allow private banks to run low reserves in good times so they can make bigger profits and garner bigger salaries, yet turn to them in bad times for assistance. Or should banks lower their profit expectations and be forced to keep much larger reserves of cash and capital built up in good times for use in bad times. Don Brash now feels “banks unable or unwilling to maintain a high level of high quality capital and a high level of liquidity should be subject to more intensive supervision, with tighter rules restricting the risks which they can incur.” There has been talk in several countries of applying a surcharge to systemically important institutions to build up a financial war chest for use in crises but all the banks have been resisting, again because it reduces profit.

The other option is for the Government and Reserve Bank to clearly state to the banks and the public what the rules are and stick to them. The Reserve Bank is trying to do this with its Open Bank Resolution, a clear set of guidelines about what happens in the advent of a bank failure and receivership. It basically codifies existing policy of closing a bank one day and opening it under statutory management the next with limited access for depositors. There is no guarantee depositors would get all or most of their money back. The Reserve Bank allowing the issuing of covered bonds has further clouded the issue and shunted retail depositors even further down the creditor list.

The most important thing is keeping the payment system functioning and winding up the banks affairs in an orderly fashion and at the same time preventing systemic panic. David Tripe has severe doubts whether this is practical. The common perception amongst the public, especially after the Government’s retail deposit guarantees, even though they were temporary and expire, is that their deposits in the big banks are guaranteed. “The Open Bank Resolution is potentially quite horrifying for the general public. I think they would be overwhelmed by the complexity of it if and when they learned what is intended….They won’t understand it. I think there are serious issues with it.”

Bernard Hickey too points out “the Reserve Bank is trying to remove the moral hazard put in place in 2008. Easy to say but what happens if there is a crisis? Does John Key stand up and say ‘you know what, I’m going to let X bank fail.’ Can you imagine the political pressure?” If National has come out in support and adheres to the Reserve Bank’s belief in market enforced prudence, what of the other parties.

Labour’s spokesman David Cunliffe avoided the question directly in a written response, although he did say Labour instituted the deposit guarantee schemes reluctantly, to avoid capital flight. “The key thing is to make sure it never gets to that point. New Zealand has one of the strongest banking systems in the world due to a heritage of strong regulation, most of it introduced by Labour. The creation of Kiwibank by Labour was in part to lessen our exposure to the Australian-owned banks and to provide an ‘honest player’ to ensure Kiwi customers were getting a fair deal.”

The Green’s spokesperson said they support the OBR in concept to reduce the problem of moral hazard and because the banks are overseas owned corporations, but would likely have some form of maximum deposit guarantee of around $50,000 per account.

ACT has no definitive policy but Don Brash is sceptical whether contagion could be prevented under the OBR and feels if it were enacted on one bank, a temporary blanket guarantee would have to be thrown over the others. “In retrospect I am not sure how practical that would be in a crisis because you would panic depositors in all the other banks.”

The OBR could perhaps work if it was implemented and well publicised in a period of financial calm, not implemented in the middle of a crisis. But it still requires the public to educate themselves and be willing to do their own due diligence on their bank’s risk profile, something which is almost inconceivable for many. How many people read all the fine print on their mortgage or hire purchase agreements for instance? Are you going to ask for, read and understand a bank’s disclosure document? Can we really trust banks not to embellish their financial position?

Regulators are indeed in a difficult position. If they have concerns about a financial institution, any public reservations or warnings would likely result in the very thing they are trying to avoid, a collapse in share price, a run on deposits and a collapse. Catch 22.

The mounting problems in Europe clearly demonstrate the absurd degree to which the financial sector can now hold the rest of any given economy to ransom. Many fear few lessons seem to have been learned from the meltdown in 2008 or the financial crises prior to that. Each time the banking industry, here and overseas quietly goes back to the way they were operating , yet each time the moral hazard and the too big to fail dilemma grows. Steve Keen alleges “The banks still think they’re God….The banks have them (politicians) over a barrel. The more debt they create the more political power they have and at the same time they’re being a drain on the economy.”

Globally, but in New Zealand and Australia too, politicians have decided the problem is simply too big to deal with. Faced with the choice of curbing the banks rampant credit creation, spending a decade or more of adjusting economies back to a position of modest sustainable growth, they have instead opted to continue the debt fuelled high and hope for the best; that time and inflation will miraculously solve the problem. We now have a global banking system which relies on perpetual growth and which threatens to meltdown everytime that “growth” slows let alone falls.

Not only that but the whole house of cards is based on nothing more than confidence. You have to question how stable a system we have when Alan Bollard says of his Parliamentary Select Committee appearance “I knew I might be asked questions about exchange rates, foreign reserves, bank liquidity and a whole range of topics on which straight forward answers could upset the financial markets. The day before the hearing I rang the chairman and explained my concern. He readily understood the dangers and assured me that he would guide the Committee away from dangerous questions in public.”

Neo-liberal governments have let the financial sector, banks especially, become disproportionately large and systemically dangerous. Now they can’t be reigned in without massive economic pain, pain no political party is willing to inflict, yet the alternative is even greater pain and potential economic collapse a bit further down the track. If one or more of New Zealand’s big banks fails it will almost certainly be bailed out regardless of Reserve Bank doctrine. The precedent has already been set and Australia’s recent permanent deposit guarantee scheme threatens a mass exodus of depositors from New Zealand banks to their Australian counterparts. For the Reserve Bank and Bill English to think otherwise is surely naïve. The time to have addressed moral hazard and enforce market discipline on the banks has long since passed, unless they intend to break up the goliaths into smaller less systemic organisations.

Even that champion of the free market Don Brash has altered his purist views. “I was very keen not to acknowledge, even to myself, that any institution was too big to fail, but try as I might I could not escape the conclusion that the closure of any one of the four would have unthinkably grave consequences for the New Zealand economy as a whole, and would not, indeed should not, be tolerated by any New Zealand government” and goes on to say “I have some sympathy with the view of Nassim Taleb, the author of Black Swan, who early in 2009 wrote ‘Nothing should ever become too big to fail…Whatever may need to be bailed out should be nationalised; whatever does not need a bailout should be free, small and risk bearing.’” As one of the architects of the original deregulation, this is a big admission.

But regardless of a government guarantee, bailout or enaction of the Open Bank Resolution, you won’t get any warning from the Reserve Bank or the Government of a bank failure. There won’t be any debate in Parliament. The Finance Minister has extraordinary powers under the Public Finance Act. Depositors will probably be safe. But the taxpayer could bear the burden for decades. That might be notionally rational for a state owned bank but these are massive private corporations arguably undeserving of such largesse. As another financial crisis looms at the same time as our election, it is an opportune time to ask our politicians what they are doing to protect our savings and put our banking system on a sustainable course.


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