The Reserve Bank of New Zealand has definitely caused some trouble with its latest bank capital consultation document. It suggests a considerable increase in the minimum regulatory capital required by banks incorporated in New Zealand.

It has led to a lot of discussions among economists, financiers and many others (lawyers are not an exception).  The bank has received 164 submissions. This degree of involvement in what could be found by many as a very dry subject could only be a positive sign for the country.

The consultation paper proposes the following:

  • To increase the conservation buffer from 2.5% to 7.5% (this is in fact the margin of safety banks must hold over minimum capital);
  • To introduce an extra 1% buffer for the large banks operating in New Zealand;
  • To increase the counter-cyclical capital requirement from 0% to 1.5% (this is the capital that the Reserve Bank uses to ease the ups and downs of business cycles.  Banks’ capacity to lend is restricted in a ‘boom’ cycle by increasing capital. This condition is then eliminated in a ‘bust’ cycle).

This indicates a 7.5% increase on the regulatory capital the big banks currently must have and 6.5% for the smaller banks.  While the majority of the banks in New Zealand far exceed the current minimums, the size of this increase indicates that in fact all of them will have to raise more capital once it is implemented.

However, the Reserve Bank is technically making raising this capital more challenging at the same time.  This is due to, following a prior consultation paper, a key decision to deprive some forms of capital of counting towards minimal regulatory capital.

Hence, on the one hand the Reserve Bank is suggesting to increase minimal capital requirements for banks while, on the other hand, it has taken a decision in principle to ban certain types of capital that could be used to fulfill these requirements. 

The Reserve Bank is suggesting to disqualify contingent debt and some types of preference shares.  The Reserve Bank has given a very thorough consideration to this matter. However, the legal reasons given, such as the risk of mis-selling and concerns about the instruments not complying their legal terms on insolvency, seem to be too conservative. 

Both of these types of capital meet the requirements for regulatory capital allowed by the Bank of International Settlement.  Both of them are well understood in capital markets internationally and providing access to it gives banks the chance to access capital from a wider range of investors.

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Given New Zealand’s new and well improved financial product disclosure, conduct and licensing regimes, as well as the effectiveness of the Financial Markets Authority in monitoring and enforcing these regimes, the risks related to these types of capital seem to be quite low.  We believe that the risk of ‘mis-selling’ these capital instruments by highly regulated issuers, would be definitely low. Moreover, there seems scant justification for concerns that these types of capital instruments may not behave according to the legal terms. New Zealand’s insolvency law is well established and aligned with international laws.  The Reserve Bank itself has wide power and discretion on bank insolvencies to guarantee that instruments indeed operate in compliance with their terms.

We also consider any 'market overreaction' risk if payments on alternative capital are suspended is exaggerated and compensated by the benefit of additional control of a bank by the holders of this capital. High quality recovery and resolution policy can also efficiently reduce this risk.

Moreover, the potential size of additional capital required by banks was not known, when this big decision to disqualify these forms of capital was made.  In effect, while banks were concerned about the loss of access to these instruments, as they were all well capitalized and did not expect any additional capital requirements to be significant, it was less of an issue at that time.

In a nutshell, the risks mentioned as reasons for disqualifying some capital types do not really sound persuasive.  The benefits of providing banks access to a wider range of capital outbalance the risks, therefore the decision is worth revising.

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