Review of the Reserve Bank of New Zealand’s Capital Adequacy Proposals

Review of the Reserve Bank of New Zealand’s Capital Adequacy Proposals 17 May 2019

© NERA Economic Consulting Authors Professor (Emeritus) Lewis Evans James Mellsop Kevin Counsell We thank Westpac New Zealand for funding work on this report, and for supplying certain data (as the report records). The analysis and views of the report are solely those of the authors.

© NERA Economic Consulting i Contents

1. Introduction and executive summary....................................................... 2
2. Inappropriate analytical framework.......................................................... 3 2.1. Are current ratios too low? ..................................................................................... 3 2.2. The RBNZ framework ............................................................................................ 6 2.3. The principle of “levelling the playing field”...........................................................11
3. Banks’ margin over the regulated requirement.....................................14
4. Effect on interest rates and lending .......................................................16

© NERA Economic Consulting 2

1. Introduction and executive summary

2. The Reserve Bank of New Zealand (“the RBNZ”) has released a paper seeking feedback on a proposal to increase the minimum level of capital required to be held by New Zealand banks (“the January 2019 paper”).1 In this report we set out our review of the January 2019 paper and proposal. We also refer throughout our report to a companion paper released by the RBNZ in April 2019 (“the April 2019 paper”),2 which sets out further detail on the RBNZ’s analysis in the January 2019 paper.

3. The RBNZ’s proposal involves raising the minimum Tier 1 capital requirement for the big four banks (Westpac, ANZ, ASB and BNZ)3 from the current 8.5% of risk-weighted assets (“RWA”) to 16%, in combination with also increasing the measure of RWA itself for these banks. The joint effect is that these four banks will be required to hold considerably more equity capital, and/or reduce their lending. The combination of the increasing capital requirement and increasing RWA amount to a change in the minimum Tier 1 capital requirement from 8.5% to, effectively, 18.5% of current RWA.4 5

4. We conclude that various flaws lead the RBNZ to propose this more stringent set of capital ratio requirements that would impose clear costs on the economy, in return for an unclear and unsubstantiated benefit.

5. More particularly: a. The RBNZ’s papers do not present any evidence that the existing capital requirements are inadequate, or that the future will be risker (and require stronger capital requirements) than the past. More generally the papers do not contain any proper problem definition; b. The RBNZ’s papers do not robustly justify the fundamental driver of the proposal, being the 1-in-200 year probability of a crisis; c. The RBNZ’s papers apply a framework that prioritises its unsubstantiated concerns about a lack of soundness (or “creditor confidence”) ahead of gross domestic product (“GDP”), with no analysis of the extent to which society would be willing to accept this trade off; d. The RBNZ introduces an additional principle (“levelling the playing field”), ostensibly to enhance competition, when in fact the RBNZ’s proposal would have the opposite effect. Attempting to level the playing field in this way would not enhance economic performance, and would lead to a reallocation of deposits to, and lending by, the less regulated finance sector. Accordingly, the RBNZ’s proposal might actually reduce soundness; e. The proposal would increase the probability of RBNZ involvement in management of banks, with no analysis of the efficiency of this, or whether it might actually undermine soundness; f. The RBNZ’s papers do not analyse the implications of an open economy and foreign (Australian) ownership of the largest four banks; and

1 RBNZ (2019), “Capital Review Paper 4: How much capital is enough?”, January. 2 RBNZ (2019), “Capital Review Background Paper: An outline of the analysis supporting the risk appetite framework”, April. 3 And the smaller banks, albeit by a slightly smaller amount. 4 From Table 9 of the January 2019 paper, the required increase in Tier 1 capital is $46.4b, which is 18.5% of current RWA for the big four banks of $251.1b. 5 If the banks’ margin over the minimum requirement is maintained, the actual Tier 1 ratio would go from 13.4% to 23.4% (the RBNZ states, at footnote 4 of the January 2019 paper, that at the end of March 2018 the aggregate Tier 1 capital ratio across all locally incorporated banks was 13.4%, implying a margin of 4.9 percentage points over the minimum requirement of 8.5%).

© NERA Economic Consulting 3 g. The RBNZ’s papers do not analyse the possibility that the banks would lower their lending in response to the proposed changes, and the implications of this for the economy. More generally the RBNZ’s papers appear to under-estimate the negative economic effects of the proposed changes. These negative economic effects would be exacerbated by the likelihood that banks would hold more equity capital than the required 16%, just as they hold a margin over required capital today. 2. Inappropriate analytical framework 5. Rigorous public policy analysis starts with careful problem definition. There is no analysis of problem definition in the RBNZ’s papers, although it is clear the RBNZ considers the current capital ratio of the banks (particularly the largest four) to be too low. 6. However: a. The RBNZ does not provide evidence that the current capital ratios are too low, or that the future will be riskier than the past and warrant higher capital ratios; b. The RBNZ applies a framework that prioritises its accordingly unsubstantiated concerns about a lack of soundness (or “creditor confidence”) ahead of GDP, with no analysis of the extent to which society would be willing to accept this trade off; and c. The RBNZ introduces an additional principle (“levelling the playing field”), ostensibly to enhance competition, when in fact the RBNZ’s proposals would have the opposite effect. 7. These flaws lead the RBNZ to propose a more stringent set of capital ratio requirements that would impose clear costs on the economy, in return for an unclear and unsubstantiated benefit. 8. We discuss each of these three points in more detail in the following sections. 2.1. Are current ratios too low? 9. It is important to note the banks currently hold materially more capital than they are required to by regulation, as the RBNZ acknowledges (at [15] of the January 2019 paper). The RBNZ states (footnote 4 of the January 2019 paper) that at the end of March 2018 the aggregate Tier 1 capital ratio across all locally incorporated banks was 13.4%. This compares with the current regulatory capital requirement of 8.5%. 10. Indeed, an internal RBNZ paper acknowledges that there are other incentives on banks to hold capital, beyond just regulatory requirements.6 In particular, this paper sets out the following factors that influence banks’ capital ratio targets: a. Regulatory minima; b. Expectations of ratings agencies and wholesale funding markets; c. International and domestic peer comparisons; d. Other internal bank analysis (e.g., stress testing); and e. An allowance for year-on-year variability above the regulatory buffer. 11. It is also important that the New Zealand banks, and indeed the economy more generally, came through the global financial crisis (“GFC”) relatively well, and this was the assessment of the RBNZ. For example, in a 2018 speech, RBNZ Deputy Governor Geoff Bascand noted that New

6 RBNZ (2018), “Background notes on capital review”, 25 July, available at: https://www rbnz.govt.nz/regulation-and￾supervision/banks/capital-review-proposals-information-release

© NERA Economic Consulting 4 Zealand’s financial sector “has weathered the GFC better than most”.7 A 2012 paper by then RBNZ Governor Alan Bollard (with Tim Ng) states that New Zealand “escaped the worst of the financial crisis”.8 12. Importantly, New Zealand has only ever had two banking crises, one in the late 1880s/early 1890s and the other in the late 1980s, both involving the state-owned Bank of New Zealand, and at least the latter crisis is not considered systemic. 9 This number of crises has been acknowledged by the RBNZ as being “limited”,10 particularly relative to the US where banking panics occur frequently.11 The nature of the financial system was certainly considerably different in the 19th century to that of today, and prudential regulation of the system today is considered “well established”, compared with “minimal regulations” in the 19th century and a “regulatory framework in a state of flux” in the late 1980s.12 13. As recently as November 2018 in its Financial Stability Report the RBNZ stated that “New Zealand’s financial system is sound”.13 14. The RBNZ has also conducted stress tests, which involve modelling a “severe macroeconomic downturn scenario”.14 The most recent (2017) stress test found that the big four banks could “absorb material losses in a downturn event while remaining solvent” and meet minimum capital requirements.15 While the RBNZ notes that stress testing results can be sensitive to the underlying assumptions,16 it nonetheless notes that it uses stress tests “to assess the soundness of the financial system”. 17 Yet the RBNZ seems to give this stress testing zero weight in reaching a view on the current capital requirements proposal. 15. Moreover, the credit ratings of the New Zealand banks by the major ratings agencies (Standard & Poor’s and Moody’s) imply a high level of soundness, and one that implies a risk of failure materially below the RBNZ’s proposed 1-in-200 year threshold. 16. In Table 1 we report the credit ratings of the New Zealand banks and their Australian parents, as well as those for selected banks in Finland, Norway and Czech Republic. We choose the banks for the latter three countries because, across a set of international comparisons reported by the RBNZ, they are the only countries that have capital ratios greater than the ratio proposed by the RBNZ.18 The banks chosen from these countries are the ones reported by the RBNZ in its international comparisons. 17. We might expect to see these relatively high capital ratios reflected in banks having consistently higher credit ratings than banks that (currently) have relatively lower capital ratios, as is the case

7 “Financial Stability – risky, safe or just right?”, 13 November 2018, available at: https://www.rbnz.govt nz/news/2018/11/financial-stability-risky-safe-or-just-right 8 Alan Bollard and Tim Ng (2012), “Learnings from the Global Financial Crisis”, RBNZ Bulletin, 75(3), 57-66. 9 The RBNZ has stated that New Zealand has not had a systemic banking crisis in its post-war economic record – see p.3 of the April 2019 paper. 10 Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26 11 Chris Hunt (2009), “Banking crises in New Zealand – an historical perspective”, RBNZ Bulletin, 72(4), 26-41. 12 Ibid., at Table 1. 13 RBNZ (2018), “Financial Stability Report”, November. 14 Charles Lilly (2018), “Outcomes from the 2017 stress test of major banks”, RBNZ Bulletin, 81(9), 3-18. 15 Ibid., at p.8. 16 See the April 2019 paper at p.23. 17 Lilly (2018), op cit., at p.3. 18 See Figure 3 below, based on the median capital ratio shown.

© NERA Economic Consulting 5 in New Zealand and Australia. While there are two instances of banks in Table 1 having higher credit ratings than the New Zealand banks (DNB Bank in Norway and OP Corporate Bank in Finland, on the Moody’s ratings), in all other cases the banks in Finland, Norway and Czech Republic shown in Table 1 have the same or lower credit ratings than the New Zealand banks. Table 1: Credit ratings of banks in NZ, Australia and selected countries Bank Standard & Poor’s Moody’s New Zealand ANZ AA- Aa3 BNZ AA- Aa3 ASB AA- Aa3 Westpac AA- Aa3 Australia ANZ AA- Aa2 NAB AA- Aa2 Commonwealth Bank AA- Aa2 Westpac AA- Aa2 Finland Aktia Bank A- Aa3 OP Corporate Bank AA- Aa2 Norway DNB Bank AA- Aa1 Czech Republic CSOB A+ Aa3 Komercni A Aa3 Ceska Sporitelna A Aa3 Source: ratings agencies. We use Standard & Poor’s local/foreign currency long-term rating and Moody’s long-term counterparty risk rating. 18. It is also possible to translate the credit ratings into default probabilities. A 2008 RBNZ Bulletin paper reports that the Standard & Poor’s AA rating is associated with a cumulative probability of default over five years of 1-in-300.19 More recent analysis by Standard & Poor’s calculates the cumulative probability of default over five years to be approximately 1-in-300 for an AA￾rating.20 That is, a company with an AA- credit rating has a 1-in-300 (0.33%) chance of defaulting by the end of a five-year period. 19. This cumulative probability that a company will default by the end of a five-year period can be converted to a probability that the company will default in any given year. That is, if an AA￾rated company has a 0.33% chance of defaulting by the end of a five-year period, what is the probability that it will default in any given year (conditional on prior survival)? This “conditional default probability” (also known as the “hazard rate”) can be calculated from the cumulative default probability, and in this case would yield a default probability of 1-in-1,500 for an AA-

19 Doug Widdowson and Andy Wood (2008), “A user’s guide to credit ratings”, RBNZ Bulletin, 71(3), 56-62. 20 See Table 26 of S&P (2018), “2017 Annual Global Corporate Default Study and Rating Transitions”, 5 April.

© NERA Economic Consulting 6 rating.21 That is, based on their AA- Standard & Poor’s rating, the New Zealand banks are assessed as having a 1-in-1,500 (or 0.067%) probability of default in any given year. This is comparable to the RBNZ’s 1-in-200 year (0.5%) threshold,22 and implies that the ratings agencies consider the risk of failure to be materially below that proposed by the RBNZ. 20. In summary, this evidence finds that the existing bank capital requirements have delivered a financial system the RBNZ has recently stated to be sound, which is corroborated by the default probabilities implied by banks’ credit ratings. The RBNZ has not provided any evidence to suggest the contrary. 2.2. The RBNZ framework 21. The RBNZ’s framework is replicated in Figure 1 below. The approach taken by the RBNZ is to choose the point shown by the blue dot, which provides greater “stability” than the status quo (the red dot) but does not maximise expected GDP (which would occur at the green dot). Figure 1: RBNZ's Stylised Risk Appetite Framework Source: Figure 3 of the January 2019 paper 22. At least based on the January 2019 paper, trading off GDP in this way is on the basis that the vague notion of “retaining creditor confidence” ([17]) is more important than maximizing expected economic output. Indeed, at [22] the RBNZ’s discussion of efficiency is based “on the assumption the soundness objective is met”, and its two-step process at [24] starts with the soundness objective before proceeding to the efficiency one. “Retaining creditor confidence” (or “soundness”) is achieved by choosing the blue dot, and then the RBNZ tests whether output could be expanded if we move further to the right in Figure 1 – there is no scope to move further to the left, even if that would increase economic output.

21 As set out in John C. Hull (2012), Options, Futures, and Other Derivatives, Eighth Edition, Prentice Hall, Boston (at pp.522-523), the five-year cumulative default probability (Q) would be given by the formula 𝑄𝑄 = 1 − 𝑒𝑒−5𝜆𝜆, where λ is the hazard rate. Where Q=0.33%, re-arranging this formula yields a value for λ of 0.067%, or approximately 1-in-1,500. 22 On our interpretation, the 1-in-200 is a conditional default probability, i.e., the probability of default in a given year, conditional on prior survival. For example, of the risk tolerances referred to by the RBNZ as context for the 1-in-200 (the April 2019 paper, at p.16), the Basel confidence level has been referred to as “the likelihood that the bank will remain solvent over a one-year horizon” (Basel Committee on Banking Supervision (2005), “An Explanatory Note on the Basel II Risk Weight Functions”, July, at p.3).

© NERA Economic Consulting 7 23. In effect the RBNZ is prioritising a concept of soundness (“retaining creditor confidence”) over that of economic performance more broadly, i.e., over that of efficiency. In the January 2019 paper, the RBNZ does not provide any justification for this – the RBNZ simply asserts (at [24]) that there should be a “two-step decision-making process”: “Step 1: Determine the level of capital that achieves the soundness objective. This is the provisional capital target. Step 2: If it seems likely that increasing capital beyond what is required to achieve soundness will entail no loss of expected output, set the capital target above the provisional target”. 24. The RBNZ does provide a justification for choosing the blue dot over the green dot in the April 2019 paper. The RBNZ argues that society is willing to trade-off some expected output to reduce the probability of a banking crisis, on the basis that society is risk averse. For example, the RBNZ states that “the evidence strongly suggests that society is not indifferent to risk, so it seems important to accommodate the possibility that society may prefer capital levels that deliver a great deal of stability even if it means some sacrifice of expected output”.23 25. However, the RBNZ does not undertake any analysis regarding how much expected output society would be willing to trade-off (i.e., the vertical drop from the green dot to the blue dot) for a given increase in stability (the right-hand shift from the green dot to the blue dot). Rather the RBNZ chooses the location of that blue dot without any analysis of its vertical or horizontal distance from the green dot, but instead on the basis of what we consider to be an arbitrary 1-in￾200 year probability of a crisis. 26. The RBNZ does acknowledge this side step. For example, it states:24 The approach adopted by the Reserve Bank incorporates society’s risk tolerance in a simple way. We represent the costs and benefits of capital objectively (without any weightings) and incorporate risk aversion by aiming to cap the probability of a crisis at some predetermined level. 27. While we are sympathetic to the difficulties of operationalising the RBNZ’s risk aversion framework, the problem with the RBNZ’s side step is that the position of the blue dot is chosen on the basis of different considerations to those underlying the conceptual argument for shifting to the right and down from the green dot. 28. The location of that blue dot on the horizontal axis is the 1-in-200-year probability of a crisis. The justifications for choosing the particular location of the blue dot are not robust, and as noted are not related to the conceptual framework adopted by the RBNZ. The RBNZ illustrates our general point where it states “[t]his paper is not intended to provide a cost-benefit assessment of the proposal”.25 In short the RBNZ is proposing a particular probability, and a particular concomitant capital ratio, without having undertaken a cost-benefit assessment of the value of these changes to society. 29. In the January 2019 paper, the only stated bases for the 1-in-200 year probability are the “precedents” referred to at footnote 5 of that paper. One of these is a 0.5% risk of insolvency used in insurance solvency standards in Europe. However, it is not at all clear how solvency standards for insurance are relevant to the required standard for banks, when the nature of risks and costs associated with events are quite different between the two industries. 30. Footnote 5 also refers to the internal ratings based (“IRB”) capital equation for credit risk specifying a 0.1% annual risk tolerance, i.e., a 1-in-1000 year probability of an event, yet the RBNZ notes that “in practice the level of solvency delivered by the equation is somewhat less due

23 The April 2019 paper, at p.12. 24 See page 12 of the April 2019 paper. 25 Page 4 of the April 2019 paper.

© NERA Economic Consulting 8 to modelling uncertainties”. Clearly a 1-in-1000 probability is not a “precedent” for a 1-in-200 year probability, and the RBNZ has not provided any detail on how “somewhat less” may change the 1-in-1000 year figure. 31. In the April 2019 paper the RBNZ provides some further examples, including 1-in-1000 years for earthquake risks for non-life insurers in New Zealand, 1-in-250 years for other non-life catastrophes, and 1-in-500 years for a US deposit insurance fund. It is acknowledged in the April 2019 paper that there is “a range of risk tolerances”. Our point is that these examples appear to provide little basis for justifying the RBNZ’s choice of the 1-in-200 year probability for banking. 32. In the April 2019 paper the RBNZ has added two more justifications for the 1-in-200 year probability. 33. The first is the broader social impacts of a crisis (e.g., on physical and mental health, family cohesion, etc). 26 However, the RBNZ’s consideration of these impacts is asymmetric – the RBNZ does not consider the social impacts of the lower GDP implied by the shift from the green to blue dot. 34. The second is “the preliminary finding from the early modelling work” (p.19), which is based on the modelled relationship between GDP and the probability of a crisis. The model is one of a closed economy, treating New Zealand as independent of world markets. From this modelling the RBNZ found that adopting the 1-in-200 probability could maximise GDP for particular input values used (as shown in Figure 5 of the April 2019 paper). But this is nothing to do with risk aversion. It does not provide a basis for moving from the green dot on Figure 1 above to the blue dot. 35. The RBNZ’s Figure 5 in the April 2019 paper is based on a closed economy model with multiple inputs – see the equation at p.10 of the April 2019 paper, for which the key variable inputs are b (the marginal impact of a change in the capital ratio on GDP) and K (the proposed capital ratio). K itself varies due to changes in the probability of default (PD), loss given default (LGD) and correlation (R). The RBNZ has noted (p.28 of the April 2019 paper) that the values of PD, LGD, and R vary over specified ranges, as does the value of b (see Table 8 of the April 2019 paper). Yet the RBNZ’s Figure 5 is based only on one set of values for b, PD, LGD, and R (being b=8.1, PD=2.25%, LGD=40% and R=0.3). 36. Taking different values for these variables (while still remaining within the ranges specified in the April 2019 paper) can yield quite different results from those shown in the RBNZ’s Figure 5. By way of example: a. In the left panel of Figure 2 below we have shown the results of the RBNZ’s model using values of PD=3%, LGD=45% and R=0.35, which is a scenario reported in the RBNZ’s Table 2 of the April 2019 paper, and we continue to use b=8.1. This shows that expected output is maximised at a 1-in-100 year probability of a crisis for Lc=40% (the orange line) or 1-in-67 years for Lc=20% (the blue line); and b. In the right panel of Figure 2 we show the results of the RBNZ’s model (with PD=2.25%, LGD=40% and R=0.3) using a value b=11.8, which is a scenario the RBNZ reports in Table 8 of the April 2019 paper. Again the Lc=40% and Lc=20% lines show output maximised at 1- in-100 and 1-in-67 years respectively.

26 Pages 17-19 of the April 2019 paper.

© NERA Economic Consulting 10 conclusion in a 13 November 2018 paper, noting that capping the probability of a crisis at 1% translates to a capital ratio of 12-13% of RWA.29 41. Our point is that the RBNZ’s problem definition consists of claiming that the capital ratios today fall short of what would be required to limit crises to once every 200 years. However, there is little justification for this claim and the 1-in-200-year aim, and no empirical evidence offered that the banks are currently under-capitalised. 42. Relative to other countries, the proposal would place New Zealand at the high end of capital requirements – see the RBNZ’s reported comparisons shown in Figure 3 below. The RBNZ has acknowledged this and states that this “moves us towards our goal, expressed back in 2017, of capital requirements that are conservative relative to our peers”.30 There is no reason given, however, as to why New Zealand needs to be moved to be more conservative, particularly given: a. the virtual absence of financial crises in New Zealand’s history; b. the evidence that the existing bank capital requirements have delivered a financial system the RBNZ has recently stated to be sound, corroborated by the default probabilities implied by banks’ credit ratings, which say that the proposed default probabilities are met under existing ratios; c. the finding from Table 1 presented earlier that having a high capital ratio is not necessarily associated with having a high credit rating;31 and d. that New Zealand may already be more conservative than our peers. 43. Regarding this latter point, we note that PwC has prepared a set of international comparisons that differ from those reported by the RBNZ. PwC’s finding from these comparisons is that New Zealand’s four large banks are currently well capitalised relative to their international peers.32 While the RBNZ has not fully accepted the PwC analysis, it has nonetheless concluded that “we would accept the overall assessment that we are likely to be more conservative than many of our peers”.33

29 See Appendix 4 of the 13 November 2018 memo from Susan Guthrie to the Financial System Oversight Committee, titled “Capital Ratio Calibration”, available at: https://www.rbnz.govt nz/regulation-and-supervision/banks/capital-review￾proposals-information-release 30 As noted in Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26 31 We recognise that this may in part reflect difficulty in making international comparisons of capital ratios, something acknowledged by the RBNZ (the RBNZ has stated that “these sorts of cross-country comparisons are extremely difficult to do, and rely heavily on the methodological approach” – Financial Policy memorandum to FSO, “2017 PwC (NZ) study”, 2 May 2018) and PwC (see PwC’s 2017 report to the New Zealand Bankers’ Association (“International comparability of the capital ratios of New Zealand’s major banks”) noting the complexity of making international comparisons). It may also reflect differences across banks and countries in the margin over the regulatory minimum capital ratio held. 32 PwC (2017), “International comparability of the capital ratios of New Zealand’s major banks”, report to the New Zealand Bankers’ Association, October. 33 Financial Policy memorandum to FSO, “2017 PwC (NZ) study”, 2 May 2018, available at: https://www.rbnz.govt nz/regulation-and-supervision/banks/capital-review-proposals-information-release

© NERA Economic Consulting 11 Figure 3: International comparisons of capital ratios Source: RBNZ (2019), “Safer Banks for Greater Wellbeing”, presentation slides from a speech by Geoff Bascand to the Institute for Governance and Political Studies, 26 February 2019. 44. In short, the RBNZ has not identified a problem with the current regime. Good public policy requires robust problem definition – otherwise the proposed solutions may result in net costs. Indeed, in its Guide to Social Cost Benefit Analysis, the New Zealand Treasury states that “[a]ny policy or decision process starts with defining a problem or opportunity and identifying the potential need for a project or regulatory proposal”.34 All the RBNZ provides is some suggestion (at [17] of the January 2019 paper) that the banking system needs to retain creditor confidence, but there is no evidence provided that existing levels of creditor confidence are too low. 45. Regulatory change that occurs in an ad hoc fashion without proper problem definition and analysis induces risk of future changes in regulation. Regulatory uncertainty harms firms’ incentives to invest and innovate, and is detrimental to long-run maximisation of social welfare (economic efficiency). 46. We also note there is no analysis by the RBNZ of the implications (if any) of Australian ownership of the four largest New Zealand banks. We would expect the RBNZ to at least consider whether the Australian banks would have stronger incentives and more ability than shareholders in standalone banks to prevent or manage crises in their subsidiaries. The Australian banks might have these incentives because they want to protect their trans-Tasman brands, meet Australian Prudential Regulation Authority (“APRA”) regulatory requirements and/or because of potential spillovers of confidence in the bank as a whole across the Tasman. Indeed, we note that the BNZ banking crisis in the late 1980s was associated with more general pressure on the financial system at the time, 35 yet only the New Zealand government-owned BNZ required a bail out. 2.3. The principle of “levelling the playing field” 47. The RBNZ has specified (at p.7 of the January 2019 paper) that one of the principles of its capital review is for there to be “as level a playing field as possible” between the big four banks and the other banks. This appears to be on the basis that the big four banks use their own internal models to determine their capital requirements, as opposed to other banks that use models prescribed by

34 New Zealand Treasury (2015), “Guide to Social Cost Benefit Analysis”, July, at paragraph [8]. 35 Chris Hunt (2009), “Banking crises in New Zealand – an historical perspective”, RBNZ Bulletin, 72(4), 26-41.

© NERA Economic Consulting 12 regulators, which the RBNZ has argued provides the former with a “competitive advantage”.36 Relatedly, the RBNZ has stated that the “current rules distort competition”.37 48. The RBNZ has stated that the big four banks can produce lower capital requirements than the other banks using their own internal models (known as the IRB approach). 38 Accordingly the RBNZ has proposed a re-calibration of these internal models, involving an adjustment to a parameter to reduce the average difference between these internal models and the standardised models of the other banks and an “output floor” that sets a lower bound on RWA produced under these models (see [86] of the January 2019 paper). 49. Nowhere does the RBNZ a) explain why the internal models are inferior to the standardised models; 39 or b) explain why the four Australian banks – these hold nearly 90 percent of New Zealand’s banking assets40 – should have the same or similar RWA to other banks given their business, associated risks and their holding by bank-parents regulated in Australia. Moreover, given the different methods for determining RWA, and the ability for the RBNZ to make changes to the RWA determined by these methods (e.g., the changes referred to at [88] of the January 2019 paper), we query whether there is even a robust interpretation of what measured RWA is. 50. It is not clear to us why the non-IRB banks could also not use their own internal models, or source the expertise to develop these models; or why they should have the same regulatory settings as the big four banks which are the banks that the RBNZ has identified as systemic (the January 2019 paper at [113]), and so matter for banking crises. But in any event, while trying to “level the playing field” in competition terms by these modelling changes, the RBNZ is raising bank costs and likely to be reducing competition by its approach more generally. 51. Indeed, standard competition economics suggests that increasing the costs of participating in a market would reduce competition. The RBNZ has estimated the additional Tier 1 capital that would be required per $100 of residential mortgage lending, as shown in Figure 4 below. Where a firm’s incremental costs increase in this way, then basic microeconomics shows that this will raise prices and lower output. For example, Pindyck and Rubinfeld (2009, pp.285-286) show that when the price of an input increases, “the higher input price causes the firm to reduce its output”, which will in turn increase prices.41 Hausman and Leonard (1999) state that the claim that prices will decrease when marginal costs decrease (and presumably their comment would also apply to cost/price increases) is “unexceptional to any student of intermediate microeconomics”.42

36 See Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26 37 RBNZ, “Safer banks=safer society”, 22 February 2019, available at: https://www rbnz.govt nz/- /media/ReserveBank/Files/regulation-and-supervision/banks/capital-review/Bank-Capital-Review￾summarised.pdf?la=en&revision=90821f7d-0336-44fb-9bab-ee70beb42464 38 Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26 39 The RBNZ does identify measurement judgements required in assessing some asset classes of the RWA that might influence this choice (at Appendix 3 of the January 2019 paper). The merits of the standardised approach are not described. 40 The January 2019 paper, at [113]. 41 Robert S. Pindyck and Daniel L. Rubinfeld (2009), Microeconomics, Seventh Edition, Pearson-Prentice Hall. 42 Jerry A. Hausman and Gregory K. Leonard (1999), “Efficiencies from the Consumer Viewpoint”, George Mason Law Review, 7(3), 707-727.

© NERA Economic Consulting 13 Figure 4: Estimated Tier 1 capital per $100 of residential mortgage lending Source: Figure 3 of Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019. 52. This is exactly why even the RBNZ is anticipating a price increase (and/or quantity decrease, as we discuss later in this report). The other key implication of reduced competition would be less innovation. 53. In summary, whatever the merits of “leveling the playing field” through the re-calibration of the models, the RBNZ’s overall proposal to increase the required capital ratios would increase banks costs and actually lessen competition, not increase it. If the RBNZ really wanted to increase competition, the more logical policy would be to reduce the capital ratios for the smaller banks. Indeed, lack of RBNZ consideration of this reduction is inexplicable, given the smaller banks present lower systemic risk, as the RBNZ acknowledges (see, e.g., [124] of the January 2019 paper). 54. There is also a potential tension between a desire to reduce banking crises and a desire to increase competition. The economics literature on the effects of competition and market structure on the banking sector is equivocal, highlighting trade-offs: for example, increased competition can enhance the efficiency of the banks, but at the same time it may also destabilise them.43 The RBNZ does not explore this tension. 55. It is also relevant that banking markets are typically characterised by similar market structures to that which currently exists in New Zealand, being a small number of large banks and a relatively large number of smaller fringe banks.44 It is not good public policy for the RBNZ to advocate a principle of “levelling the playing field”, without an analysis of whether seeking to do so is even socially desirable. 56. An important final point on this topic is that by reducing the competitiveness (raising the costs) of the regulated banks, the RBNZ’s proposal is likely to facilitate the expansion of non-regulated (or at least less regulated) financial institutions into deposit-taking and lending. These other financial institutions would have a new competitive advantage over the regulated banks. The consequent

43 For summaries of this literature see Pere Gomis-Porqueras and Benoit Julien (2007), “Market Structure and the Banking Sector”, Economics Bulletin, 4(24), 1-9; and Hong Liu, Phil Molyneux and John O. S. Wilson (2013), “Competition in banking: measurement and interpretation”, in Adrian R. Bell, Chris Brooks, and Marcel Prokopczuk (eds.), Handbook of Research Methods and Applications in Empirical Finance, Edward Elgar. 44 See, e.g., Astrid A. Dick (2007), “Market Size, Service Quality, and Competition in Banking”, Journal of Money, Credit and Banking, 39(1), 49-81.

© NERA Economic Consulting 14 reallocation of deposits to, and lending by, the less regulated sector would seem to run contrary to the RBNZ’s desire to increase soundness. This is a point noted by Firestone et al (2017), which the RBNZ has cited and relied on for its analysis in the January 2019 paper, where these authors state that migration of lending out of the regulated financial sector can lead to “systemic risks becom[ing] less effectively controlled” (while also increasing competition from these entities).45 This point is particularly salient given New Zealand’s open economy and the associated ease of movement of transactions.46 3. Banks’ margin over the regulated requirement 57. As already noted, the banks today hold a materially higher level of capital than they are required to by the RBNZ. They are likely to continue to hold a margin if the regulatory ratios are raised, even though the rise is actually in respect of the buffer. 58. At present, the regulatory framework sets a Tier 1 capital requirement of 6% with a conservation buffer of 2.5% – see Figure 5 below. If capital drops below the 6% minimum, a bank would be in breach of its Conditions of Registration. If within the conservation buffer, but above the minimum, banks “face limits on their ability to distribute their earnings, for example through dividends, and must provide a plan for the Reserve Bank’s approval setting out how the bank will rebuild its buffer” (the January 2019 paper at [91]). 59. The RBNZ’s proposal, as shown in Figure 5, is to retain the 6% Tier 1 minimum while increasing the conservation buffer, and adding two further buffers, to create a new “prudential capital buffer” of 10% (for the four large banks). Within the prudential capital buffer, banks would “be subject to automatically triggered restrictions on discretionary payments and an increasingly intensive supervisory response” (the January 2019 paper at [92]).

45 Simon Firestone, Amy Lorenc, and Ben Ranish (2017), “An empirical economic assessment of the costs and benefits of bank capital in the US”, Finance and Economics Discussion Series 2017-034. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2017.034 46 Vives (pp.59-60) analyses the increased, even disruptive, pressure banks are presently facing from non-bank (or shadow bank) organisations using digital technology and artificial intelligence, and reports “The increase in regulatory burden on traditional banks, in terms of raised capital requirements and legal scrutiny, explains about 55% of shadow bank growth in the period 2007-2015, and 35% of this dynamic is explained by the use of financial technology”. (Xavier Vives (2019), “Competition and stability in modern banking: A post-crisis perspective”, International Journal of Industrial Organization, 64, 55-69.)

© NERA Economic Consulting 15 Figure 5: Current and proposed capital ratio requirements (as a percentage of risk￾weighted assets) Source: Figure 1 of the January 2019 paper 60. It is likely that: a. The time series of Tier 1 capital as a percentage of RWA will be relatively volatile. Indeed, at [15] of the January 2019 paper the RBNZ acknowledges that banks maintain a buffer to “deal with year-to-year fluctuations in capital levels”; and b. There would be costs to banks, including a reputational one, from going close to, or below, the 16% threshold. 61. Regarding the first point (60a), Figure 6 below shows a time series of the Tier 1 capital ratios for the four large banks, from March 2013 to December 2018. The graph shows the median capital ratio across the banks, and the range of capital ratios, in addition to the minimum Tier 1 ratio (6%) and buffer (2.5%). It is clear that there is variability in the range of capital ratios across the banks, and variability in the capital ratio over time.

© NERA Economic Consulting 17 capital for these banks. We think there is a risk the RBNZ has under-estimated the negative economic effects of this. 67. The RBNZ has estimated that lending margins (the difference between lending and borrowing rates) would increase by 20 to 40 basis points.48 The January 2019 paper notes also (at [74]) that a one percentage point increase in the Tier 1 capital ratio may lead to a 6 basis point increase in the price of bank credit (so the move from 8.5% Tier 1 to 16% will lead to a 45 basis point increase). On our calculations earlier, because RWA has also increased for the big four banks, the banks will effectively be required to hold Tier 1 capital of 18.5% of current RWA, which would amount to a 10 percentage point increase in the capital ratio and therefore a 60 basis point increase in lending margins. 68. We note that in the April 2019 paper the RBNZ states, based on Figure 10 of that paper, that New Zealand’s recent past shows higher capital levels are accompanied by largely unchanging interest margins, potentially implying that the present proposal will not change lending margins. However, the RBNZ is correct to caveat that its Figure 10 is “merely illustrative”, as it does not in any way control for other factors that may have changed over the period of analysis that would also influence lending margins, or take into account that the increase in capital under the proposal is long term and of regulatory origin. 69. Also in the April 2019 paper, the RBNZ dismisses interest rate increases in the order of 20 to 40 basis points as not “particularly onerous for the economy” (p.38). However, New Zealand is already a country with relatively high interest rates by global standards. 49 Given this, we are surprised the RBNZ is so relaxed about the prospect of higher interest rates. 70. The RBNZ also argues in the April 2019 paper that a one-off 20 to 40 basis point increase in lending rates would be within the usual range of short-term movements in lending rates (p.38). However, a regulatory induced increase in lending rates is not transitory and would shift the entire lending rate curve upwards. That is, while two-year fixed mortgage rates may currently vary in the range of approximately 2.7% to 3.1% (based on Figure 12 of the April 2019 paper), an increase in lending rates of say 40 basis points would likely result in that variation occurring within the higher range of 3.1% to 3.5%. 71. Moreover, the RBNZ regularly adjusts the Official Cash Rate (“OCR”) by small amounts, typically either 25 or 50 basis points. Since its introduction in March 1999, the OCR has been adjusted 52 times, with a median and modal adjustment of 25 basis points. The RBNZ makes these adjustments on the basis that they will have a tangible impact on the economy, so to dismiss an ongoing 20 to 40 basis point change in lending rates as not being “particularly onerous” to the economy is inconsistent with the RBNZ’s use of the OCR. 72. The RBNZ also states (at [75] of the January 2019 paper) that a one percentage point increase in the Tier 1 capital ratio would lead to a 3 basis point decrease in the steady-state level of GDP. Thus the proposed 7.5 percentage point increase in the capital ratio would lead to a 22.5 basis point decrease in the steady-state level of GDP.50 To put this in context, New Zealand’s GDP in

48 As noted in Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26 49 As noted, for example, in Natalie Labuschagne and Polly Vowles (2010), “Why are Real Interest Rates in New Zealand so High? Evidence and Drivers”, New Zealand Treasury Working Paper 10/09, December; RBNZ (2007), “Why are New Zealand interest rates so persistently high by international standards”, Supporting paper A4 to Select Committee Submission, July. More recent OECD data also shows New Zealand to have the sixth highest interest rates (on average over the period from 2008 to 2017) of 25 OECD countries – see https://data.oecd.org/interest/long-term-interest-rates.htm 50 As noted at Table 6 of the April 2019 paper, the effect on GDP is on its long-run equilibrium in present value terms.

© NERA Economic Consulting 18 the year to December 2018 was $293b, 51 and the RBNZ’s GDP cost estimate is then $0.66b growing at the rate the economy grows, which has been the order of 2.5% per annum. 52 73. In contrast to the RBNZ’s forecast of margin increases, publicly-reported analysis by investment bank UBS estimates that lending rates would increase by between 86 and 122 basis points.53 ASB has estimated an increase in lending rates of between 25 and 75 basis points.54 These lending rate increases would have a higher GDP cost than that of the RBNZ noted above. 74. We have not assessed in detail the reasons for these differences, however they may in part be due to different assumptions for the Modigliani-Miller (“MM”) offset,55 for which the RBNZ uses a value of 50% . While the specific value for the MM offset is arguable, at the very least there may be a range of plausible values (as the RBNZ implies at Table 8 of the April 2019 paper) which can result in quite different results for the lending margin impact – a lower value for the MM offset would yield higher lending rate impacts. Moreover, the RBNZ’s estimate of the MM offset is drawn from studies mostly across the US and Europe.56 A more recent study focusing on Australia estimates the MM offset to be 25%. 57 This study notes that Australia has a strong dependence on bank lending for financing economic activity and a more concentrated banking sector (which we note are also features of New Zealand) than other countries such as the US, UK and Switzerland for which the MM offset has previously been estimated. 75. As context, the RBNZ’s Table 9 of the January 2019 paper notes that the big four banks would need to increase their Tier 1 capital by $12.8b. At a historic return on equity of 15%,58 this amounts to approximately $1.9b per annum in extra cost of capital. With a 50% MM effect, this amounts to just under $1b per year in extra costs. We note that elsewhere the increase in Tier 1 capital for the big four banks has been calculated as $19b,59 assuming the banks choose a buffer of two percentage points, which with a 15% return on equity and 50% MM effect would amount to approximately $1.4b in extra costs. 76. The RBNZ’s assumption appears to be that the banks would incur these extra costs, but that not all of these costs would be passed onto customers. The RBNZ states that “we expect that

51 See https://www.stats.govt.nz/indicators/gross-domestic-product-gdp 52 We note that New Zealand’s average growth rate in GDP has been 2.4% per annum over the past ten years (based on the GDP production measure, chain volume series nominal values, sourced from Statistics New Zealand). The Treasury is forecasting annual GDP growth for 2019 through to 2023 respectively of 2.9%, 3.1%, 2.7%, 2.5% and 2.3% (Half Year Economic and Fiscal Update, 2018, https://treasury.govt nz/publications/efu/half-year-economic-and-fiscal-update-2018). 53 “UBS analysts suggest Aussie banks’ response to RBNZ’s proposals to increase bank capital will have economic impact on NZ ‘larger than assumed by the RBNZ’, 1 March 2019, available at: https://www.interest.co.nz/banking/98370/ubs￾banking-analysts-suggest-aussie-banks-response-rbnzs-proposals-increase-bank 54 “ASB says RBNZ estimates of bank capital are too low”, 16 April 2019, available at: http://www.scoop.co.nz/stories/BU1904/S00469/asb-says-rbnz-estimates-of-bank-capital-impact-are-too-low.htm 55 Indeed, it has been noted that “One reason that ASB arrives at a larger impact than the Reserve Bank’s calculations is that it isn’t putting as much faith in what is known as the Modigliani-Miller Offset, named after the two economists who devised the theory in 1958” – see “ASB says RBNZ estimates of bank capital are too low”, 16 April 2019, available at: http://www.scoop.co.nz/stories/BU1904/S00469/asb-says-rbnz-estimates-of-bank-capital-impact-are-too-low.htm 56 See Table 5 of the April 2019 paper, which reports studies for the US, Europe, Switzerland, the UK and an “International” study. 57 James R. Cummings and Linh Nguyen (2019), “Impact of the Basel III capital reforms on bank funding costs: Australian evidence”, CIFR Paper No. 132/2016/Project T023, presented at the 31st Australasian Finance and Banking Conference 2018, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract id=2885050 58 As noted in RBNZ (2018), “Background notes on capital review”, 25 July, available at: https://www.rbnz.govt nz/regulation-and-supervision/banks/capital-review-proposals-information-release 59 Dominick Stephens (2019), “RBNZ’s bank capital proposal: impact on the OCR”, 15 January.

© NERA Economic Consulting 19 competitive pressures may limit banks’ ability to fully pass these costs on to others”.60 Even if this statement was correct as a matter of economics (which we dispute, particularly in the long￾run), it is clearly not right in the present circumstances, where the banks are not obliged to incur the extra costs – their alternative is to reduce their lending, a distinct possibility that is not analysed in the RBNZ’s papers. To the degree a bank would incur the extra costs, it would be because it expects to fully recover them. 61 77. As noted, there appears to be an implicit assumption in the RBNZ’s papers that the banks would continue with their existing level of lending, and would increase their equity capital to permit this. There is no analysis of the possibility that the banks would in fact lower their lending, therefore requiring less extra capital.62 78. For example, what would be the calculus of the Australian parents of the large four banks? Would raising further capital ($12.8b on the RBNZ’s calculations, or $19b as calculated elsewhere) for their New Zealand subsidiaries be the highest value use of their scarce equity capital? This is a particularly important question when at same time APRA is proposing an increase in capital for the Australian banks (albeit in banks’ Tier 2 capital requirements).63 79. A reduction in lending would of course have quite material real economic effects. These economic effects are not captured in the studies that the RBNZ refers to in determining the 3 basis point decrease in the steady-state level of GDP per one percentage point increase in the Tier 1 capital ratio. For example, the Basel Committee on Banking Supervision study referred to by the RBNZ at Table 6 of the April 2019 paper states (at p.21, emphasis added):64 The steady-state analysis assumes that the impact of higher capital and liquidity operates through the higher cost of credit. By focusing on price adjustments, the analysis does not capture any possible impact of credit rationing that might arise from more stringent requirements. The reason for this choice is precisely that the analysis focuses on the long￾run steady state, after banks have fully adjusted to the new requirements. While banks might shrink their assets by rationing credit if the transition period is too short, the impact of credit rationing is likely to be much smaller in the long run, as markets have time to clear. Non￾price effects are likely to be more important during the transition… 80. Similarly Firestone et al (2017),65 also referred to at Table 6 of the April 2019 paper, note that their analysis does not include costs of transitioning to higher capital levels. However, Firestone et al refer to the analysis of these transitional costs undertaken by Kiley and Sims (2010), which found a reduction in GDP of between 0.5% and 3% for a 2 percentage point increase in capital

60 Geoff Bascand’s speech to the Institute for Governance and Political Studies, 26 February 2019, available at: https://www.rbnz.govt nz/research-and-publications/speeches/2019/speech2019-02-26. 61 The speed and extent of pass-through may be affected by the state of the economy at the time, and whether banks raise lending rates or lower deposit rates (and the relative elasticities between depositors and borrowers), among other factors. 62 The RBNZ does refer (at [67] of the January 2019 paper) to higher capital levels increasing banks’ average funding costs, lowering the quantity of credit available. Also, in a background note, the RBNZ states that the literature shows “a positive relationship between banks’ capital levels and lending growth, due to the reduced cost of well-capitalised banks’ debt funding” (RBNZ (2018), “Background notes on capital review”, 25 July, available at: https://www rbnz.govt.nz/regulation￾and-supervision/banks/capital-review-proposals-information-release). However, we think the RBNZ may be considering a demand elasticity effect here (i.e., how an increase in lending rates may alter the demand for loans), rather than addressing the possibility that banks respond to the increased capital requirements by reducing their lending (setting aside any effect on lending rates). 63 See APRA’s proposals at: https://www.apra.gov.au/media-centre/media-releases/apra-seeks-increase-loss-absorbing￾capacity-adis-support-orderly 64 Basel Committee on Banking Supervision (2010), “An assessment of the long-term economic impact of stronger capital and liquidity requirements”, August. 65 Simon Firestone, Amy Lorenc, and Ben Ranish (2017), op cit.

© NERA Economic Consulting 20 ratios.66 Firestone et al suggest that this may be an overstatement, but nonetheless acknowledge that these transitional costs would decrease any net benefits from higher capital ratios. The RBNZ has not taken into account any costs, even if they are transitional, that arise from a reduction in lending.

66 M. Kiley and J. Sim (2010), “Technical background report: An assessment of the macroeconomic transition costs associated with higher levels of capital at financial institutions in the United States”, Federal Reserve Board, as cited in Firestone et al (2017), op cit.

NERA Economic Consulting 20 Customhouse Quay Wellington Central Wellington, New Zealand 6011

Nick Georgiev It's the perfect time to implement the RBNZ proposal and I fully support it. Considering we are at peak business cycle with interest rates going down, the banks will be able to keep mortgage rates higher and ensure they generate enough profit to retain and meet the capital requirements. We are about 2-3 years late, but better late than when the next monstrous debt crisis hits in the next year or so. OIA s9(2)(a)

Nick Robinson If a bank fails, then it should be the shareholders that take losses FIRST, and not the customers holding deposits. Anything else goes against the principles and values of the society we live in and contribute to. At the end of the day money = years of effort. To loose all you have worked for because of a over zealous bank pushing the limits, without adequate capital behind it also goes against said values and principles. OIA s9(2)(a)

1 Submission By to the Reserve Bank of New Zealand on

The Review of the Capital Adequacy Framework for locally incorporated banks: How much capital is enough? 16 May 2019 Prepared by: Roger Partridge Chairman The New Zealand Initiative PO Box 10147 Wellington 6143

2

1. INTRODUCTION AND SUMMARY 1.1 This submission in response to the review by the Reserve Bank of New Zealand (RBNZ) of the capital adequacy framework for registered banks (the Review) is made by The New Zealand Initiative (the Initiative), a Wellington-based think tank supported primarily by chief executives of major New Zealand businesses. In combination, our members provide employment to more than 150,000 people. 1.2 The Initiative undertakes research that contributes to the development of sound public policies in New Zealand which help create a competitive, open and dynamic economy and a free, prosperous, fair, and cohesive society. 1.3 Our submission focuses on three issues: (a) The relationship between the bank capital proposal and the RBNZ’s statutory objectives as set out in section 1A of the Reserve Bank of New Zealand Act 1989 (the Act); (b) The need for a full cost-benefit analysis to evaluate the proposal to almost double the required amount of high-quality capital that banks will have to hold to reduce the risk of bank failure to once in 200 years (the bank capital proposal); and (c) The relationship between the RBNZ’s consultation on the proposal and the separate Phase 2 review process being undertaken at the direction of the Minister of Finance, Safeguarding the future of our financial system: The role of the Reserve Bank and how it should be governed (the Phase 2 review). 1 1.4 In summary, we consider: (a) In advancing the bank capital proposal, the RBNZ has misdirected itself in relation to its statutory objectives. The “risk appetite framework” supporting the bank capital proposal proceeds on the mistaken assumption that the bank’s statutory objective is soundness first, and efficiency second.2 This is incorrect. The RBNZ is charged with “promoting the maintenance of a sound and efficient financial system” [emphasis added]. 3 Like other forms of safety, soundness should only be pursued to the extent it is efficient to do so. That is, if the benefits exceed the costs. The RBNZ would be acting unlawfully if it implemented its bank capital proposals on the basis of the decision-making framework it has adopted. (b) Borrowers, depositors and participants in the wider economy are all likely to be harmed if the bank capital proposal is implemented (not to mention the affected banks themselves). The RBNZ’s estimates suggest the potential harm of the bank capital proposal could be significant (and the RBNZ’s calculations may underestimate the potential adverse effects of the proposal). Given the potential costs, the RBNZ should not be proposing this change of regulatory policy without first undertaking a full cost￾benefit analysis. The bank’s omission to do this is inconsistent with good regulatory practice and is liable to judicial review. (c) The RBNZ’s proposals on bank capital requirements cut across the separate Phase 2 review the RBNZ is undertaking jointly with Treasury. The two consultation processes are inter-related. The RBNZ cannot fairly consult separately on whether to introduce deposit insurance and whether to double banks’ capital requirements. The bank capital

1 RBNZ and Treasury, “Safeguarding the Future of Our Financial System: The Role of the Reserve Bank and How It Should Be Governed,” Consultation 1 Phase 2 of the Reserve Bank Act Review (Auckland: 2018). 2 RBNZ, “Capital Review Paper 4: How Much Capital is Enough?” (Wellington: RBNZ, 2019), [13–28]. 3 Section 1A(b), Reserve Bank of New Zealand Act 1989.

3 proposal consultation process should therefore be suspended until after the Phase 2 review process has been completed and decisions made in response to it. Alternatively, the Bank should explicitly conduct these consultations jointly, so that the processes inform each other. 2. THE RBNZ HAS MISDIRECTED ITSELF IN RELATION TO ITS STATUTORY OBJECTIVES 2.1 The Initiative addressed the RBNZ’s statutory objectives in its submission responding to the Phase 2 review process.4 The RBNZ’s existing, high-level financial policy objective is to “Promote the maintenance of a sound and efficient financial system”.5 The statutory objective is soundness and efficiency. It is not soundness at any cost. 2.2 “Soundness” is an important attribute of an efficient financial system. But it is important only to the extent it promotes efficiency. Expressed differently, soundness, like other forms of safety, is best only pursued to the extent that the benefits to the community exceed the costs.6 It is not an over-riding objective. 2.3 The bank capital consultation proceeds on the mistaken assumption that the bank’s objective is soundness first, and efficiency second. This is apparent from the RBNZ’s assessment of its risk appetite framework in the RBNZ’s Capital Review Paper 4: How much capital is enough? (Paper 4).7 Paper 4 discloses that the RBNZ has proceeded as follows: • First determine what “soundness” means (and the level of capital required to achieve it). This exercise is undertaken independently of any concept of efficiency. And in the RBNZ’s working papers it involves the adoption of an (arbitrary) 1-in-200-year risk appetite for bank failure; and • Then (and only then) consider how to deliver efficiency having regard to the already selected criteria for soundness. 8 2.4 In Paper 4, the RBNZ describes the process as follows:9 23. Our risk appetite framework can be summarised as follows: • Ensure the banking system can retain the confidence of creditors when subject to an extreme shock, which means being solvent in a regulatory sense (delivering ‘soundness’); and • Having set bank capital to at least achieve the soundness objective, take advantage of opportunities to generate more stability if doing so is unlikely to impose any material loss of expected output (delivering ‘efficiency’). 2.5 This approach misconstrues the RBNZ’s statutory obligation by relegating “efficiency” to a second-order criterion. As a consequence, we consider the RBNZ has misdirected itself in law as to its statutory purpose. The RBNZ would therefore be acting unlawfully if it implemented its

4 Roger Partridge and Bryce Wilkinson, “Submission: Phase 2 of the Reserve Bank of New Zealand Act Review” (Wellington: New Zealand Initiative, 2019). 5 Section 1A(b), Reserve Bank of New Zealand Act 1989. 6 Roger Partridge and Bryce Wilkinson, “Submission: Phase 2 of the Reserve Bank of New Zealand Act Review,” op. cit. [2.3]. 7 RBNZ, “Capital Review Paper 4: How Much Capital is Enough?” op. cit. [13–28]. 8 Ibid. 9 Ibid. [23].

4 bank capital proposals on the basis of the risk appetite framework outlined in its Paper 4 supporting the proposal. 3. THE RBNZ SHOULD SUSPEND THE CONSULTATION PROCESS UNTIL AFTER IT HAS UNDERTAKEN A COST-BENEFIT ASSESSMENT The bank capital proposal will have adverse impacts on borrowers and the wider economy 3.1 According to the RBNZ’s assessments, implementing the bank capital proposal will have some adverse effects for borrowers and the wider economy. However, Paper 4 claims there will be “only minor impacts on borrowing rates for customers”.10 3.2 Yet, the RBNZ’s recently released Capital Review Paper (the Capital Review Paper) suggests that for every 1% rise in bank Tier 1 capital, lending rates will rise by 8.1-basis-points.11 With the proposal involving a near doubling of banks’ tier 1 capital from, the RBNZ’s own estimates suggest the bank capital proposal could see lending rates increase by around 0.5% or more. 3.3 These estimates relate to average lending rates. It is likely some sectors – especially capital￾intensive sectors – will face higher borrowing costs. Such sectors are likely to include high loan￾to-value borrowers (including first-time borrowers), the rural sector, and small-to-medium sized enterprises. 3.4 The RBNZ also estimates that the bank capital proposals will have an adverse impact on the wider economy. According to evidence referred to in the Capital Review Paper, every 1% rise in bank Tier 1 capital could lead to an 8-basis-point decline in GDP.12 On these numbers, the RBNZ’s bank capital proposal could see a decline in steady-state GDP of 0.32% or more. 13 3.5 As the RBNZ acknowledges, the estimated basis point effects on lending rates and GDP could be greater (or less) than these estimates depending on the assumptions made. We are aware that several market participants, including UBS, the investment bank,14 and ASB, the trading bank,15 have estimated more serious adverse effects. Adverse effects on savers through lower deposit rates have also been predicted.16 3.6 But even on the RBNZ’s more optimistic numbers, the impacts on financial markets’ participants and the wider economy are significant. Need for a full cost-benefit analysis 3.7 We acknowledge the RBNZ has adopted a net-benefits framework for the analysis in its 3 April 2019 Capital Review Paper.17 However, given the potential for adverse effects from the bank

10 RBNZ, “Capital Review Paper 4: How Much Capital is Enough?” op. cit. 5–6. 11 RBNZ, “Capital Review Background Paper: An Outline of the Analysis Supporting the Risk Appetite Framework” (Wellington: RBNZ, 2019), 36. ‘Tier 1’ capital refers to the equity provided by shareholders and ‘equity-like’ debt funding. 12 Ibid. 37. 13 Ibid. 37. 14 Jenny Ruth, “UBS doubles down on impact of RBNZ bank capital requirements,” Scoop Business (27 February 2019). 15 ASB, “Economic Note: What to Make of the Proposed Bank Capital Requirements” (Auckland: 2019). 16 Ibid. 17 RBNZ, “Capital Review Background Paper: An Outline of the Analysis Supporting the Risk Appetite Framework” op. cit. 20-44.

5 capital proposal, the RBNZ should have undertaken a full cost-benefit assessment. This was needed to inform the RBNZ’s decision-making prior to making the proposal and to inform those participating in the RBNZ’s consultation process in relation to the proposal and enable them to critique and respond to it. 3.8 Cost-benefit analysis is a fundamental requirement of good regulatory decision-making. Indeed, the Government Expectations for Good Regulatory Practice specifically provides that:18 Before a substantive regulatory change is formally proposed, the government expects regulatory agencies to provide advice or assurance on the robustness of the proposed change, including by: … • Making genuine effort to identify, understand, and estimate the various categories of cost and benefit associated with the options for change… [emphasis in original] 3.9 The RBNZ’s decision to defer undertaking a full cost-benefit analysis is contrary to the legitimate expectations of the parties affected by the proposals, including all current and future borrowers and depositors. 3.10 The RBNZ said in its recently released Capital Review Paper that it will undertake a cost￾benefit assessment to “inform and describe final decisions in the Review”.19 However, the RBNZ’s approach to date suggests it has a preconceived notion of the “correct” level of capital the banks should hold. This is apparent from the initial failure to provide any meaningful justification of the 1-in-200-year threshold which drives the bank capital proposal, and from the RBNZ’s vocal advocacy in favour of its proposal during the course of the public consultation process. 20 3.11 Consequently, an ex post cost-benefit analysis is susceptible to challenge on the grounds of pre-determination. The assessment is needed as part of the policy formulation process, not to describe “final decisions”. And an ex post assessment will not have the benefit of testing and challenge during the public consultation phase. Nor will it help inform discussion about the advantages and disadvantages of the RBNZ’s proposal. 3.12 We consider the RBNZ should: • suspend consultation on the bank capital proposal until it has completed a full cost￾benefit assessment; • reconsider whether it is appropriate to modify the banks’ capital proposal having regard to the results of the full cost-benefit assessment; and • submit any modified proposal, together with the cost-benefit assessment, for further public consultation. 3.13 Alternatively, the RBNZ should conduct a second round of consultation after it has completed its full cost-benefit analysis.

18 Treasury, “Government Expectations for Good Regulatory Practice,” op. cit. 4. 19 RBNZ, “Capital Review Paper 4: How Much Capital is Enough?” op. cit. 4. 20 See, for example, Jenny Ruth, “Orr notes limitations in bank stress tests,” The New Zealand Herald (15 January 2019) and Hamish Rutherford, “Reserve Bank says bank profits may be out of proportion to risks they face, Stuff (13 February 2019).

6 4. THE BANK CAPITAL CONSULTATION PROCESS CONFLICTS WITH THE PHASE 2 CONSULTATION PROCESS AND SHOULD BE DEFERRED 4.1 Consultation on the RBNZ’s bank capital proposals is occurring in tandem with the Phase 2 consultation process. Among other matters, the Phase 2 review process addresses the following issues: • The RBNZ’s high-level financial policy objectives (discussed in section 3 above); • Whether we should have depositor protection in New Zealand; and • How the RBNZ should be governed. 4.2 The bank capital proposal is directly related to the depositor protection question raised in the Phase 2 consultation process. The level of bank capital has a bearing on the need for depositor protection, and vice versa (the risk of a run-on-the-bank is reduced if deposits are subject to a statutory insurance scheme). 4.3 As a consequence, the RBNZ cannot fairly consult separately on whether to introduce deposit insurance and whether to double banks’ capital requirements. 4.4 Apart from the other matters addressed in this submission, we consider the capital requirements consultation process should be suspended until after the Phase 2 process has been completed and decisions made in response to it. This would have the added advantage of enabling the bank capital proposal, or any other proposals the RBNZ wishes to put forward having regard to the matters addressed in this submission, to be subjected to any new governance and decision-making processes introduced as a consequence of the Phase 2 review process. 4.5 Alternatively, the Bank could explicitly conduct these consultations jointly, so that the processes inform each other. The New Zealand Initiative Wellington 16 May 2019

From: Antony Buick To: Capital Review Cc: Roger Beaumont; Olivia Bouchier Subject: NZBA submission on Capital Review Paper No.4 Date: Friday, 17 May 2019 12:11:51 PM Attachments: 190517 NZBA submission - How much capital is enough.pdf Appendix One - Dr Graham Scott report.pdf Appendix Two - International comparability of capital ratios 2019.pdf Good morning Please find attached the New Zealand Bankers’ Association’s submission on Capital Review Paper 4: How much capital is enough? Please feel free to call if you have any questions. Regards Antony Antony Buick-Constable I Deputy Chief Executive & General Counsel I New Zealand Bankers' Association www.nzba.org.nz

NEW ZEALAND BANKERS ASSOCIATION Level 15, 80 The Terrace, PO Box 3043, Wellington 6140, New Zealand TELEPHONE +64 4 802 3358 EMAIL nzba@nzba.org.nz WEB www.nzba org.nz Submission to the Reserve Bank of New Zealand on the Consultation Paper: How much capital is enough? 17 May 2019

www.thinkSapere.com i Contents Glossary ........................................................................................................................................................................................... iii Executive summary ...................................................................................................................................................................... 1 Introduction .................................................................................................................................................................................... 3 Our assignment and approach ............................................................................................................................................... 3 The Reserve Bank proposals .................................................................................................................................................... 3 Structure of our report ............................................................................................................................................................... 4 The role of the Reserve Bank and its approach to developing the proposals ..................................................... 5 Evolution of the role of the Reserve Bank .......................................................................................................................... 5 Checks and balances on regulatory powers ...................................................................................................................... 5 Consultative processes and analytical methods .............................................................................................................. 6 Sequencing and prioritising the issues ................................................................................................................................ 7 Articulating the policy problem .............................................................................................................................................. 8 Rigidity of the capital ratio proposals .................................................................................................................................. 9 Focus on use of equity............................................................................................................................................ 9 Balancing capital requirements with supervision ......................................................................................10 Stability and efficiency.............................................................................................................................................................. 14 Assessing the economic costs ...............................................................................................................................................15 Weighing of costs and benefits ............................................................................................................................................15 Quantity of additional capital ................................................................................................................................................15 The direct economic costs of additional capital ............................................................................................................17 Increased capital requirement is an economic cost ..................................................................................17 The additional cost of bank credit ...................................................................................................................18 Reserve Bank estimate of the increased cost of credit ............................................................................19 Indirect economic costs ...........................................................................................................................................................21 Reduced economic activity from higher real interest rates ...................................................................21 Impact on business models and organisational forms ............................................................................23 Summary of economic costs ..................................................................................................................................................24 Assessing the economic benefits .........................................................................................................................................26 The benefits of more resilient banks ..................................................................................................................................26

ii www.thinkSapere.com Reserve Bank’s assumptions...............................................................................................................................26 Estimated avoided economic loss ....................................................................................................................26 Economic cost of a banking crisis ....................................................................................................................27 Change in probability of a banking crisis ......................................................................................................27 Expected value of the avoided loss in economic output ........................................................................28 Tables and Figures Table 1 Expected annual economic benefit from lower risk of banking crisis ...........Error! Bookmark not defined. Table 2 Net economic benefit of proposal - Reserve Bank assumptions . Error! Bookmark not defined. Table 3 Impact on steady state GDP from an increase in bank credit costs ...............Error! Bookmark not defined. Table 4 Estimates of the elasticity of lending volume to a 1 percentage point change in the risk￾weighted capital ratio ....................................................................................................Error! Bookmark not defined. Figure 1 Comparison of current and proposed capital ratio requirements (as percentage of risk￾weighted assets) ........................................................................................................................................................................... 4 Figure 2 Reported capital ratios versus required capital ratios ...............................................................................11 Figure 3 CET1 capital ratios reported by New Zealand banks..................................................................................16 Appendices Appendix A: Estimate of additional Tier 1 capital ....................................................................................................... 2 Appendix B: Direct economic cost of increased cost of bank credit .................................................................. 3 Appendix C: Steady-state impact on New Zealand GDP from increased cost of bank credit .................. 4 Appendix D: Value of loss in economic output from higher real interest rates .............................................. 7 Appendix E: Elasticity of lending to capital ratios ...................................................................................................... 8

GLOSSARY www.thinkSapere.com iii Glossary Abbreviation Stands for AT1 capital Additional Tier 1 capital. AT1 capital, which includes preference shares, is assessed by the Reserve Bank as the second highest quality of capital behind CET1. It is meant to absorb losses in going concern via conversion, write-down, write-off, or cancelling coupon payments. Capital Part of a bank’s funding that allows it to absorb financial losses while remaining solvent. Capital ratio A bank’s capital divided by its RWA. CET1 capital Common Equity Tier 1 capital. CET1 is assessed by the Reserve Bank as the highest quality of capital. It includes shareholders’ investment (ordinary shares and retained earnings). Also defined as accounting equity after application of regulatory adjustments. Reserve Bank The Reserve Bank of New Zealand Risk-weighted assets (RWA) Risk-weighted assets (RWA)—an assessment of a bank’s financial position taking into account the risk profile of that financial position by applying weights determined by the Reserve Bank Tier 1 capital The sum of CET1 capital and AT1 capital. This capital is meant to minimise the probability of default by absorbing losses while the bank operates as a going concern. Tier 2 capital Tier 2 capital includes undisclosed funds that do not appear on a bank’s financial statements, revaluation reserves, hybrid capital instruments, subordinated term debt—also known as junior debt securities—and general loan-loss, or uncollected, reserves. This capital is meant to absorb losses given that the bank defaults or had entered resolution.

www.thinkSapere.com 1 Executive summary

1. The Reserve Bank proposes to increase the amount of capital required to be held by New Zealand banks. Higher capital ratios are intended to make banks more resilient, and thereby reduce the risk of economic and social harm that would result from a banking crisis.
2. The Reserve Bank describes the likely costs of its proposal as “minimal” and is articulate about the economic and social cost in the event of a banking crisis. But our analysis suggests that the costs would be far from minimal; the costs New Zealand society would pay by requiring banks to maintain higher capital ratios would greatly exceed the benefits of reduced risk of a banking crisis. Adopting the core central assumptions published by the Reserve Bank, we estimate that the expected economic costs of the policy would exceed the expected economic benefits by about $1.8 billion per annum.
3. These quantitative estimates of net economic cost should be treated with caution given the uncertainty in the assumptions and underlying data. Some of these uncertainties could significantly increase the estimate of net economic cost, while others would reduce the estimate, but none would reverse the result and produce a net economic benefit for the Reserve Bank’s central estimates. The expected large net economic cost of the proposal should raise questions as to whether the proposals are optimal for New Zealand and whether there are alternative instruments that could achieve the gains at less cost.
4. The Reserve Bank’s analysis does not articulate clearly what it believes is wrong with the status quo which justifies the change. Its analysis is framed largely around the external shocks that may bring on a crisis, whereas New Zealand’s experience is that failures in banks and other financial institutions are typically the result—or at least substantially contributed to—by poor governance and management. Policies to resolve bank failures should take this into account, which leads us to scepticism that reliance on a large fraction of CET1 in Tier 1 will enable the Reserve Bank to stand back more than it otherwise might.
5. The Reserve Bank advances its risk appetite framework as the basis for its conclusion that the benchmark should be a probability of a system failure no greater than one in 200 years. However, the analysis provided to date does not explain how the Reserve Bank arrived at a capital ratio of 16 per cent, as opposed to a capital ratio closer to capital levels currently held by the banks (which are significantly higher than the existing regulatory minimum). Its published analysis does not account for the high degree of sensitivity of judgements about the optimal capital ratio to small changes in assumptions and the wide range of uncertainty around any specific number.
6. The way in which the proposed regulation has evolved in a series of steps has narrowed the scope of engagement with the banks. It has diminished consideration of options that might offer a more balanced application of regulatory instruments, might provide for more recognition of the variations in circumstances of the banks and acknowledge the interaction with Australian regulatory regimes.
7. The Reserve Bank approached its analysis by resolving the requirements for stability first, before considering the efficiency criteria, even though the Reserve Bank of New Zealand Act does not prioritise the twin requirements for stability and efficiency. This method is likely to have

EXECUTIVE SUMMARY 2 www.thinkSapere.com significantly affected the result. The very substantial increase in equity capital requirements comes across as a one-size-fits-all solution, which could be precluding a more variegated response. Given the higher cost of equity over hybrid instruments, the increase in the required capital ratio would have a material effect on the cost-benefit calculation on the hybrid decision. 8. Taking a wider perspective, the Reserve Bank has evolved over time a more rigorous approach to regulating banks than was envisaged when its Act was passed in 1989 and which gave it a high degree of independence. As a result, the Reserve Bank seems subject to fewer checks and balances and oversight by ministers, ministries and the courts than some other classes of commercial regulation, including those conducted by other independent bodies. 9. Our key conclusions are that:  The sequence of decision-making has constrained the consultation in ways that are tilted against setting a target capital ratio and then considering the lowest cost way to achieve this allowing for variations in choices of regulatory instrument and circumstances of individual banks. As a result, the proposal seems unnecessarily narrow and inflexible.  The costs of the proposal are very likely under-estimated and are large relative to the benefits.  By comparison with other countries—allowing for the hazards of these comparisons—the key issue seems to be the cost arising from the narrow focus on equity capital rather than the level of the ratio, although that is arguably on the high end of the range.  We are puzzled why the Reserve Bank is committed to the Open Bank Resolution (OBR) when it can be argued that hybrid capital is a superior bail in device.  The lack of close attention to a comparison of the proposal with the APRA framework both in terms of concept and operations seems an omission, even though we accept that the policy must work for all the registered banks regardless of their parentage.

INTRODUCTION www.thinkSapere.com 3 Introduction Our assignment and approach 10. We have been asked by the New Zealand Bankers Association to review the key proposals set out by the Reserve Bank of New Zealand in its consultation paper ‘Capital Review Paper 4 – How much capital is enough?’ (consultation paper). Our brief was to review the proposals, and the approach taken by the Reserve Bank in developing those proposals, through the lens of good public policy development and economic theory. 11. In preparing this report, we reviewed the background papers released by the Reserve Bank,1 the literature cited in those papers, and considered other relevant studies. We also undertook structured interviews of 7 New Zealand banks. These banks included wholly-owned subsidiaries and locally owned cooperative banks. 12. The opinions expressed in this report are our conclusions and may not necessarily reflect the views of either the New Zealand Bankers Association or its member banks. The Reserve Bank proposals 13. The Reserve Bank is consulting on whether to require a Tier 1 capital requirement of:  16 per cent of risk-weighted assets for systemically important banks  15 per cent of risk-weighted assets for non-systemically important banks. 14. The additional capital would be required to come from equity capital. Figure 1 compares the current capital ratio requirement with the proposed requirements.

1 Available here: https://www.rbnz.govt.nz/regulation-and-supervision/banks/capital-review-proposals￾information-release

INTRODUCTION 4 www.thinkSapere.com Figure 1 Comparison of current and proposed capital ratio requirements (as percentage of risk-weighted assets) (Reserve Bank of New Zealand, 2019a, p. 8) Structure of our report 15. The body of our report is structured into three main sections:  Section 2 considers the role and functions of the Reserve Bank and its approach to developing the proposals in the context of approaches taken elsewhere.  Section 3 evaluates the economic costs caused by the proposed increase in capital requirements.  Section 4 assesses the economic benefits of more resilient banks. 16. In a final section, we set out our main conclusions. 17. Appendices A to E set out the calculations referred to in the body of the report.

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS www.thinkSapere.com 5 The role of the Reserve Bank and its approach to developing the proposals Evolution of the role of the Reserve Bank 18. In reflecting on the approach the Reserve Bank is taking to develop and advance its proposed increase in equity capital ratios, it is useful to take a step back for a broader perspective on the role and functions of the Reserve Bank in its oversight and regulation of the banks. 19. In its development of this proposal, the Reserve Bank is still essentially operating in the modes it developed under the Reserve Bank Act 1989. That Act was conceived primarily to do three things:  Firstly, to bring down New Zealand’s underlying rate of inflation that had persisted in the mid-teens for many years.  Secondly, to ensure the integrity of financial markets with a focus on ensuring the soundness of the banking system, rather than necessarily of every bank within it.  Thirdly, to provide for a degree of independence that would prohibit the kind of poorly conceived interventions in financial markets that occurred in the early 1980s resulting in large losses passed into the public finances 20. The high degree of independence of the Reserve Bank was therefore primarily created for the conduct of monetary policy targeted on medium-term inflation rates. In the years since, the Reserve Bank has increased its regulatory functions to become far more detailed and extensive in response to the evolution of banking and financial markets. As a consequence, it has taken on roles much more like other regulators of commercial affairs, while maintaining very different institutional arrangements and culture. Checks and balances on regulatory powers 21. A consequence of the evolution of the Reserve Bank’s functions is that it develops regulatory strategies, makes specific proposals, sequences its decisions, conducts consultations, carries out social cost-benefit analyses of its own proposals and prepares Regulatory Impact Statements about them. The whole process seems subject to fewer checks and balances and oversight by ministers, ministries and the courts than some other classes of commercial regulation, including those conducted by other independent bodies. 22. For example, the Electricity Authority develops regulatory proposals through independently chaired industry working parties whose reports are peer reviewed and formal hearings in which submissions are publicly exposed. It is not unusual for its decisions and methodologies to be challenged in the courts. By contrast, the Reserve Bank’s engagement with the banking industry is less transparent and less formal, while its papers are less subject to formal peer review and its decisions and methods have never been the subject of court action. The Reserve Bank is

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS 6 www.thinkSapere.com historically the banks’ banker and its oversight of risks in the banks reflects this perspective in part. It is not a conventional commercial regulator. 23. The institutional arrangements by which bank regulations are developed are, in some respects, somewhat unusual in relation to conventional practices of commercial regulation elsewhere. While we acknowledge that there are central banks elsewhere with similar arrangements, perhaps the point has been reached that, while the case for the independence of monetary policy, within the Policy Targets Agreement, remains, questions arise about how appropriate it is for the regulation of the banking industry to be based in this degree of independence. 24. A broader consideration of the Reserve Bank’s regulatory functions goes well beyond the scope of the terms of reference for this report. The regulation of banks is a complex undertaking which necessarily is always work in progress, so there rarely is a time when it is useful or even administratively and politically feasible to take a broader look across the whole territory. But, in the background to the current consultation, the roles and functions of the Reserve Bank are being considered in the second phase of the present government’s review of the Reserve Bank. This is a propitious time to take a broader look at the configuration and conduct of these regulatory instruments. Consultative processes and analytical methods 25. The Reserve Bank has provided ample opportunity for consultations and submissions on its proposals. However, some who we have interviewed for this project see the proposed capital regulation as something the bank is already heavily committed to and so are focusing their submissions on other matters. This concerns us, as the Reserve Bank’s own papers ask submitters to respond to a collection of sensible questions. However, the way in which the proposal has emerged in the sequence of decisions does mean it has a head of steam, which seems clear from the Reserve Bank’s papers. 26. We view with some concern that the Reserve Bank proposes to do a Cost-Benefit Analysis (CBA) and the Regulatory Impact Statement at the end of the process. In balancing the benefits of higher capital levels against the costs, the Reserve Bank positions itself as an agent of society; it seeks to “take into account the concerns and views of all stakeholders in a reasonable way” (Reserve Bank of New Zealand, 2019a, p. 12). A core analytical method used by policy analysts assessing whether a proposal would provide an overall benefit to society is CBA. A CBA has desirable properties for helping policy-advisers appraise and compare different options against a benchmark of national welfare as it:  is generally the preferred (and often required) method for evaluating the impact on communities of public policy decisions, which means there are published guidelines for how to identify economic costs and benefits2

2 See for example, the New Zealand Treasury, (2015) ‘Guide to Social Cost Benefit Analysis’, available at http://www.treasury.govt.nz/publications/guidance/planning/costbenefitanalysis/guide

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS www.thinkSapere.com 7  is founded on a branch of economics known as ‘welfare economics’, which considers how to evaluate public decisions impacting the economic interests of more than one person;3 this means there is a reservoir of academic research and learning to draw upon  provides a way of organising information in a consistent and systematic way, and for making the best use of available information (The New Zealand Treasury, 2015, p. 3). 27. However, rather than undertake a cost-benefit assessment of its proposal ahead of its consultation, the Reserve Bank will carry out a cost-benefit assessment when it prepares a Regulatory Impact Statement of its final decisions (Reserve Bank of New Zealand, 2019b, p. 4). This sequencing risks:  submitters not having an opportunity to respond to the full set of costs and benefits as will be assessed by the Reserve Bank in reaching its final decisions  the information contained in the consultation paper and supporting materials not being organised in a consistent and systematic way, as would be required for a CBA  a perception, or reality, that the CBA will be used in a pragmatic way to support the preferred decision rather than as a ‘rational’ decision-making tool (Denham & Dodson, 2018). 28. Is it credible that the Reserve Bank could conclude at the end of its processes that its proposal doesn’t stand up? In some other regulated industries, concern by participants that the authorities were in effect biased towards an outcome before the consultation process is complete could raise the prospect of judicial review. Sequencing and prioritising the issues 29. Partitioning a complex multi-faceted policy into components to be sequenced and prioritised for attention is a practical necessity. However, the way in which the components are defined and sequenced influences the overall outcome. The order in which the Reserve Bank has sequenced its consideration of various interrelated bank regulations in recent years illustrates this point. Each step along the way has influenced the agenda for the next step and constrained the choices at each further step. These decisions have become heavily path-dependent and influenced by the sequence in which the issues have been addressed. 30. We have some concern that putting decisions about the Open Bank Resolution (OBR) and the use of hybrid capital instruments well before a broader discussion about options for the use of capital ratios alongside other regulatory instruments, has narrowed and prejudged the scope of the current proposal. The Reserve Bank’s papers leave open the questions of regulations regarding Tier 2 capital and the possibility of deposit insurance lurks in the wings. High-level

3 As differentiated from the economic theory of decision-making by individual consumers and enterprise owners, see for example Broadway, R. W., and N. Bruce, Welfare Economics, Blackwell, Cambridge, Mass., 1984.

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS 8 www.thinkSapere.com decisions are being made while leaving open important questions of implementation that are affecting people’s views about those higher-level proposals. 31. The sequencing of the issues is having the effect of limiting the scope of the current consultation to a singular proposal for a capital ratio involving only equity capital. The policy decision in principle to exclude hybrid instruments from Tier 1 was taken when the capital ratio was lower than is now being proposed. Given the higher cost of equity over hybrid instruments the increase in the required capital ratio has a material effect on the cost-benefit calculation of the hybrid decision. The question of whether the hybrid decision would pass a cost-benefit test in the light of the latest proposal should be central to the Reserve Bank’s ongoing consideration of its proposal. 32. The way the process has been conducted has diminished consideration of options that might offer a more balanced application of regulatory instruments available to the Reserve Bank. Had it kept options for the use of hybrids, ‘bail in’ and more reliance on Tier 2 and Pillar II for longer, a better and more efficient matching of instruments to objectives might have been feasible. Also, critical details about implementation and interaction with the regulatory requirements might have been given more attention. Our interviews reveal that the impact on competitive neutrality between different banks would be dependent on the details of implementation of the proposals that have yet to be explained. An example emerging from our interviews concerns the level of detail in the proposed scaling up of the IRB ratios. Articulating the policy problem 33. A standard question in public policy analysis of proposals to regulate private markets is to ask what are the market failures that drive a wedge between private and social evaluation of costs and benefits. The standard response in respect of banks is that a high proportion of their liabilities can be called up immediately. Banks need capital to address the mismatch in the duration of their assets and liabilities but a bank that fully hedged all its liabilities, particularly with capital, would not really be a bank—it could not take deposits. As liquidity applies to all banks as a group, a run on any one of them can trigger a run on the others, even if those other banks are financially sound. It is not in the public interest that this be allowed to happen and so governments intervene when systemically important banks are threatening to become insolvent. Sometimes, they will even intervene to bail out badly managed fringe financial institutions such as the South Canterbury Finance. People who own, manage and govern banks therefore know that governments will intervene if things go seriously wrong, which creates a moral hazard and which justifies the prudential regulation of banks to protect taxpayers and the society at large. 34. The Reserve Bank augments this moral hazard problem with a view that people value stability more than the owners and managers of banks do and would be willing to forfeit output (income) to further avoid uncertainty or disruption. The level of regulatory capital held by banks might therefore need to be higher than that which would maximise output, if that additional capital provides the benefit of reduced uncertainty or disruption.

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS www.thinkSapere.com 9 35. Standard frameworks of public policy analysis operate at the margin beyond the status quo, which axiomatically is judged to be inferior, according to some chosen criteria, to some potential future state or states, that could be achieved by reconfiguring the available policy instruments—or inventing new ones. The Reserve Bank’s analysis does not articulate clearly what it believes is wrong with the status quo which justifies the change. The clear implication of its proposal is that it believes the status quo breaches reasonable criteria for stability in the banking system. It is probable that its proposal will cause a permanent upward adjustment in interest rates and some tightening of lending criteria in riskier areas of the economy, particularly for small business and agriculture. So, the authorities will likely be pressured to be clearer about why these negative consequences of the proposal are clearly outweighed by the benefits that flow from addressing what is wrong with the status quo. The size of the required capital injection is large and has an opportunity cost similarly large. These costs are large enough to matter in the economy on a continuing basis so the benefits need to be clear and understood in the same terms. Rigidity of the capital ratio proposals 36. The very substantial increase in equity capital requirements comes across as a one-size-fits-all solution, which could be precluding a more variegated response in which those ratios could be shored up or substituted by other regulatory instruments that have comparative advantage for some issues or lower costs. This point can be illustrated by reference to the figures in the Reserve Bank papers that support the narrative behind the proposals with stylised graphs, which effectively conflate stability with capital ratios, which by implication is CET1. By contrast the APRA, in line with many other Basel countries, puts weight on various buffers and layers of complementary financial instruments, which are not only cheaper but also serve a variety of purposes, for example loss absorption in going concern and loss absorption in gone concern. Focus on use of equity 37. The Reserve Bank proposals focus on the use of equity, the most costly form of capital. The Reserve Bank considered alternative forms of capital earlier in its decision process, but its sequencing does not provide for an assessment of the costs and benefits in the context of its current proposal to significantly increase capital requirements. 38. The second Capital Review paper presented a case against contingent convertible capital instruments (CoCos) (Reserve Bank of New Zealand, 2017). The Reserve Bank relies on three arguments:  loss-absorbing effectiveness (that is, a suggested lack thereof)  fiscal risks  regime complexity. Given the economic costs of the Reserve Bank’s capital proposals (assessed in the following section of this report), only the first of these issues is relevant to this report; the other two factors relate to design issues that countries permitting CoCos appear to have solved, albeit at a cost of additional supervisory resourcing.

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS 10 www.thinkSapere.com 39. Research by Annelies Renders and Martien Lubberink offers evidence that CoCos do work. These instruments absorb losses in going concern banks (Lubberink & Renders, 2018). During the years 2009 – 2013, for example, European banks seamlessly converted €41.55bn of European bank hybrid capital into €32.44bn of equity. 40. Our concern is that the Reserve Bank does not appear to weigh its concerns with CoCos against the economic costs of achieving its stability and efficiency objectives, and whether CoCos might achieve its objectives at less economic cost. Balancing capital requirements with supervision 41. The Reserve Bank proposal focuses on specifying Tier 1 capital ratios that are visible to investors and depositors. These are Pillar 1 requirements, and cover three specific risks: credit risk, market risk, and operational risk. 42. Banks are also exposed to other risks, notably the risk of a poor governance. To cover these, often bank-specific, risks, bank supervisors and regulators rely on Pillar 2 requirements. Pillar 2 requirements are set in the Supervisory Review and Evaluation Process (SREP). This process is a dialogue between the supervisor and the bank, where both agree on a capital level that covers relevant risks. By definition, this capital requirement is bank-specific.4 43. Traditionally, Pillar 2 requirements have been largely unobservable. However, the Pillar 2 requirements are significant. Figure 2 shows the differences between reported capital ratios and required (Pillar 1) capital ratios for selected countries. The inference from the chart is that the Pillar 2 requirements largely explains the gap between reported and required capital ratios, beyond some buffer to avoid breaching the Pillar 1 requirements.

4 See the 2016 European Central Bank SREP methodology booklet available at: https://www.bankingsupervision.europa.eu/ecb/pub/pdf/srep_methodology_booklet_2016.en.pdf

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS www.thinkSapere.com 11 Figure 2 Reported capital ratios versus required capital ratios Source: World Bank 44. By contrast, the Reserve Bank proposals would predominantly rely on Pillar 1 requirements. These are publicly known. Hence, investors and depositors will know when a bank approaches a breach of its Pillar 1 requirements, potentially limiting the opportunities for the Reserve Bank to work discretely with a bank to resolve capital adequacy concerns. 45. There are clearly complex trade-offs and policy considerations between using visible and hidden thresholds. We do not express a view on those trade-offs here. Our concern is that the Reserve Bank’s assessment of these trade-offs is not apparent in its consultation paper, nor whether it might achieve its sustainability and efficiency objectives at a lower economic cost through a combination of Pillar 1 and Pillar 2 requirements, rather than focusing on Pillar 1. 46. It is possible that the Reserve Bank proposals have an aim of making prudential supervision of the banks more straightforward and to obviate the need for more detailed supervision of the banks that other instruments or complementary regulations might require. The Reserve Bank does not have the quantum of supervisory capacity that can be found in other countries. However, while capital ratios have the advantage of providing for events that were not anticipated, it seems unlikely that either different ratios, or the proposed ratios comprising cheaper capital instruments, are so inferior to what is being proposed that they are not worth evaluating as alternatives. International practices would suggest that it is not an open and shut case. Also, it would be a mistake to see the costs to the Reserve Bank of supervisory arrangements as significant in a cost-benefit calculation by contrast to the wider effects on financial markets.

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS 12 www.thinkSapere.com 47. From the perspective of the Reserve Bank, equity capital as the only qualifying instrument for Tier 1 has the advantage of providing an automatic stability buffer, in the sense that no party needs to make the decision that would be necessary if some of the Tier 1 were convertible instruments in the event of a crisis. The APRA policy is that the decision to convert will be made by the APRA, which requires that it has close oversight of the banks in order to be prepared and competent to make such a decision. Applying this policy in New Zealand would require the Reserve Bank to be more engaged in supervision than it may have inclination or capacity to be. But, because pure equity imposes higher capital costs on the banks that will be partially passed on to customers, there is a trade-off here to consider. 48. The incentives on bank boards are also relevant to this issue. Given that boards of directors are typically reluctant to declare their companies insolvent there is an argument that, if the responsibility for triggering conversion of hybrid debt lies with the board, a bank crisis might be made more severe than if the Reserve Bank controlled the trigger. If hybrid capital were permitted in Tier 1 the Reserve Bank may need to follow the APRA policy in this regard. 49. That said, we are sceptical that avoiding hybrids gives the Reserve Bank justification to do less oversight of the banks than it otherwise would either in normal circumstances or in times of stress. Any bank approaching a solvency crisis would already have the Reserve Bank taking a close interest in what is happening and would already be engaged closely with the board. This would be the case even if the Tier 1 capital is all common equity. If the share price of a bank is declining because it, or one of its subsidiaries, has deteriorating solvency indicators, then market analysts and stock market transparency will publicise this. The Reserve Bank will have to say or do something to show it has the situation covered. The Reserve Bank is—as it states in the proposal—the agent of the public in these matters, and hence we are not convinced that insisting on common equity gives it more freedom to stand back from a bank for which there is even a hint of stress. At that juncture, the Reserve Bank would be under pressure to explain itself and the OBR policy in particular. If the situation deteriorated to the point where it were considering whether to trigger the OBR, which would be no easier and possibly more challenging than triggering the conversion of hybrids, the Minister of Finance would probably already have had to provide some comfort to the markets. 50. We have some concerns that the OBR is being assumed to provide a ‘bail in’, whereas it seems to us highly unlikely that any government would allow all depositors in a major bank to take a haircut. Depositors would have a right to argue that the Reserve Bank should have seen this coming and that as the government’s designated regulator of the banks, the government should take the hit rather than the depositors. Depositors are poorly placed to monitor the performance of their banks in contrast to the regulators who have better information and a duty of care to the depositors. Requiring banks to hold additional Tier 1 capital would seem unlikely to be the most efficient method for managing these risks. 51. Further, it seems inconsistent that the Reserve Bank favours, through the OBR, a bail in from everyone including the depositors, when the implication of its decision not to recognise hybrids amounts to rejection of a bail in from the holders of hybrid instruments. These instruments should ideally be held by professional institutional investors, who are far better placed to monitor bank risks than retail investors in hybrids. Institutional investors and regulators are

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS www.thinkSapere.com 13 both better placed than depositors to monitor the risks of banks. If the Reserve Bank does reconsider its views on the use of hybrid instruments, then the regulation of the marketing of these would be an important issue. From our perspective, the OBR seems to be allocating risks to the wrong people, who are poorly placed to manage them and is politically unrealistic. 52. The analysis of risks leading to the choice of the 1 in 200 year target appears implicitly to envision banks as occasionally subjected to broader economic shocks that threaten their viability. However, bank failures in New Zealand have occurred as a consequence of bad decisions grounded in poor management and governance. The Reserve Bank is close enough to sense problems at a bank and will intervene more deeply in the affairs of such a bank even if its capital ratios are not currently threatened. There are limits to the extent to which insisting on more capital allows the Reserve Bank to take its eyes off the ball. 53. The Reserve Bank proposal provides for a buffer that is expected to provide flexibility in the application of the capital ratio requirements as a bank under stress can dip into the buffer zone provided it stays above the minimum requirement. From our interviews, it seems unlikely that Banks will see it this way. Banking is a business based on confidence, so directors and financial markets will want to see their bank clear of the buffer zone. 54. In reality the proposal is likely to prove less flexible than intended. Smaller banks without large parents have limited or no access to equity markets, while cooperative banks have no formal equity. For them, the implementation of the regulation will need to be done in a way that permits them to grow their balance sheets nonetheless. 55. The essential difference between a mutual or cooperative and a company is in the rights of control and who carries the residual claims. In a company this is the ordinary shareholders, which is why they have the ultimate right of control over appointing directors to enhance and protect the value of their shares. In a mutual these rights rest with the members. A mutual bank is owned by the members, who are usually the depositors, but their rights are not defined by the size of their deposit. They make their surpluses available to the members in various ways but, unlike a company, these surpluses are not necessarily distributed back to the members like a dividend on share capital in proportion to the size of the member’s financial participation. 56. We have been informed that the Reserve Bank is being helpful to the mutual banks in discussions about how these banks can access the capital needed to meet the proposed increases in regulatory capital ratios. They will likely need to access capital externally, but cannot offer investors ordinary shares. Treating an outside investor just like a depositor would be a hard sell as the investor would have highly attenuated rights over board appointments and the distribution of surpluses. Also, to be available in the event of insolvency, it would have to be available to pay the bank’s liabilities. The cost of such capital would be high and the instrument would be classified as a hybrid. So, just as with the OBR, we perceive the Reserve Bank as being hostile to hybrid instruments for Tier 1, but is in effect accepting them in other aspects of the overall regulatory framework. 57. A difference we perceive between the respective approaches of the APRA and the Reserve Bank is that the former is more focused on what to do when a bank is threatened with insolvency, while the latter is more focused on ensuring such an occurrence is extremely rare. This is a

THE ROLE OF THE RESERVE BANK AND ITS APPROACH TO DEVELOPING THE PROPOSALS 14 www.thinkSapere.com significant policy difference, but even allowing for this preference by the Reserve Bank, we see merit in the APRA concept of Total Loss Absorptive Capacity (TLAC), which facilitates more open discussion about what is the best way to achieve a specified level of TLAC in view of the trade￾offs and practical points raised above. This approach offers a pathway to an outcome that is less constrained by the sequencing of decisions about components of the overall framework. Stability and efficiency 58. The Reserve Bank has sequenced its analysis by putting its consideration of stability ahead of and separate from its consideration of the other requirement in its legislation—to consider efficiency. The Act does not guide them about the balance to be struck so, while we would not question the Reserve Bank’s view that a high level of comfort about the stability of the system is essential, the question arises as to whether the pragmatic decision to set a stability target in place in isolation first, then turn to efficiency has unnecessarily biased the analysis of the optimal capital ratio. The question of whether there is a further increase of the capital ratio above the 16 per cent target for stability purposes that improves both stability and efficiency is addressed in the negative. But the analysis does not illuminate whether a lower capital ratio or one with a different composition might have produced a reduction in cost with little or any loss of stability. The stylised graph at figure 1, (Reserve Bank of New Zealand, 2019b), shows a steeply falling benefit curve which under reasonable assumptions would intersect the cost curve at a point where the benefit curve is very flat. While this can be said to support the proposal— at least more than if the intersection was at a point where the benefit curve was more steeply sloped—the reality is that the level of uncertainty is very high about just where these curves (and hence their intersection) are located and how stable these positions are. 59. The analysis in the Reserve Bank papers does not help much on this point. The Reserve Bank appropriately intends to choose a capital ratio in the flat section of the benefit curve where diminishing returns in terms of the stability objective have set in. Given the uncertainty about the location and stability of the cost and benefit curves the Reserve Bank has chosen a point it apparently believes is well into the range of diminishing returns. But within this range a small change in the position of the cost curve can result in a large change in the associated capital ratio associated with the stability target. This suggests that there is a bound of uncertainty around the target ratio so that the analysis could support other conclusions within this range. 60. The proposal claims only that the chosen ratio is within a range based in the three approaches it has taken, but there is not much from which to evaluate the consequences of moving the target within the range. The fact that the search for a ‘win-win’ ratio above the chosen target could not find one makes it probable that a similar analysis at a somewhat lower target would produce the same conclusion. There is just not enough information about the trade-off between stability and efficiency and how stable it is, to know where some point that could be described as ‘optimal’ is located within ‘stability-efficiency space’. 61. In the remainder of this report we assess the economic costs and benefits of the Reserve Bank proposals.

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 15 Assessing the economic costs Weighing of costs and benefits 62. The Reserve Bank (correctly) characterises its task in setting capital ratios as “balancing the benefits of higher capital levels, in terms of improved financial stability, against potential costs, such as economic output that may be foregone from imposing excessively high requirements” (Reserve Bank of New Zealand, 2019a, p. 2). We would add to this characterisation that the task should also involve considering whether some of the expected benefits could be achieved using lower-cost instruments, as discussed above. 63. In this chapter, and the chapter that follows, we review the Reserve Bank’s assessment of the costs and benefits consistent with a CBA method. We show that the costs identified by the Reserve Bank would not be minimal and that its assessment missed out some important societal impacts. We review the expected benefits using the same conceptual approach. The result is, that on the basis of the information released by the Reserve Bank, the societal costs of its proposals would substantially exceed the benefits. Quantity of additional capital 64. To assess the potential cost of the Reserve Bank proposals, an estimate is needed of the quantity of additional capital banks would hold as a result of the change in regulatory requirements—that is, the quantity of capital in addition to the amount banks would hold in any event to cover their assessment of lending risk and to satisfy credit rating agencies and other stakeholders. 65. The Reserve Bank proposals would increase the regulatory minimum for Tier 1 capital from 8.5 per cent of risk-weighted capital to 16 per cent (for large banks) and to 15 per cent of risk￾weighted capital for smaller banks, an increase in the regulatory minimum of 6.5 to 7.5 percentage points (see Figure 1 above). However, all banks currently hold more capital than required by the regulatory minimum, with the ratios reported by individual banks varying considerably. The CET1 measure is the relevant measure as the Reserve Bank proposed to require that the regulatory requirements be met by ordinary capital. Figure 3 shows the CET1 capital ratios reported by the New Zealand banks.

ASSESSING THE ECONOMIC COSTS 16 www.thinkSapere.com Figure 3 CET1 capital ratios reported by New Zealand banks Source: Reserve Bank Financial Strength Dashboard 66. All banks we interviewed stated that they would continue to hold a buffer above the minimum capital ratio set by the Reserve Bank. Most banks consider that the prospect of adverse publicity and reputational damage, should a bank dip below the requirements (even if the regulatory regime provides for an escalating supervisory response), would result in their boards setting a buffer above the regulatory requirements.5 Management would set a margin above the board determined minimum. 67. The banks we interviewed were still evaluating the size of the buffer they would maintain, but most said a buffer of 1.0 to 2.0 percentage points would be needed to cater for economic shocks and avoid breaching the regulatory requirements (or seeking emergency capital from its shareholders). Also, any bank seeking to grow its total lending will need capital in advance of that growth and hence a larger buffer on top of whatever buffer it would set in a no-growth situation. 68. In its explanatory paper, the Reserve Bank assumed a voluntary buffer equivalent to 0.5 per cent of total exposure at default (EAD) (Reserve Bank of New Zealand, 2019b, p. 42). This assumption equates to approximately 1.0 per cent of risk weighted assets, the lower end of the range the

5 Some small banks indicated that depending upon how the Reserve Bank reports the capital held by banks, they may need to hold Tier 1 capital levels equivalent to the larger banks to avoid the impression that they are not meeting the Reserve Bank requirements. This incentive would result in a slightly larger average increase in the additional capital held by banks than our estimate.

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 17 banks advised us they were likely to maintain. The Reserve Bank observes that banks can be expected to take a view on the appropriate voluntary buffer (Reserve Bank of New Zealand, 2019a, p. 12), but does not provide an explanation for its assumption of 0.5 percentage points of EAD. We adopt a mid-point assumption that banks would maintain a buffer of 1.5 percentage points of risk weighted assets. 69. On the basis of this assumption, and the estimates of CET1 capital provided by the Reserve Bank in its explanatory paper (Reserve Bank of New Zealand, 2019b, p. 43), we estimate that the Reserve Bank proposals would require an aggregate increase in bank capital of 4.3 per cent of unweighted assets. This calculation uses the same measure of unweighted assets (total exposure at default) as used by the Reserve Bank. Our calculation of this working assumption is shown in appendix A. Our estimate is higher by 0.3 percentage points than the Reserve Bank estimate of 4 per cent contained in its explanatory paper (Reserve Bank of New Zealand, 2019b, pp. 37, 43). This difference is due to the variance in assumption as to the likely size of the buffer over the regulatory minimum that banks would hold under the new proposals. 70. An increase in the quantity of capital held by banks would have:  direct economic costs, because of the higher real interest rates incurred by borrowers; and  indirect economic costs as: o higher real interest rates impact on investment and other economic decisions o firms change business models and organisational forms in response to the change in regulatory requirements. 71. We review these economic impacts before turning to consider the estimated benefit from the reduced risk of a banking crisis. The direct economic costs of additional capital Increased capital requirement is an economic cost 72. In its non-technical summary, the Reserve Bank acknowledges that increased capital requirements “could make it more expensive for New Zealanders to borrow money from a bank” (Reserve Bank of New Zealand, 2019a, p. 5). However, the body of the consultation paper, and the subsequently released Capital Review Background Paper (Reserve Bank of New Zealand, 2019b), focus on balancing the benefits of greater financial system stability with the indirect cost, or flow-on effect, from the loss of economic output due to higher bank credit costs. There is no explicit discussion in these Reserve Bank papers of the additional amount paid by borrowers as an economic cost. 73. The inference appears to be that the Reserve Bank considers the direct cost, of higher payments made by borrowers, to be a transfer payment. In cost-benefit assessments it is usual practice to ignore transfer payments because the benefits to the recipients are assumed to offset the costs to the payers (The New Zealand Treasury, 2015, p. 10). The argument in this case is, presumably,

ASSESSING THE ECONOMIC COSTS 18 www.thinkSapere.com that additional payments by borrowers would be passed on to the providers of the capital and therefore should be viewed as a transfer payment. 74. However, the additional payments by borrowers that will result from the Reserve Bank proposals are not a transfer to the owners of capital; they are payments that reflect the opportunity cost of that capital—the cost to society from the use of that capital in the banking sector. The providers of that additional capital do not receive a transfer from borrowers over and above the risk adjusted return they would receive from employing that capital elsewhere. 75. The change in the quantum of equity held by New Zealand banks can be ignored for simplicity in a cost benefit assessment, as off-setting the increase in the quantity of equity would be a reduction in the quantity of bank debt; a change in the capital ratio would not in of itself change the quantity of funds committed to the banking sector, just the mix of debt and equity. However, the increased costs society incurs to achieve the increase in equity is a measure of the economic cost of maintaining that higher level of equity. 76. For example, a household facing higher mortgage rate costs would incur a loss of welfare—this is the direct price households would pay under the Reserve Bank proposals for the lower risk of a banking crisis. The additional payments by households would not be a transfer payment; it would not be offset by higher payments to the owners of equity, as the owners of equity would expect to receive a return commensurate with the risk of that investment, whether invested in the bank or in an alternative asset. 77. The increase in payments by borrowers is not a perfect measure of the direct economic cost of the additional capital because one reason equity is typically costlier than debt is the tax shield for debt, and tax payments are a transfer. In the analysis that follows, we assess the quantum of the direct economic cost as a result of higher bank credit costs, but acknowledge that a dollar value estimate derived from those additional charges will likely be an over-estimate of the direct economic costs because of the tax impacts. The additional cost of bank credit 78. In its consultation paper, the Reserve Bank says “a reasonable point estimate is that a one percentage point increase in a bank system’s Tier 1 capital ratio from current levels may lead to a 6 basis point increase in the price of bank credit once Modigliani-Miller effects are taken into account” (Reserve Bank of New Zealand, 2019a, p. 28). This sentence appears to be poorly phrased. In a decision paper provided to its Financial System Oversight Committee dated November 2018 (Reserve Bank of New Zealand, 2018, p. 7), the Reserve Bank clarified that: We estimate that 100 basis points increase in the Tier 1 ratio would increase the weighted average cost of capital by 6.6 basis points with a flow-through effect on lending rates (which we estimate would increase by 8.2 bps). 79. In its subsequent explanatory paper, the Reserve Bank stated that: “The estimated impact is an increase in lending rates of 8.1 basis points” (Reserve Bank of New Zealand, 2019b, p. 36). The Reserve Bank does not explain the small adjustment from 8.2 basis points to 8.1 basis points. As the explanatory paper contains the most recent comment from the Reserve Bank, we presume

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 19 that the Reserve Bank’s current estimate is each additional percentage point increase in Tier 1 capital (as a percentage of unweighted assets) would increase the cost of bank credit by 8.1 basis points. On the basis of this assumption, and our working assumption of an increase of 4.3 percentage points in Tier 1 capital (as a percentage of EAD), we estimate the Reserve Bank proposals would result in an additional cost of bank credit to New Zealand borrowers of about $1.6 billion per annum. Our calculation is shown in appendix B. 80. The Reserve Bank does not appear to take this direct economic cost of its proposals into account. To the extent this increase in costs to borrowers includes tax effects it likely overstates the direct economic cost of the Reserve Bank proposals, as discussed above. However, there are also strong reasons for concluding that the Reserve Bank may well have underestimated the increase in bank credit charges. These reasons are discussed below. Reserve Bank estimate of the increased cost of credit 81. In our estimate of the direct economic cost of the Reserve Bank’s proposals, we utilised the Reserve Bank’s estimate of the increased cost of credit emanating from its proposals, that is, 8.1 basis points. However, as we now explain, the true increase in the cost of credit, and hence in the direct economic cost, could be considerably higher. The Modigliani-Miller offset—the literature 82. As a bank increases its Tier 1 capital, it becomes a less risky investment for both its equity and debt investors. Hence, in theory, some or all of the additional cost of funding would be offset by a fall in the required return on investment—this offset is referred to as the “Modigliani-Miller offset”. 6 The Reserve Bank reviewed a range of recent studies and concluded that around half of the increase in funding costs would be offset by a lower required return on a bank’s capital and non-capital funding (Reserve Bank of New Zealand, 2019a, p. 27). On the basis of this assumption, the Reserve Bank concludes that a reasonable point estimate is that a one percentage point increase in a banking system’s Tier 1 capital ratio from current levels may lead to an 8.1 basis point increase the price of bank credit once Modigliani-Miller effects are taking into account (Reserve Bank of New Zealand, 2018, p. 7). 83. One of the difficulties in assessing the implications of the literature for New Zealand is that the studies utilise a wide range of capital ratio measures. Some use total capital in the numerator, others use Tier 1 capital, and still others use CET1 capital. Some use total assets in the denominator while others use risk-weighted assets. As a result, inferring a Modigliani-Miller offset appropriate to New Zealand requires some (fairly heroic) adjustments of the estimates appearing in the research literature.

6 The American economists, (Modigliani & Miller, 1958), in what has often been described as the most important paper ever written in corporate finance, showed that a firm’s total cost of capital in a perfect market is independent of its mix of debt and equity funding.

ASSESSING THE ECONOMIC COSTS 20 www.thinkSapere.com 84. A further complicating factor is that the definition of particular types of capital sometimes change over time. For example, in the literature we have reviewed, Tier 1 capital often includes convertible instruments. Hence, a 1 percentage point increase in ‘capital’ in the typical study the Reserve Bank is relying on might correspond to significantly less than a 1 percentage point increase in equity capital. If so, this could have a substantial effect on the estimated elasticity. For example, if convertible instruments made up 50% of ‘capital’ in a study, then a 1 percentage point increase in ‘capital’ would correspond to only a 0.5 percentage point increase in the Reserve Bank’s definition of capital and so the implied elasticity would rise from 8 basis points to 16 basis points. 85. In summary, we do not dispute the Reserve Bank summary of the literature it has reviewed, but given the uncertainties outlined above, stress that its estimate of 8.1 basis points from the literature comes with a very large margin of error. Constraints on funding of New Zealand banks 86. We interviewed a number of New Zealand banks that are wholly owned subsidiaries of offshore parents, as well as domestically owned banks. These banks all raised concerns that the capital raising options available to them would not provide the Modigliani-Miller offset assumed by the Reserve Bank. 87. With regard to debt funding, the New Zealand subsidiaries of offshore parents advised us that their debt costs are a margin above the rates available to their parents; the banks say it would be unrealistic to assume that the cost of debt for a New Zealand subsidiary would fall below the cost of debt available to the parent. We agree with this argument in principle. 88. However, it seems the Reserve Bank has not assumed that the Modigliani-Miller offset would impact on the cost of debt. In its explanatory paper (released subsequent to many of our interviews), the Reserve Bank explains that “our calculation assumes all of the increase in average funding costs is captured in lending rates, with no impact on borrowing costs” (Reserve Bank of New Zealand, 2019b, p. 36). Such an assumption would be consistent with several of the studies referred to by the Reserve Bank which set the Modigliani-Miller effect on the cost of debt to zero by assumption (for example (Cline, 2016), and (Miles, Yang, & Marcheggiano, 2012)). 89. In relation to the cost of equity, the New Zealand subsidiaries all referred to the internal capital allocation rules of their parent entity. The central theme is that investors cannot buy shares just in the New Zealand subsidiary, only in the overall group. The New Zealand subsidiaries range from being a very small part of the parent group to close to 25 per cent. Any risk reduction might therefore have only a small effect on the group’s cost of equity for several major New Zealand banks. As a result, the parent could be expected to continue to set the same required return for the New Zealand subsidiary as for the other parts of the group in its internal capital allocation decisions. As one bank put it to us “the parent sets the return it requires to make capital available, and if that return cannot be achieved, reallocates the capital to other activities within the group.”

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 21 90. In concept, the arguments presented by the banks suggest imperfect capital allocation—a one size fits all internal capital allocation rather than fine tuning for relative risk. However, it is not unusual for businesses to apply heuristics in business decision-making. There are many real￾world examples of economic decision-making where the benefits of fine-grained analysis do not warrant the costs involved. The Reserve Bank does not appear to consider the implications of real-world capital allocation decisions in assessing the likely cost of its proposals. 91. The argument by the banks is that, in practice, the New Zealand subsidiaries would experience little if no change in the cost of equity provided by their parent entities; that is, the Modigliani￾Miller offset would be minimal or possibly zero. If that were the case, the impact on lending rates might be up to twice that estimated by the Reserve Bank; that is 16 basis points rather than 8 basis points for each percentage point change in capital requirements (perhaps less where the New Zealand subsidiary is a larger part of the parent group). 92. The difficulty of applying estimates of the Modigliani-Miller effect from the literature, and the practicalities of raising capital for New Zealand based banks, would caution against relying on an estimate of 8 basis points for each percentage point change in capital requirements. The impact on the direct economic cost of the Reserve Bank proposals of changes in this assumption would be very significant. For example, if the cost of bank credit were to increase by 16 basis points, rather than 8 basis points, the direct economic costs would increase from $1.6 billion to $3.1 billion per annum for the additional 4.3 percentage points of capital (see appendix B). Indirect economic costs 93. In addition to the direct economic cost of higher bank credit costs as a result of the change in capital requirements, there would be flow-on, or indirect economic costs as:  higher real interest rates impact on investment and other economic decisions  firms change business models and organisational forms in response to the change in regulatory requirements. 94. We consider each component of indirect economic cost in turn. Reduced economic activity from higher real interest rates 95. As lending rates rise, firms borrowing capital would find it is no longer profitable to borrow as much, and therefore would invest less in plant and equipment. With less capital formation, total output would reach levels lower than otherwise. The economic effect of a permanent (for as long as the regulatory requirement for higher capital is in force) increase in real interest rates is therefore to reduce the steady-state level of GDP. 96. The Reserve Bank does not make its own assessment of the effect on economic output from a permanent increase in real lending rates. It reviews the literature for studies on the increase in capital requirements on steady-state, or permanent, GDP. This approach implicitly accepts the elasticity of steady-state GDP to a higher cost of bank credit assumed in the overseas studies as

ASSESSING THE ECONOMIC COSTS 22 www.thinkSapere.com applicable to New Zealand. In its consultation paper, the Reserve Bank states (Reserve Bank of New Zealand, 2019a, p. 28): By lowering credit availability at a given price, from the studies we have surveyed we consider a percentage point increase in the Tier 1 capital ratio could lead to a 3 basis point decline in the steady-state level of GDP. 97. The reference to a 3 basis point decline appears to be an error. In its explanatory paper, the Reserve Bank presents (in its table 7) an estimate that a one percentage point change in the leverage ratio would reduce GDP by 8 basis points (Reserve Bank of New Zealand, 2019b, p. 37), but provides no explanation for how it arrived at this value. In its decision paper of November 2018, the Reserve Bank advised its Financial System Oversight Committee that it assumed a decrease of 8.8 basis points for each percentage point increase in bank capital (Reserve Bank of New Zealand, 2018, p. 8). The Reserve Bank explained that it had not done its own macroeconomic modelling, but had used an estimate obtained by the Federal Reserve for the United States economy. 98. The structural differences between New Zealand and the United States economies mean it is dangerous to be overly reliant on a United States assessment of the likely effects. In appendix C, we undertake our own assessment of the impact of the Reserve Bank’s capital proposals on GDP using the methodology of Miles et al. (2012) applied to New Zealand conditions. 99. Applying New Zealand specific parameters produce much higher estimates of the reduction in the steady-state GDP from a permanent increase in real interest rates than the 8.8 basis points estimated by the Reserve Bank. Using alternative, plausible, scenarios we obtain estimates of 17 basis points to 40 basis points loss in steady state GDP for each percentage point increase in capital (Table 3, appendix C). 100. The range of estimates arrived at from applying New Zealand parameters, and their sensitivity to the dataset they are estimated from (see appendix C), indicate these estimates are subject to considerable uncertainty. However, all of the estimates derived from New Zealand parameters are significantly higher than—at least double—the values assumed by the Reserve Bank from applying elasticities derived from the United States economy. The presumption must be that had the Reserve Bank undertaken its own assessment of the effect of its proposals on New Zealand economic output (rather than rely on United States relationships) it may have concluded the costs were substantially higher than the effects advised to its Financial System Oversight Committee. 101. Assessing the likely effect of the proposals in New Zealand (instead of assuming the effects from the literature and overseas studies) could materially affect an assessment of the costs of the proposals relative to the benefits:  Taking the Reserve Bank assumption of an 8.8 basis point reduction in steady￾state GDP (given an 8.1 basis point increase in the cost of bank credit), and our estimate of a 4.3 percentage points increase in Tier 1 capital, would result in a loss in economic output of about $1.1 billion per annum. The calculation of this cost estimate is shown in appendix D.

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 23  Applying the lowest New Zealand parameter estimates (as shown in appendix C) would double this cost estimate to $2.1 billion per annum.  If the Modigliani-Miller effect is less than the Reserve Bank assumes (for example, because of funding constraints) and as a result of the cost of credit increases are higher than the Reserve Bank assumes, then these economic cost estimates would increase proportionately; for example, if the Modigliani-Miller effect were close to zero, and the cost of bank credit were to increase by 16 basis points then the economic cost estimates presented in the bullet points above would double again. 102. These estimates of lost economic output are additional to the estimates of the direct welfare loss to borrowers discussed above (paragraphs 72 to 92 above). The proposals may also lead to changes in business models, competition between banks, and disproportionate effects on particular customer segments. Impact on business models and organisational forms 103. A change in the regulatory minimum capital requirements for New Zealand banks can be expected to alter the incentives and efficient organisation of banking in New Zealand. The Reserve Bank appears not to have considered these changes in incentives on the broader efficiency of the banking system (beyond reducing the risk of a bank failure). All of the banks we interviewed identified changes that would occur to the services they provide or the business models they employ to deliver those services. Risk of disintermediation 104. All of the banks we interviewed stressed that the higher cost of bank credit that would result from the Reserve Bank proposals would not be spread evenly across their lending portfolio. Those borrowers with a higher risk weighting would face a disproportionate increase in the cost of credit, and possibly a reduction in the credit available to them. All of the banks we interviewed expected the agricultural and small business sector to face higher than average increases in bank credit charges. 105. The Reserve Bank also considers that some of the cost of additional capital would be met by banks paying depositors less (Reserve Bank of New Zealand, 2019b, p. 36). Some depositors, especially retired people, are sensitive to changes in cash-flows. These customers may look for alternative investments should lower deposit rates not meet their cash-flow needs. 106. The potential for disproportionate impacts raises the prospect of a fringe of customer groups not being satisfied by products available from the banking sector, or facing increased costs, and hence the risk of disintermediation; that is, the risk that some of these customers might seek services outside of the banking sector. In the past, entities such as finance companies have emerged offering higher deposit rates than banks and providing finance to entities unable or unwilling to obtain funds from the banking sector. The Reserve Bank consultation paper does not assess this risk.

ASSESSING THE ECONOMIC COSTS 24 www.thinkSapere.com Tilting the field for competition 107. The Reserve Bank papers do not evaluate whether its proposals would tilt the field for competition, and if so, what effect that might have on the efficiency of banking services offered to New Zealanders. Several banks observed, for instance, that large New Zealand corporates would be able to access funding directly from offshore entities that were not subject to the same capital requirements as New Zealand banks. 108. Similarly, the existing arrangements allow some banks to apply risk weightings determined by internal models and require other banks to apply different weights determined by a standardised approach. The proposals would alter these arrangements, and change the amount of regulatory capital some banks would need to hold to provide banking services to the same customer group, relative to their competitors. Clearly such changes have implications for competition in the market for banking services. However, the Reserve Bank papers do not provide an assessment of whether the suite of changes it proposes would enhance or dull competition for the long-term benefit of New Zealanders. Capital rationing 109. The Reserve Bank appears to assume that all effects on output operate via higher credit charges. There is no discussion in its consultation paper of the direct effects banks might apply, for example, by applying a higher loan threshold and thus reducing loan growth. Our interviews with the banks suggested this was a distinct possibility. Consistent with this view, there is a literature that estimates the effects of higher capital ratios on the volume of lending and lending growth. These estimates are invariably negative, statistically significant, and fairly substantial (see appendix E for a summary). Reductions in lending on this scale would have a deleterious effect on GDP.7 110. New Zealand mutual banks face particular problems in meeting additional capital requirements, because the capital of these banks has typically been built from retained earnings. Unless some form of hybrid capital instrument is acceptable to the Reserve Bank, the New Zealand mutual banks would necessarily have to curtail their growth objectives (relative to their growth objective in the absence of increased capital requirements). This outcome would appear to tilt the market against the cooperative organisational form. The Reserve Bank does not appear to consider how its proposals will impact on the choice of organisational form. Summary of economic costs 111. An increase in the capital required to be held by New Zealand banks would make it more expensive for New Zealanders to borrow money from a bank. The Reserve Bank did not include

7 While some of the estimated decreases can be attributed to the impact of higher credit charges on loan demand, the size of these estimates relative to those implied by studies that focus on the credit charge route alone suggest that a substantial component is due to a reduction in loan supply.

ASSESSING THE ECONOMIC COSTS www.thinkSapere.com 25 in its consultation paper an estimate of these direct losses in economic welfare. We estimate these direct economic losses at around $1.6 billion per annum as a result of the Reserve Bank proposal, if the cost of bank credit increases by 8.1 basis points for each additional percentage point of capital.8 112. These costs would increase proportionately if the Reserve Bank has underestimated the effect on the cost of bank credit. For example, if the Modigliani-Miller effect were close to zero (for example, because of funding constraints) the direct economic costs would increase to around $3.1 billion per annum. 113. The permanent increase in real interest rates as a result of banks holding additional capital would also lead to reduced economic output.  Taking the Reserve Bank assumption of an 8.8 basis point reduction in steady￾state GDP (given an 8.1 basis point increase in the cost of bank credit), and our estimate of a 4.3 percentage points increase in Tier 1 capital, would result in a loss in economic output of about $1.1 billion per annum.  Applying the lowest New Zealand parameter estimates would double this cost estimate to $2.1 billion per annum.  If the Modigliani-Miller were close to zero, and the cost of bank credit were to increase by 16 basis points, then these economic cost estimates would double again. 114. Hence, the economic costs would be at least $1.6 billion plus $1.1 billion, a total of $2.7 billion per annum, on the Reserve Bank’s own assumptions. The cost may be several times this level, once the assumptions are adjusted for New Zealand conditions. The proposals may also lead to changes in business models, competition between banks, and disproportionate effects on particular customer segments. 115. While we recognise that the costs may be a small percentage of GDP, we do not agree with the Reserve Bank characterisation of the costs of its proposal as “minimal” (Reserve Bank of New Zealand, 2019a, p. 5). The costs of the Reserve Bank proposal, using its assumptions, are very large and will continue to be incurred each year the policy remains in place.

8 As discussed above, to the extent this increase in costs to borrowers includes tax effects it likely overstates the direct economic cost of the Reserve Bank proposals.

ASSESSING THE ECONOMIC BENEFITS 26 www.thinkSapere.com Assessing the economic benefits The benefits of more resilient banks Reserve Bank’s assumptions 116. By increasing the amount of capital banks would be required to hold, the Reserve Bank expects the banks will be more resilient to economic shocks and downturns. The Reserve Bank anticipates three categories of benefit from more resilient banks. By reducing the probability of a banking crisis (following an economic shock), the increased capital would lessen:  the harm to mental and physical health, family cohesion and community connectedness caused by economic stress (unemployment, falling incomes, reduced savings and or declining asset values) (Reserve Bank of New Zealand, 2019b, p. 17)  instability; the Reserve Bank is persuaded by the literature that people value stability as well as economic output (Reserve Bank of New Zealand, 2019b, p. 10)9  the output losses that would result from bank failures (Reserve Bank of New Zealand, 2019b, p. 5). 117. The Reserve Bank does not attempt to provide a monetary value of the social harm from a severe downturn. Nor does it attempt to assess the willingness to pay for stability; rather, it asserts that the stability people value would likely be met if banks held sufficient capital to cover losses so large that they might only occur once in every 200 years (Reserve Bank of New Zealand, 2019a, p. 13). We agree that avoiding social harm and providing stability are policy objectives valued by society. However, as discussed below:  the proposed increase to capital ratios appears to be a high cost instrument for advancing those policy objectives—the economic costs would greatly exceed the economic benefits  it is not clear how the Reserve Bank arrives at its capital ratios given its stability target. Estimated avoided economic loss 118. Higher capital ratios are intended to make banks more resilient to economic shocks, and thereby avoid the economic and social harm that would result from a banking crisis. Estimating the economic benefit (the avoided economic loss) obtained by the higher capital ratios therefore requires estimates of two key parameters:

9 Hence, people may be willing to forego some output (income) to avoid uncertainty or abrupt disruption—this is why, for instance, people are often prepared to buy insurance when the premiums they pay will exceed the expected pay out under the policy.

ASSESSING THE ECONOMIC BENEFITS www.thinkSapere.com 27  the economic output that would be lost should a banking crisis occur  the reduction in the probability of a banking crisis if the banks hold more capital. Economic cost of a banking crisis 119. The Reserve Bank provides a range, expressed as a percentage of GDP, of the output losses that might result from a banking crisis. This range stretches from 20 per cent of GDP to 90 percent. The Reserve Bank selects 63 per cent as its central case for illustrative purposes (Reserve Bank of New Zealand, 2019b, p. 32). 120. An economic disaster that might lead to economic loss of these magnitudes would be a rare event. The stereotype economic disaster of the Great Depression is estimated by one author to have reduced GDP per capita in the United States by 31 percent; in New Zealand the decline was 18 per cent (Barro, 2006, p. 828). The reason that the estimates relied upon by the Reserve Bank arrive at much larger potential loss is that they attempt to count not just the loss over the period of the crisis, but also the lost output out into the future (for example, because investments were not made during the crisis lowering future output). For example, (Cline, 2016) estimates a median output loss from banking crises in advanced countries over the period 1977 to 2015 at 23 per cent of GDP, measured over a 5 year period of the crisis. However, that median figure increases to 64 per cent once an estimate of losses into the future are included. The Macroeconomic Assessment Group of the Basel Committee on Banking Supervision, in an earlier study, arrived at a median total loss of 64 per cent of base GDP—this is the estimate adopted by the Reserve Bank as its central case. 121. We have some reservations about adopting a median figure from a broad study, as those results may be impacted by events in countries with very different regulatory arrangements to New Zealand (for example, Greece during the global financial crisis, or Finland in 1991). It is difficult too, in these studies, to distinguish between loss in output from an economic event which leads to a banking crisis (an increase in bank capital cannot stabilise an economy), from a banking crisis that leads to a loss in economic output. Having said that, the large range applied by the Reserve Bank, from 20 per cent to 90 per cent of GDP, allows for considerable uncertainty in its central case estimate of 64 per cent. Change in probability of a banking crisis 122. As the Reserve Bank observes, the level of capital maintained to mitigate the risk of a banking crisis depends on risk appetite (it should also depend on whether other instruments could achieve the same or similar outcomes at less cost). In its decision paper for the Financial System Oversight Committee in November 2018, the Reserve Bank advised that if it sought to cap the risk of insolvency at 1 per cent, rather than 0.5 per cent, its target for Tier 1 capital would be 12 per cent and 13 per cent of RWA (Reserve Bank of New Zealand, 2018, p. 5). The Reserve Bank explains this estimate in appendix 4 of the same paper. 123. A Tier 1 capital target of 12 per cent to 13 per cent would place the target at approximately the existing levels of bank capital—the Reserve Bank reports that the current weighted average

ASSESSING THE ECONOMIC BENEFITS 28 www.thinkSapere.com ratio of Tier 1 capital to RWA in the New Zealand banking system is 12.2 per cent (Reserve Bank of New Zealand, 2019b, p. 2). This level is above the existing regulatory minimum. 124. Hence, the Reserve Bank estimates that the proposed increase in capital would reduce the risk of bank insolvency from the current level of 1 per cent to 0.5 per cent, a reduction in the probability of a banking crisis of 0.5 percentage points.10 Cline reports the same changes in probability of a banking crisis for changes in capital ratios of the same magnitude (Cline, 2016, p. 28). Expected value of the avoided loss in economic output 125. Bringing together the estimated change in probability of a banking crisis from a higher capital ratio, with the Reserve Bank’s assumptions of the loss in economic output from a banking crisis, allows an approximate estimate of the dollar value of the annual economic benefit expected by the Reserve Bank. In any given year, the requirement for banks to hold additional capital over current levels would, under the Reserve Bank’s assumptions, reduce the risk of a banking crisis by 0.5 per cent compared to the risk that is being incurred under the current capital levels. The cost of a banking crises, were it to occur, would amount to a loss of economic output equivalent to 20 to 90 per cent of annual GDP. Hence, the expected annual economic benefit to New Zealand would be the reduction in the probability of the crisis multiplied by the expected cost of that crisis. 126. Table 1 calculates the expected annual economic benefit for the range of estimates of the magnitude of a banking crisis assumed by the Reserve Bank. It shows that, under the Reserve Bank’s central assumption that a banking crisis would cost the equivalent of 63 per cent of the base year GDP, a reduction in the probability of the crisis of 0.5 per cent would have an expected annual economic benefit (avoided economic loss) of $900 million. Table 1 Expected annual economic benefit from lower risk of banking crisis

10 The reduction in risk may be higher than 0.5 per cent, if the banks retain a buffer over the new regulatory minimum as we anticipate. Economic benefit - avoided lost economic output Notes A Annual GDP - steady state $ billions $ 286 Estimate of avoided economic cost from more resilient banks B Assumed economic loss if banking crisis occurs as % of steady state GDP 20% 63% 90% C = A x B Dollar value of economic cost if banking crisis occurs $ billion $ 57.1 180.0$ 257.1$ D Change in probability of bank failure due to higher capital 0.50% 0.50% 0.50% E = D x C Annual benefit from avoided economic cost - $ millions $ 286 900$ 1,286$ Low avoided cost Central estimate High avoided cost

ASSESSING THE ECONOMIC BENEFITS www.thinkSapere.com 29 127. These estimates of economic benefit are substantially less than the estimates of economic cost discussed above. Table 2 compares the expected annual economic benefit with the expected annual economic cost. Table 2 Net economic benefit of proposal - Reserve Bank assumptions 128. Hence, the policy would reduce net economic welfare by almost $1.8 billion per annum using the Reserve Bank’s central assumptions. 129. The estimates shown in Table 2 should be treated with caution given the uncertainty in the assumptions:  in its consultation paper, the Reserve Bank presents relationships between capital ratios and the probability of a banking crises from the literature which suggest the proposals would result in a larger change in probability than the analysis contained in its decision paper (Reserve Bank of New Zealand, 2019a, p. 18). For example, the probabilities presented by the Reserve Bank in its table 3 would suggest a change in probability of about 1.43 per cent, which if applied in the calculation in table 2 above would reduce the central case economic loss from $1.8 billion to about $100 million per annum  the estimates of economic loss are based on the Reserve Bank assumption of 1 percentage point increase in bank credit leading to an 8 basis point reduction in GDP; applying New Zealand parameters may at least double this estimate, increasing the deficit on the Reserve Bank’s central case by an additional $1 billion per annum  the estimates of economic cost are based on the Reserve Bank assumptions as to the Modigliani-Miller effect; the economic cost would be substantially higher if internal capital allocation rules for New Zealand subsidiaries result in less of an offset  it is not evident how the overseas studies referred to by the Reserve Bank in its discussion of probability should be adjusted for the New Zealand circumstances where over 88 per cent of the banking sector is comprised of subsidiaries of offshore parents (and hence the risk is the extent of support by the parent in a time of crisis)  the estimates of economic cost exclude the impact of capital rationing and disintermediation, but likely include some double counting in the estimates of the direct economic cost of increased bank credit. 130. Some of these uncertainties would significantly increase the estimate of net economic cost, some would reduce that estimate, but none would reverse the result and produce a net economic benefit for the Reserve Bank’s central estimates. The expected large net economic Economic benefit $ 286 $ 900 $ 1,286 Economic cost (8 bps) $ 2,670 $ 2,670 $ 2,670 Net economic benefit -$ 2,384 -$ 1,770 -$ 1,384 RB low- 20% GDP avoided RB central- 63% GDP avoided RB high- 90% GDP avoided

ASSESSING THE ECONOMIC BENEFITS 30 www.thinkSapere.com cost of the proposal should raise questions as to whether the proposals are optimal for New Zealand and whether there are alternative instruments that could achieve the gains at less cost. Literature suggests lower optimal ratio than 16 per cent 131. In Table 8 of its consultation paper, the Reserve Bank presents its summary of the optimal capital ratios estimated in the literature. (The Reserve Bank explains that it also did some modelling, but that modelling produced such a range it was not used to calculate an optimal ratio for New Zealand) (Reserve Bank of New Zealand, 2019a, pp. 28 -29). 132. If the numbers its table 8 are taken at face value, and an assumption is made that they are all equally valid, then the average is 13.6 per cent. Two of the studies do not actually estimate optimal capital ratios, and the estimate from Cline (2016) should really just be 12 per cent. Making these adjustments increases the average slightly to 13.75 per cent. But 13.75 per cent is still less than 16 per cent. 133. This point can also be illustrated by reference to the papers cited by the Reserve Bank in its table 8 (Reserve Bank of New Zealand, 2019a, p. 28). For example, Miles et al (2012) estimate an output-capital elasticity of 4.4 basis points for the United Kingdom (and hence an optimal capital ratio of, on average, 18 per cent), while Cline (2016) estimates the same elasticity to be 7.7 basis points for the United States (and hence an optimal capital ratio of 12 per cent). But both the 4.4 basis points and 7.7 basis points estimates are less than the elasticity the Reserve Bank estimates for NZ (8.8 basis points), and so the New Zealand optimal capital ratio must fall somewhere below the estimates of Miles et al and Cline. Thus, the Reserve Bank’s own figures suggest an optimal capital ratio of less than 12 per cent. 134. Hence, it is not clear how the Reserve Bank arrives at an optimum capital ratio of 16 per cent from Table 8. As with the quantification of costs and benefits, the literature cited by the Reserve Bank appears to suggest a capital ratio lower than 16 per cent would be optimal.

CONCLUSION www.thinkSapere.com 31 Conclusion 135. A banking crisis, should one eventuate, would be very costly in terms of lost economic output (the Reserve Bank assumes an impact equivalent to 20 to 90 per cent of GDP) and social stresses. In setting capital ratios, the Reserve Bank says its task is to balance the benefits of higher capital ratios against the costs of higher bank credit charges. 136. The Reserve Bank describes the likely costs of its proposal as “minimal”. But our analysis suggests otherwise; that the costs would be far from minimal. Taking the Bank’s own assumptions on changes to credit costs, households and businesses would face direct economic welfare losses of the order of $1.6 billion per annum; indirect economic effects from flow-on losses of economic output would add a further $1.1 billion per annum. These costs would exceed by a substantial margin the expected benefit, at least on the central assumptions used by the Reserve Bank in its proposal. The net loss in economic welfare would be about $1.8 billion per annum. 137. An entity acting in the best interests of society would not knowingly promote a policy that would impose significantly higher costs than its benefits, after suitable adjustments for risk aversion (that is, a premium to avoid disruption). 138. The Reserve Bank’s analysis does not articulate clearly what it believes is wrong with the status quo which justifies the change and why the negative consequences of the proposal are clearly outweighed by the benefits; cause and effect are not dealt with methodically in considering the benefits. The most recent paper focuses on the negative impacts of an economic disaster, with which few people would disagree, but bank failures are as likely to be caused by a severe recession as to be the cause of one. Further, the analysis is framed largely around the external shocks that may bring on a crisis, whereas New Zealand’s experience is that failures in banks and other financial institutions are typically the result—or at least substantially contributed to— by poor governance and management. Policies to resolve bank failures should take this into account, which leads us to scepticism that reliance on a large fraction of CET1 in Tier 1 will enable the Reserve Bank to stand back more than it otherwise might. 139. The Reserve Bank advances its risk appetite framework as the basis for its conclusion that the benchmark should be a probability of a system failure no greater than one in 200 years. It justifies this by reference to international norms, stress tests and attempts to model and cross￾check some concept of the public’s ‘risk appetite’. However, the analysis provided to date does not explain how the Reserve Bank arrived at a capital ratio of 16 per cent, as opposed to a capital ratio closer to capital levels currently held by the banks (which are significantly higher than the existing regulatory minimum). 140. The way in which the proposed regulation has evolved in a series of steps has narrowed the scope of engagement with the banks and has diminished consideration of options that might offer a more balanced application of regulatory instruments, might provide for more recognition of the variations in circumstances of the banks, and the interaction with Australian regulatory regimes. The analysis does not account for the high degree of sensitivity of

CONCLUSION 32 www.thinkSapere.com judgements about the optimal capital ratio to small changes in assumptions and the wide range of uncertainty around any specific number. 141. The Reserve Bank’s approach to the analysis resolves the requirements for stability first before considering the efficiency criteria even though the Reserve Bank of New Zealand Act does not prioritise the twin requirements for stability and efficiency. This method is likely to have significantly affected the result, given that the analysis provided shows that the point at which the benefit and cost curves cross, to arrive at the optimal capital requirement, looks quite unstable. The analysis concludes that there is no net benefit to increasing the capital requirement further above its chosen target, but it seems to us that this result might have been similar at a lower capital ratio had the method used permitted an examination of this possibility. 142. The very substantial increase in equity capital requirements comes across as a one-size-fits-all solution at a level of generality, which could be precluding a more variegated response in which those ratios could be shored up or substituted by other regulatory instruments that have comparative advantage for some issues or lower costs. Given the higher cost of equity over hybrid instruments the increase in the required capital ratio has a material effect on the cost￾benefit calculation on the hybrid decision. 143. Taking a wider perspective, the Reserve Bank has evolved over time a more rigorous approach to regulating banks than was envisaged when its Act was passed in 1989 and which gave it a high degree of independence. This has led to some significantly different characteristics from other frameworks and practices of commercial regulation and justifies in our view attention to the justification for these differences in the second phase of the review of the Reserve Bank currently underway. The Reserve Bank seems subject to fewer checks and balances and oversight by ministers, ministries and the courts than some other classes of commercial regulation, including those conducted by other independent bodies. We are not proffering advice here about how and where that review should land, but only that the status quo poses some questions deserving attention. 144. Our key conclusions are that:

1. The sequence of decision-making has constrained the consultation in ways that are tilted against setting a target capital ratio and then considering the lowest cost way to achieve this allowing for variations in choices of regulatory instrument and circumstances of individual banks. As a result, the proposal seems unnecessarily narrow and inflexible.
2. The costs of the proposal are very likely under-estimated, and large relative to the expected benefits.
3. By comparison with other countries—allowing for the hazards of these comparisons—the key issue seems to be the cost arising from the narrow focus on equity capital more than the level of the ratio, although that is arguably on the high end of the range.
4. We are puzzled why the Reserve Bank is committed to the OBR when it can be argued that hybrid capital is a superior bail in device.
5. The lack of close attention to a comparison of the proposal with the APRA framework both in terms of concept and operations seems an omission, even though we accept that the policy must work for all the registered banks regardless of their parentage.

BIBLIOGRAPHY www.thinkSapere.com 33 Bibliography Aiyar, S. C., Calomiris, W., & Wieladek, T. (2016). How does credit supply respond to monetary policy and bank minimum captial requirements? European Economic Review 82(C) pp 142-165. Barro, R. J. (2006). Rare disasters and asset markets in the twentieth century. The Quarterly Journal of Economics . Bridges, J., Gregory, D., Nielsen, M., Pezzini, S., Radia, A., & Spaltro, M. (2014). The Impact of Capital Requirements on Bank Lending. Bank of England Working Paper No 486. Cline, W. R. (2016). Benefits and Costs of Higher Capital Requirements for Banks. Washington DC: Peterson Institute for International Economics. Conway, P. L. (2015). Who benefits from productivity growth? The labour income share in New Zealand. Wellington: New Zealand Productivity Commission Working Paper. Cosimano, T. F., & Hakura, D. (2011). Bank Behaviour in Response to Basel III: a Cross Country Analysis. IMF Working Paper No 11/119. Denham, T., & Dodson, J. (2018). Cost Benefit Analysis: The State of the Art in Australia. Centre for Urban Research, RMIT University, ATRF 2018 Proceedings. Department of Conservation. (2018). DOC's Budget 2018 explained. Department of Conservation. Francis, W., & Osborne, M. (2009). Bank Regulation, Capital and Credit Supply: Measuring the Impact of Prudential Standards. UK Financial Services Authority Occassional Papers No 36. Junge, G., & Kugler, P. (2013). Quantifying the impact of higher capital requirements on the Swiss economy. Swiss Journal of Economics and Statistics, 149(3), pp.313-356. Lubberink, M. J., & Renders, A. R. (2018). Are Banks' Below-Par Own Debt Repurchases a Cause for Prudential Concern? Journal of Accounting, Auditing & Finance 33(1), 1-29. Miles, D., Yang, J., & Marcheggiano, G. (2012). Optimal bank capital. Economic Journal, March, pp. 1- 37. Modigliani, F., & Miller, M. (1958). The cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review 48 (3): 261-297. Noss, J., & Toffano, P. (2016). Estimating the impact of changes in aggregate bank capital requirements during an upswing. Journal of Banking & Finance 62(C), pp 15-27. Reserve Bank of New Zealand. (2017). Capital Review Paper 2: What should qualify as bank capital? Issues and Options. Wellington: Reserve Bank of New Zealand. Reserve Bank of New Zealand. (2018). Capital ratio calibration: decision paper for Financial System Oversight Committee. Reserve Bank of New Zealand. Reserve Bank of New Zealand. (2019a). Capital Review Paper 4: How much capital is enough?

BIBLIOGRAPHY 34 www.thinkSapere.com Reserve Bank of New Zealand. (2019b). Capital Review Background Paper: An outline of the analysis supporting the risk appetite framework. Wellington: The Reserve Bank of New Zealand. Schanz J, D. A. (2011). The long-term economic impact of higher capital levels. BIS Papers, pp. 73-81. Steenkamp, D. (2016). Factor substitution and productivity in New Zealand. Reserve Bank of New Zealand Discussion Paper 2016/12. The New Zealand Treasury. (2015). Guide to Social Cost Beneit Analysis.

2 www.thinkSapere.com Appendix A: Estimate of additional Tier 1 capital Increase in bank capital under Reserve Bank proposals Reproducing RB estimate of 4 percentage points $bn A Current risk weighted assets - 31 March 2018 289.5 B Current total assets - 31 March 2018 565.0 C Current actual CET1 32.5 D Proposed required CET1 52.5 E RB estimated actual (assuming buffer of 0.5 of EAD) 55.5 F=E-C Increase in CET1 23 G=F/A Increase in CET1 as % of RWA 7.9% H=F/B Increase as % of total assets 4.1% Increase in CET1 with 2 pps voluntary buffer I=Ax2% CET1 voluntary buffer of 2pps 5.8 J=I+D Estimated total CET1 with 2pps voluntary buffer 58.3 K=J-C Increase in CET1 - 2pps buffer 25.8 L=K/A Increase in CET1 as % of RWA - 2pps buffer 8.9% M=K/B Increase as % of total assets - 2ppa buffer 4.6% N=(M+H)/2 Mid point estimate 4.3% Assumption sources A Reserve Bank, Capital Review Paper 4, table 9. B Reserve Bank Financial Strength Dashboard C,D,E Reserve Bank, Capital Review Background paper, table 10

BIBLIOGRAPHY www.thinkSapere.com 3 Appendix B:Direct economic cost of increased cost of bank credit Notes Component Estimate A Increase in capital (percentage points) 4.3 B Increase in cost of credit (for each % of capital) 0.081% C=A x B Increase cost of credit 0.350% D Gross bank loans - billions $ 453 E=CxD Increased credit costs - millions $ 1,584$ Assumption sources: A: Authors estimate - see appendix A B: Reserve Bank of New Zealand, 2019b, p. 36 D: Reserve Bank statistics https://www.rbnz.govt.nz/statistics/s30-banks-assets-loans-by-sector Notes Component Estimate A Increase in capital (percentage points) 4.3 B Increase in cost of credit (for each % of capital) 0.16% C=A x B Increase cost of credit 0.691% D Gross bank loans - billions $ 453 E=CxD Increased credit costs - millions $ 3,129$ Direct economic cost of increased cost of bank credit - scenario 1 Direct economic cost of increased cost of bank credit - scenario 2

4 www.thinkSapere.com Appendix C:Steady-state impact on New Zealand GDP from increased cost of bank credit 145. In assessing the likely steady-state or permanent GDP impact on changes to the capital requirements of banks, papers by (Cline, 2016), (Miles, Yang, & Marcheggiano, 2012), (Junge & Kugler, 2013) and (Schanz J, 2011) start with a constant elasticity of substitution production function and show that the elasticity of output with respect to the cost of capital can be written as: 𝑑𝑌 𝑑𝑃𝑘 𝑃𝑘 𝑌 = −𝜎 𝛼 1−𝛼

where σ is the elasticity of substitution between capital and labour, and α is the elasticity of output with respect to capital (which is equal to the income share of capital). Once the elasticity of output with respect to the cost of capital is estimated, a given change in the cost of capital can be translated into a GDP effect via: ∆%𝐺𝐷𝑃 = 𝑑𝑌 𝑑𝑃𝑘 𝑃𝑘 𝑌 . ∆%𝑓𝑖𝑟𝑚𝑐𝑐 Where ∆%𝐺𝐷𝑃 is the percentage change in steady-state GDP and ∆%𝑓𝑖𝑟𝑚𝑐𝑐 is the proportionate increase in the cost of capital to firms. 146. To estimate the elasticity of output with respect to the cost of capital for New Zealand, two values are needed: σ, the elasticity of substitution between capital and labour, and, α, the elasticity of output with respect to capital. Steenkamp (2016) provides estimates of the elasticity of substitution between capital and labour for New Zealand under the assumption of a constant elasticity of substitution production function using annual data from 1996 to 2012. His estimates of σ are 0.86 in the general specification and 1.13 when assuming Hicks neutrality (which he notes is his preferred specification). When the model is estimated on quarterly data (1996Q1-2016Q2), the estimates of σ change to 1.407 in the general specification and 0.49 when assuming Hicks neutrality; the range of estimates, and their sensitivity to the dataset they are estimated on, indicate considerable uncertainty around σ. 147. Pinning down a value of α (the elasticity of output with respect to capital, which is equal to the income share of capital) is easier. Eyeballing figure 3 in Steenkamp (2016) suggests labour’s share of output is just under 60 per cent and, by implication, capital’s share is just over 40 per cent. This result is consistent with Conway (2015), who found that the labour share of income in the New Zealand economic has declined from a high of 65.9% in 1981 to 56.% in 2010. 148. To estimate the proportionate increase in cost of capital to firms (∆%𝑓𝑖𝑟𝑚𝑐𝑐) requires assumptions about the:  percentage of firm finance from bank lending  current cost of capital for New Zealand firms.

BIBLIOGRAPHY www.thinkSapere.com 5 149. In a study referenced by the Reserve Bank, Miles et al. (2012) assume these two values are one third and 10 per cent respectively. A cost of capital estimate of 10% is unrealistically high in the current New Zealand environment. The New Zealand Treasury recommends a 6% discount rate to reflect the opportunity cost of capital in long-term investments.11 In estimating the opportunity cost of capital, the Treasury assumes that the percentage of firm finance from debt is one third.12

150. If firms rely on bank debt for a third of their capital, and the cost of bank credit increases by 8.1 per cent (for each additional percentage point of capital held by the banks), then the overall cost of capital for New Zealand firms would likely rise by 2.7 basis points (one third of 8.1 basis points). Adopting the Treasury discount rate as an estimate of the opportunity cost of capital, a 2.7 basis points increase in the cost of capital translates into a 0.45% increase in the cost of capital for firms in proportional terms.
151. Table 3 provides a calculation, using the above formulas, of the reduction of steady-state GDP owing to the change in capital requirements under three scenarios. The scenarios reflect different assumptions about the elasticity of substitution between capital and labour. Table 3 Impact on steady state GDP from an increase in bank credit costs Notes Scenario 1 Scenario 2 Scenario 3 The elasticity of production with respect to capital (α) 0.44 Elasticity of substitution between capital and labour (𝜎) 0.49 0.86 1.13 Implied elasticity of output with respect to capital 𝑑𝑌 𝑑𝑃𝑘 𝑃𝑘 𝑌 A -0.39 -0.68 -0.89 Impact of a one percentage point increase in capital requirements on lending rates B 8.1 basis points 8.1 basis points 8.1 basis points Proportionate increase in firms' cost of capital E 0.45% 0.45% 0.45%

11 The estimate of the current rate (May 2018) is available here: https://treasury.govt.nz/information-and￾services/state-sector-leadership/guidance/financial-reporting-policies-and-guidance/discount-rates. 12 The methodology used by the Treasury to estimate the opportunity cost of capital is available here: https://treasury.govt.nz/publications/guide/public-sector-discount-rates-cost-benefit-analysis-html

6 www.thinkSapere.com Impact of a one percentage point increase in capital requirements on steady-state GDP impact (basis points) A*E -17 -30 -40

BIBLIOGRAPHY www.thinkSapere.com 7 Appendix D: Value of loss in economic output from higher real interest rates Notes Component Estimate A Increase in capital (percentage points) 4.3 B Lost output (for each % of capital) 0.088% C=A x B Lost output % of GDP 0.380% D GDP billions 285.7$ E Lost economic output - millions $ 1,085$ Assumption sources: A: Authors estimate - see appendix A B: Reserve Bank of New Zealand, 2019a, p. 28 D: Calculated as follows: f Real (2009/10 dollars) GDP in year to March 2018 billion 243$ g 0.2% h = f x(1-g)Implies potential GDP billion 242.5$ i GDP deflator 1.178 j = h x i GDP March 2018 dollars billion 285.7$ Lost economic output - Reserve Bank cost assumptions Output gap for year to March 2018 (February 2019, Monetary Policy Statement)

8 www.thinkSapere.com Appendix E: Elasticity of lending to capital ratios Table 4 Estimates of the elasticity of lending volume to a 1 percentage point change in the risk-weighted capital ratio Study Estimate of elasticity (Francis & Osborne, 2009) -1.20 (Cosimano & Hakura, 2011) -0.65 (Bridges, et al., 2014) -3.50* (Noss & Toffano, 2016) -4.50 (Aiyar, Calomiris, & Wieladek, 2016) -0.50 Source: See Noss and Toffano (2014, Table 7).

• Elasticity of lending growth, not volume.

© 2019 Sapere Research Group About the authors Dr Glenn Boyle: Glenn is an economic consultant, Sapere director, and adjunct professor at the University of Canterbury. Previously, he was professor of finance at the University of Canterbury, executive director of the NZ Institute for the Study of Competition and Regulation and professor of finance at Otago University. Glenn is also a lay member of the New Zealand High Court and Co-Chair of the Australia-New Zealand Shadow Financial Regulatory Committee. His primary consulting and research activities are in financial economics, corporate finance and banking. Associate Professor Martien Lubberink (PhD Economics, Groningen, NL) teaches banking and accounting at Victoria University. He has worked at Lancaster University, UK. After his sabbatical year at UNC Chapel Hill, Dr Lubberink joined De Nederlandsche Bank, the central bank of the Netherlands (July 2008). Here he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide and for banks in Europe (Basel III, CRR, and CRD IV). He also acquired comprehensive expertise on intra-group finance, capital requirements for financial conglomerates, and on capital instrument issuances that qualify for Tier 1 and Tier 2 bank capital. He publishes academic work on bank capital in leading journals. Dr Lubberink taught bank regulation and risk management at Utrecht University, the VU University in Amsterdam. Kieran Murray, Managing Director, Sapere, provides expert evidence, testimony and reports in the fields of regulation, competition analysis and public-policy, including market design. He has served as an economic consultant on these matters for public agencies and private companies in over 15 countries in the Asia Pacific Region. Kieran co-founded and jointly leads Sapere. He is an expert lay member of the New Zealand High Court and serves as an International Arbitrator for the PNG Independent Consumer and Competition Commission. Dr Graham Scott was Secretary to the New Zealand Treasury from 1986 to 1993 and a key figure in advising on far-reaching economic and public management reforms. He has since worked in over 50 countries, at all stages of development. Graham Chaired the New Zealand Health Funding Authority and the New Zealand Electricity Market. In 1994 he was a Visiting Scholar at the International Monetary Fund. He has a PhD (Economics) from Duke University and a MCom from University of Canterbury. He was awarded the Order of the Companion of the Bath by the Queen for contributions to government reform in New Zealand.

10 www.thinkSapere.com About Sapere Sapere is one of the largest expert services firms in Australasia, and a leader in the provision of independent economic, forensic accounting and public policy services. We provide independent expert testimony, strategic advisory services, data analytics and other advice to Australasia’s private sector corporate clients, major law firms, government agencies, and regulatory bodies. ‘Sapere’ comes from Latin (to be wise) and the phrase ‘sapere aude’ (dare to be wise). The phrase is associated with German philosopher Immanuel Kant, who promoted the use of reason as a tool of thought; an approach that underpins all Sapere’s practice groups. For more information, please contact: Graham Scott Phone: +64 4 915 7590 Mobile: +64 21 421755 Email: graham@grahamscott.co.nz Wellington Auckland Sydney Melbourne Canberra Level 9 1 Willeston Street PO Box 587 Wellington 6140 Level 8 203 Queen Street PO Box 2475 Shortland Street Auckland 1140 Level 18 135 King Street Sydney NSW 2000 Level 2 161 Collins Street GPO Box 3179 Melbourne 3001 PO Box 252 Canberra City ACT 2601 P +64 4 915 7590 F +64 4 915 7596 P +64 9 909 5810 F +64 9 909 5828 P +61 2 9234 0200 F +61 2 9234 0201 P +61 3 9005 1454 F +61 2 9234 0201 (Syd) P +61 2 6100 6363 F +61 2 9234 0201 (Syd) www.thinkSapere.com independence, integrity and objectivity

International comparability of the capital ratios of New Zealand’s major banks – update paper New Zealand Bankers’ Association 17 May 2019

17 May 2019 Dear Sir, International comparability of the capital ratios of New Zealand’s major banks – update report We are pleased to enclose our update paper regarding the International comparability of the capital ratios of New Zealand’s major banks, which we have carried out in accordance with your instructions and our letters of engagement dated 14 February and 3 April 2019. We are grateful for the assistance and support of NZBA during the project and for the contribution of the four major New Zealand banks who provided the data and analysis necessary for this update paper. We would be pleased to discuss any aspect of this report with yourselves, the participating banks or the Reserve Bank of New Zealand. Yours faithfully, Chris Cooper Partner Mr Antony Buick-Constable Deputy Chief Executive and General Counsel New Zealand Bankers’ Association PO Box 3043 Wellington 6140 PricewaterhouseCoopers, ABN 52 780 433 757 One International Towers Sydney, Watermans Quay, Barangaroo, GPO BOX 2650, SYDNEY NSW 2001 T: +61 2 8266 0000, F: +61 2 8266 9999, www.pwc.com.au Level 11, 1PSQ, 169 Macquarie Street, Parramatta NSW 2150, PO Box 1155 Parramatta NSW 2124 T: +61 2 9659 2476, F: +61 2 8266 9999, www.pwc.com.au Liability limited by a scheme approved under Professional Standards Legislation.

PwC 13 3. APRA’s perspectives on comparability of capital ratios Relative conservatism Australia vs New Zealand New Zealand Bankers’ Association APRA identified the most material aspects of relative conservatism in its IRB framework to be as follows: Impact (basis points) Areas of relative conservatism applicable to the major banks in New Zealand (see Appendix B for further details) Impact (basis points) Level of judgement1 (basis points) Relative conservatism within definition of capital 130 NZ’s rules are equivalent (but impact lower due to different balance sheet composition) 60 - 20 per cent loss given default (LGD) portfolio constraint required for residential mortgage exposures and higher correlation factors 150 NZ applies additional constraints to PDs, LGDs and correlations which produce average risk weights of 28% (vs 24% for Australia) 190 +/- 20 Capital requirement for IRRBB, which is not included in the Basel capital framework’s minimum requirements 30 A standardized approach is used for traded and non-traded market risk which is more conservative than Basel’s advanced approach 50 - LGD parameter for unsecured non-retail exposures 80 NZ advanced banks apply the same conservative LGD parameters 40 +/- 5 Credit conversion factors (CCFs) for undrawn non-retail commitments 30 NZ advanced banks apply the same conservative CCFs 20 - Use of supervisory slotting and the scaling factor for specialised lending 50 NZ also requires supervisory slotting 60 +/- 15 Risk weights for other retail exposures covered by the standardised approach to credit risk 10 NZ also applies additional risk weights to retail exposures 10 - Exchange rate used to convert Euro-denominated thresholds in the Basel capital framework into Australian dollars. 5 NZ also applies thresholds in local currency 30 - NZ also requires higher RWAs for farm lending by comparison to Basel minimum 120 +/- 20 Application of conservatism factor (60) +/- 60 APRA’s estimated overall impact 485 Overall impact (after rounding down by 60 basis points) 520 Unquestionably strong 10.5% (APRA rules) = 15.35% internationally equivalent basis (10.5% + 4.85%) In 2017 NZ major banks were at 10.3% (RBNZ rules) = 15.5% internationally equivalent basis (10.3% + 5.2%) 1 Adjustments to PD or LGD models require judgement and hence have a level estimation uncertainty of possibly 10% to 20%

PwC 15 4. Comparisons with banks in other countries (cont’d) New Zealand Bankers’ Association • RBNZ’s capital rules require the New Zealand major banks to hold higher risk weights against their loans (and therefore higher capital) by comparison to the minimum levels prescribed by the Basel Pillar 1 rules. • Australia also has capital rules that produce higher risk weights than the Basel requirements, although not as high as New Zealand. • By contrast, the Nordic countries of Sweden, Denmark and Finland have relatively low risk weights – less than half the risk weights observed in New Zealand. • The graphs opposite show the impact of the RBNZ rules on relative risk weights for Corporates and Retail Mortgages asset classes (which for the NZ major banks make up 36% and 46% of credit RWAs respectively). • The risk weights of the New Zealand banks have been adjusted to an internationally equivalent basis by unwinding any RBNZ rules that are not in line with the Basel Pillar 1 rules. Conclusion: For NZ major banks, a downward revision to risk weights is necessary for international comparability 82% 71% 61% 31% 47% 43% 0% 50% 100% NZ proposed NZ current Australia Sweden, Denmark and Finland Other international peers NZ Basel Basis Risk weights - Corporates 34% 28% 24% 11% 18% 15% 0% 50% 100% NZ proposed NZ current Australia Sweden, Denmark and Finland Other international peers NZ Basel Basis Risk weights - Retail mortgages 4.2 Comparative risk weights

PwC Comparisons have been made to banks in countries that are considered to have similar characteristics to New Zealand. Comparisons were made on the following bases: 1) Basel Pillar 1 rules, 2) local capital rules and, 3) Comparative risk weights. Country CET1 ratio Basel Pillar 1 rules NZ current uplift vs Country av. (local rules)2 NZ proposed uplift vs Country av. (local rules)2 Risk weights corporate Risk weights retail mortgage Canada 10.7% 4.8% 16.4% 43% 6% Sweden1 13.2% 4.2% 15.8% 29% 6% Austria 13.4% 1.7% 13.3% 57% 20% Ireland 14.1% 1.1% 12.7% 92% 31% Singapore 14.4% 0.6% 11.5% 65% 11% Netherlands 14.9% 0.4% 12.0% 42% 15% Australia 15.1% 0.9% 9.8% 61% 24% New Zealand 15.5% N/A N/A 71% 28% Norway1 16.9% -5.6% 2.7% 47% 19% Denmark1 17.8% -2.1% 9.6% 36% 15% Finland1 22.1% -7.7% 3.9% 36% 10% 17 6. Comparisons with peer countries New Zealand Bankers’ Association 1 CET1 for Norway and Sweden include a Basel I Floor; however Denmark and Finland do not. 2 Difference between the CET1 ratio average of NZ banks restated under local rules and the local banks average (for current and proposed ratios). Refer to Appendix A3 and D for detail on how NZ CET1 ratios have been restated to each jurisdiction local rules. Key conclusions: Based on the analysis presented on the following pages, we have drawn the following conclusions:

1. NZ’s current capital levels appear to be: • Superior to banks in Canada, Austria, Ireland, Singapore, Netherlands and Australia. • Similar to banks in Sweden, Denmark and Finland (see pages 21, 22 and 23 for rationale). • Inferior to banks in Norway.
2. RBNZ’s proposed capital rules would increase capital levels in New Zealand above all peer countries, including Norway.

PwC 28 Table A1 – Summary of CET1 adjustments Appendix A: Detailed analysis of differences New Zealand Bankers’ Association Ref ANZ 31/03/2017 ASB 31/12/2016 BNZ 31/03/2017 WNZ 31/03/2017 Weighted Average CET1 (RBNZ) 10.2% 9.7% 10.6% 10.7% 10.3% Deferred tax asset NZ1 0.0% 0.3% 0.4% 0.4% 0.3% Revaluation reserve NZ2 0.0% 0.1% 0.0% 0.0% 0.0% Farm lending NZ3 0.9% 1.6% 1.8% 0.9% 1.2% Currency threshold adjustments NZ4 0.2% 0.5% 0.2% 0.4% 0.3% Specialised lending NZ5 0.8% 0.0% 0.7% 0.7% 0.6% Unsecured non-retail LGD NZ6 0.7% 0.1% 0.4% 0.2% 0.4% Undrawn non-retail EAD NZ7 0.1% 0.2% 0.2% 0.3% 0.2% Local government reclassification NZ8 0.0% 0.0% 0.0% 0.0% 0.0% Secured residential lending NZ9 1.2% 2.6% 1.9% 2.4% 1.9% Market risk NZ10 0.7% 0.7% 0.4% 0.0% 0.5% Retail exposures NZ11 0.0% 0.3% 0.0% 0.0% 0.1% Adjustment for expected loss 0.3% 0.2% 0.3% 0.5% 0.3% Total adjustment 4.9% 6.6% 6.3% 5.8% 5.8% Internationally comparable CET1 ratio before rounding 15.1% 16.3% 16.9% 16.5% 16.1% Rounded down by 60bps -0.6% -0.6% -0.6% -0.6% -0.6% Adjusted Internationally comparable CET1 ratio (current RBNZ rules) 14.5% 15.7% 16.3% 15.9% 15.5% Proposed RBNZ rules1 16% 16% 16% 16% 16% Internationally comparable CET1 ratio (proposed RBNZ rules)2 27.2% 28.0% 27.3% 25.8% 27.1% 1 The CET1 ratio under proposed RBNZ rules assumes that the proposed Tier 1 requirement of 16% is satisfied by CET1 capital and no buffer is maintained. The RWA amount has also been adjusted to reflect the impact of changing the calibration of the “IRB scalar” from 1.06 to 1.20 and the impact of using standardised approach for sovereign and bank portfolios. 2 For the re-statement of the CET1 ratio under proposed RBNZ rules to an internationally comparable basis, adjustments have been made to CET1 Capital. No further adjustments were required to be made in relation to internationally comparable RWAs. Note: When expressed in capital ratio terms, the cumulative impact of all adjustments exceeds the sum of each individual adjustment when calculated on a stand-alone basis. The difference between the cumulative and ‘sum of the parts’ impact has been allocated to each item above, in proportion to the stand-alone benefit. Table A2 below shows the actual stand-alone CET1 and RWA of each individual adjustment.

PwC Capital and RWA values have been rounded to the nearest $ million. 29 Table A2 – Summary of CET1 adjustments (in NZ$ millions) Appendix A: Detailed analysis of differences (continued) New Zealand Bankers’ Association ANZ 31/03/2017 ASB 31/12/2016 BNZ 31/03/2017 WNZ 31/03/2017 Totals 31/03/2017 Ref Capital RWA Capital RWA Capital RWA Capital RWA Capital RWA CET1 (RBNZ) 8,689 84,947 5,192 53,490 6,294 59,643 5,765 53,908 25,940 251,988 Deferred tax asset NZ1 - - 123 - 182 - 171 - 475 - Revaluation reserve NZ2 - - 25 - - - - - 25 - Farm lending NZ3 - (4,776) - (5,438) - (6,524) - (3,055) - (19,793) Currency threshold adjustments NZ4 - (1,307) - (1,961) - (667) - (1,431) - (5,366) Specialised lending NZ5 - (4,695) - - - (2,756) - (2,416) - (9,867) Unsecured non-retail LGD NZ6 - (3,916) - (438) - (1,672) - (871) - (6,897) Undrawn non-retail EAD NZ7 - (798) - (578) - (811) - (963) - (3,150) Local government reclassification NZ8 - (54) - (3) - 109 - (17) - 35 Secured residential lending NZ9 - (6,824) - (8,319) - (6,672) - (7,694) - (29,509) Market risk NZ10 - (4,190) - (2,529) - (1,425) - (184) - (8,328) Retail exposures NZ11 - - - (1,033) - - - - - (1,033) Adjustment for expected loss 152 - 63 - 126 - 214 - 555 - Total adjustment 152 (26,561) 211 (20,299) 308 (20,418) 385 (16,631) 1,055 (83,908) Internationally comparable CET1 / RWA 8,841 58,386 5,403 33,191 6,602 39,225 6,150 37,277 26,995 168,080 Rounded down by 60bps - 2,400 - 1,200 - 1,400 - 1,400 - 6,400 Adjusted Internationally comparable CET1 / RWA 8,841 60,786 5,403 34,391 6,602 40,625 6,150 38,677 26,995 174,480 Proposed RBNZ rules 16,404 102,523 9,415 58,844 10,764 67,275 9,608 60,052 46,191 288,695 Proposed Internationally comparable ratio 16,556 60,786 9,626 34,391 11,072 40,625 9,993 38,677 47,246 174,480 1 The CET1 ratio under proposed RBNZ rules assumes that he proposed Tier 1 requirement of 16% is satisfied by CET1 capital and no buffer is maintained. The RWA amount has also been adjusted to reflect the impact of changing the calibration of the “IRB scalar” from 1.06 to 1.20 and the impact of using standardised approach for sovereign and bank portfolios. 2 For the re-statement of CET1/ RWAs under proposed RBNZ rules to an internationally comparable basis, adjustments have been made to CET1 Capital. No further adjustments were required in rela ion to internationally comparable RWAs.

PwC Capital and RWA values have been rounded to the nearest $ million. 30 Table A3 – Overseas jurisdiction specific CET1 adjustments (in NZ$ millions) Appendix A: Detailed analysis of differences (continued) New Zealand Bankers’ Association ANZ 31/03/2017 ASB 31/12/2016 BNZ 31/03/2017 WNZ 31/03/2017 Weighted Average CET1% Capital RWA CET1% Capital RWA CET1% Capital RWA CET1% Capital RWA CET1% Internationally comparable 14.5% 8,841 60,786 15.7% 5,403 34,391 16.3% 6,602 40,625 15.9% 6,150 38,677 15.5% With proposed new rules 27.2% 16,556 60,786 28.0% 9,626 34,391 27.3% 11,072 40,625 25.8% 9,993 38,677 27.1% UK restatement Total adjustments (UK) (87) 5,499 (251) 90 (462) 3,063 (441) 2,129 CET1 UK 13.2% 8,754 66,286 14.9% 5,152 34,481 14.1% 6,140 43,688 14.0% 5,709 40,806 13.9% Proposed CET1 UK 24.8% 16,469 66,286 27.2% 9,375 34,481 24.3% 10,610 43,688 23.4% 9,552 40,806 24.8% Singapore restatement Total adjustments (SG) (90) 4,695 - - (62) 2,756 (114) 2,416 CET1 Singapore 13.4% 8,751 65,482 15.7% 5,403 34,391 15.1% 6,540 43,381 14.7% 6,036 41,093 14.5% Proposed CET1 Singapore 25.1% 16,466 65,482 28.0% 9,626 34,391 25.4% 11,010 43,381 24.0% 9,879 41,093 25.5% Europe restatement Total adjustments (EU) - - (250) - (400) - (330) - CET1 Europe 14.5% 8,841 60,786 15.0% 5,153 34,391 15.3% 6,202 40,625 15.0% 5,820 38,677 14.9% Proposed CET1 Europe 27.2% 16,556 60,786 27.3% 9,376 34,391 26.3% 10,672 40,625 25.0% 9,663 38,677 26.5%

PwC 31 Appendix A: Detailed analysis of differences (continued) New Zealand Bankers’ Association ANZ 31/03/2017 ASB 31/12/2016 BNZ 31/03/2017 WNZ 31/03/2017 Weighted Average CET1% Capital RWA CET1% Capital RWA CET1% Capital RWA CET1% Capital RWA CET1% Norway restatement Total adjustments (NW) - 22,987 (250) 11,589 (400) 17,597 (330) 17,500 CET1 Norway 10.6% 8,841 83,774 11.2% 5,153 45,980 10.7% 6,202 58,222 10.4% 5,820 56,177 10.7% Proposed CET1 Norway 19.8% 16,556 83,774 20.4% 9,376 45,980 18.3% 10,672 58,222 17.2% 9,663 56,177 18.9% Australia restatement CET1 (RBNZ) 10.2% 8,689 84,947 9.7% 5,192 53,490 10.6% 6,294 59,643 10.7% 5,765 53,908 10.3% Proposed RBNZ rules 16.0% 16,404 102,523 16.0% 9,415 58,845 16.0% 10,764 67,275 16.0% 9,608 60,052 16.0% Total adjustments (AU) (880) (7,352) (153) (1,759) 45 (9,643) (11) (5,872) CET1 AU 10.1% 7,809 77,595 9.7% 5,039 51,731 12.7% 6,339 50,000 12.0% 5,754 48,036 11.0% Proposed CET1 AU 20.0% 15,523 77,595 17.9% 9,262 51,731 21.6% 10,809 50,000 20.0% 9,597 48,036 19.9% Table A3 (continued) – Overseas jurisdiction specific CET1 adjustments (in NZ$ millions) Capital and RWA values have been rounded to the nearest $ million.

PwC Capital and RWA values have been rounded to the nearest $ million. 32 Table A4 – Summary of Total Capital adjustments (in NZ$ millions) Appendix A: Detailed analysis of differences (continued) New Zealand Bankers’ Association ANZ 31/03/2017 ASB 31/12/2016 BNZ 31/03/2017 WNZ 31/03/2017 Weighted Average TC % Capital RWA TC % Capital RWA TC % Capital RWA TC % Capital RWA TC % Total capital (RBNZ) 13.8% 11,701 84,947 13.7% 7,316 53,490 13.3% 7,927 59,643 12.8% 6,903 53,908 13.4% Capital instruments subject to phase-out (234) (220) (181) - Total capital Basel III fully phased-in (RBNZ) 13.5% 11,467 84,947 13.3% 7,096 53,490 13.0% 7,746 59,643 12.8% 6,903 53,908 13.2% International comparable adjustments 152 (26,561) 211 (20,172) 308 (20,418) 385 (16,631) Rounded down by 60bps 2,400 1,200 1,400 1,400 Total capital (internationally comparable) 19.1% 11,619 60,786 21.2% 7,307 34,518 19.8% 8,054 40,625 18.8% 7,288 38,677 19.6% Internationally comparable TC ratio - proposed RBNZ rules 31.8% 19,334 60,786 33.3% 11,452 34,391 30.8% 12,524 40,625 28.8% 11,131 38,677 31.2%

PwC 33 Appendix B: Analysis of RBNZ treatments New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study Capital deductions NZ1 Deferred tax asset Basel III para 69: Deferred tax assets (DTAs) that rely on future profitability of the bank to be realised are to be deducted in the calculation of Common Equity Tier 1. Deferred tax assets may be netted with associated deferred tax liabilities (DTLs) only if the DTAs and DTLs relate to taxes levied by the same taxation authority and offsetting is permitted by the relevant taxation authority. Where these DTAs relate to temporary differences (eg allowance for credit losses) the amount to be deducted is set out in the “threshold deductions” section below. All other such assets, eg those relating to operating losses, such as the carry forward of unused tax losses, or unused tax credits, are to be deducted in full net of deferred tax liabilities as descr bed above. The DTLs permitted to be netted against DTAs must exclude amounts that have been netted against the deduction of goodwill, intangibles and defined benefit pension assets, and must be allocated on a pro rata basis between DTAs subject to the threshold deduction treatment and DTAs that are to be deducted in full. The RBNZ did not adopt the threshold deduction approach for deferred tax assets for temporary differences. Instead these exposures must be deducted in full from CET1 capital. RBNZ does not permit netting of DTL against DTA arising from the carry forward of unused tax losses or tax credits, but Basel allows netting. DTAs which meet Basel threshold treatment have been added back to CET1, and risk-weighted at 0%. NZ2 Revaluation reserve Basel II para 52: Common Equity Tier 1 capital consists of the sum of the following elements:  Accumulated other comprehensive income and other disclosed reserves Basel requires all other reserves to be included in CET1. RBNZ requires revaluation reserves of tangible fixed assets, foreign currency translation reserves and reserves arising from revaluation of security holdings be included in Tier 2 capital. Reclassify asset revaluation reserves classified by the banks in Tier 2 capital to CET1. n/a Goodwill and other intang bles Basel III para 67: Goodwill and all other intangibles must be deducted in the calculation of Common Equity Tier 1, including any goodwill included in the valuation of significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation. With the exception of mortgage servicing rights, the full amount is to be deducted net of any associated deferred tax liability which would be extinguished if the intangible assets become impaired or derecognised under the relevant accounting standards. The amount to be deducted in respect of mortgage servicing rights is set out in the threshold deductions section below. Basel requires exposures classified as intangible assets amounts to be deducted in full net of any associated deferred tax liability, with the exception of mortgage servicing rights which are to be deducted based on set threshold deductions. RBNZ requires the full amount of intangible assets to be deducted net of any associated deferred tax liability. No adjustment applicable to NZ major banks

PwC 34 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study n/a Credit enhancements provided to affiliated insurance groups and associated funds management and securitisation vehicles No requirement RBNZ requires the full amount of credit enhancements where the credit enhancement has not been expensed under certain circumstances to affiliated insurance groups, associated funds management and securitisation vehicles to be deducted from CET1 capital. No participant banks had any credit enhancements provided that has not been expensed to affiliated insurance groups and associated funds management and securitisation vehicles in these certain circumstances – no adjustment made for this item. n/a Funding provided to affiliated insurance groups and associated funds management and securitisation vehicles No requirement RBNZ requires the full amount of funding provided under certain circumstances to affiliated insurance groups, associated funds management and securitisation vehicles to be deducted from CET1 capital. No participant banks had any funding provided to affiliated insurance groups and associated funds management and securitisation vehicles in these certain circumstances – no adjustment made for this item. n/a Advances of a capital nature provided to connected persons No requirement For any fair value gains and losses relating to financial instruments for which a fair value cannot be reliably be calculated, except that a fair value loss that has arisen from credit impairment on a loan and that has been recognised in retained earnings must in all cases be deducted from CET1 capital. No participant banks hold any financial instruments where the fair value cannot be reliably calculated – no adjustment made for this item.

PwC 35 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study n/a Holdings of own shares Basel III para 78: All of a bank’s investments in its own common shares, whether held directly or indirectly, will be deducted in the calculation of Common Equity Tier 1 (unless already derecognised under the relevant accounting standards). In addition, any own stock which the bank could be contractually obliged to purchase should be deducted in the calculation of Common Equity Tier 1. The treatment described will apply irrespective of the location of the exposure in the banking book or the trading book. In addition:  Gross long positions may be deducted net of short positions in the same underlying exposure only if the short positions involve no counterparty risk.  Banks should look through holdings of index securities to deduct exposures to own shares. However, gross long positions in own shares resulting from holdings of index securities may be netted against short position in own shares resulting from short positions in the same underlying index. In such cases the short positions may involve counterparty risk (which will be subject to the relevant counterparty credit risk charge). This deduction is necessary to avoid the double counting of a bank’s own capital. Certain accounting regimes do not permit the recognition of treasury stock and so this deduction is only relevant where recognition on the balance sheet is permitted. The treatment seeks to remove the double counting that arises from direct holdings, indirect holdings via index funds and potential future holdings as a result of contractual obligations to purchase own shares. Following the same approach outlined above, banks must deduct investments in their own Additional Tier 1 in the calculation of their Additional Tier 1 capital and must deduct investments in their own Tier 2 in the calculation of their Tier 2 capital. The RBNZ does not have any requirements in respect of deduction of gross long positions net of short positions and look through holdings of index securities. No participant banks have holdings of their own shares – no adjustment made for this item. n/a Market value of securities holdings No requirement For any unrealised revaluation losses on securities holdings where the book value of the securities exceeds the market value but the resulting unrealised loss has not been incorporated into the accounts, the full value of the difference should be deducted from CET1 capital. No participant banks have any of such securities holdings – no adjustment made for this item.

PwC 36 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study n/a Reverse mortgages No requirement RBNZ requires deduction from CET1 capital of the amount to which the loan value of a reverse residential mortgage loan exceeds the value of the security for the loan that is residential property No participant banks have reverse mortgages loans where the value exceeds the value of the security – no adjustment made for this item. n/a Insignificant holdings of financial institution capital Basel III para 80: The regulatory adjustment descr bed in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation and where the bank does not own more than 10% of the issued common share capital of the entity. In addition:  Investments include direct, indirect and synthetic holdings of capital instruments. For example, banks should look through holdings of index securities to determine their underlying holdings of capital.  Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (eg subordinated debt). It is the net long position that is to be included (ie the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).  Underwriting positions held for five working days or less can be excluded. Underwriting positions held for longer than five working days must be included.  If the capital instrument of the entity in which the bank has invested does not meet the criteria for Common Equity Tier 1, Additional Tier 1, or Tier 2 capital of the bank, the capital is to be considered common shares for the purposes of this regulatory adjustment.  National discretion applies to allow banks, with prior supervisory approval, to exclude temporarily certain investments where these have been made in the context of resolving or providing financial assistance to reorganise a distressed institution. RBNZ does not specify netting rules for holdings in both the banking book and trading book. No participant banks have insignificant holdings of financial institution capital – no adjustment made for this item.

PwC 37 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study n/a Significant holdings of financial institution capital Basel III para 86: Investments included above that are common shares will be subject to the threshold treatment described in the next section. RBNZ did not apply the threshold deduction approach. Instead the full amount of the investment is deducted. No participant banks have significant holdings of financial institution capital – no adjustment made for this item. Credit risk RWAs – standardised NZ11 Retail exposures – risk weight 100% Basel II para 69: Claims that qualify under the criteria listed in paragraph 70 may be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. Exposures included in such a portfolio may be risk-weighted at 75%, except as provided in paragraph 75 for past due loans. Basel requires retail exposures to apply a 75% risk weight. RBNZ requires all retail exposures (excluding residential mortgage loans) to apply a 100% risk weight. Reduce risk-weighting to 75% on relevant portfolios subject to the standardised approach. n/a Retail mortgage risk – risk weight > 35% Basel II para 72: Lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk-weighted at 35%. In applying the 35% weight, the supervisory authorities should satisfy themselves, according to their national arrangements for the provision of housing finance, that this concessionary weight is applied restrictively for residential purposes and in accordance with strict prudential criteria, such as the existence of substantial margin of additional security over the amount of the loan based on strict valuation rules. Supervisors should increase the standard risk weight where they judge the criteria are not met. Basel requires retail mortgage lending to be risk-weighted at 35%. RBNZ prescribes risk weights by different levels of LVR distinguishing between non property-investment residential mortgage loans and property￾investment residential mortgage loans, and if there is lenders mortgage insurance. RBNZ's minimum risk weights are 35% or higher. Immaterial or no impact for New Zealand major banks

PwC 38 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study Credit risk RWAs: AIRB NZ3 Farm lending There are no specific Basel requirements for farm lending. Basel II does not specify any specific treatment for farm lending exposures. For farm lending exposures within the corporate asset class, RBNZ requires:  Own estimates of LGD must be greater than or equal to minimum LGDs that correspond to different levels of LVRs  The firm-size adjustment for small￾medium sized entities for firms with consolidated turnover of less than $50 million must not be applied  The effective maturity period for each facility is subject to a minimum of 2.5 years Participants banks calculated the impact on RWA for farm lending exposures by:  Removing the minimum LGD requirements  Applying the firm-size adjustment of $50 million  Removing the minimum effective maturity period of 2.5 years

PwC 39 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study NZ4 Currency threshold adjustments Basel II para 232, 234, 273: 232. The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis. Supervisors may choose to set a minimum number of exposures within a pool for exposures in that pool to be treated as retail.  Small business exposures below €1 million may be treated as retail exposures if the bank treats such exposures in its internal risk management systems consistently over time and in the same manner as other retail exposures. This requires that such an exposure be originated in a similar manner to other retail exposures. Furthermore, it must not be managed individually in a way comparable to corporate exposures, but rather as part of a portfolio segment or pool of exposures with similar risk characteristics for purposes of risk assessment and quantification. However, this does not preclude retail exposures from being treated individually at some stages of the risk management process. The fact that an exposure is rated individually does not by itself deny the eligibility as a retail exposure. 234. All of the following criteria must be satisfied for a sub- portfolio to be treated as a qualifying revolving retail exposure (QRRE). These criteria must be applied at a sub￾portfolio level consistent with the bank’s segmentation of its retail activities generally. Segmentation at the national or country level (or below) should be the general rule. a. The exposures are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers’ outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the bank. b. The exposures are to individuals. c. The maximum exposure to a single individual in the sub- portfolio is €100,000 or less. d. Because the asset correlation assumptions for the QRRE risk weight function are markedly below those for the other retail risk weight function at lower PD values, banks must demonstrate that the use of the QRRE risk weight function is constrained to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands. Supervisors will review the relative volatility of loss rates across the QRRE subportfolios, as well as the aggregate QRRE portfolio, and intend to share information on the typical characteristics of QRRE loss rates across jurisdictions. For small business exposures, Basel II set a threshold of €1 million to be included in the retail portfolio. RBNZ converted this threshold to New Zealand Dollars on a 1:1 basis (effectively setting a lower threshold). For retail revolving exposures, Basel II sets the maximum exposure to a single individual in the qualifying revolving retail sub-portfolio at €100,000. RBNZ converted this threshold to New Zealand Dollars on a 1:1 basis (effectively setting a lower threshold). However, RBNZ has not allowed exposures to be included in a qualifying revolving retail portfolio. Such (otherwise qualifying) exposures fall into the other retail portfolio (or possibly the corporate portfolio), which results in a higher capital requirement. The Basel II firm size adjustment for small and medium-sized entities that are risk-weighted on the corporate curve cuts out for firms with a turnover above €50 million. RBNZ converts this threshold to New Zealand Dollars on a 1:1 basis (effectively setting a lower threshold). Participant banks calculated the risk￾weighted asset impact:  if the current retail threshold was increased to NZ$1.6 million from NZ$1 million  if the current retail revolving exposure asset class classification was allowed and the threshold was increased to NZ$160,000 from NZ$100,000  if the SME turnover threshold was increased to NZ$80 million from NZ$50 million

PwC 40 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study e. Data on loss rates for the sub-portfolio must be retained in order to allow analysis of the volatility of loss rates. f. The supervisor must concur that treatment as a qualifying revolving retail exposure is consistent with the underlying risk characteristics of the sub-portfolio. 273. Under the IRB approach for corporate credits, banks will be permitted to separately distinguish exposures to SME borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than €50 million) from those to large firms. A firm-size adjustment (i.e. 0.04 x (1 – (S – 5)/45)) is made to the corporate risk weight formula for exposures to SME borrowers. S is expressed as total annual sales in millions of euros with values of S falling in the range of equal to or less than €50 million or greater than or equal to €5 million. Reported sales of less than €5 million will be treated as if they were equivalent to €5 million for the purposes of the firm-size adjustment for SME borrowers.

PwC 41 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study NZ5 Specialised lending Basel II para 215 and 275: 215. Under the IRB approach, banks must categorise banking- book exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below. The classes of assets are (a) corporate, (b) sovereign, (c) bank, (d) retail, and (e) equity. Within the corporate asset class, five sub-classes of specialised lending are separately identified. Within the retail asset class, three sub classes are separately identified. Within the corporate and retail asset classes, a distinct treatment for purchased receivables may also apply provided certain conditions are met. 275. Banks that do not meet the requirements for the estimation of PD under the corporate IRB approach will be required to map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. RBNZ took a decision to not allow any internal modelling of specialised lending (SL) risk parameters and to prescribe the more conservative slotting approach for all SL sub-asset classes. The difference between the RWA calculated using the supervisory slotting methodology and the RWA calculated using participant banks risk estimates was deducted from the regulatory RWA. The following modelling assumptions were used :  Current internally calculated PD, LGD and EAD.  RWAs were calculated using the Basel framework defined HVCRE curve, which is more conservative than the standard corporate RWA function. It is noted that the supervisory slotting approach is a method defined by the Basel Framework, and so arguably not a departure. However given the widespread use of internal modelling overseas, it has been adjusted for the purposes of comparability.

PwC 42 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study NZ6 Unsecured non retail LGD Basel II para 468: A bank must estimate an LGD for each facility that aims to reflect economic downturn conditions where necessary to capture the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss of all observed defaults within the data source for that type of facility. In addition, a bank must take into account the potential for the LGD of the facility to be higher than the default-weighted average during a period when credit losses are substantially higher than average. For certain types of exposures, loss severities may not exhibit such cyclical variability and LGD estimates may not differ materially (or possibly at all) from the long-run default-weighted average. However, for other exposures, this cyclical variability in loss severities may be important and banks will need to incorporate it into their LGD estimates. For this purpose, banks may use averages of loss severities observed during periods of high credit losses, forecasts based on appropriately conservative assumptions, or other similar methods. Appropriate estimates of LGD during periods of high credit losses might be formed using either internal and/or external data. Supervisors will continue to monitor and encourage the development of appropriate approaches to this issue. RBNZ published rules permit the use of own estimate LGDs in line with the Basel framework. However LGDs under RBNZ approved models typically result in higher LGDs than international norm, and are consistent with those used by APRA regulated parent banks. Participant banks calculated the RWA impact of a LGD ceiling at 45% for non-retail lending. NZ7 EAD: Non retail CCF Basel II para 316: Banks which meet the minimum requirements for use of their own estimates of EAD (see paragraphs 474 to 478) will be allowed to use their own internal estimates of CCFs across different product types provided the exposure is not subject to a CCF of 100% in the foundation approach (see paragraph 311). RBNZ published rules permit the use of own estimate EADs in line with the Basel framework. However LGDs under RBNZ approved models typically result in higher EADs than international norm, and are consistent with those used by APRA regulated parent banks Participant banks calculated the RWA impact of reducing CCF on non-retail undrawn exposures to 75%.

PwC 43 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study NZ8 Local government Basel II para 57, 58: 57. Claims on domestic PSEs will be risk-weighted at national discretion, according to either option 1 (Sovereign) or option 2 for claims on banks. When option 2 is selected, it is to be applied without the use of the preferential treatment for short-term claims. 58. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established. Where this discretion is exercised, other national supervisors may allow their banks to risk weight claims on such PSEs in the same manner. Basel II allows discretion for risk￾weighting public sector entities to either Sovereign or Bank asset class. RBNZ requires public sector entities (local authorities as defined for the purposes of the Local Government (Rating) Act 2002 to be included in Bank asset class. Participant banks calculated the RWA impact of reclassifying public sector entities to Sovereign asset class from Bank asset class. NZ9 Secured residential lending Basel II para 266, 328: 266. Owing to the potential for very long-run cycles in house prices which short-term data may not adequately capture, during this transition period, LGDs for retail exposures secured by residential properties cannot be set below 10% for any sub￾segment of exposures to which the formula in paragraph 328 is applied. During the transition period the Committee will review the potential need for continuation of this floor. 328. For exposures defined in paragraph 231 that are not in default and are secured or partly secured by residential mortgages, risk weights will be assigned based on the following formula: Correlation (R) = 0.15 Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R/(1 – R))^0.5 × G(0.999)] – PD x LGD Risk-weighted assets = K x 12.5 x EAD The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraph 468) and the bank’s best estimate of expected loss (descr bed in paragraph 471). The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5, and the EAD. Basel II prescr bes a 10% floor for LGD and 0.15 correlation factor for exposures secured by residential mortgages that must be applied at the sub segment of exposures to which the risk weight asset formula is applied. RBNZ prescribes minimum LGD and correlation factor by different levels of LVR distinguishing between non property-investment residential mortgage loans and property-investment residential mortgage loans. RBNZ's minimum LGD requirements are 10% or higher, and correlation factor are 0.15 or higher. In addition, the RBNZ may require banks to apply the TUI model to calibrate their PD estimates. Participant banks calculated the RWA impact of:  Applying a flat 15% LGD factor as a proxy for the 10% LGD floor permitted by Basel.  Using the Basel defined correlation factor.  Removing supervisory overlays to PDs where applied.

PwC 44 Appendix B: Analysis of RBNZ treatments (continued) New Zealand Bankers’ Association Ref Description Basel framework treatment RBNZ treatment Approach taken in this study Market risk NZ10 Market risk Basel II para 718: 718(Lxx). The use of an internal model will be conditional upon the explicit approval of the bank’s supervisory authority. Home and host country supervisory authorities of banks that carry out material trading activities in multiple jurisdictions intend to work co-operatively to ensure an efficient approval process. Basel has market risk standards for both standardised and internal modelling approaches. The RBNZ has a standardised approach based loosely on the Basel Market Risk Amendment of 1996 to calculating exposures to interest rate, exchange price and equity price movements, and are markedly different from the current Basel standards. Participant banks calculated the impact of:  Re-calculating RWAs for traded market risk using an internal (i.e. VaR) based model.  Eliminating RWAs for non-traded interest rate risk.

PwC 45 Appendix C: Comparative data: NZ banks compared to major international banks New Zealand Bankers’ Association Major international banks of the countries analysed in this study, and the 4 NZ major banks, ranked from lowest to highest by internationally comparable CET1 ratios. Rank Bank Country Date Reported CET1% (unadjusted) Dividend adjustments Other adjustments Internationally Comparable CET1% 1 Banca Monte dei Paschi Italy 31/12/2016 8.2% 8.2% 2 Bank of Nanjin China 31/12/2016 8.2% 8.2% 3 China Everbright Bank China 31/12/2016 8.2% 8.2% 4 Bank of Beijing China 31/12/2016 8.3% 8.3% 5 Ping An Bank China 31/12/2016 8.4% 8.4% 6 Huaxia Bank China 31/12/2016 8.4% 8.4% 7 Shanghai Pudong Bank China 31/12/2016 8.5% 8.5% 8 Industrial Bank (China) China 31/12/2016 8.6% 8.6% 9 Mebuki Financial Japan 31/03/2017 8.6% 8.6% 10 Postal Savings China 31/12/2016 8.6% 8.6% 11 China Minsheng Bank China 31/12/2016 9.0% 9.0% 12 Bank of Jiangsu China 31/12/2016 9.0% 9.0% 13 Suntrust Bank United States 31/12/2016 9.4% 9.4% 14 Branch Banking and Trust United States 31/12/2016 10.0% 10.0% 15 Bank of Montreal Canada 31/10/2016 10.1% 10.1% 16 National Bank of Canada Canada 31/10/2016 10.1% 10.1% 17 Fifth Third Bank United States 31/12/2016 10.3% 10.3% 18 Agricultural Bank of China China 31/12/2016 10.4% 10.4% 19 Toronto-Dominion Bank Canada 31/10/2016 10.4% 10.4% 20 Resona Holdings Japan 31/03/2017 10.7% 10.7% 21 Bank of America United States 31/12/2016 10.8% 10.8% 22 Royal Bank of Canada Canada 31/10/2016 10.8% 10.8%

PwC 46 Appendix C: Comparative data: NZ banks compared to major international banks (continued) New Zealand Bankers’ Association Rank Bank Country Date Reported CET1% (unadjusted) Dividend adjustments Other adjustments Internationally Comparable CET1% 23 Citic Bank China 31/12/2016 10.8% 10.8% 24 Banco Santander Spain 31/12/2016 10.6% 0.4% 11.0% 25 Bank of Communications China 31/12/2016 11.0% 11.0% 26 Scotiabank Canada 31/10/2016 11.0% 11.0% 27 Sumitomo Mitsui Trust Bank Japan 31/03/2017 11.0% 11.0% 28 PNC United States 31/12/2016 11.1% 11.1% 29 Concordia FG Japan 31/03/2017 11.1% 11.1% 30 Unicredit Italy 31/12/2016 11.2% 11.2% 31 CFG Community Bank United States 31/12/2016 11.2% 11.2% 32 Wells Fargo United States 31/12/2016 11.3% 11.3% 33 BBVA Spain 31/12/2016 10.9% 0.4% 11.3% 34 CIBC Canada 31/10/2016 11.3% 11.3% 35 Mizuho Financial Group Japan 31/03/2017 11.3% 11.3% 36 Natixis France 31/12/2016 10.4% 1.0% 11.4% 37 Bank of China China 31/12/2016 11.4% 11.4% 38 Banco BPM Italy 31/12/2016 11.4% 11.4% 39 China Merchants Bank China 31/12/2016 11.5% 11.5% 40 Svenska1 Sweden 31/12/2016 9.4% 2.1% 11.5% 41 USB Bancorp United States 31/12/2016 11.7% 11.7% 42 Mitsubishi UFJ Bank Japan 31/03/2017 11.8% 11.8% 43 Deutsche Bank Germany 31/12/2016 11.8% 0.1% 11.9% 44 Sabadell Spain 31/12/2016 12.0% 12.0% 45 BNP France 31/12/2016 11.5% 0.5% 12.0% 46 Societe Generale France 31/12/2016 11.5% 0.6% 12.1% 47 JP Morgan United States 31/12/2016 12.2% 12.2% 48 Sumitomo Mitsui Financial Group Japan 31/03/2017 12.2% 12.2% 49 Commerzbank Germany 31/12/2016 12.3% 12.3% 50 Bank of Ireland Ireland 31/12/2016 12.3% 12.3% 51 Caixabank Spain 31/12/2016 12.4% 12.4% 52 Credit Agricole France 31/12/2016 12.1% 0.4% 12.5% 53 SEB1 Sweden 31/12/2016 10.5% 2.0% 12.5%

PwC 47 Appendix C: Comparative data: NZ banks compared to major international banks (continued) New Zealand Bankers’ Association Rank Bank Country Date Reported CET1% (unadjusted) Dividend adjustments Other adjustments Internationally Comparable CET1% 54 Citibank United States 31/12/2016 12.6% 12.6% 55 Barclays United Kingdom 31/12/2016 12.4% 0.2% 0.10% 12.7% 56 ICBC China 31/12/2016 12.9% 12.9% 57 Intesa Sanpaola Italy 31/12/2016 12.9% 12.9% 58 China Construction Bank China 31/12/2016 13.0% 13.0% 59 Bankia Spain 31/12/2016 13.0% 13.0% 60 Erste Bank Austria 31/12/2016 12.8% 0.4% 13.2% 61 United Overseas Bank Singapore 31/12/2016 13.0% 0.20% 13.2% 62 Nordea1 Sweden 31/12/2016 11.4% 2.0% 13.3% 63 Bawag Austria 31/12/2016 13.3% 0.1% 13.5% 64 Rabobank Netherlands 31/12/2016 13.5% 0.03% 13.5% 65 Raiffeisen Austria 31/12/2016 13.6% 13.6% 66 BNP Fortis Belgium 31/12/2016 13.6% 13.6% 67 Credit Suisse Switzerland 31/12/2016 13.5% 0.6% 14.1% 68 NAB Australia 31/03/2017 10.1% 4.4% 14.5% 69 Standard Chartered United Kingdom 31/12/2016 13.6% 0.1% 0.8% 14.5% 70 ANZ NZ New Zealand 31/03/2017 10.2% 4.3% 14.5% 71 HSBC United Kingdom 31/12/2016 13.6% 0.5% 0.5% 14.6% 72 Royal Bank of Scotland United Kingdom 31/12/2016 14.1% 0.6% 14.7% 73 OCBC Singapore 31/12/2016 14.7% 0.1% 14.8% 74 UBS Switzerland 31/12/2016 13.8% 1.0% 14.8% 75 DBS Group Singapore 31/12/2016 14.1% 0.9% 15.0% 76 Lloyds Bank United Kingdom 31/12/2016 13.6% 1.0% 0.4% 15.0% 77 ING Group Netherlands 31/12/2016 14.2% 0.8% 15.0% 78 WBC Australia 31/03/2017 10.0% 5.3% 15.3% 79 ANZ Australia 31/03/2017 10.1% 5.2% 15.3% 80 CBA Australia 31/12/2016 9.9% 5.5% 15.4% 81 ASB New Zealand 31/12/2016 9.7% 5.9% 15.7% 82 Allied Irish Banks Ireland 31/12/2016 15.3% 0.5% 15.8% 83 WNZ New Zealand 31/03/2017 10.7% 5.2% 15.9% 84 Dexia Belgium 31/12/2016 16.2% 0.0% 16.2%

PwC 48 Appendix C: Comparative data: NZ banks compared to major international banks (continued) New Zealand Bankers’ Association 1 A transitional floor was in effect in Sweden in 2017 which required banks to maintain Total Capital of at least 80% of RWAs calculated under Basel I. Norwegian banks on the o her hand apply the Basel 1 floor as a top-up to their Basel III RWAs which impacts their published CET1 ratios. For consistency, the capital ratios of Swedish banks have been adjusted to the same basis as Norway, which is more internationally comparable given Sweden’s low risk weights. 2 Basel I floor information not available. For peer banks in the same country the floor was binding and he information published on their Pillar III reports. Explanation for adjustments made in Appendix C: Dividend adjustment: • Add back ‘foreseeable dividend’ if it has been deducted in published CET1 ratio (European banks). Other adjustments: • Australian banks: as per self-reported international comparability disclosures • New Zealand banks: Adjustments as per Section 4 of this report. • Singapore banks: Estimated benefit if exposures treated under supervisory slotting were re-calculated using a corporate risk weight equivalent to NZ internationally adjusted specialised lending exposures (42%). • UK banks: Estimated benefit if: (i) exposures treated under supervisory slotting were re-calculated using a corporate risk weight equivalent to NZ internationally adjusted specialised lending exposures (42%) and (ii) sovereign exposures subject to 45% LGD floor were re-calculated using average sovereign risk weight reported by NZ major banks (4%). Rank Bank Country Date Reported CET1% (unadjusted) Dividend adjustments Other adjustments Internationally Comparable CET1% 85 BNZ New Zealand 31/03/2017 10.6% 5.7% 16.3% 86 KBC Group Belgium 31/12/2016 15.8% 0.7% 16.5% 87 Swedbank1 Sweden 31/12/2016 13.0% 3.7% 16.8% 88 Jyske Denmark 31/12/2016 16.5% 0.3% 16.8% 89 Den Norske Bank1 Norway 31/12/2016 16.0% 0.9% 16.9% 90 Nordea Norge1 Norway 31/12/2016 17.0% 17.0% 91 Danske2 Denmark 31/12/2016 16.2% 1.1% 17.3% 92 ABN Amro Netherlands 31/12/2016 17.0% 0.4% 17.4% 93 Unicredit Austria Bank Austria 31/12/2016 18.0% 18.0% 94 Nykredit1 Denmark 31/12/2016 18.8% 18.8% 95 OP Cooperative2 Finland 31/12/2016 19.9% 19.9% 96 Aktia Bank OYJ2 Finland 31/12/2016 19.5% 2.0% 21.5% 97 Nordea Finland1 Finland 31/12/2016 22.7% 1.6% 24.3% 98 WBC NZ (Proposed rules) New Zealand 31/03/2017 16.0% 9.8% 25.8% 99 ANZ NZ (Proposed rules) New Zealand 31/03/2017 16.0% 11.2% 27.2% 100 BNZ (Proposed rules) New Zealand 31/03/2017 16.0% 11.3% 27.3% 101 ASB (Proposed rules) New Zealand 31/12/2016 16.0% 12.0% 28.0%

PwC 49 Appendix D: Jurisdiction specific adjustments New Zealand Bankers’ Association This Appendix summarises the findings from the analysis of local capital rules applicable in the overseas countries selected as comparable to New Zealand. The research was made for two purposes: (i) findings where a jurisdiction has not fully applied the Basel Framework (and so RBNZ may be more conservative if they have fully applied the Framework) and (ii) areas where that jurisdiction has been identified as being more conservative than the Basel Framework (and where RBNZ may be less conservative than that jurisdiction if they have applied the Basel minimum). The source of the information presented in the appendix includes RCAP reports, Pillar 3 reports, information published by national authorities and the accumulated experience of PwC global network in the countries. For Australia, the APRA international comparability study was taken into account to identify what adjustment should be applicable to New Zealand under Australian rules. Country / Area Finding PwC comment Canada – less conservative than Basel Inclusion of Preference Share Capital Does not require preferred shares (accounted as liabilities & incl. in Additional Tier 1) to include the automatic conversion trigger at the capital ratio of 5.125 per cent of risk￾weighted assets (as required by Basel). Does not impact calculation of disclosed capital ratios. No adjustment made. Canada – more conservative than Basel Definition of capital and transitional arrangements Office of the Superintendent of Financial Institutions (OSFI) expects all banking institutions to attain target capital ratios equal to or greater than the 2019 capital ratios from 2013. Does not impact calculation of disclosed capital ratios. No adjustment made. The Canadian Capital Adequacy Requirements (CAR) Guideline requires that any discretionary repurchases of common shares are subject to the prior approval of the Superintendent. Does not impact calculation of disclosed capital ratios. No adjustment made. Paragraphs 16 and 29 of the CAR Guideline require that amendments to the terms and conditions of additional Tier 1 and Tier 2 instruments are subject to the prior approval of the Superintendent. Does not impact calculation of disclosed capital ratios. Not applicable to CET1. No adjustment made. Counterparty credit risk (Annex 4) OSFI’s expectation that banks will provide documented justification for their use of two different pricing models, in the case where the pricing model used to calculate counterparty credit risk exposure is different to the pricing model used to calculate market risk over a short horizon. Qualitative requirement. Does not impact calculation of disclosed capital ratios. No adjustment made. OSFI’s expectation that banks will provide documented justification for their choice of cal bration methods, when two different calibration methods are used for different parameters within the effective expected positive exposure model. Qualitative requirement. Does not impact calculation of disclosed capital ratios. No adjustment made.

PwC 50 Appendix D: Jurisdiction specific adjustments (continued) New Zealand Bankers’ Association Country / Area Finding PwC comment Market risk OSFI does not allow banks using the Standardised Approach to include unrated securities in the “qualifying” category for the computation of interest rate risk. Neglig ble OSFI does not fully implement the futures-related arbitrage strategies that attract lower market risk capital charges. Immaterial or not relevant for NZ banks. No adjustment made. European Union – more conservative than Basel Credit risk: IRB Basel allows risk weight for short-term, self-liquidating letters of credit with unrated banks to be lower than the risk weight of the bank’s sovereign of incorporation; the Capital Requirements Regulation (CRR) does not include a similar provision. Neglig ble Foreseeable dividend treatment Under European regulation banks are required to deduct foreseeable or expected future dividends from CET1. Material. This adjustment was applied to the New Zealand banks when comparing with European banks. European Union – less conservative than Basel Credit risk: IRB (SME) Exposures to SMEs: As noted in the previous discussion of the credit risk standardised approach, under the transitional provisions in the CRR, capital requirements for credit risk on exposures to SMEs, both in the EU and abroad and under both the standardised and IRB approaches, are multiplied by a factor of 0.7619. This is a material deviation that EU authorities noted was introduced in response to local economic conditions. It is scheduled to be reviewed by 2017. Material. Impractical to adjust EU banks to reverse this sub￾equivalence: public disclosures do not contain sufficient granularity. Credit risk: IRB (sovereign) Material deviations from the Basel framework revolve around the exclusion of some significant exposures from the IRB framework. The exclusions cover a variety of exposures including sovereigns, Member State central banks and regional governments, local authorities, administrative bodies, public sector entities, intragroup exposures, and equity exposures incurred under legislative programmes to promote specified sectors of the economy. Most of these exposures are eligible for zero risk weight under the standardised approach, whereas they would typically be subject to a small positive risk weight under the advanced IRB approach. Data for the sample banks indicate that the impact on the CET1 ratios of four banks would be significant while that for one would be moderate. Material. Impractical to adjust EU banks to reverse this sub￾equivalence: public disclosures do not contain sufficient granularity.

PwC 51 Appendix D: Jurisdiction specific adjustments (continued) New Zealand Bankers’ Association Country / Area Finding PwC comment Norway – less conservative than Basel Credit risk: IRB (SME) Exposures to SMEs: As noted in the previous discussion of the credit risk standardised approach, under the transitional provisions in the CRR, capital requirements for credit risk on exposures to SMEs, both in the EU and abroad and under both the standardised and IRB approaches, are multiplied by a factor of 0.7619. This is a material deviation that EU authorities noted was introduced in response to local economic conditions. It is scheduled to be reviewed by 2017. Material. Impractical to adjust EU banks to reverse this sub￾equivalence: public disclosures do not contain sufficient granularity. Credit risk: IRB (sovereign) Material deviations from the Basel framework revolve around the exclusion of some significant exposures from the IRB framework. The exclusions cover a variety of exposures including sovereigns, Member State central banks and regional governments, local authorities, administrative bodies, public sector entities, intragroup exposures, and equity exposures incurred under legislative programmes to promote specified sectors of the economy. Most of these exposures are eligible for zero risk weight under the standardised approach, whereas they would typically be subject to a small positive risk weight under the advanced IRB approach. Data for the sample banks indicate that the impact on the CET1 ratios of four banks would be significant while that for one would be moderate. Material. Impractical to adjust EU banks to reverse this sub￾equivalence: public disclosures do not contain sufficient granularity. Norway – More conservative than Basel Credit risk: IRB (Mortgages and Corporate) Finanstilsynet has set requirements for the PD level (0,9% floor aprox.) in the retail mortgage loans portfolio by defining the level during recessions, in addition to weighting good and bad economic periods. Finanstilsynet has also issued requirements for LGD levels for corporates (40% floor aprox.) and retail mortgage (20% floor). Material. Impractical to adjust Norwegian banks to reverse this sub-equivalence: public disclosures do not contain sufficient granularity. Basel I floor Norwegian banks are subject to a transitional rule for capital adequacy calculations which stipulates that total risk-weighted assets cannot be reduced to less than 80 per cent of the corresponding figure calculated according to the Basel I regulations. Material. Adjustments were made to the New Zealand banks when comparing to the Norwegian banks.

PwC 52 Appendix D: Jurisdiction specific adjustments (continued) New Zealand Bankers’ Association Country / Area Finding PwC comment Singapore – less conservative than Basel Credit risk: Standardised Approach – Expanded list of eligible financial collateral Structured deposits inclusion in the list of eligible financial collateral deemed inappropriate since the structured deposits are not comparable to deposits treated as “cash” and have higher risk. Only impacts 2 per cent of the deposits in Singapore. Applicable to standardised approach. Negligible impact for NZ majors. No further adjustment necessary for NZ major bank ratios to compare to Singapore. Credit risk: Internal Ratings-Based Approach – Definition of Retail Exposures (PM) Allows some exposures to individuals ineligible for retail exposure treatment to be risk￾weighted at 100 per cent rather than being considered corporate exposures category under the IRB Approach. Also does not restrict the residential mortgage treatment of retail exposures only to exposures to individuals that are owner-occupiers of the property. Determined as potentially material in Singapore (some banks noted an increase in ratio, others a decrease). No further adjustment necessary for NZ major bank ratios to compare to Singapore. Singapore – more conservative than Basel Definition of capital and transitional arrangements Explicit CET1 capital adequacy requirement, to be set at 6.5 per cent (as compared to the Basel III minimum of 4.5 per cent) Does not impact calculation of disclosed capital ratios. No adjustment applicable for this report. Tier 1 capital adequacy requirement increased from the Basel III minimum of 6 per cent to 8 per cent. As above. Slotting approach – Specialized lending Mandatory use of supervisory slotting for specialised lending exposures. While not a departure from Basel, will result in more conservative risk weights than if own estimates are permitted. Material. Included for NZ major bank ratios to compare to Singapore.

PwC 53 Appendix D: Jurisdiction specific adjustments (continued) New Zealand Bankers’ Association Country / Area Finding PwC comment Australia – less conservative than New Zealand Farm lending A specific supervisory overlays is required to risk estimates for farm lending. Material. The adjustment was applied to New Zealand banks when comparing with Australian Banks. Specialised lending - scaling factor APRA allows the removal of 1.06 scaling factor on exposures under supervisory slotting approach. Material. The adjustment was applied to New Zealand banks when comparing with Australian Banks. Australia – more conservative than New Zealand Capital deductions (Intangible assets) APRA requires the deduction of additional intangible assets compared to New Zealand rules. This deductions include: loan and lease origination fees and commissions paid to mortgage originators and brokers, costs associated with debt raisings, costs associated with issuing capital instruments, securitisation start-up costs and other capitalised expenses. Material. The adjustment was applied to New Zealand banks when comparing with Australian Banks. Capital deductions (Equity investments) Additional APRA deductions include total holdings in banks, financial institutions, insurers and fund managers. Neglig ble Australia – Other adjustments Trading Book: Internal Model The use of internal modelling for traded market risk is allowed. Depending on the bank’s risk profile, this may be either an increase or decrease in market risk RWAs across trading and banking book. Material. The adjustment was applied to New Zealand banks when comparing with Australian Banks. Secured residential lending - 25% average RW While both jurisdictions are super-equivalent with regards to residential lending, an adjustment has been applied to the New Zealand banks to restate to the Australian average (25%). Material. The adjustment was applied to New Zealand banks when comparing with Australian Banks.

PwC 54 Appendix E: Glossary New Zealand Bankers’ Association ADI Authorised deposit-taking institutions Advanced banks Banks which have been accredited to use their own models for calculating risk-weighted assets AIRB (or Advanced IRB) Advanced internal ratings-based approach APRA Australian Prudential Regulation Authority Basel Framework Basel Framework includes Basel II, Basel 2.5 and Basel III and refers a number of documents. Refer to the BCBS’ Regulatory Consistency Assessment Programme (RCAP), Assessment of Basel III regulations – Canada June 2014, Annex 3: List of capital standards under the Basel Framework used for assessment. BCBS Basel Committee on Banking Supervision BIS Bank for International Settlements CCF Credit conversion factor CET1 Common Equity Tier 1 CRR Capital Requirements Regulation D-SIB Domestic systemically important bank DTAs Deferred tax assets EAD Exposure at default EL Expected loss FIRB (or Foundation IRB) Foundation internal ratings-based approach G-SIB Global systemically important bank G-SIFI Global systemically important financial institutions G-SII Global systemically important insurers HVCRE High-volatility commercial real estate Internationally comparable CET1 Measurement using Basel Framework rules and allowing for national regulatory treatments which would impact on how those rules are implemented in that jurisdiction by comparison to international norms IRB Internal Ratings-Based approach IRRBB Interest rate risk in the banking book LGD Loss-given-default LVR Loan to value ratio O-SII Other systemically important institutions PD Probability of default PSE Public sector entity QRRE Qualifying revolving retail exposures RBNZ Reserve Bank of New Zealand RCAP Regulatory Consistency Assessment Programme RUF Revolving underwriting facility RWAs Risk-weighted assets SL Specialised lending SME Small and medium-sized entity TC Total capital

1 PO Box 5304 Wellington 6145 P: 04 939 9134 E: admin@nzipim.co.nz www.nzipim.co.nz To Ian Woolford Financial System Policy and Analysis Department Reserve Bank of New Zealand PO Box 2498 Wellington 6140 Email: CapitalReview@rbnz.govt.nz Submission on: Capital Review Paper 4: How Much Capital is Enough? From: The New Zealand Institute of Primary Industry Management Date: 17 May 2019 Contact: Stephen Macaulay Chief Executive PO Box 5304 Wellington 6145

2 Introduction The New Zealand Institute of Primary Industry Management (NZIPIM) welcomes the opportunity to submit on the Reserve Bank of New Zealand’s (RBNZ) consultation paper Capital Review Paper 4: How Much Capital is Enough? By way of background, NZIPIM is the peak industry body for the rural profession. We have over 1,050 members from a diverse range of occupations within the rural profession, including farm management advisors, rural bankers, farm accountants, fertiliser consultants, rural valuers, representatives from industry good organisations, CRIs, universities and agribusiness service providers. Our members work with farmers on a day-to-day basis in helping them achieve their goals in running successful and financially sustainable farm business enterprises. This has wider flow-on benefits for the economic and social wellbeing of New Zealand, generating primary export earnings of $42.7 billion to the year ending June 2018.1 NZIPIM agrees that it is important to ensure that banks maintain capital requirements to safeguard New Zealand’s financial system. However, given the scale and velocity of the proposed changes on bank capital requirements outlined within the consultation paper, NZIPIM believes there is a risk that this will likely impact on banks’ lending arrangements within New Zealand’s agricultural and horticultural sectors. Overview of the primary industry Based on feedback received from members there is considerable uncertainty within the farming community brought about by increased on-farm environmental regulations, growing statutory requirements and additional compliance costs for farm businesses. In a recent NZIPIM membership survey, over 55% of all respondents reported significant knowledge gaps and understanding of new environmental regulations by farmers, particularly on how to maintain profitable and sustainable businesses under environmental limits being rolled out by a number of regional councils across the country. Not since the late 1980s have we seen the type of upheaval and uncertainty now being experienced on-farm. We are also seeing increasing requirements from the marketplace from more discerning consumers, along with growing threats posed by new and emerging food technologies such as alternative meat and milk proteins, and lab-cultured foods. All these developments challenge the very way we produce, process and market our agri-food and fibre products to the world. Farming is typically a capital intensive business. Farmers continue to rely on bank capital to help grow and develop their farming businesses, and to cover funding shortfalls during certain times of the season or through unexpected events such as a severe market downturn or extreme weather occurrences.

1 Situation and Outlook for Primary Industries: March 2019 (link)

3 We are concerned that the proposal may lead to increased borrowing costs, adding greater costs to farm businesses at a critical juncture for the agricultural and horticultural sectors. This is also comes at a time when farm confidence is already in the doldrums, which we will expand upon further in this submission. Recommendations NZIPIM recommends that:  Clearer justification and transparency be provided on proposed bank capital levels compared to the Australian Prudential Regulation Authority (APRA) and other central banks globally to ensure New Zealand businesses are not negatively impacted compared to our international competitors.  Deeper consideration and analysis be undertaken about the likely unintended consequences of increasing bank capital requirements through an in-depth cost-benefit analysis with detailed breakdown by sectors (e.g. agriculture, business sector, commercial property, residential housing, etc).  A more measured approach be adopted in building capital reserve levels within the banking sector, which limits any disruption to the economy as much as possible. Comments on the consultation paper

1. RBNZ wants enough capital in the system to cover large unexpected losses in the event of an extreme shock, and have determined this position to be a one in every 200-year event. RBNZ believes this objective is reasonable and consistent with its legislated responsibility to maintain financial system “soundness”. It is difficult to determine whether this is reasonable without understanding how the one in 200-year event measure was determined, and how this compares with other central banks globally. If this type of measure is over and above that used or considered by other international central banks, what additional risk factors were considered as part of RBNZ’s analysis? If, rather, this is largely based on insurance solvency standards across Europe, what relevancy, if any, does this have to New Zealand?
2. RBNZ are proposing to increase the amount of capital systemically important banks are required to hold from a minimum 10.5% of risk weighted assets (RWA) to setting the Tier 1 capital ratio at 16% of RWA, or 18% including Tier 2 capital. For non-systemically important banks it is proposed that the Tier 1 capital ratio be set at 15% of RWA, or 17% including Tier 2 capital. 2 This represents a significant increase of capital to be held by banks from the current levels. While increasing minimum regulated capital from 10.5% seems a prudent approach, the proposed new Tier 1 capital ratio target of 16% for large banks

2 The 18% percent combines: 2% Tier 2 capital, 6% Tier 1 capital, 7.5% Conservation Buffer, 1% Domestic-Systematically Important Bank Buffer and 1.5% Counter-Cyclical Buffer. Smaller banks are not required to hold the 1% Domestic-Systematically Important Bank Buffer.

4 would appear to be significantly higher than the APRA capital requirements, whereby major Australian resident banks need to have Common Equity Tier 1 capital ratios of at least 10.5% to meet the “unquestionably strong” benchmark. 3 Clearer justification and transparency is needed on proposed new bank capital levels compared to that required by APRA and other central banks. 3. We note the proposed Counter-Cyclical Capital Buffer (CCyB) is an untested new macroprudential tool being considered by RBNZ. The 1.5% CCyB is part of the increase in buffers that takes Tier 1 capital to 16%. We note that this buffer is an experimental and unproven tool on top of already significant capital increases that require further consideration, particularly given that most banks typically operate with more capital than required by RBNZ. 4. The lack of a cost-benefit analysis is a shortcoming in the consultation paper and in our view has stifled deeper consideration and objective discussion by those potentially impacted by the changes, namely borrowers. The Reserve Bank Governor has acknowledged increased capital requirements would add around 20 to 40 basis points of additional premium between the costs at which banks borrow and lend, while other market commentators estimate upwards of 125 basis points (Swiss investment bank UBS). The upshot is that there will be additional costs to borrowers as banks build their capital positions over a proposed five-year period. Agricultural debt has continued to climb and is currently sitting at around $63 billion, with around two-thirds of that debt in the dairy sector. Assuming a 100 basis point increase in interest rates, this would add around $630 million in interest costs for farmers.4 Increased borrowing costs come at a time when farmers are faced with new environmental regulations and productivity limits in a number of regions across the country. Farmers are increasingly being asked to consider and implement strategies to mitigate their environmental risks, many of which require additional capital without necessarily increasing profitability (e.g. developing riparian margins, building feed or stand-off cattle pads, establishing wetlands, etc). The added cost of borrowing, or potentially restrictions on being able to borrow, could undermine a farmer’s ability to meet new environmental regulations, which could limit the types of practice change being sought on-farm. We are also seeing a generational shift on-farm as owners look to retire or exit the business. Succession arrangements and/or equity partnership arrangements to help transition the family farming business require access to capital to enable this to occur successfully. If capital becomes more difficult to obtain, this transition process will slowdown, thus reducing the opportunity for many young people to enter the agricultural and horticultural industries. This generational transition is needed to further enhance the productivity potential of farms and to speed up the adoption of new and innovative farm practices required to address growing environmental and in-market regulations.

3 APRA announces ‘unquestionably strong’ capital benchmarks July 2017 (link) 4 RBNZ: Sector lending (registered banks and non-bank lending institutions) (link)

5 Up until recently, we were also beginning to see realignment occur within the industry where poorer performing farm businesses were being acquired by much more successful ones, including large family enterprises, corporate farming businesses, and young first farm owners able to attract both debt and equity capital for themselves. While such arrangements have the potential to improve the overall financial health and performance within the agricultural and horticultural sectors and lower banks’ overall risk profile, added financial costs as a result of increasing capital requirements will slow this process down. Banks are already referencing the proposed changes to increase bank capital levels in their discussions with farmers. Anecdotally, members are reporting that banks are tightening their requirements on banking and financial arrangements on-farm through more aggressive repayment of loans, lending margins and access to credit facilities. We have some concerns that the proposed changes could accelerate bank demands on repayment of credit facilities beyond the capacity of the farm businesses to meet them, which in turn could have destabilising affect across the sector. 5. Should banks need to accumulate more capital, weighing up risk will feature more highly in their deliberations, particularly the impact of scarce capital being transferred to other sectors in the economy or potentially being allocated away from the economy entirely. Lending to farm business enterprises attracts higher risk weighting in banks’ capital calculations as they need to hold more capital for lending in the agricultural and horticultural sectors. Banks may steer away from the sector and look at other sectors where less capital is required on a risk weighted basis, such as residential property. With increased capital potentially being directed to home loans we could see a lift in house prices, which would be contrary to Government’s desire to keep a lid on property prices, particularly for first home buyers. 6. The requirement for banks to achieve desired capital levels should be considered over a longer transition period, rather than the five-year period proposed in the consultation paper, to limit any disruption to the economy as much as possible. Thank you for your consideration of this submission as part of the consultation process. On behalf of the rural profession, NZIPIM is happy to organise a meeting with a representative of RBNZ to discuss the points raised in this submission.

Oliver Saint I am a New Zealander who arrived in Auckland in 1971 from Hong Kong where I had been in practice as a Chartered Accountant for 8 years. Prior to that I emigrated from England where I was born. I am now retired from practice and the various businesses I was involved in New Zealand (Merchant Banking, Sharebroking and Investment Analysis. There are two points I wish to make in support of my submission:-

1. There is much discussion as to how best to proceed and the consensus so far has been collating the correct ratios and figures. I AM VERY SUSPICIOUS THAT FIGURES THEMSELVES MAY NOT TELL THE FULL STORY..
2. My attention has been drawn to the recent comment by the CEO of National Australia Bank as to whether a director should be responsible for misdemeanours following losses or other irregularities experienced by the company. If the report is correct I am speechless. I ask that the Reserve Bank become more pro-active where possible and call for the names and experience of all directors and if possible ensure that at least one director is a New Zealander with banking experience. I appreciate that shareholders will have the last say and the matter will have to be treated delicately but it should be possible to handle. Sincerely Oliver Saint. OIA s9(2)(a)