Reserve Bank releases capital adequacy issues paper

The Reserve Bank published an issues paper today on regulation of banks’ capital adequacy.

It’s seeking feedback by Friday 9 June and will follow up with detailed consultation documents on policy proposals & options for each of 3 components later this year, with a view to concluding the review by the first quarter of 2018.

Deputy governor Grant Spencer foreshadowed the broad-ranging capital review in March, in a speech in which he compared the average housing risk weights of large banks in 6 countries.

New Zealand was clearly the most heavily weighted towards housing at 28.3%, followed by Australia at 23.5% (and its bank overseers also tightening the reins), then a long way back to Denmark 13.9%, the UK 11.7%, Canada 7.2%, Sweden 6.8%.

The Reserve Bank aims to identify the most appropriate capital adequacy framework, taking into account experience with the current framework & international developments.

The review will focus on the 3 key components of the current framework:

  • The definition of eligible capital instruments
  • The measurement of risk, and
  • The minimum capital ratios & buffers.

Paper sets out 2 sides

In its issues paper summary, the bank said it recognised the need to balance the benefits of higher capital against the costs, but set out 2 sides to the argument: “It is expected that a higher level of capital would reduce the probability & severity of bank failures and would smooth out credit cycles.

“But banks typically argue that capital is a costly source of funding and that if they had to seek more of it they would need to pass on costs to customers, leading to reduced investment & growth.

“There has been debate about the extent to which these costs reduce national welfare. In one view the capital levels of banks are inefficiently low because of implicit government guarantees of creditors or other incentives. Raising the minimum capital requirement restores efficiency by reversing the implicit subsidy to bank shareholders, and in this way improves overall welfare.

“A growing number of academics, most notably Anat Admati from Stanford University & Martin Hellwig from the Max Planck Institute for Research on Collective Goods (as well as some regulators) have argued that the costs to society as a whole of higher capital are very low and that capital requirements should be much higher than they are now.

“These authors are associated with the ‘big equity’ view and are distinguished by the extent to which they see significant increases in capital as being possible without net negative economic impacts.

“Empirical studies have attempted to quantify the costs & benefits of increasing capital requirements, and to determine the optimal capital ratio which has the greatest net benefit. In the more mainstream studies the Reserve Bank has considered so far, a typical optimal ratio is about 14%, but estimates do vary widely (the range is roughly 5-17%). The Reserve Bank will continue to review & assess these studies, but also welcomes the views of submitters on this issue.”

The bank said that, at this early stage of the review, it hadn’t formed a view on the final calibration of capital requirements, but said it was likely to take into account the studies it had seen, as well as empirical evidence.

Links:
Review of the capital adequacy framework for registered banks
Grant Spencer’s March speech

Attribution: Bank release.

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