RBNZ says monetary policy could be used to stimulate the economy if necessary during proposed transition to tougher bank capital requirements

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The Reserve Bank (RBNZ) hasn’t ruled out using monetary policy to stimulate the economy if its proposals for banks to hold significantly more capital come into fruition.

The RBNZ says, in its quarterly Monetary Policy Statement (MPS), that if during the proposed five-year transition to tougher bank capital requirements being fully implemented, “additional support to demand is required,” then “monetary policy would be able to respond as needed”.

However the RBNZ notes the transition period it is proposing is long.

It also says that other factors impacting the business cycle, like global economic conditions, will have a bigger impact on the economy than its proposed bank capital requirements.

The RBNZ is proposing banks be made to hold around 40% more “high quality” capital. The value of this is equivalent to about 70% of the banking sector’s expected profits over a five-year transition period.

Speaking at a media conference, Governor Adrian Orr confirmed the RBNZ hadn’t factored possible tougher capital requirements into its official cash rate (OCR) outlook released on Wednesday.

Elsewhere in the MPS, the RBNZ says higher bank capital requirements could improve the government’s fiscal position because increased bank equity funding “would likely increase tax revenue” from the banking sector since debt funding is tax-deductible while equity funding is not.

It suggests the value of any perceived implicit public guarantee of the banking system would be reduced as the system becomes safer, improving the government’s credit profile.

In its MPS, it says the following about how its bank capital proposals might affect the economy:

The impact of banks being required to fund their operations with more (and higher-quality) capital will have both transitory and long-term effects on the economy. The transitory impacts of a change in capital requirements would be spread over at least the transition period. However, market prices, such as lending rates, could adjust more quickly.

Transition phase

All other things unchanged, bank funding costs would rise as a result of their higher capital requirements, because the cost of equity (in terms of investors’ required rate of return) is usually higher than debt. This could lead banks to increase lending rates, lower deposit rates, and/or tighten credit standards in order to retain their expected return on equity.

However, in reality, the impact on the lending and deposit rates will be affected by a range of offsetting forces.

The extent that banks will be able to pass on their potentially higher funding costs – in the form of higher lending rates and lower deposit rates – will be constrained by:

• competition from both within the banking sector and alternative sources of funding (for example, capital markets); and

• other interest rates in the economy being broadly unchanged, or lower, as risk premia in New Zealand decline.

Long-term effects

The increased stability of the banking system should reduce the risk premium associated with investing in New Zealand. This results in a reduction in the expected frequency and severity of economic disruption associated with systemic financial crises.

The cost of both equity and debt funding for banks would also decrease. A higher proportion of equity funding (lower leverage) means that banks’ return on equity will be less variable, and so investors’ required rate of return should decline. A larger equity cushion also reduces the probability of bank creditors facing losses, meaning that creditors should demand less compensation for credit risk.

In the long run, bank lending rates are likely to be slightly higher. How much higher depends on a range of factors, such as how much the cost of equity and debt for banks declines, the degree to which risk premia in New Zealand fall, and how competitive pressures affect banks’ ability to pass on costs to customers in the form of higher lending rates or lower deposit rates. The Bank expects that the spread of banks’ lending rates to the rates at which they borrow will settle in the range of around 20 to 40 basis points higher as a result of the proposed changes, although the exact effect is uncertain.

Higher bank capital requirements could also improve the government’s fiscal position. A higher share of bank equity funding would likely increase tax revenue from the banking sector since debt funding is tax-deductible while equity funding is not. The value of any perceived implicit public guarantee of the banking system would also be reduced as the system becomes safer, improving the government’s credit profile.

Interest.co.nz on Tuesday spoke the Finance Minister, Housing and Urban Development Minister and shadow Finance Minister on how they thought the RBNZ’s proposed capital review would affect the economy. See their takes here.

You can also read interest.co.nz’s three-part series on the RBNZ’s capital proposals here, here, and here.

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