Reserve Bank of New Zealand Capital Review Briefings for the Minister of Finance

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Ref #8674602 v1.2 RESERVE BANK COVER SHEET REPORT NUMBER 5301 DATE 29 July 2019 SUBJECT Slides for Minister of Finance meeting with the RBNZ on 31 July 2019 regarding the agricultural sector FROM Ian Woolford ACTION SOUGHT Review slides in advance of meeting on 31 July. SECURITY CLEARANCE In-Confidence

2 29 July 2019 MEMORANDUM TO THE MINISTER OF FINANCE On 31 July 2019 you are meeting with the RBNZ to discuss the possible impacts of the Capital Review proposals on the agricultural sector of the New Zealand economy. The attached slides provide some background information in advance of the meeting. Recommendation It is recommended that you review the attached slides in advance of your meeting with the RBNZ on 31 July. Ian Woolford Manager, Financial Policy Please sign the enclosed original and email to ministerials@rbnz.govt.nz NOTED: Hon Grant Robertson Minister of Finance

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Ref #8684926 v1.1 Reserve Bank Report: Update on rural sector engagement as part of the Capital Review To Minister of Finance Date 26 August 2019 Authorised by Geoff Bascand Report no 5315 Prepared by Ian Woolford Security rating In-Confidence Action Sought Action sought Deadline Please note that the Reserve Bank has been meeting with members of the agricultural sector, and will continue to engage with them throughout the final stages of the Capital Review. Reserve Bank Contact for Telephone Discussion (if required) Name Position Telephone Ian Woolford Manager, Financial Policy 04 471 3739 Actions for the Minister’s Office Staff Note any feedback on the quality of the report.

2 26 August 2019 MEMORANDUM TO THE MINISTER OF FINANCE On 31 July 2019 you met with the Reserve Bank to discuss the possible impacts of the Capital Review proposals on the agricultural sector of the New Zealand economy. At the meeting, you encouraged the Reserve Bank to engage with the rural sector on the proposals. Reserve Bank staff have been meeting with members of Federated Farmers across New Zealand as part of the engagement with rural groups. The table below provides a list of these meetings. Date Meeting 15 August Canterbury Federated Farmers, Ashburton 21 August Federated Farmers Board, Wellington 5 September Bay of Plenty Federated Farmers, Edgecumbe 23 September Manawatu and North Island East Coast Federated Farmers, Woodville 24 September Taranaki Federated Farmers, Inglewood 25 September (tbc) Waikato Federated Farmers, Hamilton There are also additional meetings with Federated Farmers members being arranged for Balclutha (Otago-Southland provinces) and Northland. At these sessions, attendees from the Reserve Bank have outlined the Capital Review proposals, and the Reserve Bank’s perspective on banks’ lending to the rural sector. The sessions have also recognised the many pressures facing the sector, including environmental and water regulations, the existing indebtedness in the sector, as well as concerns many in the sector have about possible bank responses to the Capital Review proposals. A senior manager also shared the Reserve Bank’s perspective in a panel session at the annual conference of the NZ Primary Industries Management (NZPIM) earlier this month. This was attended by about 200 farmers and other organisations involved with the industry and generated a thoughtful discussion. The Reserve Bank has been actively listening to farmers’ concerns. The key points made by Federated Farmers members at these sessions have been:  Concern that the sector is facing significant adjustment from government policy and that the cumulative impact of multiple policy changes is generating significant economic and social uncertainty in the sector;  A recognition that some farmers are highly indebted, which makes any additional regulatory and/or financial pressures difficult for them to manage;

3  Support and recognition that a secure banking system is needed; and  The importance of banks continuing to support the rural sector. The Reserve Bank has encouraged Federated Farmers to engage directly with banks about the decisions banks are making in advance of final Capital Review changes. The Reserve Bank is also addressing the recommendations made in Federated Farmers’ submission on the Capital Review, and have been discussing these at meetings with the sector. These recommendations are that:  A more appropriate level of risk tolerance is chosen;  A robust and independent cost-benefit analysis is undertaken; and  Transitional arrangements allow for a more measured, gradual pace of change, thereby easing costs of getting to desired new levels for bank capital. We are considering these issues, as well as points raised by other submitters during final stages of the Capital Review. A robust cost-benefit assessment is a key feature of this work. In discussions with the rural sector, the Reserve Bank has emphasised to Federated Farmers that responses will ultimately be up to the decisions banks make. For example, while a longer transition period could allow for a more gradual pace of change, banks may choose to front-load any interest rate increases. Other Engagement The Reserve Bank has been engaging with MPI on the potential impacts of the Capital Review on the agricultural sector, as well as on the existing indebtedness of those in the sector (particularly in dairy). The Reserve Bank has also met with representatives from a range of other business groups. We are looking at ways to extend this further, including by engaging with SMEs.

4 Recommendation It is recommended that you note that the Reserve Bank has been meeting with members of the agricultural sector, and will continue to engage with them throughout the final stages of the Capital Review. Geoff Bascand Deputy Governor/General Manager Financial Stability Please sign the enclosed original and email to ministerials@rbnz.govt.nz NOTED: Hon Grant Robertson Minister of Finance

Reserve Bank Report: Capital Review – External Experts Reports To Minister of Finance Date 23 September 2019 Authorised by Geoff Bascand Report no 5333 Prepared by Richard Downing Security rating In-Confidence Action Sought Action sought Deadline Note that the External Experts Reports will be published on the Reserve Bank’s website on 1 October 2019. 1 October 2019 Reserve Bank Contact for Telephone Discussion (if required) Name Position Telephone Geoff Bascand Deputy Governor 04 471 3675 Richard Downing Adviser, Financial Policy 04 471 3735 Actions for the Minister’s Office Staff Inform the Reserve Bank if the Minister of Finance would like to meet officials to discuss the External Experts Reports. Note any feedback on the quality of the report.

2 Recommendation

1. It is recommended that you: a) Note that the External Experts Reports on the Capital Review will be published on the Reserve Bank website on Tuesday, 1 October 2019 b) Note that the Reserve Bank will formally respond to the points raised by the External Experts as part of the final decisions on the Capital Review in December c) Note that Reserve Bank officials are available to discuss the Reports with you d) Note that the External Experts Reports, the draft Media Release and accompanying Q&A are attached to this Report. Hon Grant Robertson Minister of Finance /09/2019 Geoff Bascand Deputy Governor Reserve Bank of New Zealand 23/09/2019

3 23 September 2019 MEMORANDUM TO THE MINISTER OF FINANCE Background and Summary The Reserve Bank began a review of the capital adequacy framework applying to locally incorporated registered banks in 2017. The aim of the Capital Review is to identify the most appropriate framework for setting capital requirements for New Zealand banks, taking into account how the current framework operates and international developments in bank capital requirements. In May the Reserve Bank commissioned three External Expert Reports to independently review the Reserve Bank’s analysis and advice underpinning the Capital Review proposals. The External Experts were asked to take into account the objectives of the Capital Review, as well as the domestic context, the available literature, the international debate, and policy developments globally, relating to the role of bank capital in supporting the soundness and efficiency of the financial system. The three experts are:  Dr James Cummings: Lecturer in Finance at the University of Sydney, formerly based at Macquarie University, and before that on the staff of the Australian Prudential Regulation Authority (APRA).  Professor Ross Levine: Willis H. Booth Chair in Banking and Finance at the Haas School of Business, University of California, Berkeley, and formerly an economist at the Board of Governors of the Federal Reserve and the World Bank.  Professor David Miles: Professor of Financial Economics at Imperial College, London, and formerly Chief UK economist of Morgan Stanley during the GFC. From 2009 to 2015 Professor Miles was a member of the Monetary Policy Committee at the Bank of England All Final Reports were received by 31 August. Since that time the Reserve Bank has been reviewing the documents. The Reports were discussed by the Reserve Bank Board at their September meeting (19 September 2019). The Final Reports show that all three External Experts were complimentary of the quality of the advice underpinning the Capital Review proposals. The External Experts also signalled their overall comfort with the direction proposed in the Capital Review. Each Expert also raised a number of points that they suggested be considered further during the final stages of the Capital Review. That work is under way. Scope of the External Experts Reports The External Experts were asked to cover the following topics:  Is the problem that the Capital Review seeking to address well specified?

4  Has the Reserve Bank adopted an appropriate approach to evaluate and address the problem? For example, is the range of information considered and the analytical approach appropriate?  Do the inputs and cited pieces of evidence used by the Reserve Bank in its approach appropriately capture the relationship between bank capital and financial system soundness and efficiency?  Has the analysis and advice taken into account all relevant matters, including the costs and benefits of the different options?  Have the issues raised in submissions been assessed fairly and adequately? Note that as the Reserve Bank has not yet responded to submissions on the fourth consultation paper, the External Experts were asked to consider only those responses to the Reserve Bank’s assessment of issues raised in the submissions on the first three consultation papers.  Have the key risks been adequately considered across the proposals in the Capital Review?  Was the advice and analysis underpinning the Capital Review reasonable in the New Zealand-specific context? To support their review, the External Experts were provided all of the submissions received by the Reserve Bank in response to the consultation papers for all stages of the Capital Review. They were also provided copies of the papers considered by the Reserve Bank’s Financial System Oversight Committee during the Capital Review. The Experts were also invited to meet with any external people or groups of their choosing. Each of the Experts met with the following groups:  The New Zealand Bankers Association. Dr Graham Scott, and others from Sapere Research Group, who carried out research and analysis for NZBA, were also part of the meetings with Dr Cummings and Professor Miles.  One of the big banks: Westpac NZ (WNZL) was selected by the NZBA to meet with the External Experts to provide an industry perspective on the Capital Review proposals. Overview of Reports The Final Reports show that all three External Experts were complimentary of the quality of the advice underpinning the Capital Review proposals. The External Experts also signalled their overall comfort with the direction proposed in the Capital Review. All three External Experts commented favourably about the quality of the analysis. The Experts also pointed to the transparency of the process and commented that that the Reserve Bank had carefully considered the points raised by submitters during the first three consultation papers, noting that the Bank has not yet responded to submitters on the fourth consultation paper. These points are summarised below:  Dr Cummings: Concludes that the proposals are based on sensible analysis and advice in the New Zealand context.  Professor Levine: Concludes that the RBNZ conducted a sound analysis of bank regulatory capital requirements in New Zealand, employed appropriate data, methods, and evidence, considered a broad and proper array of factors, addressed thoroughly submissions by banks and others regarding the RBNZ’s

5 analysis and proposals, and focused intently on the New Zealand-specific features of capital regulatory reform.  Professor Miles: Concludes that the Capital Review was done with care and in an open minded way. He rejects the idea that the analysis has omitted a cost￾benefit framework or that it errs consistently in favour of more equity. Professor Miles draws attention to the asymmetry of risks and concludes that, if anything, the Reserve Bank has taken a risk neutral perspective. Each expert also raised a number of points that they suggested be considered further during the final stages of the Capital Review, as summarised in Annex 1. Of the points in Annex 1 raised by the External Experts, the comments by Professor Levine about gaps in the analysis of the incentives on banks and barriers to entry to new market participants may attract the most attention. Professor Levine notes that he does not think this gap would mean the capital requirements should be higher or lower than proposed, but rather there should be further analysis of these points. Dr Cummings’ estimates of the costs of equity (which are lower than the Reserve Bank’s assumptions) may also attract attention. Reserve Bank Response The External Experts Reports will be a valuable component of the final decision￾making processes, alongside submissions from the public and industry, and engagements with a number of groups including the rural and small business sectors. The Reserve Bank has a number of processes underway to address the points raised by the External Experts, as well as points made in submissions on the Capital Review. This includes:  Refining estimates of the costs and benefits of the proposals.  Considering a range of perspectives about possible interest rate impacts.  Assessing the impact of incentives on the various groups that make up the financial ecosystem.  Additional analysis of the definition of capital and processes for determining the level of risk-weighted assets. All of this work will feed into final Capital Review decisions, scheduled to be announced in the first week of December. Final decisions will also incorporate responses to the points made by the External Experts. The Reserve Bank does not intend to formally respond to the External Experts reports until the final decisions are announced. Communications and Next Steps The Reserve Bank plans to publish the External Experts Reports on the Reserve bank website on Tuesday 1 October. Publication will be accompanied by:  A Media Release.  Q&A  A short summary of the Reports (as set out on Annex 1).

6 Copies of the draft Media Release and Q&A are attached for your information. The Reserve Bank has met with Treasury to discuss the Reports from the External Experts. We will be providing embargoed copies to key media, accompanied by an offer of a roundtable briefing ahead of publication, to support accurate and considered reporting. We will give the New Zealand Bankers’ Association 24 hours’ notice of publication. Reserve Bank officials are available to discuss the External Experts Reports, or any other aspect of the Capital Review, with you.

1 Reserve Bank Report: Capital and Deposit Insurance To Hon Grant Robertson, Minister of Finance Date 27 September 2019 Authorised by Geoff Bascand, Deputy Governor/General Manager Financial Stability Report no 5334 Prepared by Ian Woolford, Manager Security rating In confidence Action Sought Action sought Deadline For information only. N/A Reserve Bank Contact for Telephone Discussion (if required) Name Position Telephone Geoff Bascand Deputy Governor/General Manager Financial Stability 04 471 3675 Ian Woolford Manager, Financial Policy 04 471 3739 Actions for the Minister’s Office Staff Please advise above contacts if further information or discussion is required. Note any feedback on the quality of the report.

2 Recommendation

1. It is recommended that you: a) Note the Reserve Bank’s views on the relationship between capital requirements and deposit insurance. b) Request further discussion with Reserve Bank officials if so desired. Hon Grant Robertson Minister of Finance /09/2019 Geoff Bascand Deputy Governor Reserve Bank of New Zealand 27/09/2019

3 Relationship between Capital Requirements and Deposit Insurance This note explains the Reserve Bank’s views on the relationship between bank capital requirements and deposit insurance. Background In response to the Reserve Bank’s fourth Capital Review consultation paper: How much capital is enough?, some submitters suggested that the implementation of a deposit insurance system in New Zealand should be factored into the Reserve Bank’s proposed capital requirements. This issue was addressed in the Reserve Bank’s Summary of Submissions (released 1 July 2019) in a section that included other issues related to Phase 2 of the Reserve Bank Act Review, as follows: Phase 2 of the Reserve Bank Act Review Some submitters suggest that issues being reviewed as part of Phase 2 of the Reserve Bank Act Review, currently underway, intersects with proposals in the Capital Review. A few say that the Capital Review consultation should wait for the Phase 2 consultation process, given it will cover issues such as depositor protection, the crisis management framework, and the intensity of banking supervision. It is suggested that the existence of a depositor protection framework, a strong framework for resolving failed banks, and more intense supervision could all be reasons to set capital requirements lower than proposed by the Reserve Bank. Also, the Phase 2 Steering Committee, Independent Expert Advisory Panel, and Minister of Finance have encouraged the Reserve Bank to explain how Phase 2 matters, such as deposit insurance, have influenced, or been taken into account, in the Capital Review. The in-principle decision to implement deposit insurance has been taken by Cabinet, and the design work is underway on deposit insurance. As far as we are aware, the design and calibration of deposit insurance is not being influenced by capital settings. However, the latest Phase 2 consultation noted that stronger capital levels reduce the expected cost of providing deposit insurance. This paper narrowly focusses on the conceptual link between capital adequacy and deposit insurance, in order to explain why we are proceeding with Capital Review decisions now, including decisions on the calibration of capital. Bank Capital Requirements The objective of minimum bank capital requirements is to promote the ability of banks to withstand large unexpected financial losses, so that in the event such losses occur, they can maintain the confidence of depositors and other creditors, and

4 continue to provide credit and critical services to the economy. Higher capital requirements, and correspondingly higher levels of capital, increase a bank’s capacity to incur such losses. Capital is the ‘fence at the top of the cliff’. From an individual bank’s perspective, the existence of a deposit insurance framework does not reduce the risk that it will be faced with large unexpected financial losses. For example, the existence of deposit insurance does not improve the credit risk profile of the bank’s borrowers and therefore should not lower the ‘probability of default’ (PD) used by the bank to determine its capital requirements. Additionally, the existence of deposit insurance does not decrease the potential losses the bank would incur in the event of borrower default – the bank’s ‘loss given default’ (LGD). Indeed, the Basel capital framework does not take into account the existence (or non-existence) of deposit insurance in determining bank capital requirements. The two requirements are separable in their design and calibration. Deposit Insurance While the specific objectives of New Zealand’s deposit insurance system have yet to be determined, the key objective of deposit insurance is to reduce the negative impact on depositors that results when their bank fails. Deposit insurance will be the manner in which depositors are protected, and can be thought of as the ambulance at the bottom of the cliff. Deposit insurance is not expected to have much of an impact, from a macro (system) perspective, on the probability of bank failure(s) in New Zealand. It may contribute to financial stability at the margin by mitigating the extent of bank runs and also improve the political credibility of resolution tools. But it is only one component of the financial safety net – for example, deposit insurance doesn’t improve the ability of banks to absorb losses, or address the liquidity risk created by uninsured depositors and other uninsured creditors. A deposit insurance system in New Zealand is intended to provide depositors with certainty that in the event of a bank failure, they will be promptly reimbursed (time frames yet to be determined, but possibly within seven days) by the deposit insurer for the amount of their deposits, up to a pre-determined limit. In the absence of a deposit insurance system, depositors would still be eligible to recover the value of their deposits through the liquidation process; however, this is a lengthy process that normally takes years. Or, in the event of a bank being placed into OBR, they could access the majority of their funds immediately, and then wait for the balance of their funds to be released or extinguished as the losses are crystalized through the resolution process. As such, deposit insurance can be viewed primarily as a mechanism to provide certainty of, and accelerate, depositors’ recoveries in the event of a bank failure. This will reduce the social cost of a bank failure for insured depositors.

5 Our View We see the issue of deposit insurance and capital adequacy as separable, in that the consideration of the Capital Review can proceed in advance of the design decisions on deposit insurance, and that the assessment of the calibration of capital should not be less conservative than otherwise in the presence of deposit insurance. We do not agree with the proposition that the existence of a deposit insurance system would lower the probability and/or impact of bank failure(s) in New Zealand. At the moderate deposit insurance coverage levels proposed (i.e., between $30,000 to $50,000, per depositor, per institution), we can largely ignore the impact of deposit insurance on capital requirements. If anything, were depositor protection levels to be increased materially, capital requirements should arguably be increased as the existence of deposit insurance could increase the risk that deposit-takers will suffer large losses due to increased risk-taking or riskier entities being favoured, and increased moral hazard (reduced market discipline from insured depositors, who no longer have incentives to monitor their bank’s behaviour, and increased risk-taking by banks). While many academics and regulators accept the longstanding belief that the existence of deposit insurance increases moral hazard, on balance, they see the benefits of a deposit insurance system as outweighing the increased moral hazard impacts. For the reasons explained, we do not believe that the calibration of minimum capital requirements should take into account the existence (or non-existence) of a deposit insurance framework.1

The objectives of bank capital requirements and deposit insurance are distinct and should not be conflated (see Table below for comparison of deposit insurance and capital requirements). While the existence of a deposit insurance framework may alleviate the impacts of a bank’s failure on that bank’s insured depositors, it does not reduce the probability of that bank failing in the first place. It may, however, reduce the impacts of a bank failure for insured depositors, but historical experience shows that crises are very costly even in jurisdictions where deposit insurance exists. Indeed, the social and economic loss estimates underpinning our capital proposals are all from countries with deposit insurance regimes. In other words, even though an ambulance (deposit insurance) is waiting at the bottom of the cliff, it doesn’t mean there should be a weaker fence at the top (minimum capital requirements). Were a bank to fall off the cliff, the damage to New Zealand’s landscape would be significant and lasting and could only be offset to a minor degree by the existence of a deposit insurance framework – it would provide

1 It should be noted that most jurisdictions around the world increased capital requirements following the global financial crisis even with the presence of a deposit insurance framework. We are not aware of suggestions, even by industry, that the extent of those increases should have been limited due to the existence of a deposit insurance framework.

6 some shield for day-to-day transactions and savings and bill payments (but not income loss) for small (less wealthy) depositors.

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1 Reserve Bank Report: Rural outreach To Minister of Finance Date 4 Nov 2019 Authorised by Geoff Bascand, Deputy Governor Report no. 5354 Prepared by Susan Guthrie Security rating Action Sought Action sought Deadline  Note the Reserve Bank had 7 meetings with Federated Farmers provincial executive committees, ranging from Northland to Otago, and also met with the Federated Farmers National Board. The topic of the meetings was the Capital Review.  Note the Reserve Bank is considering the feedback provided in these meetings, including the suggestion to extend the transition period.  Note the meetings were useful in deepening our understanding of the issues facing the rural sector, their key concern about the Capital Review, and the nature of the messaging from banks to the sector.  Note that based on the anecdotes shared in these meetings, we remain concerned about some loan repricing behaviour and will be discussing this issue with banks. Reserve Bank Contact for Telephone Discussion (if required) Name Position Telephone Ian Woolford Manager, Financial Policy +64 4 471 3739

2 Actions for the Minister’s Office Staff Note any feedback on the quality of the report.

3 I. Introduction The Reserve Bank is proposing to increase bank capital requirements and final decisions will be announced in early December. The proposal is designed to make the banking system more resilient. However, the proposal has concerned Federated Farmers, as they have concerns that as a result of the Capital Review, some farm borrowers may face larger increases in borrowing costs than other sectors and/or decreased access to debt funding. When the equity share of a bank’s total funding increases, the bank’s average cost of funding may increase.1 Some banks have signalled that they intend to maintain return on equity by increasing borrowing costs and fees to some customers (and the rural sector in particular). The main reasons for pricing differences across sectors appears to be banks’ own risk appetite towards the dairy sector at the moment, and the lack of competition in the agricultural sector (compared to, for example, mortgage lending). The potential for lending rates on rural loans to rise more than for other types of lending reflects what we believe to be a lack of competition in rural lending. Although there are some signs of interest among potential new entrants, rural lending is dominated by five banks (and one – ANZ – has nearly half the market). But more importantly, farm lending requires banks to have an in-depth knowledge of the borrower and this knowledge takes time to develop. Rural banking thus has a long-term ‘relationship’ basis, and this makes it more difficult for borrowers to switch banks in the pursuit of cheaper interest costs (it also acts as a barrier to new entrant banks). Because relatively few banks compete in the rural lending market, and lending is based on long-term relationships, the rural sector may bear a disproportionate share of the increase in interest income sought by some banks. In their submission to the bank capital review outlined the importance of competition, stating that “ Farmers do not have the ability to influence the farm-gate prices they receive and therefore cannot pass on higher interest costs to their customers in order to maintain their profitability. The Reserve Bank has concerns that some banks may be using the bank capital review to expand rural lending margins to an unreasonable degree, using the bank capital proposal as ‘cover’ (i.e. to minimise the reputational harm that would otherwise accompany an expansion in margins). Based on the anecdotes shared in these meetings, we remain concerned about the aggressive repricing behaviour of some banks and plan to raise this issue with the banks concerned. II. Rural meetings In August and September Ian Woolford, Manager Financial Policy at the Reserve Bank, and colleagues travelled around New Zealand to meet with Federated Farmers provincial

1 There are offsetting cost factors however. As the equity share increases, the risks associated with that investment decline. Hence the rate of return required on equity is expected to be lower, the higher is the share of equity in the bank’s total funding. 2 ANZ Bank’s (redacted) submission to the Capital Review, 17 May 2019. Available at RBNZ.govt.nz. s(18) s(18)(c)(i)

4 executive committees. Most meetings had between 10-20 attendees comprising committee members, Federated Farmers local staff, members of local rural support trusts and, in one case, (Waikato) the local Rural Women representative. 7 regional meetings were held in total, ranging from Northland to Otago (details of each meeting are provided in Appendix 1). In additional Geoff Bascand, Deputy Governor, met with the National Board of Federated Farmers on 15th August. The meetings had several purposes: o To outline the rationale for proposed bank capital increases and provide details of the proposal; o To describe the Reserve Bank’s views about the expected impacts on lending rates, with a focus on the rural sector, outline the lending rate increases some banks and external commentators have indicated and discuss these differences in view; o To explain the way regulatory capital requirements can affect capital, and the way that bank’s risk appetites and expected rate of return on equity can drive pricing decisions; o To learn about participants’ views of the capital proposal; and o To learn about the behaviour of banks towards rural customers following the announcement of capital proposal. III. Feedback from the meetings The bank capital reforms are occurring at a time banks have a reduced appetite for rural loans due to a number of factors unrelated to bank capital. These factors include, but are not limited to, significant policy reforms designed to address deteriorating water quality and climate change, persistent debt servicing difficulties for some borrowers, reduced volumes of land sales (impacting on anticipated capital gains) and higher lending standards per se. The decline in banks’ appetite for rural lending began in 2015, around the time dairy prices fell sharply. This can be seen from trends in the Reserve Banks’ Credit Conditions Survey (refer Figure 1 in Appendix 2). Although there was acknowledgement among farmers that the Reserve Bank’s proposals made sense from a ‘big picture perspective’, in the rural meetings farmers expressed concern about the magnitude of the changes, the pace of change and what the changes mean for farmers. The general view expressed at the meetings was that the capital proposals have come at a bad time, albeit the changes in and of themselves may be sensible. A view expressed in all meetings was that, rather than any one reform, it is the interaction and concurrence of the bank capital reforms and other significant policy reforms that is putting a severe strain on the sector. For example, in order to meet new environmental standards farmers are having to invest in farm upgrades but as a result of the capital review banks appear to have become less willing to extend the credit required (and/or the cost of the credit that is available is rising much more than it otherwise might). A common theme of the meetings was the plethora of changes facing the sector, and uncertainty about the details of some of the changes, is giving rise to concern. Examples commonly cited were the Essential Freshwater proposals and climate change policy (Zero Carbon Bill and ETS) and changes to address other environmental issues. There was also concern about incentives for forestry which, in combination with water and climate change

5 policy, are resulting in (or threatening to result in) wholesale conversion of pastoral farms to forestry with adverse impacts on rural communities. Overall, meeting participants were strongly of the view that the direction of government policy (including but not primarily the capital reforms) is having a detrimental impact on the morale of the sector and many felt that confidence in the sector has not been so low since the 1980s. This in spite of good commodity prices, a lower exchange rate, and low interest rates. There was strong support among attendees for a longer transition period for the capital reforms. There was a minority view that a short period would help the smaller banks compete. A few attendees supported the idea of establishing a new Rural Bank or the Government injecting capital into Kiwibank to allow it to enter the rural market (although on balance most of those attending the meetings seemed to think the existing rural lenders will remain dominant for the foreseeable future). IV. Implications for the Capital Review The Reserve Bank is considering the feedback provided in these meetings as it moves towards final decisions, including the suggestion to extend the transition period. Recommendation

1. It is recommended that you: a) Note that the Reserve Bank has undertaken 7 meetings with Federated Farmers provincial executive committees, ranging from Northland to Otago, and also met with the Federated Farmers National Board. The topic of the meetings was the Capital Review. b) Note the Reserve Bank is considering the feedback provided in these meetings, including the suggestion to extend the transition period. c) Note the meetings were useful in deepening our understanding of the issues facing the rural sector, their key concern about the Capital Review, and the nature of the messaging from banks to the sector. d) Note that based on the anecdotes shared in these meetings, we remain concerned about some loan repricing behaviour and will be discussing this issue with banks. Hon Grant Robertson Minister of Finance xx/xx/xxxx Geoff Bascand Deputy Governor Reserve Bank of New Zealand Xx/xx/xxxx

6 Appendix 1 Below is a list of key attendees at the meetings. This list includes only the senior Federated Farmers office holders. Ashburton – 15 August 2019 • Michael Salveson, Chair of Canterbury Regional Policy Committee and Immediate Past-President of Mid Canterbury Federated Farmers. • David Clark, President Mid Canterbury Federated Farmers • Cam Henderson, President North Canterbury Federated Farmers • Jason Grant. President South Canterbury Federated Farmers • Simon Williamson, President Otago Federated Farmers • Rob Stokes, Chair of Federated Farmers South Island High Country industry group Federated Farmers National Board – Wellington, 21 August 2019 • Andrew Hoggard, Vice President • Chris Lewis, Dairy Chair • Miles Anderson, Meat & Wool Chair • Karen Williams, Arable Chair • Chris Allen, Board member • Andrew Maclean, Board member • Terry Copeland, Chief Executive Edgecumbe – 5 September 2019 • Darryl Jensen, President Bay of Plenty Federated Farmers • Colin Guyton, President Rotorua-Taupo Federated Farmers • Gifford McFadden, Past-President Rotorua-Taupo Federated Farmers Whangarei – 19 September 2019 • John Blackwell, President Northland Federated Farmers Woodville – 23 September 2019 • Sally Dryland, Co-President Tararua Federated Farmers • Neil Filer, Co-President Tararua Federated Farmers • Jim Galloway, President Hawkes Bay Federated Farmers • Richard McIntyre, Chair of Federated Farmers Sharemilkers Subsection Inglewood – 24 September 2019 • Mark Hooper, President Taranaki Federated Farmers • Donald McIntyre – Immediate Past-President Taranaki Federated Farmers Hamilton – 25 September 2019 • Andrew McGiven, President Waikato Federated Farmers • Alan Cole, President Auckland Federated Farmers Mosgiel – 27 September 2019 • Simon Davies, President Otago Federated Farmers • Phill Hunt, Immediate Past-President Otago Federated Farmers • Stephen Korteweg, Past President Otago Federated Farmers • Geoffrey Young, President Southland Federated Farmers

Reserve Bank Report: Final Decisions on the Capital Review To Hon Grant Robertson, Minister of Finance Date 26 November 2019 Authorised by Geoff Bascand, Deputy Governor/General Manager Financial Stability Report no 5360 Prepared by Ian Woolford, Manager Security In confidence Action Sought Action sought Deadline For information only. Note: Market Sensitive N/A Reserve Bank Contact for Telephone Discussion (if required) Name Position Telephone Geoff Bascand Deputy Governor/General Manager Financial Stability 04 471 3675 Ian Woolford Manager, Financial Policy 04 471 3739 Actions for the Minister’s Office Staff Please advise above contacts if further information or discussion is required. Note any feedback on the quality of the report.

2 Recommendation

1. It is recommended that you: a) Note the final decisions on the Capital Review that the Reserve Bank will announce publicly on 5 December 2019 at 12pm. b) Note that a copy of the decisions and public communication documents, including a near-final draft of the Reserve Bank’s Regulatory Impact Assessment, containing the detailed cost benefit assessment, will be sent to you prior to the 5 December announcement. c) Note that additional Capital Review background documents will be released by the Reserve Bank on 12 December 2019. d) Note that some of these background documents include briefings from the Reserve Bank to you related to the Capital Review (should you agree to this). e) Note that the release of any briefings from the Reserve Bank to you will be coordinated with your office. f) Note that discussion with Reserve Bank officials is scheduled for 3 December (ahead of the announcement) and indicate if any other briefing is required. Hon Grant Robertson Minister of Finance /11/2019 Geoff Bascand Deputy Governor Reserve Bank of New Zealand 26/11/2019

3 Purpose

1. This note details the Reserve Bank’s final decisions on the Capital Review, which will be released publicly on 5 December 2019 at 12pm.
2. It also serves to inform you that the Reserve Bank will be publicly releasing additional Capital Review background documents on 12 December 2019, which include briefings from the Reserve Bank to you (should you agree to this). The release of these documents will be coordinated with your office. Background – The Capital Review proposals
3. The Reserve Bank launched the Capital Review in May 2017 and released four consultation papers that related to different parts of the capital framework.
4. The most recent consultation paper, released in December 2018, proposed a significant increase to minimum capital requirements for banks, as follows: Current Requirements Dec 2018 Proposal (D-SIBs) Dec 2018 Proposal (non D-SIBs) Common Equity Tier 1 7% 14.5% 13.5% Total Tier 1 8.5% 16% 15% Total Capital (Tier 1 + Tier 2) 10.5% 18% 17%
5. As the proposed requirements included a 1% ‘domestic systemically important bank’ (D-SIB) capital buffer, the capital requirements for non D-SIBs (small banks) would be 1% lower than D-SIBs.
6. It was also proposed that a ‘capital floor’ of 85% be introduced into the framework. This floor would require banks that use their own models to measure capital (‘internal ratings based’ (IRB) banks) – which in New Zealand are the four large banks – to have capital no lower than 85% of that measured by the models prescribed by the Reserve Bank (the ‘standardised’ approach).
7. The consultation paper also asked for views on whether the 2% Tier 2 component of the total capital requirement should be kept. If removed, this would reduce the total capital requirement from 18% to 16% for D-SIBs and from 17% to 15% for non D￾SIBs.
8. The consultation also considered the adoption of a ‘leverage ratio’. The leverage ratio is an ‘un-risk-weighted’ measure of capital adequacy, as it does not adjust for the riskiness of different asset classes.
9. The above proposals, combined with other, more technical, proposed changes to the capital framework would result in a significant increase in capital requirements for

4 New Zealand’s banks, and therefore a materially reduced probability of bank failures and threats to financial stability. 10. A five year transition period was proposed. Consultations and Decision-Making 11. The Reserve Bank conducted an unprecedented level of consultation with this Review, particularly following the December 2018 consultation paper, to ensure we gathered and understood the perspectives of all New Zealanders. 12. In addition to the public consultations, in which we received 161 submissions in response to our December 2018 consultation paper, we directly engaged with banks, businesses, ratings agencies, other regulators, industry associations, the agricultural sector (farmers), non-governmental organisations, representatives of the Māori community, and members of the public. 13. We also engaged three external experts to provide us, and the public, with their perspectives on the reasonableness of the Reserve Bank’s analysis and proposals. The three experts indicated overall comfort with the direction of the Capital Review and suggested further areas for analysis. 14. We used an external agency (Kantar) to conduct a series of focus groups with members of the public. This helped inform our perspective on how the public might assess society’s risk-reward trade-off inherent in bank capital settings. This engagement took the form of deliberative workshops, where, over four hours, members of the focus groups considered the merits of the capital proposals. On balance, there was broad support for the proposals. 15. The Reserve Bank undertook an extensive and rigorous process in coming to final decisions, considering the feedback from all stakeholders, including the external experts. This process included exhaustive discussions at internal Reserve Bank committee meetings, where different perspectives and options were challenged and debated at length. 16. The final decisions by the Governor were arrived at through discussion and consensus in the Reserve Bank’s Financial Stability Committee. The final decisions are supported by cost-benefit analyses, and fulfil the principles established at the outset of the Review. The Reserve Bank’s Board have been kept fully informed of the progress of the review and engaged in the Bank’s approach. Final Decisions 17. The final decisions confirm the minimum Tier 1 capital requirement of 16% and the total capital requirement of 18% (i.e., we have retained Tier 2 capital in our framework). 18. We have decided to reverse a previous in-principle decision that was made earlier in the consultation process. The previous in-principle decision was to not allow redeemable perpetual preference shares (i.e., shares that could be redeemed by the

5 bank) as Additional Tier 1 (AT1) capital. In light of the higher Tier 1 ratio being adopted, the risks posed by these instruments were reviewed and found to be tolerable. We have thus decided to allow redeemable perpetual preference shares as AT1 capital. This decision reduces the expected economic cost of increasing Tier 1 capital. We expect the reversal of this previous in-principle decision to be well received by some banks. 19. Complementing the decision to accept redeemable perpetual preference shares as AT1 capital, the decision has been made to allow a larger role for AT1 (up to 2.5%, from the proposed 1.5%). This decision to allow up to 2.5% of AT1 capital (rather than 1.5%) was made on the basis that our objectives for resilience and stability could still be achieved, while at the same time, lowering the expected economic impact of these changes. Given this change, there is a corresponding 1% reduction in the Common Equity Tier 1 requirement. 20. It was also decided that the D-SIB capital buffer would be increased from 1% to 2%, which would lower the capital requirements for non D-SIBs (small banks) by 1% relative to the original proposals. 21. The Reserve Bank will proceed with introducing a ‘capital floor’ of 85%. 22. The Reserve Bank will not proceed with the adoption of a leverage ratio. 23. The transition period will be extended from five years to seven years, and implementation will commence from 1 July 2020 (rather than 1 April 2020 as had earlier been proposed). We expect the additional two years of transition time will better smooth the economic impacts of these changes. A longer transition period was recommended by both industry and many members of the public and industry groups (such as Federated Farmers). 24. In sum, the Reserve Bank’s capital requirements will be as follows: Dec 2018 Proposal (D-SIBs) Final (D-SIBs) Dec 2018 Proposal (non D-SIBs) Final (non D-SIBs) Common Equity Tier 1 14.5% 13.5% 13.5% 11.5% Total Tier 1 16% 16% 15% 14% Total Capital (Tier 1 + Tier 2) 18% 18% 17% 16% 25. A chart comparing the status quo, December 2018 proposals, and final decisions is provided in the Appendix. Market Impacts 26. We expect most of these final decisions to be roughly in line with the expectations of banks and the market.

6 27. However, there is still uncertainty about what the actual reactions may be. We will be speaking with the FMA to discuss the expected market impacts on the day of the announcement. It is possible that the New Zealand Exchange (NZX) and the Australian Securities Exchange (ASX) will halt trading on bank-listed securities immediately prior to the announcement. Regulatory Impact Assessment 28. Prior to the 5 December announcement, we will send you a near-final Regulatory Impact Assessment (RIA), which will include a detailed cost benefit assessment of the expected impacts of the final decisions. 29. The Financial Stability Committee considered a near-final version of the cost-benefit assessment that had been independently and positively reviewed by John Yeabsley (NZIER). Engagement with Treasury 30. The Reserve Bank has met with Treasury throughout the Capital Review. The Treasury were provided with a draft RIA on 18 November (in advance of final decisions) and were informed of the final decisions on 26 November. Next Steps 31. We are scheduled to meet with you on 3 December and will provide drafts of announcement material at that time. 32. The Reserve Bank will inform certain stakeholders of these final decisions on an embargoed basis prior to being publicly announced. These stakeholders include: the Reserve Bank’s Board of Directors (done on 25 November), APRA (4 December), COFR members (4 December), and the New Zealand Bankers Association (NZBA) and their members (the morning of 5 December). We are also offering briefings to other political parties, as indicated to your office. These briefings would take place on 4 and 5 December, should there be interest. 33. The Reserve Bank will hold a ‘lock up’ for media from 10am to 12pm at the Reserve Bank on 5 December 2019. One objective of this ‘lock up’ is to promote accurate media reporting of these decisions, which we expect to come out shortly after the public announcement at 12pm. 34. The decision announcement will involve release of the following documents:  A publicly accessible, ‘go-to-guide’ for the capital decisions  The policy decisions (pitched appropriately for banks and analysts)  The Regulatory Impact Assessment  A Response to Submissions  Media release and website material 35. The Reserve Bank will hold a media conference at 1pm on 5 December 2019, which will be livestreamed on our website.

7 36. Reserve Bank officials will meet with bank directors to discuss these decisions on 9 December in Wellington and on 10 December in Auckland. 37. The Reserve Bank will also release additional Capital Review background documents on 12 December 2019, which include briefings from the Reserve Bank to you related to the Capital Review (should you agree to this). The release of these documents is intended to add transparency and credibility to the process. 38. We will closely monitor the impacts of this announcement and inform you of any relevant matters.