Pretty much every modern economy has a two tiered banking system. There is inevitably a central bank which acts as the banker for the trading banks which operate in that economy. The central bank sets interest rates and significantly influences monetary conditions in its economy. The trading banks borrow funds (partly by taking deposits) and make loans at the retail level. They perform several important functions, including circulating credit within the economy.
Few would doubt that the health of an economy’s banking system is critical to the success of that economy. While this is surely true in all phases of the economic cycle, it is especially true in times of economic stress. With the world entering a Covid downturn in 2020, it is appropriate to examine both global and domestic banking issues. Four questions arise:
- Have central bank policies since 2008 been optimal?
- What has changed for central banks as they now respond to Covid?
- Are the capital adequacy rules for trading banks optimal?; and
- Are cultures within trading banks appropriate?
Unfortunately this paper raises concerns under all four of these questions. They are not easy questions open to succinct answers but they are vital questions for the future success of all economies.
1. CENTRAL BANK POLICIES SINCE 2008
When New Zealand’s finance minister, Roger Douglas, gave the world the first truly independent inflation targeted Central Bank in 1989, the Reserve Bank of New Zealand was directed to set monetary policy independent of politicians. It was given the objective to tame inflation (‘stagflation’) which had been often accompanied by stagnant economies, and was a major concern in all world economies over more than 25 years to that time: and to keep inflation thereafter in a target band. Other countries soon followed and also gave their central banks autonomy over monetary policy.
The experiment was successful. Independent central banks around the world did tame inflation. Indeed for the years through the late 1990’s and early 2000’s inflation remained low even although central banks seemed to be operating with surprisingly low interest rates, and their economies were buoyant.
A WHOLE NEW PROBLEM- THE 2008 MELTDOWN
The 2008 credit crunch (when trading and investment banks had to be bailed out on a massive scale) comprised two distinct but related problems. First, there was a liquidity crisis: banks lost confidence in other banks and financial institutions, and were reluctant to lend to them. Credit markets seized up. Secondly, the banking crisis flowed through to the real economy and caused a major slowdown.
After 2008, central banks were no longer fighting inflation but rather, deflation. First they injected massive credit into their respective economies and freed up the liquidity seizures. In essence these liquidity issues were significantly resolved within a year. Central banks did well in restoring liquidity. At the same time they moved to address the slowdown in the real economy by lowering interest rates, sometimes as far as zero and in some countries even below zero. When that was not enough to get growth going again, the US Federal Reserve launched into unchartered new policy.
QUANTATIVE EASING
Although Japan had for some years before 2008 tried largely unsuccessfully to revive its economy by excessive government spending and lax monetary conditions, the Fed under Professor Bernanke largely copied Japan’s technique when it launched a programme called “Quantitative Easing” (ie printing money). Other central banks around the world soon adopted the same practice. World economies became the subject of a massive new economic experiment run by central banks.
Although central banks claimed to be still targeting inflation (in accordance with their mandates) it appears with Quantitative Easing they were effectively trying to eliminate the business cycle. Prior to Covid, central banks were acting as if economic downturns could be avoided if only they pursued monetary policy aggressively enough.
Despite the monetary resources thrown at economies by central banks after 2008, there has been little analysis (in the media at least) of how very low interest rates and excessive credit effect economies. The impact is no doubt multi-faceted, but includes the following:
- Lower interest rates bring forward consumption. A consumer wants a car. He can save more, and buy the car next year. Or he can take out a car loan today, and buy the car now. Lower interest rates encourage borrowing and buying the car earlier – they help bring forward consumption (which should stimulate the economy). The problem – having bought his car this year our consumer doesn’t need another car next year. So there are diminishing returns from this effect. It gets harder (and requires ever lower interest rates) to keep consumption up. Put another way, it seems intuitive that central banks face diminishing returns from lower interest rates, in trying to bring forward consumption.
- Secondly, cheap money encourages people to borrow. Ready credit drives up the price of all asset classes – shares, houses, commercial property, art and the like. The Economist headed a cover story a couple of years ago, ‘The Bull Market in just about Everything’. As assets rise in price/value, so the owners of those assets begin to feel more wealthy and open their wallets. Economic recovery is slow, as it takes some years for this wealth effect to show up in economic improvement. But this is definitely a second stimulatory effect of an expansive monetary policy. The drawbacks from this are that it creates societal wealth disparities between those who own assets and those who don’t. It inflates the price of assets, because buyers believe central banks are going to keep their prices high and rising- not because fundamentals such as PE multiples and earnings per share justify the prices being paid. Also when central banks stop pumping up the economic balloon there is a good chance those same asset prices will decline again – the economic contraction is simply postponed. That is what started to happen at the end of 2018, when the Fed started to reduce its balance sheet (ie. started to reverse Quantitative Easing). The share market swooned; and the Fed had to halt its balance sheet contraction.
- Thirdly, lower interest rates are presumed to stimulate business investment, the most important driver of economic growth. You would think that if a business can borrow at lower cost it will be more likely to order a new machine. And no doubt this does happen, but the effect does not appear to be as strong as central banks would like. The primary consideration for a company deciding to buy a new machine is whether there is a market for the additional products that machine will make. Lower interest rates in the economy where that company operates, are at best an unreliable contributor towards creating those additional markets needed, before that company orders any new machines.
- Lower interest rates leave borrowers paying less on their debts- so they have more funds left over after paying their mortgage or their car loan, which they can then spend in the economy. While this is obviously true, it is a benefit of monetary policy which can be overstated. Many loans have fixed interest rates, so borrowers are either delayed or in extreme cases, never receive the benefit of the drop in market rates. Banks need not pass the full decrease in wholesale rates , through into the rates they charge their customers. In more worrying economic times especially (which is when interest rates are most likely to be cut), people in many cases elect to save rather than spend the amounts they obtain from their interest reductions (this happened significantly over the lockdown in NZ) – so the benefits people receive from lower interest rates do not always find their way back into the economy. And bank depositors and lenders on fixed interest securities earn less income on their funds, which they can then in turn spend in the economy. And those depositors and fixed interest investors often suffer drops in their incomes quicker, than borrowers start to benefit from their cheaper mortgages. So in total, the benefit of cheaper interest rates to an economy can be less significant than might be imagined in theory. But clearly lower rates feeding through into leaving borrowers with more to spend in the economy, is still a significant direct result and benefit of expansionary monetary policy.
- Finally, when interest rates are driven down close to zero, there is a ‘TINA’ effect- There is No Alternative. Retirees and others who previously relied on fixed income, cannot any longer earn an adequate income off their fixed interest investments, so they tend to move across and invest in riskier bonds or even equities, and hope to improve their returns that way- thereby helping drive up share and secondary bond markets.
These factors suggest monetary policy will likely work with a time lag: which is what is generally observed. Fiscal policy, if it directs cash into the economy (as happened with the recent wage subsidy scheme) can operate more immediately. But monetary policy can also direct cash straight into an economy, if Central Banks buy government and even corporate bonds on the market- as is now happening to finance government budget deficits- (see Chapter 6 below).
UNEXPECTED NEGATIVES OF MONENTARY POLICY
Since 2008 it has become apparent central bank expansionary policies also have downsides. Low interest rates lower market yields on all asset classes – fixed interest, shares, property. Pension funds and retirees struggle to earn sufficient income from their investments. World pension funds are now pretty much all under water (many seriously so), after a decade of sub-normal returns. Expansionist monetary policies have assisted those currently employed to keep their jobs (perhaps to a disappointing extent). But those current employees being assisted to keep their jobs today will potentially face lower pensions when they retire tomorrow. And those who have already retired face much lower incomes in their retirement (if they are prudent); or have been trying to keep their incomes up by taking risks with their investments which are excessive for their age and stage in life. Expansionist monetary policy delivers benefits to some parts of the populace- but it also delivers detriments to others.
There is another negative, which has hardly become apparent as yet – expansive central bank monetary policy is difficult (if not impossible) to reverse. If central banks pump up the economic balloon it is difficult to take the pump away without the balloon starting to deflate again. It may be, that if economies start to boom again in the future, central banks will be able to raise interest rates to more normal levels (even if this did not prove possible after 2008, and before the onset of Covid). But if or when economies improve, will central banks that indulged in Quantititive Easing be able to shrink their balance sheets again, and reverse their cash injections? The one attempt to do this by the Fed in 2018, was unsuccessful, and caused markets to have a ‘taper tantrum’.
It seems easier to reverse a fiscal deficit that has been run to help support an economy (if politicians have fiscal discipline). Tax revenues rise automatically as the economy improves. The Government runs surpluses for a few years, and lowers the Government Debt-to-GDP ratio again. It was not apparent after 2008, and before Covid, that central banks would as easily be able to reverse Quantititive Easing and move up from ultra-low interest rates. Experience thus far suggests fiscal policy may be a better tool than monetary policy in smoothing economic cycles.
DEBT BINGE
More worryingly, with unlimited cheap credit at amazingly low interest rates, THE WORLD BINGED ON DEBT after 2008. A contemporary of mine proudly told me a couple of years ago that his son (in his early 30’s) had just sold his first home and bought a second for $1.2m. He had $400,000 deposit from the gain made on his first home and had borrowed $800,000 from the bank. Wow, I said, that’s a big mortgage for a young man with a couple of kids, and a wife who probably can’t work for a few years. Not a problem, said my friend – he is only paying around 4.5% on the loan. It is a situation which has surely been repeated millions of times around the world since 2008.
The worst debt binging has occurred in:
- Emerging markets (Turkey, Argentina, South Africa)
- House owners in countries such as Hong Kong, Australia and New Zealand where house prices have inflated significantly
- USA, where companies have borrowed excessively to make share buybacks (driving up their share prices in the process).
- Some Governments have also run large deficits and saddled their countries with large debt. The USA and Japan are prominent examples: although in attempting to fight off a post Covid economic slowdown, most countries (including New Zealand) are belatedly now following the lead of these two countries, and themselves running up major debt (see Chapter 6 following).
With the coronavirus downturn, it will be miraculous if a number of these debt binges do not come back to hurt all of us significantly. Overcommitted debtors risk falling into default when a downturn appears, even in a world of very low interest rates; and if they do the downturn will be exacerbated. Even if debtor default is avoided, there is plenty of economic theory which says that heavily indebted countries and companies take much longer to bounce back to full economic health. There has to be a real concern that debt binges since 2008 are going to come back and bite the world in Covid’s economic aftermath.
DOWNTURNS ARE NOT ALL BAD
Economic recessions and the business cycle bring reality checks. Herds of investors, left unchecked, tend to push markets and valuations too far – ‘irrational exuberance’ in Greenspan’s famous description. Economic downturns increase competitive pressures in an economy. They reduce asset prices, cause rash investors losses and bring them back to more conservative and cautious viewpoints for a few years. Zombie companies fail, and their assets are redeployed to more productive uses within the economy. Major downturns create the opportunity for significant (and often needed) societal change to occur, as I have already suggested. If central banks succeed in eliminating the business cycle modern investors can load up on risk and not worry. If things get nasty, the central banks will rush in and save you. Investor behaviour (and trading bank behaviour) would surely change significantly (and not for the better), if enough people believe economic downturns have become a thing of the past. So while they do damage, and cause pain, economic downturns also play a role in keeping investor behaviour within bounds.
IS THERE A TRADE-OFF BETWEEN THE SEVERITY AND LENGTH OF DOWNTURNS?
There is another implication of monetary policy being used to try and ward off downturns. Think of it as a macroeconomic catharsis, rather like bankruptcy at the commercial level. The system of bankruptcy law we inherited from the UK initially appears harsh. When a person or a company fails financially, bankruptcy/liquidation follows. Remaining assets are thrown on the market and frequently sold for a fraction of their true value. Creditors and investors take their losses. Markets are cleared. Then everyone is free to get on with life again. The alternative is to try to realize the assets more slowly and for a better price. Minimise the losses. The problem with this: people know there is a distressed seller yet to unload. They hang back waiting to get a bargain. The economic downturn is prolonged.
Four years ago I saw in Greece abandoned property developments everywhere. But mortgagee sales were not allowed. Result: the Greek economic downturn dragged on for years. Maybe there is a trade-off. Have a recession, clear out the zombie companies, clear the markets, take your pain. Then the economy is free to bounce back. Or have the central banks stave off the recession with monetary policy. The recovery is slowed or even stalled altogether. Debt builds up, which makes the recovery even slower again. Less severe pain, less upside, and the whole process drawn out over a longer period.
Japan adopted expansionary monetary and fiscal policy well before 2008 and its economy was yet to come back to robust health almost two decades later, when Covid struck. Economies around the world (including New Zealand) were kept in positive economic territory from 2018 until Covid hit, only by ultra-low interest rates right around the world. So where monetary policy is used to try and keep an economy out of recession, it appears it will likely cushion the severity of the downturn; but at the likely cost of delaying or even nullifying an early or strong recovery.
HAD CENTRAL BANKS ALREADY GONE TOO FAR BEFORE COVID STRUCK?
Even before Covid, the limitations of monetary policy were surely apparent. Twelve years had passed since the GFC in 2008, and many economies around the world were still on significant monetary support. By all means smooth the business cycle with modest adjustment of monetary policy, but for central banks to try to eliminate the cycle will likely be seen with the benefit of hindsight as having gone too far.
Arguably central banks, with their new found autonomy, over-reached in the 12 years between 2008, and Covid. Such an outcome was understandable- indeed difficult for central banks to avoid. Expansive monetary policy kicks the can down the road. It enables economies to defer their problems- which politicians in particular and the populace in general, always want to see happen. Once central banks started on the policies, to change course would have been a tacit acknowledgment the central banks were wrong to bring their economies so far down the monetary intervention road in the first place. With central banks right across the world adopting such policies, it was very difficult for individual central banks to take a more conservative line, and not to join them. So for central banks, all impetus has been in favour of keeping going with ever more interventions, and hope the policies eventually work , even if the final outcome of the policies and how to reverse them again, is unclear.
We already had ultra-low interest rates, massive debt in some areas, overvalued markets and a slowing world economy before the virus arrived as a major exogenous shock. Hindsight is a wonderful thing but USA, Europe and Japan in particular (fortunately New Zealand to a lesser extent) may well look back in a few years and conclude they were already in a disadvantageous economic position before the virus. Where to now?
2.CENTRAL BANK RESPONSE TO COVID
There is no doubt the lockdowns around the world have resulted in major shocks to the world economy. The response of governments and central banks everywhere has been to provide further massive fiscal and monetary stimulus to their economies. The extent of that monetary stimulus in the US, can be seen from the above graph. In the week 9-13 March 2020, the Federal Reserve injected $1trillion (that is $1,000,000,000,000) into the markets, and announced a further $500billion would follow over the next month. Large cash injections like this are sometimes jokingly referred to by economists, as ‘helicopter money’. I seriously question if there is a helicopter large enough, to carry $1trillion aloft, in order to drop it into the US economy.
Think about this graph. At $4 trillion, the Fed was still thinking it could reduce its balance sheet again, and actually had quite detailed plans to do so at the end of 2018 (until the ‘Taper Tantrum’, and Trump made them back off). Indeed there is an observable if limited reduction in the balance sheet for about a year around that time. The scary thing, is that by now going to $7 trillion, the Fed has surely put it beyond their own (or anyone else’s) wildest imagination that they will ever be able to bring their balance sheet back down again. Selling a large part of the securities back into the markets, and reversing the process, is realistically impossible, as the sales would be too large for the markets to absorb, and drive interest rates up very high. The Fed has also been buying corporate bonds- some of mixed quality, which would be difficult to sell back into the markets other than at a large loss. With those cash injections of mid-March 2020 the Fed has surely crossed the Rubicon. The US dollar has long since ceased to be backed by gold. It is now backed by nothing more than paper entries which have diverged in a major way from the real US economy. Realistically, the only thing that is going to shrink the Fed balance sheet in the future is some catastrophic market unwind (in the course of which the US$ will cease to be the world’s reserve currency).
It seems that in one week Covid sufficiently impacted the world in general, and the US in particular, such that the world will never be the same again. As Vladimir Lenin (not generally a friend of Western capitalist banks) said: ‘There are decades when nothing happens, and weeks when decades happen’. History may show that the week of 9-13 March 2020 (aptly ending with black Friday) may have been one of those weeks when decades happened.
You may not agree with me but if I am right it is fascinating how turning points in history can occur almost by accident. The foundations underpinning Western economic supremacy in the world, arguably were irreversibly weakened that week. Very few people were aware of an event that could change the lives of their grandchildren markedly. It was probably a decision made by 25 people at most, deep in the Fed, who themselves didn’t realise the full long term implications of what they were doing. And yet it was very possibly a world turning point.
Will these massive cash injections from the Fed and other central banks be sufficient to keep the world out of recession or even depression, and minimise the negative financial impacts of the worldwide Covid lockdowns? Time will tell. Since March, world sharemarkets have improved impressively, and there are some positive signs for the real economy. But many wage subsidy and support programmes are still running, and the key time will be when these fiscal programmes cease. A 2020/21 corporate collapse somewhere around the world, of a similar magnitude to Wall St’s Lehman Brothers bank in 2008, would certainly have a high risk of creating market meltdown despite the major interventions, and initial positive signs.
Will these massive paper entries on top of the existing huge public and private debt piles in the US,and also in Europe, permanently weaken the financial strength of the West, however well the world economies otherwise come back from the Covid shocks? Assuredly they will, leaving our children and grandchildren with debt piles that look likely to be unmanageable. The economic world post Covid, will never be the same again.
New Zealand has now with its 2020/2021 Budget, and allied NZ Reserve Bank quantitative easing, belatedly but rapidly gone down the same path as the United States and Europe. I have analysed the New Zealand position in chapter 6 on our 2020/21 Budget, which follows. New Zealand started out far more cautiously than the US and Europe in the degree of our monetary interventions; but we have in the middle of 2020, caught up worryingly fast.
3.TRADING BANKS AND CAPITAL ADEQUACY
We should never discount the critical role trading banks play in clearing payments through modern economies. Cash is rapidly disappearing and everyone now relies on trading bank operated systems, to make their payments. These systems operate very successfully and we take them for granted. But an aspect of trading bank activity that has attracted much attention, especially since the worldwide bailouts of 2008, is bank stability. Discussion has focused on their capital adequacy. Generally banks around the world have been forced to raise the percentages of their loan books which are backed by their own capital – and the worldwide banking system is more stable as a result (although it will likely be tested yet again, with the Covid-induced downturn). Central banks deserve credit for driving these improved safety margins even if they are not yet fully in place in New Zealand.
Governments, expressly by law, underwrite a part of bank deposits. Further, even to the extent they do not underwrite them, governments cannot afford to let large banks fail, because the resulting damage to their economy is too great. So governments implicitly underwrite all large trading bank activity. This reality means governments are very interested to see that the trading banks within their economy are stable and properly capitalised. This issue of stability merits close analysis.
IT ALL COMES FROM BASEL.
The Bank for International Settlements (BIS) is based in Basel, Switzerland. As its name suggests, BIS operates as a bank through which international payments are transacted. As part of this international clearing role, BIS would want to know that banks making payments through it are solvent and their obligations to BIS will be met.
The Basel Committee, initially called, ‘The Committee on Banking Regulations and Supervisory Practices’, was established by the G10 leading world economies in 1974. It is headquartered at BIS. The committee now has a membership of 45 institutions around the world. The committee has established a series of international standards for bank regulation, most notably its Accords on capital adequacy. The purpose of the Accords is ‘to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses’. The Accords do not have legal force. Members are responsible for their implementation in their countries. The Accords are international standards which countries around the world can adopt to measure and regulate the financial stability of their trading banks.
Three Accords have been issued. These are now called Basle 1 (1988), Basel 2 (2004) and Basel 3 (2017). Not unexpectedly, complexity has increased from Accord 1 to Accord 3. They all proceed on the same fundamental approach. Trading banks need adequate capital to back the risk assets (especially loans to customers) they hold. Risk assets range from government stock and deposits with the central bank (low risk) to loans the bank has made to its customers (much higher risk). Very little capital is needed to back their secure assets; substantial capital should be held to back their most risky assets.
Basel 1 categorises the assets of financial institutions into five risk categories (0%, 10%, 20%, 50% and 100%). With very secure assets, no capital need be held to back them. So no part of the face value of these very secure assets need be counted in the bank’s risk weighted assets. They are assigned a 0% risk category. With significantly risky assets that could potentially be lost entirely, 100% of their face value must be added to the bank’s risk weighted assets. This methodology is applied across the whole of the assets held by a trading bank. Basel 1 calls for trading banks to have capital equal to 8% of its risk weighted assets, calculated in accordance with these formulae.
Basel 2 and Basel 3 while more complex, continue the same methodology of calculating the risk weighted assets of individual trading banks, and then require a specified percentage of those total risk weighted assets to be backed by the trading bank’s own capital.
BASEL ACCORDS FAVOUR RESIDENTIAL LENDING
There is a key point to make about the Basel Accords: the three accords all provide a lesser risk weighting for residential mortgages than for most other forms of lending. Under Basel 1 banks were required to count only 50% of their residential mortgages in calculating their risk-weighted assets (whereas they had to count 100% of other lending, including commercial lending and commercial real estate). Under Basel 2 , 50% dropped to only 35% of residential mortgages which had to be counted in a bank’s risk-weighted assets. Under Basel 3, risk weights attaching to residential mortgages vary, depending on the Loan to Value ratio of the mortgage. Thus if the mortgage loan is less than 50% of the value of the property, only 20% of the loan is included in the bank’s risk weighted capital. This increases to 25% when the loan is between 50% and 60% of the property value. It becomes 30% when the loan is between 60% and 80% of the property value; 40% between 80% and 90% of the property value; 50% between 90% and 100% of the property value; and 70% of a residential mortgage loan has to be counted in the bank’s risk weighted capital, when the amount of the loan exceeds the value of the property over which it is secured.
Thus under all three Basel accords, RESIDENTIAL MORTAGES REQUIRE LESS TRADING BANK CAPITAL TO BACK THEM, THAN OTHER FORMS OF BANK LENDING.
The Basel Accords appear to have been promulgated with only bank stability in focus. And in assessing bank stability, residential mortgages are assessed to be less risky than other types of bank lending. The Basel Accords strongly encourage trading banks to prefer residential mortgages over other forms of lending.
WHAT HAPPENS WHEN REGULATION SKEWS BANK LENDING TOWARDS HOUSES?
Our son recently returned to New Zealand with his family after 10 years overseas. He had enough capital to buy a house or a business but not both. Unlike many New Zealanders he decided to buy a business and to rent a house.
Finance for about 60% of the cost of the business was eventually provided by his bank – but only because I personally guaranteed it. The loan was over five years at 6.7%. The bank charged an establishment fee. The loan required steep monthly repayments, calculated to repay the whole advance on a table basis over the five years. Cash which would otherwise have been available to invest and improve the business in those first five years had to be repaid to the bank.
Had our son opted to buy a house, the mortgage loan would have been much larger and no guarantee would have been required from me. No establishment fee would have been sought. In fact it is probable banks would have been falling over themselves to provide house mortgage finance to him. Any housing loan would have been at about a 25% lower interest rate, for a much higher percentage of the cost of the house (notwithstanding Loan to Value restrictions then in force) and over 25 years or some similar lengthy period, with minimal table mortgage reductions. In short, a house mortgage would have been available on far more attractive terms, than the commercial loan my son was able to obtain to buy his business.
All of this flows directly from Basel: banks (particularly in Australasia) strongly favour housing loans, over business loans.
HOUSING v. BUSINESS- WHICH BENEFITS SOCIETY MORE?
My son’s new business is proving successful. It now employs eight staff. It is generating GST, PAYE, ACC levies, Company tax, Fringe Benefit Tax, etc for the Government. It makes a product that customers want to buy. It generates benefits for New Zealand every day it operates. What if instead my son had bought a house? What benefit would that have generated? Yes, buying a house indirectly supports the New Zealand building industry, but if (as would be probable) my son had bought an existing house there is no benefit for the country. Buying a business and creating jobs, income and production in this country is surely doing something of greater social benefit than buying a house. And yet banks are incentivised by the Basel Accords to be highly supportive of house buying and unsupportive of business buying. It is no coincidence that house prices have risen significantly in many parts of the world since Basel 1. We have strongly incentivised our banks under Basel to push residential lending – and they have done exactly that.
Much of the money the banks lend into the New Zealand housing market – around one dollar in four – is borrowed from offshore. Bank funding of the domestic housing market significantly contributes to New Zealand’s private international debt, which is at high levels and a detriment for the country. New Zealand has ended up with the worst of both worlds – houses its next generation of potential home buyers cannot afford (without being bankrolled by their parents) and high private international debt to fund that overvalued housing market. The way our banks are regulated, has played a definite part in these unfortunate outcomes.
TIME TO DEPART FROM THE BASEL RULES ON RESIDENTIAL LENDING
Even if house prices were to drop by say 25% (a major decline), a good percentage of house mortgages are under 80% of the property’s value. So banks will still recover most of their housing loans. Business assets, however, rarely realise anything like their value as a going concern if the business shuts down. A bank can easily lose a large chunk of its lending to a failed company. Business lending is more risky than house lending. The Basel Accords correctly recognise this. Should it therefore not be priced higher by the banks?
But business lending does more for an economy and society than house lending. The Basel Accords fail to recognise that. So how to balance these two factors? Perhaps the solution is to say there should be two different criteria, both of which banks need to meet, as they distribute credit around different sectors of the economy. First their lending should comply with Basel – so the banks should be secure. But secondly, bank lending should reflect the long term best interests of the economy.
Offer banks financial incentives to lend to the productive sector of the economy: exporters, farmers, businesses (even if our diary industry has too much debt). Perhaps banks need only pay tax on, say, 90% of the interest from loans to the productive sector each year. (The exact form of this incentive would need careful study). The idea would be to make lending to the productive sector equally profitable with lending on residential mortgages. Yes residential mortgages would still need less capital to back them, but the return to banks from lending to the productive sector would be larger, so they could balance the two different types of lending much better than they do at the moment.
The detail of this sort of policy would likely be complex and is unimportant at this point. What is important is that our banking sector needs change, so that it is no longer financially incentivised to favour houses over other forms of lending.
Basel has been set up solely with bank stability in mind. It is damaging the NZ economy in the outcomes it is producing. We need to reverse that and take the heat out of house prices while putting more wind behind our productive sector.
4. TRADING BANK CULTURES
Bankers used to be staid, conservative people, in dark suits. They were custodians of funds which the populace deposited with their bank for safekeeping. They were careful and cautious, and made it their primary mission to look after the people’s money and to make sure they were always able to give it back to the bank’s customers when it was called for.
In the years leading up to the 2008 banking shakeout, bankers changed. Banks got much more into trading and commercial banking activities as an adjunct to their more traditional trading bank roles. With those more risky market related activities, attitudes within banks also changed. In the early years of that more commercially driven approach, vast profits were made. With large profits came a culture of awarding large bonuses. With large profits and large incentives came shortened horizons, arrogance and changed attitudes among bankers.
Traders among them rigged LIBOR (a benchmark world interest rate). They sold insurance and other products which were not in the best interests of customers. They worked around sanctions. They closed their eyes to money laundering. They massively underpaid their tax in NZ. Overall, it would be fair to say banks threw off their conservative approach of the last few hundred years and became profit driven , short sighted, and far less risk averse in the period leading to 2008. There has to be concern that those attitudes may still prevail, even though trading banks are now better capitalised and more closely supervised.
I have banked with the same bank for almost all my life. In the early years I respected and trusted my bank. Today, I see my bank as a collection of individuals who have been incentivised to try and extract as much money from me (their customer), as they can. Yes of course, there are still good traditional conservative bankers within the system but I worry they are no longer in the majority and no longer in control of the ship. These days I trust my bank less. I respect my bank less. The Hayne Royal Commission in Australia, laid bare the disappointing level of behaviour banks now are prone to. I worry that my bank (which I am sure is similar in its approach to the other banks operating in New Zealand) can be left to carry on in business without careful supervision, because it can no longer be trusted always to do the right thing.
Business commentator Brian Gaynor wrote an excellent article on banking in the New Zealand Herald on 16 November 2019. He pointed out that in the 2017/18 financial year the four Australian-owned banks paid combined dividends out of New Zealand to their parents in Australia of $7.78 billion. Yet in the five years 2015 to 2019 inclusive, the combined annual profits of those four banks in New Zealand were between $4212m (lowest combined profit in 2016) to $5128m (highest combined profit in 2018).
Accounting 101: by paying very substantially more to their parent banks in dividends than they were earning in profits, the Australian banks were reducing the capital of their New Zealand subsidiaries. Is it any wonder that a year or two later, Westpac NZ and ANZ both got called out for under-calculating their required New Zealand capital by using unauthorised models? Is it any wonder that the RBNZ then required the banks substantially to increase their New Zealand capital to around 16% of their risk weighted assets?
Yes, requiring the banks to increase their capital was an appropriate and necessary step for the Reserve Bank to take, because the banks have forfeited the right to be trusted that they will keep their capital at the required level. So prescribe a generously high level of capital, assuming the banks will try to work around it and minimise the amount they hold. But even once they have done that, there should still be plenty of capital left safely to back their lending. It is a bit like saying the speed limit is 100kph while assuming everyone will drive at 110kph.
The concern we all should have is that even though they may be better capitalised, the culture in our trading banks remains too short-sighted and too profit driven for the long term health and stability of our banking industry. Yes, the Hayne Commission has embarrassed the banks into toning down their excesses. Yes, the tighter market through and after Covid will constrain the opportunities banks have to extract revenue from customers. But we still have a banking industry – a critical industry for the long term health of the New Zealand economy – in the hands of people who appear in some of their actions to lack sufficient foresight and to have not been ensuring their trading banks operate responsibly in New Zealand. As a start, the Reserve Bank should make it illegal for any registered bank in New Zealand to offer other than very modest bonuses or share incentives to their staff. But ideally, we want to see an internal culture change and have the banking sector return to its more conservative pre-2008 behaviour.
SUMMARY
There are limits to the extent a central bank such as the Reserve Bank of New Zealand should use monetary policy to try to counteract the business cycle. If significant action is needed to smooth an economic cycle, fiscal policy (operated conservatively) should be preferred.
The Covid-induced worldwide financial shocks have changed the world forever. Countries that were already over-indebted before Covid struck, will be particularly hard hit; and particularly slow to recover. The US is especially vulnerable.
Trading banks should be incentivised to increase business lending, and to scale back residential mortgage lending.
The corporate culture in the trading bank sector remains a cause for concern. It does not appear yet to have fully retreated to pre-2008 positions. Steps are still needed to make bank management more conservative in their business operations.
Covid – Catalyst for Change 