Submissions on Reserve Bank of New Zealand Capital Review Paper 4

Dairy Holdings Ltd To: Reserve Bank of New Zealand Submission on: Review of Capital Adequacy Framework for locally incorporated banks Capital Review Paper 4 How much capital is enough? From: Dairy Holdings Limited Date: 7 May 2019 Contact: BLAIR ROBINSON CHIEF OPERATING OFFICER Dairy Holdings Limited PO Box 224, Ashburton, New Zealand

Page 2 of 4 SUBMISSION REVIEW OF CAPITAL ADEQUACY FRAMEWORK FOR LOCALLY INCORPORATED BANKS Capital Review Paper 4 How much capital is enough?

1. INTRODUCTION 1.1. Dairy Holdings Limited welcomes the opportunity to submit to the Reserve Bank of New Zealand (RBNZ) on the Review of the Capital Adequacy Framework for Locally Incorporated Banks. 1.2. The comments within this submission come from consultation within the Dairy Holdings Limited Management Team. 1.3. We reserve the right to be heard in support of our submission and we would be happy to appear to clarify any points if this is required.
2. STRONGER BANKS AND STRONGER BANKING SYSTEM 2.1. Dairy Holdings Limited supports the strengthening of the New Zealand banking sector. This should make banks safer for investors and borrowers and ensure the country is better positioned to weather a banking crisis. 2.2. There appears to be much debate as to what level of capital is appropriate for New Zealand banks to hold to achieve the goal of withstanding a one in two￾hundred-year crisis. Dairy Holdings appreciates there is the need to increase the amount of capital banks hold.
3. INCREASED COST OF BORROWING 3.1. RBNZ has stated “Interest rates (borrowing and lending) could change – but we don’t expect by much. Lending margins above borrowing cost are likely to expand by 20-40 points.” 3.2. All the major trading banks have indicated directly to Dairy Holdings Limited that they intend to fully pass onto the customer all the increased cost associated with the RBNZ imposed increased capital requirements. 3.3. In fact, some trading banks are already enforcing a lift of up to 50 basis points onto fixed term loans and margins above wholesale floating rates as existing facilities mature over, above what they were charging prior to the capital

Page 3 of 4 adequacy debate starting. Banks have seized the opportunity to increase margin before the submission period has closed and well before any costs are incurred on their behalf. 3.4. The increase in margin already being charged is significantly above that signalled by RBNZ. 3.5. With more capital on hand, the New Zealand banking sector would become a lower risk environment and bank shares would become lower risk investments. 3.6. It seems inequitable then that the banks could propose to pay dividends on bank shares at similar yields to today when the risk to bank shareholders from a failure of the baking system will significantly diminish. 3.7. Recommendation 3.7.1 The RBNZ provide guidance to the banking sector as to how the increased cost of capital is to be apportioned in a fair and equitable manner. 4. FOLLOW THE LEADER 4.1. RBNZ states in its supporting material that “Banks make profits from lending. The competitive market will continue and if one bank pulls back in a particular segment of lending, we expect another will step up.” 4.2. Dairy Holding’s Limited’s observation over time is quite the opposite and that banks very much follow each other’s lead. It is understandable that banks operate this way as they all operate under the same macro influences. These have historically been milk price related or aligned with offshore capital availability. 4.3. A lack in profitability in a section of the dairy industry and a material reduction in bank sector appetite has resulted in weak liquidity in the dairy land market. All banks appear to be “pulling back” at present 4.4. Dairy Holdings Limited supports the ‘reset’ of the banking industry with regard to lending parameters. 4.5. Dairy Holdings sees significant risk in the perfect storm materialising where banking margins increase markedly (100+ basis points) due to extra capital costs and customer risk ratings increases, bank sector reduction in appetite stifles ability for growth and liquidity in the land market and a milk price shock causes massive deterioration in all asset values.

Page 4 of 4 4.6. Recommendation 4.6.1 The RBNZ implement the increase in capital costs over a longer period of time than is currently proposed or at least have the option to extend the time period if required. It is imperative at the same time, RBNZ ensures trading banks continue their drive to strengthen Agri sector businesses through improving their profitability. 5. ABOUT DAIRY HOLDINGS LIMITED 5.1. Dairy Holdings Limited is a growing dairy business that provides our customers with the highest quality food from 100% pasture. 5.2. Dairy Holdings Limited is a large farming business operating 75 farms in the South Island. These are a mix of dairy and grazing blocks. 5.3. Producing 17.5m Kg MS from 50,000 cows, Dairy Holdings Limited is the largest supplying shareholder of Fonterra. 5.4. Dairy Holdings Limited is owned by three New Zealand family groups being the Armer’s, Turley’s and Wallace Group.

Dairy Women’s Network PO Box 1468, Waikato Mail Centre, Hamilton 3240 2/36 Thackeray Street,Hamilton Lake, Hamilton 3204 P 07 974 4850 Freephone 0800 396 748 www.dwn.co.nz 16th May 2019 Ian Woolford Financial System Policy & Analysis Department Reserve Bank of NZ PO Box 2498 Wellington 6140 Email: CapitalReview@rbnz.govt.nz Bank capital review SUBMISSION TO THE RESERVE BANK OF NEW ZEALAND ON CAPITAL REVIEW PAPER 4: HOW MUCH CAPITAL IS ENOUGH?

1. INTRODUCTION

1.1 Dairy Women’s Network (DWN) welcomes the opportunity to submit to the Reserve Bank of New Zealand on its Capital Review Paper 4: How Much Capital is Enough? 1.2 DWN takes a close interest in banking and financial policy as Dairy Women take a major role in the dairy farming business with regards to accounting and finance. 1.3 DWN runs modules to upskill its membership (which totals over 10,000 dairy women) on how to manage the budgets, cashflows, and farm finances. Post Module analysis has shown that our training has excellent uptake by participants in the day to day running of the farms business management and we are focused on increasing financial literacy within our industry. 1.4 We agree that it is important for bank capital requirements to safeguard the financial system and for the NZ economy. However, we are concerned about the impact that significantly increase capital requirements would have on our farming families and the economic well-being of NZ. 2 OUR VIEWS ON THE CAPITAL REVIEW PAPER It is fair to assume Government involvement in any 1 in 200 year shock no matter what industry is impacted. Banking is no different. A financially robust and growing economy, with a strong tax base and low Government debt are key factors in the ability for the Government to take appropriate action. As NZ’s largest financial contributor to the economy, the primary industries play an important role in providing the Government with this financial robustness. Higher customer margins, charged by banks to reflect higher regulatory capital requirements will divert potential investment capital for the primary industries to increased, and less productive, interest costs. Value must be placed on the critical role and contribution of the land-based sectors to New Zealand’s current and future prosperity, and the importance of these sectors to addressing global challenges, such as food supply, biodiversity loss, and climate change.

a. We are concerned that the Banks requirement to hold more capital will translate to higher margins on our rural loans. Some of our members have already received a letter from their banker indicating that margins could be increased despite the decrease in OCR (May 2019). We do not believe that the Banks will absorb the increase in capital requirement from profits. See Appendix I. b. Investment in Environmental infrastructure is also a priority for Dairy Farmers as our Government, our Communities and our Milk Processors demand higher standards of environmental compliance. Increased interest rates will use capital that Farmers should be investing into environmental infrastructure. In addition to the environmental infrastructure spend, Dairy farmers will be faced with a M bovis levy and a green house gas levy. The future may require Dairy Farmers to decrease production and/or possibly diversify in response to Green House Gas (GHG) targets. c. We are concerned about the impacts of higher interest rates, environmental infrastructure spend, M Bovis, and GHG levy will have on the well-being of our Dairy Farmers. Rural Health Needs Survey Report Mystery Creek Field days 2018, found that one in five farmers have contacted someone for help with mental health or addiction problems for themselves in the past year. 2.2 Banks are large commercial enterprises and have Boards of Directors with relevant experience and competencies to reflect this. Risk mitigation to respond to such circumstances as financial shocks are a core function of these Boards and directors carry accountability for this. Personal reputational and financial risk for directors is significant. Regulatory Capital requirements are a minimum requirement only and NZ banks have demonstrated a track record of holding capital over and above these regulatory minimums in line with the point above in relation to Board risk management accountabilities.

3. SUMMARY We agree that it is important for bank capital requirements to safeguard the financial system and the wider NZ economy. However, we are very concerned about the impact that significantly increased capital requirements would have on farmers and their families. We have evidence that already banks are using capital requirements as a reason to lift margins, that coupled with the requirement to further invest in environmental infrastructure, M Bovis, GHG levies, we are concerned for the well being of our farmers. We believe the Banks will have the experience and competencies to ensure their balance sheets hold enough capital over and above the regulatory minimums. We respectfully encourage the Reserve Bank to carefully reconsider reducing the requirement of capital from a 200 year shock to 100 years or to transition the change over an extended period of time to allow our farming businesses to adjust. Dairy Women’s Network

Dan McGuire Kudos to the Reserve Bank for making this proposal. I sincerely hope that the RB will not back down in the face of opposition. The proposal is very modest. I would like to see even higher capital ratios. I use three New Zealand Banks, two of them owned by an Australian parent bank. There is no deposit guarantee like there is with my United States bank. Therefore higher levels of capital in reserve are appropriate and necessary. New Zealand will face another General Financial crisis in the near future. All the conditions that preceded the 2008 crisis are back, except the levels of debt and the banks' gambling in derivatives are much higher now than before the last crisis. I commend the RBNZ and its chairman Adrian Orr for excellent work. Stick to your guns. OIA s9(2)(a)

Daryl Brand Macro prudential tools are better to use than tier 1 capital ratios, it just means that RBNZ needs to be engaged appropriately. OIA s9(2)(a)

David & Rebecca Whillans Please see our submission on the attached file. OIA s9(2)(a)

Classification: PROTECTED Hi RBNZ Team and Mr Orr, Can you please consider the younger generation of farmers coming through when making these capital changes and the pressures/ challenges we already face. I understand the drivers for your proposal however the impact on us trying to get established on a farm in the current conditions is hard enough let alone now having yet another barrier in the way. My wife & I (both 40 & graduates of Lincoln University) run a 330ha mixed cropping farm in Mid Canterbury. We both work off farm in full time professional roles that are agriculture based. We are doing this to try and get ahead of the curve as we understand that just running a mixed cropping farming business standalone will not drive sufficient profitability to get ahead. What does “get ahead” mean to us? It means:  Repay debt, grow our equity, build resilience & sustainability into our business;  Invest in modern farming infrastructure & technology;  Invest in modern warm & dry housing for our family;  Invest in good quality warm house for our farm manager & his family;  Be able to run our business in a sustainable manner that has a much lower environmental footprint now than it has had for the last 20 years;  Meet all of our community requirements (e.g. being involved with & being able to donate/ support Mayfield School; Mayfield A&P Association; Mayfield Playcentre; Ruapuna pool & domain; etc etc.  We are young & believed taking on some risk at this stage of life is achievable for us. The banking industry has recently successfully managed through the GFC, a severe dairy down turn & is now looking closely at the global economic slowdown plus a slowing housing market in Auckland and associated issues that will arise out of that. We are already hearing noises of increasing lending margins/ implementing line of credit charges on overdrafts/ restricting capital for agriculture/ restricting of 4 and 5 year fixed rates as the cost of capital with them is currently unknown. All of these changes appear to be directly attributable to your proposals; they will only serve to justify a lift in Banking returns and place even more pressure on us & reduce our short term & long term sustainability. We understand you want banking shareholders to take more risk by holding more capital for what is a profitable and low risk business which is understandable. However; all we see happening is increasing borrowing costs/ restriction of facilities/ restriction of loan terms all being passed onto the end user (us). We are currently both working 16 to 18 hours a day in our professional roles and in our farming business. We are already have enough pressure on us implementing many changes from a business/ animal welfare/ environmental/ staffing/ managing m.bovis etc etc point of view. And then we have to also deal with the daily hatred by the media & general public plus constantly changing local & central government demands & regulations. Mr Orr – can you please consider us, our family, our business and our community in your capital proposals. We believe your current proposal needs revision as currently the unintended consequences are significant. Thanks & Regards David & Rebecca Whillans

David Geary I support increasing the required bank capital. The safer the banks are, the better. We all expect banks to never fail, and so they shouldn't. And they shouldn't require a government bailout when times are tough, either. OIA s9(2)(a)

David Hanna I lead a community organisation that works with whanau experiencing relational and financial stress. The provision of accessible and professional health and social support services are critical to supporting this group of society live lives that have meaning and engage as productive citizens. It is this part of the community that will eventually pay a high price if Government needs to bail out a major bank, increasing public debt and forcing a reduction in government spending. The impacts of this scenario span generations and could significantly reduce our economies human capital. For these reasons our organisation (Wesley Community Action) supports the proposed changes to increase the amount of capital that trading banks need to maintain. The small cost of potentially raised banking costs are out-weighted by the considerable risk should the Government be forced to bail out a significant bank. The part of the community we represent have least ability and capacity to engage in these policy considerations however are potentially the most impacted upon if a major bank fails. OIA s9(2)(a)

david king i 100% support the new capital adequacy increases proposed by the reserve bank. please dont be put off implementing these proposals due to the squeeling of bank shareholder. its not about them. OIA s9(2)(a)

7 March 2019 Banking & Finance Australian Banking Sector appetite); and 4) cut the unsustainably high dividend payout ratios. Whilst a partial listing would likely be welcomed by NZ investors and the broader NZ economy, it creates some capital/tax inefficiencies for the parent and thus may not be the most preferred outcome. The banks have until 3 May 2019 to lodge their submissions. APRA's proposed changes to APS222 (Associations with Related Parties) further complicate matters. It increases the sensitivity of related-party investments. It proposes, amongst other things, to cut the exposure limit (debt + equity) to an individual ADI from 50% of Total Capital to 25% of Tier 1 capital and aggregate exposures to all related ADIs from 150% of Total Capital to 75% of Tier 1 Capital. We expect the majors to actively consult with APRA on this proposal and the Australian Banking Association's response is found here . Recall, at level 1, the New Zealand major banks are deconsolidated and the capital investments into these subsidiaries risk weighted at 400%. This is particularly relevant when dividends are upstreamed and then reinjected as equity capital in the subsidiary. Our rudimentary valuations of the four Australian-owned NZ banks are presented below, using the simple GGM model - refer Figure 1. There is NZ$86bn of value residing in there. Two points are worth making:

1. the additional capital shaves only 1% off the valuation. However, one could argue that the beta should decline to reflect less gearing and the consequent lower required return. Equally, one may argue that the terminal growth rate should fall given the slightly higher capital strain may mean there is less willingness by the parent to allocate capital to it. Either way the debate is moot because the change in the value of the firm is very minor. Modigliani & Miller - the value of a firm is unaffected by how that firm is financed.
2. the market capitalisation of the listed NZ equity market is only ~NZ$130bn. The banks, both individually and collectively, would consequently represent a likely indigestible morsel. Hence our view, that a partial NZ listing of certain banks might be a sensible and well received outcome (adds weight/size and certainty to the NZ equity market plus creates a vested interest in a bank's customer base) in NZ although the capital/tax inefficiencies may be a barrier. Figure 1: Impact on implied valuation based on Gordon Growth model… minor change in firm value NZ$m FY18 Pro-forma FY18 Pro-forma FY18 Pro-forma FY18 Pro-forma ROE 15.1% 11.9% 15.4% 11.6% 14.4% 10.3% 13.3% 10.4% Implied P/B multiple (x) 2.3 1.7 2.4 1.6 2.2 1.4 2.0 1.4 Book value 12,945 17,349 7,637 10,887 7,160 10,936 7,064 9,609 Value of NZ business 29,759 29,537 18,023 17,914 15,498 15,286 13,802 13,715 Change in value (1%) (1%) 1%) (1%) Implied P/E (x) 15.2 14.3 15.3 14.2 15.1 13.6 14.7 13.7 Assumptions NZ 10 yr bond rate 2.17% Beta 1.00 Risk prem 6.0% Cost of equity 8.2% Growth 2.85% ANZ CBA/ASB NAB/BNZ WBC Source: Deutsche Bank, Company data. Note: Proforma incorporates additional equity in NZ, including additional earnings Page 2 Deutsche Bank AG/Sydney Provided for the exclusive use of on 2019-03-07T20:49+00:00. DO NOT REDISTRIBUTE

7 March 2019 Banking & Finance Australian Banking Sector Figure 2: Arithmetic - pro-forma impact of additional capital requirements NZ$m FY18 Pro-forma FY18 Pro-forma FY18 Pro-forma FY18 Pro-forma nterest income 6,390 6,489 4,188 4,264 4,055 4,139 3,989 4,047 Interest expense 3,240 3,182 2,149 2,104 2,109 2,060 2,145 2,109 Net interest income 3,150 3,307 2,039 2,159 1,946 2,080 1,844 1,938 Other income 1,126 1,126 553 553 610 610 373 373 Operating revenue 4,276 4,433 2,592 2,712 2,556 2,690 2,217 2,311 Expenses 1,517 1,517 879 879 1,045 1,045 915 915 Core profit 2,759 2,916 1,713 1,833 1,511 1,645 1,302 1,396 Impairment 55 55 80 80 82 82 PBT 2,704 2,861 1,633 1,753 1,429 1,563 1,299 1,393 Tax 751 795 456 490 400 437 363 389 NPAT 1,953 2,067 1,177 1,264 1,029 1,125 936 1,004

• change 6% 7% 9% 7% Dividend pay-out ratio (3yr avg) 89% 40% 63% 68% Average equity 12,945 17,349 7,637 10,887 7,160 10,936 7,064 9,609 Average interest earning assets 142,059 144,260 89,911 91,536 90,685 92,573 87,552 88,824 Average interest bearing liabilities 122,220 120,018 78,004 76,379 80,655 78,766 75,203 73,930 Net interest spread 1.85% 1.85% 1.90% 1.90% 1.86% 1.86% 1.70% 1.70% Yield from free funds 0.37% 0.45% 0.36% 0.46% 0.29% 0.39% 0.40% 0.48% Net interest margin 2.22% 2.29% 2.27% 2.36% 2.15% 2.25% 2.11% 2.18% Return on equity 15% 12% 15% 12% 14% 10% 13% 10% Common equity Tier 1 9,081 13,485 5,890 9,140 6,810 10,586 6,290 8,835 Additional Tier 1 2,776 1,395 1,000 946 900 1,095 1,500 914 Total Tier 11,857 14,879 6,890 10,086 7,710 11,682 7,790 9,749
• incremental CET1 required 4,404 3,250 3,776 2,545
• new AT1 (capped at 1.5%) 1,395 946 1,095 914 Increase in total Tier 1 required 5,798 4,196 4,872 3,459 Risk weighted assets 82,147 92,997 55,682 63,036 64,492 73,010 53,820 60,928
• assumed growth 4% 4% 4% 4% 4% 4% 4% 4%
• capital strain (req'd CET1) 10.5% 14.5% 10.5% 14.5% 10.5% 14.5% 10.5% 14.5%
• capital strain (NZ$m) 345 539 234 366 271 423 226 353 Free cash flow 1,608 1,527 943 898 758 702 710 651
• change in FCF (5%) (5%) (7%) (8%) Common equity Tier 1 11.1% 14.5% 10.6% 14.5% 10.6% 14.5% 11.7% 14.5% Additional Tier 1 3.4% 1.5% 1.8% 1.5% 1.4% 1.5% 2.8% 1.5% Total Tier 1 ratio 14.4% 16.0% 12.4% 16.0% 12.0% 16.0% 14.5% 16.0% Parent (FY18) Level CET1 11.6% 10.8% 10.4% 10.5% Level 1 T1 13.6% 12.8% 12.8% 12.8% Level 2 CET1 11.4% 10.1% 10.2% 10.6% ANZ CBA/ASB NAB/BNZ WBC Source: Deutsche Bank, Company data. Note: Proforma incorporates additional equity in NZ, including additional earnings kou Deutsche Bank AG/Sydney Page 3 Provided for the exclusive use of on 2019-03-07T20:49+00:00. DO NOT REDISTRIBUTE

7 March 2019 Banking & Finance Australian Banking Sector Page 4 Deutsche Bank AG/Sydney Provided for the exclusive use of on 2019-03-07T20:49+00:00. DO NOT REDISTRIBUTE

7 March 2019 Banking & Finance Australian Banking Sector Appendix 1 Important Disclosures Other information available upon request Disclosure checklist Company Ticker Recent price Disclosure ANZ ANZ.AX 27.78 (AUD) 6 Mar 2019 1, 4, 7, 11, 14, 15 Commonwealth Bank CBA.AX 74.75 (AUD) 6 Mar 2019 1, 7, 14, 15 National Australia Bank NAB.AX 25.46 (AUD) 6 Mar 2019 1, 7, 14, 15 Westpac WBC.AX 27.25 (AUD) 6 Mar 2019 1, 7, 14, 15 *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors . Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at https://research.db.com/ Research/Disclosures/CompanySearch. Aside from within this report, important risk and conflict disclosures can also be found at https://research.db.com/Research/Topics/Equities? topicId=RB0002. Investors are strongly encouraged to review this information before investing. Important Disclosures Required by U.S. Regulators Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States.See Important Disclosures Required by Non-US Regulators and Explanatory Notes.

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1 17 May 2019 Ian Woolford, Manager, Financial Policy Prudential Supervision Department Reserve Bank of New Zealand PO Box 2498 Wellington, 6140 Dear Ian Capital Review Paper 4. How Much Capital Is Enough? Introduction Thank you for the opportunity to provide feedback on the Issues Paper – Capital Review Paper 4. This submission is supplemental and additional to the NZBA submission on the same paper and has been written on behalf of The Co-operative Bank, Kiwibank, SBS Bank and TSB Bank (“NZ-Owned Banks”). The NZ-Owned Banks are members of the NZBA and support in principle the submission of the NZBA on the same paper. However, there are some matters of specific relevance to this group that we wish to address in this submission. A glossary of terms used in this submission is attached. Executive Summary In principle, we welcome moves to introduce a level playing field and a regulatory regime that decreases system risk through recalibration of aspects of the current capital framework. In order for NZ to have a sound, efficient and “fair” banking system:  NZ-Owned Banks must achieve the same risk weightings across their various lending portfolios as the Australian banks. This ensures portfolio allocation decisions are not impacted by inconsistent models and that one type of bank does not achieve significant ROE advantages because of the model it uses. The differentials that the IRB banks currently enjoy create an uneven playing field. There is no empirical information to suggest that the credit performance of the IRB bank portfolios is superior to that of Standardised banks, or that these IRB models make the portfolios any safer.

 NZ-Owned Banks also need the ability to meet capital requirements through non-CET1 capital instruments. Without these, NZ-Owned Banks’ growth will be constrained, limiting competition in the sector. The current regime favours listed and foreign-owned

2 banks. In respect of the latter, the Australian banks have an ability to flow through capital from the Australian parent, often with a regulatory advantage from jurisdictional arbitrage.  There should be a meaningful differentiation in capital levels held between DSIBs and the rest of the industry to ensure that the system is protected. While not the RBNZ’s intention, we have concerns that proposed changes will widen rather than reduce the competitive gap between large and small banks. We have concerns that the objective to align IRB and Standardised risk weightings may not be effective given the proposed approach, which may still result in significant differences to residential lending, small businesses banking and agricultural lending risk weightings. The range of capital instruments available to NZ-owned banks is already too limited. Proposals to further restrict the amount and type of non-CET1 capital will continue to advantage the Australian Banks (i.e. the playing field will not be level- even if the IRB/BS2A differential is reduced) and make it harder for the NZ-Owned Banks to meet the increased capital targets. Consequentially, this will limit the opportunity of the NZ Banks to grow. We are not aware of any other country that has disallowed AT1 (with contingent characteristics) and Tier 2, or required such a high proportion of CET1. Other countries have adopted a more pragmatic approach recognizing that some flexibility in relation to allowable instruments is necessary to achieve higher capital ratios. AT1 and Tier 2 should be available to all banks on practical terms and in meaningful quantities. If the RBNZ is not inclined to increase the scope of non-dilutionary capital for all banks, it should at least be available to small banks because:  It would lessen the current advantage to foreign-owned and listed banks, facilitating a more competitive market.  The RBNZ’s objectives are system wide and would still be met.  A differential approach has merit because the regime already comprises two separate regulatory frameworks, and it would be consistent with the approach taken in Australia. A combination of changes are required to the RBNZ’s proposals to ensure that a competitive market exists and there is a level playing field. There are a number of ways the proposed small bank requirements could be amended to achieve those objectives. 1.0 Background The NZ-Owned Banks support RBNZ’s objective of ensuring that New Zealand’s banking system has a robust capital adequacy system that is able to withstand shocks. The NZ-Owned Banks also support the objective to promote competition through a more level playing field. However, we are concerned that the changes proposed by the RBNZ will have adverse consequences for customers. We support the NZBA submission that RBNZ should:

3 a) Reduce the total capital requirement. b) Allow a more diverse range of capital instruments. c) Create a more realistic transition framework; and d) Undertake a cost-benefit analysis as a priority. In addition to these key issues, which affect the whole banking sector, there are a number of matters that directly impact the smaller NZ-owned Banks. The balance of this submission addresses those matters. 2.0 Importance of NZ Owned Banking Sector New Zealand-owned banks occupy an important position in a banking industry that is dominated by foreign-owned banks. The New Zealand-Owned banks consistently rank ahead of the foreign banks for customer service, often lead the market on pricing initiatives and have return expectations that better balance the outcomes of all stakeholders, particularly shareholders and customers. As a result, the NZ-Owned Banks have grown above system at 8.6% pa over the last 10 years (compared with 4.1 % for total market). Lending asset market share for the NZ-Owned banks has increased from 4.4% to 6.8% over the same period. As the NZ-Owned Banks grow, financial stability benefits from increased scale of smaller banks and decreasing concentration to the IRB banks. The NZ-Owned banks have demonstrated conservative balance sheets with aggregate CET1 ranging from 11.3% to 14.7% compared with 10.3% to 11.8% for the big four Australian￾owned banks. Market share growth has not been accompanied by deteriorating credit metrics. All of the equity of the NZ-Owned Banks is provided from New Zealand. There are no other markets competing for the use of that capital. It is employed only here and the profits remain within New Zealand. Notwithstanding their combined minority market position, New Zealand-Owned banks have shown considerable market leadership. Importantly, they provide an alternative to the large Australian-owned banks. This has been achieved under a regulatory regime that has delivered significant commercial disadvantage to the New Zealand banks because of the substantial disparity that arises between application of the Standardised and IRB approaches to risk weightings. The latter being lower and advantageous for product pricing. A resilient, effective and efficient market stems from both financial stability and an environment that supports competition. It is critical that the capital changes deliver both.

4 Particularly, that increased financial stability does not come at the cost of decreased competition or increased concentration of the four systemically important banks. The capital rules as proposed give rise to significant risk that the NZ-Owned banks continue to be constrained in their ability to compete, and importantly, step into the market if the foreign owned banks ration credit. The proposal to more closely align risk weightings between the IRB approach and Standardised approachesis welcomed and could level the playing field, depending on the final form of the proposed changes. However, the changes to required quantum of capital and allowable capital instruments will constrain the ability of the NZ-Owned Banks to grow. 3.0 Level Playing Field: Alignment of IRB vs Standardised Approaches 3.1 Rationale for Alignment Since 2006 the four Australian-owned banks have calculated their own credit risk weightings applying the IRB models approach under BS2B. Smaller New Zealand￾owned banks are required to apply Standardised risk weightings as prescribed in BS2A. A significant divide has arisen between the two approaches whereby large banks calculate significantly lower risk weighted assets and are therefore required to hold materially less capital (as a whole and across most portfolios). This has created uneven competition where the IRB banks enjoy significant competitive advantage arising from the regulatory framework. The differential that has been identified by the RBNZ’s QIS exercise showed average RWA outcomes under the models’ approach equated to 76% of the Standardised approach, noting that there is considerable variation across exposure categories. The NZ-Owned Banks operate primarily in the categories of residential mortgages and SME lending. The observed average ratios for the IRB Banks in those categories are considerably lower at 69% and 61% (respectively) of Standardised risk weightings. This means that the Standardised banks require 45% and 64% more capital for the same risk (for residential mortgages and SME lending respectively). We note also that the QIS outcomes stated above represent the IRB average, and the differential is even greater for some of the large banks.

5 ₁ Source: RBNZ Capital Review Paper 4, p52 This illogical outcome is most difficult to justify in relation to residential mortgages where a loan to the same borrower secured by the same house, in the same street requires 45% more capital to be held by a Standardised bank. For the NZ-Owned Banks, the requirement to carry extra capital of this magnitude has a significant impact on ROE. While smaller banks expect a lesser return than large banks on account of the latter’s scale advantage, the impact on ROE from this regulatory anomaly can be as great, or even greater, than the cost to income ratio differential compared with large banks. For portfolios of similar risk, RWA outcomes should be similar, regardless of which approach is used. 3.2 Supporting Evidence 3.2.1 Background The NZ-Owned Banks by their nature have conservative risk appetites with lending portfolios that are demonstrably of similar (if not better) quality than IRB Banks. This is most easily observed in respect of the residential mortgage category. The following analysis compares the mortgage portfolios of the NZ-Owned Banks with the characteristics of the IRB bank portfolios.

8 We understand that applying the increased scalar of 1.2x will increase the IRB risk weightings by c.13% (1.2/1.06). This would move the QIS averages for residential mortgages from 69% to 78% and SME lending from 61% to 69%. RBNZ has advised that no further adjustments are initially expected on account of the Output Floor. At these levels, Standardised banks will still be required to hold 28% more capital for residential mortgages (100%/78%) and 45% for SME lending (100%/69%). These outcomes would clearly not deliver a level playing field. Further, the RBNZ’s sensitivity analysis demonstrates that differences will arise between IRB Banks. This favours some IRB banks over others and it is difficult to see the justification for different outcomes within the same regulatory rulebook. The NZ-Owned Banks are supportive of a regime that results in a ratio of IRB/Standardised risk weightings of not less than 90%, noting that even 90% is not level, provided that:  The approach is effective in delivering a 90% outcome for each category (at a minimum, residential mortgages, SME lending and rural are considered as a separate categories); and  The target average outcome of not less than 90% represents the outcome for each IRB bank, not the average of the IRB banks. 4.0 Access to Capital for NZ-Owned Banks 4.1 Background The range of capital instruments for NZ-owned banks is already too limited. Proposals to further restrict the amount and type of non-CET1 will continue to advantage the Australian Banks (i.e. the playing field will not be level, even if the IRB/Standardised differential is reduced) and make it harder for the NZ-Owned Banks to meet the increased capital targets. 4.2 CET 1 4.2.1 Ordinary Shares CET1, comprised of ordinary share capital and retained earnings is the RBNZ’s preferred form of capital. The NZ-Owned Banks already have challenges accessing further CET1 and those challenges are likely to be exacerbated. This relates not only to structure (two of the four submitting banks are mutuals) but also scale and illiquidity, given that none of the NZ-Owned Banks are listed.

9 The current regime favours listed and foreign-owned banks. In respect of the latter, the Australian banks have an ability to flow through capital from the Australian parent, often with a regulatory advantage from jurisdictional arbitrage. The NZ-Owned Banks have demonstrably lower return expectations than the larger IRB banks. It is also possible, given the sheer size of the industry capital required, that large foreign-owned banks move to raise some of that capital from the New Zealand market. Financial investors are likely to prioritise larger banks delivering higher yields, further compromising NZ-Owned Bank’s access to ordinary share capital. The lower returns generated by the NZ-Owned banks are due in part to belief in a more balanced score card, which includes (amongst other things) servicing groups of customers who may not be profitable and avoiding hard selling techniques. A regime with a focus on CET1 will drive competition for scarce capital in markets that primarily reward financial outcomes. Ensuring that good market conduct is not compromised by the pursuit of profits is a principle regulators globally encourage. It is imperative that the smaller banks have access forms of capital other than ordinary shares. A bank should not be disadvantaged from having the ability to compete on account of being unlisted and wholly New Zealand owned. 4.2.2 Retained Earnings The other available form of CET1 is retained earnings. The NZ-Owned Banks have modest dividend policies (particularly compared with large banks) with payment ratios up to 20% (noting that mutuals don’t pay any dividends). They already heavily re-invest their profits in balance sheet growth. The challenges for small banks arising from the proposed changes extend well beyond the transition issues arising from lifting capital levels in relation to existing exposures. These changes threaten the outlook of small banks. Given the modest ROE’s, future growth will be considerably constrained, particularly if any meaningful dividend policy is retained. The NZ-Owned Banks have ROE’s ranging from c.6%-9%. The upper end of that range arises from use of a greater proportion of hybrid capital. Adjusting those ROE’s to reflect return on regulatory capital, which is a reasonable proxy for future ROE’s if all capital is CET1, the outcome for all four NZ-Owned Banks is in the region of 6%- 7%. Under the Capital Asset Pricing Model (“CAPM”), the Modigliani and Miller effect (“MM Effect”) suggests that increases in the level of capital reduces financial risk, which in turn reduces the expected return on equity. The RBNZ contends that as

10 a result, the costs of the proposals should be absorbed in part by a reduction in expected equity returns. Banks that set their cost of equity under CAPM are likely to have expected returns of 14%-15% post-tax. We agree, in that case, there should be a reduction in expectations for the MM Effect. However the NZ-Owned Banks do not set their cost of capital under CAPM and their expectations are much more modest. With ROE’s of 6%-7% there simply isn’t the freeboard to expect that the MM Effect should mean that these banks should be content with lower returns. Further, the RBNZ expects that any repricing on lending margins will be relatively insignificant (largely on account of the MM Effect). If that is the case, the NZ￾Owned Banks are essentially left with an increased capital burden with little in the way of offset. We estimate the level of lending growth that can be funded from retained earnings generated by returns of 6%-7% assuming the proposed capital level of 17%, a self-imposed 1% safety margin and a conservative dividend policy of 20%, is less than 5%. After allowing for necessary investments in technology (which result in a Tier 1 deduction), the long run growth prospects are even lower (and this is before having regard for any additional transitional burden). The transition period will reduce growth capacity even further as banks are required to generate sufficient equity to cover the additional capital required for existing balance sheet exposures. Five-year historical lending growth for the NZ-Owned Banks ranges from 7%-13% p.a. with a weighted average of 9% demonstrating an affinity of customers with New Zealand-owned banks. It is unlikely that asset growth funded from retained earnings could continue at those levels – at a time when there may be even greater demand for credit if foreign-owned banks look to constrain credit and/or prioritise deployment of capital in other markets. The outlook for meaningful growth from retained earnings is very limited. 4.2.3 AT1 Capital Given the constraints on access to CET1 capital, an alternative source of capital is imperative for the smaller banks. The RBNZ proposals allow up to 1.5% of total capital to be in the form of AT1 capital. There are two fundamental issues:  The allowable limit of 1.5% - which equates to only 10% of the required capital amount (before allowing for any self-imposed buffer) is simply too low; and

11  The features that the RBNZ propose as allowable non-CET1 capital are unattractive to the capital markets. The current rules allow the total minimum Tier 1 requirement of 8.5% be comprised of non-CET1 Tier 1 capital, which equates 17.6% of that requirement. The proposed requirements continue to restrict AT1 to 1.5% against a much larger Tier 1 requirement of of 15%/16%. This represents a significantly lower allowable proportion of non-CET 1- only 10% of total required Tier 1 capital for a non￾systemically important bank. In terms of an overarching approach to capital instruments, a key difference between the APRA and RBNZ approaches is that the former is more focused on outcomes when there is an insolvency, whereas the RBNZ approach is more focused on ensuring such an occurrence is extremely rare. Notwithstanding this difference in approach, there may be merit in the APRA concept of Total Loss Absorptive Capacity (“TLAC”) which facilitates more open discussion about the best way to achieve the objective in light of the tradeoffs. The TLAC approach has been adopted by other jurisdictions including the UK, Europe and the USA. With regard to corporatised banks (Kiwibank and TSB) the absence of an ability to call an AT1 instrument will discourage investment by fixed income investors. The attributes of a non-callable perpetual share are similarly unattractive to equity investors who do not see them as comparable to ordinary shares given their characteristics. Thus instruments as allowed under the proposed changes may appeal to neither debt nor equity investors as they may not align with market expectations. For mutuals (The Co-operative Bank and SBS) we note there has been some progressin relation to a mechanism that enables Tier 1 issuance. While this would be helpful, it is of itself of limited benefit as it does not address the wider issues identified above (in relation to the quantum that can be issued and the comparative economics with large banks). As currently structured, the NZ-Owned Banks assessment of their ability to issue AT 1 capital under the proposed new rules varies depending on their respective attributes (scale, credit rating, corporate structure) but ranges from no ability to difficult. 4.2.4 Tier 2 We recognise the RBNZ’s view that it considers going concern capital as the preferable form of capital. Nonetheless, Tier 2 capital still absorbs losses to the benefit of depositors and is less complex to issue. Given the very high Tier 1 requirement proposed we do not agree that an additional Tier 2 requirement is necessary. It does not necessarily follow however that Tier 2 should not be allowable.

12 We are not aware of any other jurisdiction that has eliminated Tier 2 as an allowable form of capital for some component of total capital requirements. We note in particular, the proposed approach by APRA raises total capital required by 5% but does allow banks to used Tier 2 capital to meet the higher target. Economists Tailrisk2 contend that this would provide the same benefits, in a crisis, as CET1 capital, but at one fifth of the cost. Given our comments above regarding access to CET1 and AT1 we believe it is important that small banks (if not all banks) continue to have access to an amount of Tier 2 capital. 4.3 Conclusions on Smaller Bank Access to Capital The necessary consequence of materially increased capital requirements must be reasonably practical access to capital. The RBNZ capital review seeks to both materially increase the required level of capital while at the same time significantly decrease the available sources. As currently proposed, that combination is unworkable for the small bank sector. As explained above, ordinary share appetite is likely to be scarce, retained earnings do not represent a meaningful solution, and as it stands there will be limited practical access to alternate forms of capital. The inevitable reality of the forgoing is that small banks will have very limited ability to grow, and increased capital requirements will further restrict already modest dividend policies (for corporatized banks) relevant to small bank owners. Furthermore, there will be fewer levers to pull to recapitalize a small bank in the event of any significant level of unexpected losses. The consequence of that is an investment proposition that may be unattractive to investors – both current and future. The market is currently comprised of large banks with very high expected (and achieved) equity returns coupled with very high dividend payout ratios. Conversely, the smaller bank sector ROE expectations and dividend payout ratios are more modest. As proposed, it is difficult to see how these modest and reasonable expectations can be preserved under the changes. This could fundamentally undermine the economic outlook for the small bank sector. In these circumstances there is a risk that small banks are ultimately absorbed by the large banks (competitively in the market or by acquisition). That would only serve to increase concentration on the existing systemically important banks and lessen competition. While we welcome proposed changes that level the playing field, that outcome is moot if the regime does not reasonably allow access to capital to enable growth. 2. Tailrisk economics; the 30 billion dollar whim. March 2019

13 5.0 Other Components of the Proposals 5.1 D-SIB While all banks, irrespective of size, are important, the failure of very large banks can have a much greater impact on financial stability. The Basel III rationale for the adoption of additional capital requirements for systemically important banks was to acknowledge the negative externalities of the failure of systemic banks on the financial system and to reduce the moral hazard risk arising from implicit government guarantees. Regulators globally have added GSIB and DSIB requirements to calibrate the increased adverse consequences of the failure of large banks on the financial system. Imposed buffers adopted in other jurisdictions vary and some apply a graduated approach. We note the range applicable in the UK and in the US for systemic banks ranges from 1% to 3.5%. NZ (and also Australia) differs from larger markets in that a small number of banks represents substantially all of the market. Thus the rational for adoption of additional requirements for systemically important banks in the local context is arguably stronger than other markets. Considering the risk that the RBNZ is looking to mitigate, the higher levels of concentration of systemically important banks in New Zealand, and the approach taken in other jurisdictions, we believe that the proposed differential between large and small banks of 1% does not adequately reflect the economic impact of the failure of a systemically important bank compared with the failure of a small banks. Particularly given that the largest bank, with assets of $164 billion is 82 times larger than the smallest bank which has $2 billion in assets. It will be important for reporting purposes (e.g. the RBNZ Dashboard) that presentation clearly communicates that the DSIB’s are carrying extra capital because they are systemically important, rather than any inference that the non-systemically important banks are under-capitalized. 5.2 Transition Period The RBNZ proposes a transition period of five years. Our preference is that period be extended to eight years. A longer transition period may be necessary if essentially all required capital is required to be funded from retained earnings, particularly if there is a downturn in the credit cycle during that period. The new proposals bring into question the economic prognosis for the small bank sector. While an extension to the five-year period is helpful it is not a panacea for sub￾optimal regulatory outcomes for small banks which must be remedied as part of the process; otherwise the resulting issues will simply be deferred.

14 5.3 CCB In principle we support inclusion of a Counter Cyclical Buffer that could be temporarily reduced by the RBNZ. 5.4 Leverage Ratio We do not support the implementation of a leverage ratio. 5.5 Other Matters While not specifically contemplated by the consultation, there are two other matters that we believe are worthy of consideration. They relate to Basel III Standardised Risk Weightings and treatment of investments in technology. Our thoughts on those are contained in Appendix 1 and Appendix 2.

15 6.0 Requested Amendments to the Proposed Changes 6.1 Background Small banks are important to the market providing price and customer service leadership. The RBNZ’s stated objective is to reduce the risk to the overall system. Because non-DSIB banks comprise only 12% of the market, it is possible to make changes that enable RBNZ’s overall system objective to be met, while ensuring small banks have the ability to fulfil their role in the market. It would be necessary to amend a number of components to achieve an effective outcome. As stated earlier, we believe there should not be any incremental Tier 2 requirement over and above the proposed Tier 1 targets. However further amendments to the framework for small banks are needed to deliver an effective levelling of the playing field (IRB/Standardised gap), realistically accessible financial instruments that constitute acceptable capital, allowable in meaningful quantities, and a larger DSIB buffer. 6.2 Level Playing Field on Risk Weightings We have concerns that the proposed approach to align IRB and Standardised risk weightings will continue to result in significant differentials. It is important that the risk weightings for each IRB bank are not less than 90% of the Standardised risk weighting for each category. In particular, residential mortgages, SME and rural lending. 6.3 Allowable Instruments (under BS2A) 6.3.1 AT1 Instruments To be palatable to the investor market, as an absolute minimum, AT1 instruments must be callable. We believe that would increase their marketability while at the same time avoid the bail-in characteristics of contingent convertible instruments that the RBNZ may prefer to avoid. 6.3.2 Mutual Instruments It is important that the process to enable issuance of a Tier 1 instrument by a mutually-held bank is completed. 6.3.3 Tier 2 Instruments Small banks should also continue have the ability to issue Non-CET1 in the form of Tier 2. This would reduce system Tier 1 by less than 0.1% while at the same

16 time still result in the increased total capital requirements being met (for both large and small banks). It would also broaden the total sources of capital available to the sector (i.e. by including debt equity capital markets) which will be important given the total market capital requirement, and it would allow large banks and small banks to access different pools of capital for a portion of their requirements. 6.4 Allowable Level of Non-CET1 Capital The allowable level of 1.5% Non-CET1 capital should be increased to at least 2.5% under BS2A. Increasing the allowable amount of non-CET1 to 2.5% represents 16% of the Tier 1 requirement (for a non-systemically important bank), which is not inconsistent with the current ratio. Nonetheless, total required CET1 would still significantly increase from current required levels. Given the relatively small component of the market to which this would apply, total system Non-CET1 would only increase from 1.5% to 1.6%. 6.5 DSIB Buffer The NZ-Owned Banks recommend increasing the DSIB buffer to not less than 2%. 6.6 Summary of Requested Capital Changes The changes requested above are summarized as follows:  Ensuring the IRB/Standardised Output Floor is effective at 90% on a Category basis for each Bank.  Broadening the quantum and available sources:  Increasing allowable non-CET1 capital to 2.5%,  Which could be comprised of — AT1 instruments with features that will be acceptable to markets; and — Tier 2  Increasing the DSIB buffer from 1% to 2%. The following charts present the proposals outlined above (assuming for present purposes total Tier 1 requirements of 15% and 16% are adopted notwithstanding our earlier comments on the appropriateness of those levels).

17

19 Appendix 1 Basel III Standardised Risk Weightings The Basel Committee has recently published revised standardised risk weightings. These risk weightings have international credibility. A number of residential mortgage weightings are lower than the current BS2A risk weightings with the most significant differences at very low LVR levels. We would support adoption of these risk weightings under BS2A as they relate to residential lending. It would also be consistent with the RBNZ’s balanced approach to levelling the playing field: Adoption of Basel 3 risk-weightings for residential mortgages would lower capital requirements for smaller banks, provide more granularity within the standardized system, encourage lower LVR lending and somewhat reduce the current differential between the IRB and standardised approaches. It would also benefit the IRB banks through the operation of a lower effective floor. Adoption of Basel III risk weights represent an enhancement rather than alternative to the proposed approach to level the playing field.

20 Appendix 2 Treatment of IT Investment One of the challenges facing all banks is investment in IT and risk systems. While critical a large proportion of such investments are classified as intangibles and therefore require a deduction from Tier 1 capital. That treatment preserves the principle of recognizing capital only to the extent it has been invested in realisable financial assets that can absorb losses. However, the practical impact is that the regulatory treatment of investment in such infrastructure is punitive from a capital perspective. Conversely, given the essential nature of such investment, it may be more appropriate to incentivise banks that to make such investment (and possibly penalize those who do not). Encouraging investment in core and risk systems will help reduce the probability of financial distress. The rules should be changed to encourage that outcome, rather than solely focusing on what capital resources are available in the event of distress. The deduction to capital required for core IT and risk systems investment is very much an ambulance at the bottom of the cliff. One approach would be to apply a risk weighting to investment in IT and core risk systems – say, 100%, rather than a deduction from capital.

21 Glossary APRA: Australian Prudential Regulation Authority AT1: Additional Tier 1 CET1: Common Equity Tier 1 DSIB: Domestic Systemically Important Bank GSIB: Global Systemically Important Bank IRB Bank: A NZ bank that calculates its risk weighted assets using internally developed models as allowed under RBNZ’s BS2B handbook NZBA: New Zealand Bankers Association QIS: Quantitative Impact Study ROE: Return on Equity Standardised Bank: A New Zealand bank that calculates its risk weighted assets using scheduled risk weightings prescribed in RBNZ’s BS2A handbook

Doug Widdowson Good afternoon. I attach my submission. I have no objection to it being made publicly available. Regards Doug Widdowson OIA s9(2)(a)

Ian Woolford Financial System Policy and Analysis Department Reserve Bank of New Zealand 17/5/2019 Bank Capital Review Submission Thank you for the opportunity to comment on your proposal. I am comfortable that this submission can be made public if required. My views are those of myself only, and no one else. Please excuse any errors of grammar. My commentary is non-technical in nature and reflects my position as a consumer of financial services with some understanding of the operations of the prudential and regulatory framework for banks, and how these are interpreted within the industry. Firstly – I must clearly and unequivocally state that I support the proposals both in terms of approach and in terms of the absolute value outcomes that are being presented. What I am commenting on are merely thoughts at the margins, and views on potential impacts to consumers such as myself. Risk Appetite - I agree that one of the expectations of the regulator of financial institutions is to ensure that social harm arising from failures in their regulated entities is minimised. Regulation only exists because society has agreed that the market itself cannot fully address the impacts and outcomes of decisions made -usually because of asymmetric power and information. In the case of the financial system – most consumers of the system would have no idea about its functioning and operations – and therefore would not be effective in holding owners to account. Therefore, the Reserve Bank is essential to perform such a function for society. Furthermore, most of these consumers would be unlikely to respond to any consultation document – leading to asymmetry in responses to questions asked by the RBNZ as well. However, these consumers are the very people that are hurt when banks and financial institutions fail – not the wholesale market, and not sophisticated investors – think for example of all those impacted by the finance company failures of a decade ago. Therefore, the Reserve Bank needs to not only ensure that such failures are kept to a minimum and but also recognise that that commentators in general would tend to support a bank led approach to capital management rather than a society led approach. I believe that increased shareholder capital is the most effective means of ensuring that society’s implicit risk appetite can be met and support your conclusions in that area. Impact of the proposed increases – there is no denying that one of the impacts of the proposed requirements to increase bank capital will be a push by banks to improve their credit margins to build their retained earnings organically, rather than through a capital injection from shareholders – either directly via additional capital raising, or indirectly via reduced dividend flows. This could have negative consequences for the NZ economy. However, that argument ignores the following three items that would (in my opinion) put any damper on the ability of banks to increase borrowing rates, or reduce deposit rates in an unconstrained manner:  The current state of the NZ economy – which sees the RBNZ pushing as many of the tools that it has at its disposal to stimulate spending through monetary policy – eg OCR at unprecedented low rates – and the assessment that demand for credit will remain muted;  The fact that shareholders will be still focussing on achieving some return, and the existence of a strong and consumer focused competition watchdog within the NZ regulatory system– while an informal cartel may be able to reduce the supply of credit over the short term – this is doomed to fail – either through demands of shareholders who will still demand a return for the level of risk being taken – or regulatory imposts of the competition watchdog;

 The ability of sophisticated NZ corporates to access international markets directly and the existence of other banks or NBDTs that could support the consumer end of the market in the short term. Secondly, credit rationing may be another consequence of the regime moving forward – either directly, or via pricing – where lending which was previously available in unconstrained amounts to sectors of the economy due to their minimal impact on capital levels, and the absolute low level of capital required – will now be more carefully assessed. I do not believe that this necessarily a bad thing. In fact, I believe that lending decisions that have a material impact on the level of capital being employed will lead to excellent financial decisions being made – in terms of focus now being on lending to sectors that can generate the greatest margin for banks. This by its nature means the proposals would have to be the most productive sectors of the economy to enable appropriate income generation for all stakeholders to cover such costs and will lead to better investment in productive assets in NZ, and thereby increase the overall wealth of the nation. Furthermore, a revision of focus away from non-productive asset funding to funding genuinely productive assets must be positive – and bank focus will be on higher margin lending – with the lower margin lending on non-productive assets (such as housing or dairy intensification) being the focus of entities that can accept lower returns because of their business model. Furthermore, asset price inflation will also be discouraged – again a positive for the future stability of NZ. Higher Capital for D-SIBS – I am not convinced that an additional add on for capital for D-SIBS is an ideal solution for the problem of systemic importance. This implies that the regulator believes they are too big to fail and therefore will be bailed out in a crisis. I am sure that that is not the intent of the regulator – given its approach to crisis management through OBR and the reluctance to assess deposit insurance. However, the importance of the systematically important banks to overall society is not to be downplayed – but so too is their co-dependence on each other. This issue is not so much around each being too big to fail, it’s that these together are too small within the NZ economy to be able to absorb the failure of one of them without all being significantly weakened to the point of failure – leading to overall systemic crisis. Because of this, I believe that there is a strong case for having a higher level of accountability to the regulator (and in fact to each other) in terms of their operational capability and capacity and exposures that would lead to systemic failure events. This focus could more effectively be dealt with under a specific requirement to have an assessment of systemic importance management and risk dealt with under the ICAAP regime – and that the requirement under that regime would be to require an add on to capital of at least 1% of RWA unless the Bank can prove that their processes can reduce the risk level to a lower amount – or a greater amount if necessary (and that this be the subject of audit and director sign off). In respect of the identification models – simplicity has its attractions and a focus on absolute asset size is important – however – the multifaceted approach suggested in the consultation paper on D￾SIBS is supported – with the caveat that customer numbers (as linked to number of voters) will also need to be considered as any intervention will always be a political decision in the final analysis – as direct intervention by the RBNZ would require sign off by the Minister. Countercyclical Capital Buffer – while I understand the conceptual requirements for considering a countercyclical capital buffer and believe that it is a useful tool in the arsenal of capital management, once imposed it can never really be removed – and especially in times of crisis. Firstly – ratings agencies would ignore its removal; Secondly, depositors would ignore its removal, and thirdly, its removal would precipitate a banking crisis. Theoretically it makes sense – but it is a nonsense to say it can be removed – really all that it should be is an early warning indicator of enhanced regulatory oversight. I do not believe any amount is necessary for this buffer – but if it is merely for a reporting threshold, (and shareholder distribution control threshold) then 1.5% is appropriate.

Tier Two Capital – I support the RBNZ’s focus on going concern capital rather than gone concern capital, but I do believe that tier two capital and AT1 does have some role in the market in respect of improving efficiency. Firstly, as an adjunct for loss absorbency in times extreme stress – but only on condition it converts to common equity if activated – ie the debt is only preferential to existing shareholders, not shareholders put in by a statutory manager or other agency. Secondly, it is limited to funding the countercyclical capital buffer and a percentage (say 25%) of the conservation buffer, and once absorbed in supporting that, it converts to common equity. Thirdly, while there is some argument that other corporate structures such as cooperative companies, building societies and trustee banks are absolutely reliant on these structures to ensure appropriate capital levels, there is no reason for any of these corporate forms to only be reliant on this – they can choose to issue equity and retain their corporate form, and they can slow their growth down to levels that are sustainable. In fact, given my earlier argument about focus moving away from their traditional areas of excellence, they may find it easier to internally generate capital anyway. Escalating Supervisory Response – I support this approach Output Floor for IRB – I absolutely agree with the RBNZ on imposing an output floor on model approaches of the larger banks. The current regime has allowed them to pick and choose what their capital levels should be based on their own and their parent’s requirements at the time, rather than the needs of the NZ financial system and society as a whole. However, I believe the output floor should be set at 100% of the standardised model approach. I am keen for this approach as I believe it will level the playing field between the large model banks and the smaller standardised banks, and the even smaller NBDT sector. This would encourage more competition, and fairer pricing. Currently the system structurally favours the larger banks, meaning that the smaller banks and NBDTs are always playing catch up, and are less profitable for shareholders because of the greater amount of capital that must be employed. However, it must be accepted that the internal models, if appropriately managed and calibrated, and constantly back tested may be slightly better at predicting failure for capital absorption than the standardised approach. Therefore, I would propose that advanced banks that have model approvals be able to add back, through their ICAAP process, the benefits to capital that their models bring – but this add back be limited to 85% of the standardised model. This would serve three purposes. Firstly – reward the large banks for the work that they are doing in effectively managing risk on a more granular basis that the simple model allows. Secondly, support and improve the disclosure regime so that wholesale and other funders, and ratings agencies are able to clearly see the benefits that the models generate, and thirdly, focus director attention clearly and unambiguously at the risk reduction that these models present, and ensure that they are comfortable with the control processes in place to deliver those risk reductions and allow them to sign off on their accuracy. In addition, the Reserve Bank should provide an absolute requirement that internal models and the outputs of those models are subject of audit review and sign off. The current approach where they are excluded from review is both disingenuous and effectively a licence to game the system. A condition of any model approval moving forward is that it should be auditable, and that an audit of the outputs should be conducted at least annually and that performance results should be reviewed by the auditors as part of the audit. This could be conducted in a manner like that undertaken by the ratings agencies in their transition analyses. These are conducted annually on their ratings models and made publicly available. These assessments measure the stability of the model and the relative accuracy of the model – both key in any advanced capital model approach. Other points for consideration – One of the key benefits of introducing this regime and increasing the absolute level of capital for all banks is the improvement in outcome that it will deliver for NZ retail depositors. Currently, they are a distant last in any queue if a bank gets into trouble, and even more so with Australian depositor preference. This ranks any Australian depositor of an Australian Bank ahead of any New Zealand depositor – and therefore allowing

Earl White Subject: Thoughts on Capital Review Background These are personal views, not the views of my employer Bancorp Treasury Services Limited. By way of background, I have been involved in financial markets for over 35 years in New Zealand and overseas and started in the banking sector in New Zealand as a foreign exchange trader only months before the float of the NZ dollar in 1985. Since 1990 I have been involved in the ‘Treasury Advisory’ area and currently I personally have responsibility for supplying advisory services to clients with total debt portfolios in excess of $10.0 billion and FX exposures in excess of $3.0 billion. I also advise on over $1.5 billion of cash and fixed interest investments. I am a CA member the Chartered Accountants of Australia and New Zealand, have a Bachelor’s Degree in Finance from Massey and a post-graduate Diploma in Finance from Auckland University. I am a CFTP (Senior) member of the FTA (Australia) and a member of INFINZ. Comments on the Reserve Bank’s Capital Review Paper 4 My comments are not going to be in the form of detailed analysis, rather a high level view my thoughts on your proposal and why I support the proposed changes. I am sure you will be swamped with analytical submissions where the banking sector will have an army of ‘bright young things’ modelling a vast array of doomsday scenarios to try and turn public opinion and those of our politicians, against your proposals. My key points in relation to increasing capital are: -  The ‘Big Four’ Australian owned banks have an implied underwrite from New Zealand taxpayers as they are in the ‘too big to fail’ category that is a fact of life after the GFC;  I have little confidence that in the situation of deep financial stress in Australia,  Australian politicians would accept outflows from its banks to prop up our financial system;  Bank shareholders are making excess returns compared to most other areas of business and their leverage levels are in stark contrast to the gearing constraints they have placed on a wide range of borrowers since the GFC;  I strongly believe we need much more shareholder skin in the game, here, not implied by parentage. I think the proposal you have put forward goes a long way to easing these risks. In relation to the arguments being put forward around how your proposal will lead to massive increases in margins, lending contractions etc., I make the following points:-  I continue to see very little evidence that the majority of the banking sector in New Zealand takes into account its implied underwrite and also I continue to see little evidence that poor decision-making is lessening and behaviour to customers and the effective monitoring of risks being taken is improving to be a material offset to the risk taxpayers potentially face from reckless bank behaviour,  I continually see short termism in decision making lending behaviour and pricing and flip flopping on supposed core strategy changes if they seem to contract revenue in near-term;

 In almost all distressed circumstances banks still aggressively protect their perceived position, using their scale and deep pockets to engage in legal battles that often exhaust any customer pushback;  Banks happily offload assets that they are uncomfortable with, often by lead managing a bond issue, to retail investors locked into (often) their Kiwi saver funds, at pricing they wouldn’t lend at;  This helps sustain the profitability that bankers argue is down to their vast skills. However, as receiver of large bonuses when in banking I did and still hold the view that the underpinnings of material performance based remuneration is just a mirage. Banks make money often despite performance of staff, especially in the highly paid Treasury and Corporate Finance areas and of course at the rarefied executive suites;  Because of the special position they hold in the economy the majority of profit is from the franchise, the machine but the myth of special skills has now been taken as fact and accepted by regulators, shareholders and customers. The ‘excessive bonus levels compared to the real world are an ongoing perpetuation of the myth that staff somehow create the massive profits by their intellect. While this is true for a very few the ‘special’ skills bankers believe they apply are vastly overestimated.  This means that even before shareholders take their returns a significant portion of potential equity is taken by employees, as cash and equity.  Before the GFC between 2002 and 2007 Australian based banks had an average ROE peaking at 20.4%. At this time the RFR (10 year bond) was averaging around 6.50%. After the GFC ROE fell to around 14.0% by as capital requirements increased. RFR circa 3.0%. ROE is still well into double digits at time RFR is approaching 2.0%.  In New Zealand ROE as per your website for big four ranges from 13.1% to 15.3%. The RFR here (5 year bond used by ComCom for regulatory WACC calculations) has averaged around 2.5% over last 3 years and is around 1.80% currently. Regulated entities, Power Gas etc. (indication for airports) had Vanilla WACC midpoints from ComCom for 2019 from 5.22% (Transpower) to 6.30% for airports. It will be falling further.  In my view the Big 4 have the same ‘monopoly’ positon as many of the above and their argument that it is unacceptable for shareholders to accept lower returns/less gearing is self-serving and plain wrong. In summary I believe the proposed capital changes are vital for the ongoing health of the New Zealand financial system and also to protect taxpayers from another bailout. I also believe the unwillingness of bank shareholders to accept that they should apply ‘excess’ profits to reduce leverage is self-serving and is not supported by the returns now made by the rest of the business sector. There are large areas of expense the banks can prune to maintain returns AND build capital without arbitrarily trying to maintain their excess profits by pushing materially higher margins onto customers. Regards Earl White

Fax McKernan No less than 50% OIA s9(2)(a)

From: Nick Clark To: Capital Review Subject: Federated Farmers submission on Bank Capital Requirements Date: Thursday, 18 April 2019 1:33:02 PM Attachments: 181207 Federated Farmers Banking Survey November 2018 (Research First).pdf 190418 Final Submission on Bank Capital Review.pdf Dear Reserve Bank of NZ Please find attached a copy of Federated Farmers of NZ’s submission on the Reserve Bank’s Capital Review Paper 4: How Much Capital is Enough. Also attached is a copy of the report from Federated Farmers’ November 2018 Banking Survey, which is referred to in the submission. Federated Farmers would welcome the opportunity to discuss the points we have made in our submission. Kind regards Nick NICK CLARK MANAGER GENERAL POLICY Federated Farmers of New Zealand PO Box 20448, Christchurch, New Zealand         www.fedfarm.org.nz This email communication is confidential between the sender and the recipient. The intended recipient may not distribute it without the permission of the sender. If this email is received in error, it remains confidential and you may not copy, retain or distribute it in any manner. Please notify the sender immediately and erase all copies of the message and all attachments. Thank you P THINK BEFORE YOU PRINT This email communication is confidential between the sender and the recipient. The intended recipient may not distribute it without the permission of the sender. If this email is received in error, it remains confidential and you may not copy, retain or distr bute it in any manner. Please notify the sender immediately and erase all copies of the message and all attachments. Thank you.

2 SUBMISSION TO THE RESERVE BANK OF NEW ZEALAND ON CAPITAL REVIEW PAPER 4: HOW MUCH CAPITAL IS ENOUGH?

1. INTRODUCTION 1.1 Federated Farmers welcomes the opportunity to submit to the Reserve Bank of New Zealand on its Capital Review Paper 4: How Much Capital is Enough? 1.2 Agriculture is a significant contributor to the economy:  For the year to June 2018 62.2 percent of the value of New Zealand’s $55.5 billion merchandise exports came from agricultural products1 .  Agriculture’s direct contribution to GDP is around 5-6 percent but that does not include its indirect contribution through food processing and services used by farmers2 .  As at February 2018 53,500 agricultural businesses employed 84,400 people (excluding business owners)3 .  Since 1978 productivity in the agricultural sector has grown faster than for the economy as a whole4 . 1.3 Farmers are also important players in the financial system. As at February 2019 agricultural sector debt totalled $62.8 billion5 and farmers also have substantial financial assets, including bank deposits. Dairy farm debt, which makes up about two￾thirds of total agricultural debt, is regarded by the Reserve Bank to be one of the key risks to the financial system (the others being the global economy and the housing market). 1.4 Federated Farmers takes a close interest in banking and financial policy and recently we submitted on both phases of the Reserve Bank Act Review and on a Farm Debt Mediation Bill. We also undertake six-monthly Banking Surveys, which take the pulse of farmers’ relationships with their banks. 1.5 This submission makes general comments on banking and farming and comments on the proposals contained in the consultation paper. We agree that it is important for bank capital requirements to safeguard the financial system and the wider economy. However, we are concerned about the impact that significantly increased capital requirements would have on farmers and the wider economy through increased costs of borrowing and tighter conditions for lending.
2. RECOMMENDATIONS 2.1 Federated Farmers recommends that the proposed increases in bank capital be revisited to ensure: (a) A more appropriate level of risk tolerance is chosen; (b) A robust and independent cost-benefit analysis is undertaken; and (c) Transitional arrangements allow for a more measured, gradual pace of change, thereby easing costs of getting to desired new levels for bank capital.

1 MPI’s Situation & Outlook for Primary Industries for June 2018 and Statistics NZ’s monthly Overseas Merchandise Trade Statistics for June 2018. 2 Statistics NZ GDP quarterly statistics (most recent is for December 2018 quarter). 3 Statistics NZ annual Business Demography Statistics (most recent is for 2018, as at February) 4 Statistics NZ annual Productivity Statistics (most recent is for 1978-2017) 5 Reserve Bank of NZ monthly Sector Credit Statistics (most recent is for February 2019)

3 3. GENERAL COMMENTS ON BANKING AND FARMING 3.1 Federated Farmers takes a close interest in banking issues. Farming has been and will continue to be reliant on bank capital for investment to grow the business, become more productive and to respond to environmental requirements, for seasonal finance, and in some cases for survival. For some farmers, interest can be the largest single farm expense and with agricultural debt now approaching $63 billion, a 1 percent change in interest rates is worth nearly $630 million per annum to farmers. Banks’ decisions can have a huge impact on farm businesses and farming families’ economic and social well-being. 3.2 Since 2000, agricultural debt has increased dramatically. Figure 1 below shows agricultural debt rising from $12 billion in January 2000 to $62.8 billion in February 2019, a five-fold increase. Other sectors have also seen increases over that period but not to the same extent – household and personal consumer debt has increased nearly four-fold and business debt has increased nearly three-fold. Source: Reserve Bank of NZ Sector Credit Statistics 3.3 Dairy farmers hold more than $40 billion of debt, around two-thirds of total agricultural debt. There was very rapid growth in dairy (and agricultural) debt during the mid-late 2000s driven largely by expansion of dairying from new conversions but also investment in existing dairy farms to make them more productive and to meet environmental requirements. After a flat period in the years after the Global Financial Crisis, dairy debt increased again in 2014-16 as banks supported farmers through a prolonged downturn in dairy prices. From 2017-18 annual growth in agricultural debt moderated to around 2 percent as the post-2016 recovery in dairy incomes prompted banks to wind-back that support. Over recent months annual growth has quickened again to 3.6 percent but this is still well below that for the housing and business sectors6 . 3.4 For some time the Reserve Bank has included dairy sector indebtedness as one of the financial sector’s key vulnerabilities. Its November 2018 Financial Stability Report observed that:

6 Ibid. To compare, for the year ended February 2019 the annual growth rate for housing debt was 6.2 percent and that for business debt was 5.5 percent. Personal consumer debt grew more slowly at 2.0 percent. 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan 2018 Jan 2019 Agricultural Debt 2000-19 ($ million)

4 “Indebtedness remains high in the agriculture sector, particularly for dairy farms. While the sector is currently profitable, commodity prices are volatile, and the sector remains vulnerable to another downturn. In addition, there are a number of longer-term challenges facing the sector, including managing the risks of climate change. It remains important for the sector as a whole to continue to repair its balance sheets, to restore resilience to a future downturn and to allow farms to invest to adapt to medium￾term challenges.” 3.5 As well as climate change, other medium-term challenges include Mycoplasma bovis and tighter regulation of freshwater management. The Reserve Bank considers the sector’s debt levels limit its capacity to withstand market downturns and invest to adapt over the longer term. It is keen for dairy farmers to pay down debt. 3.6 In our recent six-monthly Banking Surveys, Federated Farmers has detected a tightening of conditions faced by farmers, erosions in the levels of farmer satisfaction with banking relationships and with bank communication (both off high levels), and an increase in perceived pressure faced by farmers, especially by dairy farmers and even more so by sharemilkers. For more information, please refer to the report from the November 2018 survey attached as an appendix. The next survey will be undertaken in May 2019. 3.7 Historically low interest rates have been very helpful for farmers coping with high debt levels in a challenging environment. Any large increases in interest rates will cause stress for many farmers and severe distress for some. We are therefore anxious about the potential increases in lending rates and tighter credit conditions arising from the review’s proposed increases for bank capital. 4. SPECIFIC COMMENTS ON THE PAPER 4.1 The Reserve Bank is concerned about the potential for bank failures to impose significant economic and social costs. It considers that if banks have too little capital it increases the risk of bank failure, which could impose significant economic and social costs and adversely impact on people’s wellbeing. 4.2 Banks are required to hold a ratio of 10.5 percent capital to risk-weighted assets7 . The four largest banks (ANZ, ASB, BNZ, and Westpac) are authorised to use an Internal Ratings Based (IRB) approach, which reduces this ratio, but smaller banks need to comply with the standardised approach. 4.3 The Reserve Bank considers current bank capital requirements to be insufficiently conservative and it wants them tightened to the extent that failures would occur very infrequently, with once every 200 years quoted. Risk tolerance is a crucial issue for setting capital requirements. Whether ‘one in 200 years’ is appropriate is in our view highly debatable and we discuss this further in paragraphs 4.18 to 4.20 below.

7 This 10.5 percent is broken into three categories – 2 percent Tier 2 capital, 6 percent Tier 1 capital, and 2.5 percent Conservation Buffer.

5 4.4 The Reserve Bank believes a ‘one in 200 years’ approach needs an increase in the capital ratio to 18 percent for large banks8 and 17 percent for small banks9 . Such requirements would put New Zealand among the more conservative countries for bank capital and will make them more conservative than Australia’s. 4.5 Transitioning to this more conservative approach will be a particular challenge for the four large banks, especially as their IRB models have to date allowed them to hold less capital. For the other banks using the standardised approach the changes will not be so significant and indeed many are already holding amounts of capital close to the proposed levels. 4.6 According to the Reserve Bank’s analysis, the four large banks will need to increase their Tier 1 capital by $12.5 billion while the other banks will need to increase theirs by $0.4 billion. These amounts do not include the replacement of outstanding Tier 1 capital that would no longer qualify under proposed changes to the capital framework, which will cost around $6 billion for large banks and $0.15 billion for other banks. This means the total cost to the banking sector will be close to $20 billion. 4.7 The Reserve Bank estimates that capital requirements would have to increase between 20 percent and 60 percent, representing about 70 percent of the banking sector’s expected profits over a five-year transition period. It would also increase banks’ average funding costs and these higher costs would be passed on (in full or in part) to bank customers through a combination of reduced deposit rates and higher lending rates. The Reserve Bank thinks the additional premium between the costs at which banks borrow and lend will be modest at between 20 and 40 basis points. Other market commentators have suggested the cost could be much higher, with KPMG estimating a range of 80 to 125 basis points and UBS estimating 125 basis points. 4.8 It is not clear whether average cost estimates would apply equally to housing, agricultural and business borrowing given the different characteristics (including risk weightings) for each sector but we are concerned that the impact could be particularly pronounced for riskier sectors like agriculture. Putting aside this uncertainty, Federated Farmers is very concerned about the wide range of cost estimates and what they could mean for bank customers. With the agricultural sector having close to $63 billion in debt, the Reserve Bank’s modest cost estimate would cost the sector $125- 250 million per annum while market commentators’ worst-case scenario would cost the sector close to $800 million per annum. 4.9 As well as higher costs of borrowing, Federated Farmers also expects banks to become more conservative in their lending and to apply more restrictive lending conditions to both new and existing lending, especially for agricultural lending. Agricultural lending is already higher risk weightings under Basel III and we fear that conditions could become even tougher under these proposals. While conservative lending is not necessarily a bad thing, a balance is needed to ensure that an overly risk-averse approach does not cause a credit crunch and that existing borrowers are not put under undue pressure, which would certainly not be good for their ‘wellbeing’.

8 This 18 percent is broken into five categories – 2 percent Tier 2 capital (unchanged), 6 percent Tier 1 capital (unchanged), 7.5 percent Conservation Buffer (up from 2.5 percent), 1 percent Domestic-Systematically Important Bank Buffer, and 1.5 percent Counter-Cyclical Buffer. 9 This 17 percent is broken into four categories. The difference compared to the large banks’ 18 percent is due to the small banks not requiring to hold the 1 percent Domestic-Systematically Important Bank Buffer.

6 4.10 Further to this point, some banks might even consider exiting certain types of lending, including agricultural lending. A recent article in the Australian newspaper speculates on this and the text of it is reproduced below10 . Banks ponder trans-Tasman futures as NZ raises capital requirements Australia’s top four banks are believed to be continuing to assess their strategies for operations across the Tasman as they brace themselves for higher capital requirements being handed down by the Reserve Bank of New Zealand. While one school of thought is that the banks could be mulling a decision to hive off the subsidiaries altogether, the thinking among many in the market is that such a move would be highly dramatic and unlikely, given that they are strong providers of revenue and seen as core to their operations. However, there is also discussion that at a high level, the financial powerhouses could be examining whether to scale back certain offerings or sell off loan books as return on equity remains a key focus, particularly for ANZ boss Shayne Elliott. One idea doing the rounds is that Westpac and the National Australia Bank subsidiary, Bank of New Zealand, would sell down their agriculture lending books that are estimated to be worth about $700 million and $1 billion respectively. But some say that agricultural lending would be tough for a lender that was not one of the top four banks because it was difficult to do without a banking licence. However, others say that on the contrary, the NAB is considering a move to distance itself from all activities across the Tasman except largely small business lending and agriculture lending, although a NAB spokesman says this is not the case, while Westpac is looking at a partial selldown — probably through an initial public offering. But one analyst says that this option for Westpac would not solve all of its problems and would come with much risk. There is also speculation that the Commonwealth Bank’s New Zealand subsidiary ASB could be looking at an exit of all elements of lending except mortgages. ANZ’s intentions remain unclear. In Australia, some question whether NAB is also looking at narrowing its focus to small business lending and agriculture, but still embarking on large-scale infrastructure funding. It comes at a time when all banks are examining their portfolios to determine where they can receive an adequate return on equity following the royal commission into banking. The plan remains to simplify and focus on core operations. The new minimum capital level requirements to be introduced by the Reserve Bank of New Zealand, which will soon come into force, will substantially lower return on equity levels for banks in New Zealand, leaving their Australian owners assessing if they are better off selling the operations and reinvesting the money elsewhere.

10 Banks ponder trans-Tasman futures as NZ raises capital requirements, The Australian, 4 April 2019.

7 ASB Bank accounts for about 6 per cent of CBA’s earnings and about 12 per cent of revenue, while BNZ generates 14 per cent of earnings for NAB. For ANZ, New Zealand is about one-third of its earnings. Return on equity for New Zealand banks would be about 7 per cent under the law changes, compared to about 8 per cent for NAB and 11 per cent for CBA, at a time banks are looking to boost ROE levels to about 15 per cent. 4.11 While this article is speculative, if some or all of what is suggested comes to pass it could be highly disruptive and costly to bank customers (including farmers) and to the wider economy – regional and national. 4.12 For farmers an increase in costs along the lines of the Reserve Bank’s modest estimate would be unwelcome enough while the worst-case scenario would be devastating. More restrictive credit conditions and possible disruption from banks recalibrating their operations would also have adverse effects on farmers. 4.13 The Reserve Bank should recognise that farmers have been contending with major policy challenges around  Climate change;  Freshwater management;  Indigenous biodiversity;  Tax, including the threats of a capital gains tax and environmental taxes (albeit now receded since the Government decided not to proceed with a capital gains tax or – at least in this term of Parliament – water resource rentals and fertiliser tax);  Employment relations; and  Immigration. 4.14 Farmers are facing these generally negative policy challenges while exposed, without any subsidies or protection, to  The ups-and-downs of the global economy and therefore commodity prices, interest rates and exchange rates;  The vagaries of the weather; and  The ever-present threat of weed, pest and disease incursions. 4.15 Taken together these challenges are having an adverse impact on farmers’ wellbeing. Many farmers are feeling beleaguered and embattled and are not feeling understood, let alone supported, by the public, the media and by politicians. It is little wonder that various business and farming confidence surveys (including Federated Farmers’ own six-monthly Farm Confidence Surveys) are so negative and that word has been filtering through of farmers under severe stress. In the current climate, farmers do not need the added spectre of significantly higher borrowing costs and tougher lending conditions especially when imposed on them by policy-makers. 4.16 We agree that the Reserve Bank’s Official Cash Rate (OCR) could be reduced to help soften the blow and we think this will probably be required if the changes drive up interest rates and otherwise restrict credit. However, assuming that OCR cuts will be passed on to consumers (which is not a foregone conclusion), we note the OCR is already very low by historical standards and the room to cut it deeply is limited. Furthermore, a large cut could reduce the OCR’s future efficacy if subsequently economic conditions warranted further cuts (i.e., there would be little left in reserve). 4.17 Federated Farmers therefore considers that the Reserve Bank must do three things as a high priority:

8 4.18 Firstly, the Reserve Bank needs to revisit its risk tolerance leading it to a ‘one in 200 years’ approach. It is important to strike a balance between the costs and benefits of a particular risk appetite. Risk can never be completely eliminated, even at great cost, and there will be a point where the added cost of reducing risk begins to outweigh the added benefits of the reduced risk. We believe ‘one in 200 years’ will be beyond that point, especially if market commentators’ estimates of the costs are more accurate than the Reserve Bank’s. 4.19 We note the discussion on risk appetite in the consultation paper and the analysis of international findings and further information released subsequently. We acknowledge that in the New Zealand context there are some specific risks to financial stability, such as exposure to the global economy, housing debt and dairy debt. Yet all countries have their own specific risk factors and in New Zealand’s case there are also strong compensating factors, particularly our high quality institutions (including strong frameworks for monetary and fiscal policy), which should not be underestimated. We believe these should enable us to take a less risk averse approach than proposed. 4.20 Federated Farmers therefore considers a ‘one in 100 years’ approach to be more appropriate. 4.21 Secondly, given the wide range in cost estimates, the Reserve Bank needs to commission independent economic research to narrow the range in cost estimates and to specify specific estimates for housing, agriculture and business borrowing. It should then apply the results to a macroeconomic model that will show the impacts on the national economy as well as sectors (including agriculture) and regions and assess them against the benefits of taking a more conservative approach. 4.22 Thirdly, if after this additional work it decides it should proceed, the Reserve Bank needs to review the proposed transition period to ensure it allows enough time for the banking sector to meet any new requirements in a measured way that does not impose unreasonable costs on their customers and the economy. The higher the bank capital requirement the longer the transition period should be. 5. ABOUT FEDERATED FARMERS 5.1 Federated Farmers is a member-based organisation that represents farmers and other rural businesses. Federated Farmers has a long and proud history of representing the needs and interests of New Zealand’s farmers. 5.2 The Federation aims to add value to its members’ business. Our key strategic outcomes include the need for New Zealand to provide an economic and social environment within which:  Our members may operate their business in a fair and flexible commercial environment;  Our members’ families and their staff have access to services essential to the needs of the rural community; and  Our members adopt responsible management and environmental practices.

From: fiona.g To: Capital Review Subject: Bank capital review Date: Friday, 12 April 2019 2:48:30 PM To who it may concern, I am a member of the public with no direct connection to the banking industry. I would strongly support the introduction of much higher capital requirements, as I believe the banks have been too light on holding large reserves, as the more that is set aside, the less they can profit. These low reserve requirements have been vastly in their favour as they have been making very large profits from this low reserve requirement. I think the ratio should be between 25 - 35 % of the total that should be held back. This may also prevent the ridiculous issuing of interest only loans that profit the banks, with over leveraged investors or home “owners” beholden to the banks; taking all the risk of capital onto the investors, whilst the banks profit by holding the property as collateral should things take a turn for the worse. This overstimulation of certain sectors of the economy has incentivised lending to property over the last while, which has resulted in driving up the costs of doing this - namely housing prices. So there is a massive disconnect to reality as the banks are forcing up the prices in a very over leveraged market to the point where there is a very real threat of homeowners having to take the brunt of the fall, which will come, it is just a matter of when. By limiting the banks ability to pump this market, it effectively curtails the value price increase in the assets being bought and sold. Also I find it preposterous that the bank can dictate to homeowners around their affordability to pay these mortgage payments, expecting the 20% deposits or in some cases 40%, when they themselves are the principle cause of the price rise in the first place as they have an ability to take extreme risk with other peoples money. The irony is not lost on me that the banks are leveraged to the tune of 92% in some cases (perhaps I have this wrong, I do wish it was not true), would they ever allow their clients this largess? I doubt it. Essentially they are gambling with other peoples money and their futures. I would also advocate for the banks to hold part of this reserve in gold, as this has no counter party risk. As well, to separate the banking industry that holds savers deposits from the institutions that can make money on peoples savings. I am sure there is a better set of terms for this, but I do not know them. Thank you for taking the time to consider my input, and I do hope it furthers the decision to curtail the current very low reserves banks have got away with for so long. Regards, Fiona Gray.

From: Shaun Roberts To: Capital Review Cc: Matt Sturmer; Brent Stephen Subject: Bank capital review Date: Friday, 17 May 2019 4:08:47 PM Attachments: Submission on cap review paper 4 public version.pdf Submission on cap review paper 4 confidential version.pdf Hi Ian Please find attached our submission in relation to the RBNZ’s Capital Review Paper 4. We have attached two versions of our submission, a confidential version with signatures and a public version without. Kind regards Shaun Shaun Roberts Director, Head of Debt Capital Markets Level 21 157 Lambton Quay, Wellington Caution:

This message and accompanying data may contain information that is confidential and/or subject to legal privilege or copyright. If you are not the intended recipient you are notified that any use, dissemination, distribution or copying of this message or data is prohibited. If you have received this email message in error, please notify us immediately and erase all copies of the message and attachments. Email communications are not secure and are not guaranteed by Forsyth Barr Limited to be free of unauthorised interference, error or virus. Anyone who communicates with us by email is taken to accept this risk. This email, and any attachments, may contain views or opinions that are those of the sender and not necessarily the views or opinions of Forsyth Barr Limited.

While every effort has been made to obtain accuracy, no liability is accepted for any errors or for opinion expressed. Forsyth Barr Limited Level 21 Vodafone on the Quay 157 Lambton Quay PO Box 5266 Wellington 6145 T: (04) 499 7464 F: (04) 495 8198 17 May 2019 Ian Woolford Financial System Policy and Analysis Department Reserve Bank of New Zealand WELLINGTON By email: CapitalReview@rbnz.govt.nz Dear Ian SUBMISSION ON CAPITAL REVIEW PAPER 4: How much capital is enough? We welcome the opportunity to submit on the Review Paper referred to above (dated January 2019). Consistent with our submission on earlier capital review papers, we have limited the submission to our views on those areas in which we believe that we have particular experience. In addition, we have made several broad-based observations of other aspects of the proposed reforms, and on some of the context within the Review Paper. As background, Forsyth Barr has been an active participant in the Additional Tier 1 and Tier 2 public market over recent years, both in relation to syndicate roles on primary offers and secondary market trading. In addition, we are one of the leading participants in the wider New Zealand equity and debt capital markets. As such, we believe that we are well positioned to provide feedback on the subjects at hand from a markets-based viewpoint. In summary, our key points are: ● we recommend that Tier 2 be maintained in bank capital requirements, as Tier 2 capital provides numerous advantages (outlined below) at negligible cost to the wider economy; ● we also recommend that the details around the final form of Tier 2 capital be consistent with the term structure of the current regime (ie, 10 year term, with call no earlier than 5 years). This will improve the feasibility of the instrument, create a level playing field, whilst also ensuring a smooth transition from the existing regime; ● more generally, we submit that any decisions regarding the capital adequacy framework should also have regard to the role of regulatory capital in the wider market and economy. Specifically, development of local capital markets can reduce the duration and severity of any future bank crisis, and hence measures to encourage banks to list either/or equity/debt capital locally should be considered. These could be in relation to concessions on capital ratios, or alternatively risk weights/floor;

2 ● the development of the regulatory capital market has played an important role in the local capital market. The Government has a Building Capital Markets work stream in its Business Growth Agenda, and the progress of the regulatory capital market has assisted in improving our public capital market; and ● suggest that RBNZ reconsiders the inclusion of redemption features in perpetual preference shares. Tier 2 capital feedback – maintenance of Tier 2 capital layer We recommend that a Tier 2 capital layer be maintained in the capital requirements for banks. Tier 2 plays a key role in boosting overall capital levels, providing senior lenders with an additional buffer of lower ranking capital, at a very efficient cost. Maintaining a Tier 2 layer enables the RBNZ to more readily maintain higher total capital ratios at levels comparable to (or above) other markets, and is also consistent with other jurisdictions (including Australia). We also suggest RBNZ could consider widening the prescribed Tier 2 layer to deliver its total capital targets at a minimal cost to the wider economy. We note that Australian authorities have proposed increasing their Tier 2 layer to boost capital ratios in that market: ● in the Review Paper, the RBNZ asserts that “Tier 2 capital can support resolution actions, but not the on-going operation of the bank”. We suggest that Tier 2 does support the on-going operation of a bank. The assertion above ignores the comfort that senior lenders (depositors) receive from lower ranking capital on an on-going basis (notwithstanding the type of capital). Having higher levels of subordinated capital provides benefits to the on-going operation of a bank by providing the market with confidence as to the extent of potential losses in the event of a default. Accordingly, we believe that viewing Tier 2 capital solely from a regulatory capital perspective fails to consider its wider benefits in supporting the investment proposition to senior lenders such as retail depositors; ● the Tier 2 layer can represent a significant proportion of a bank’s total capital (~10-20% of capital even under the proposed ratios), enabling the RBNZ to target higher levels of total capital meeting the RBNZ’s objective at a fraction of the cost for the banks compared with other forms of capital. Tier 2 is typically priced at ~100bp over equivalent senior funding, which is significantly lower than Common Equity or Additional Tier 1, which is generally multiples of senior cost. This allows overall capital to be maintained at ratios approaching 20%, with the additional cost across a bank’s funding book being largely insignificant. To illustrate, spreading 100bp for a 2% capital layer across a balance sheet with a RWA/face value of 50% would increase total funding cost of borrowers by ~1bp; and ● in addition, we believe that the market is more likely to develop for Tier 2 instruments under the RBNZ’s proposed capital reforms, hence the benefits that accrue to a financial system from having its banks externally scrutinised is more likely under a scenario where Tier 2 is retained. Accordingly, the maintenance of the current 2% Tier 2 layer in the bank capital structure is consistent with the RBNZ’s overarching objectives and provides material benefits both for the bank, the capital markets and the wider economy, . As outlined above, there are numerous advantages of having Tier 2 capital requirements, whilst the disadvantages and costs are minimal. Further, we suggest that consideration be given to increasing the level of this capital, noting the Australian position on the matter. We outline below our thoughts on the specific form of Tier 2 capital.

3 Form of subordinated debt to qualify as Tier 2 capital We note the Review Paper’s reference to Tier 2 capital consisting of “long-term subordinated debt” and “long term redeemable preference shares”, with the specific requirements to be finalised. Our proposition is that the 5+5 structure common to previous issues meets the RBNZ’s objectives and has been unequivocally demonstrated to be an acceptable market instrument. It is well understood by investors and the market, and would allow for a smooth transition in respect of this aspect of the bank capital reforms. This is important as it contributes to a more level playing field between locally owned and offshore banks. Incentives for banks to list capital instruments locally We note that the RBNZ has previously considered the merits of requiring banks to list shares locally. The benefits of such listings to both the wider financial market and to the banking sector within that were robustly discussed in the Bank Steering Group paper dated 28 November 2017 (“BSG Paper”): ● local listings may bring corporate governance improvements, and increased external scrutiny/transparency; ● well developed local markets provide an alternative to bank credit and have the potential to reduce the duration and severity of a banking crisis; ● capital raised domestically is generally considered more favourably than capital from a foreign entity, whilst the development of a vibrant local market will facilitate quicker access during a crisis; ● the lack of depth in local equity and debt markets suggests that the duration and severity of a banking crisis in New Zealand may be more severe than elsewhere, all else being equal. This is a contributing factor to setting prudential policies more conservatively in New Zealand than elsewhere (at least until such time as a suitable market development policy is identified and implemented); A local listing of banks is likely to contribute to this market development, and accordingly we suggest that the RBNZ look to promote this by looking to incorporate appropriate incentives in the new standards. The BSG Paper looked at requiring the local listing of bank’s equity/debt. However, we suggest that the RBNZ could look to incentivise such a policy by granting banks that list locally concessions in relation to either (or both) required capital ratios and/or risk weightings (through the floor or otherwise). The concessions could be in relation to either or both equity and debt capital (ie, across Common Equity Tier 1, Additional Tier 1, or Tier 2), and could vary depending on the proportion of each type of capital listed on the local market. We believe that the above may also further level the playing field between larger and smaller banks, as the latter are typically New Zealand focussed and accordingly are more likely to take advantage of such a feature Importance of bank capital issues to NZDX Further to the above point regarding the long term health of the local capital markets, as outlined below the bank capital sector was a leading contributor to the growth of the wider market over 2014-2016. Accordingly its importance to the health of the local

4 market should not be underestimated, and capital policy decisions should take into consideration effect on local capital markets ● the BSG Paper asserts that “it would appear that NZDX would have grown significantly without the (relatively limited) bank debt capital listing that has occurred”. This view is based on the premise that only “19% of the increase in the market capitalisation of NZDX has been due to listing of bank capital instruments”; ● note that the market capitalisation data considered in the BSG Paper significantly underestimates the contribution of bank debt capital raisings to NZDX’s growth over 2014-2016. Approximately half the growth in capitalisation of the wider market is due to the compliance listing of six tranches of LGFA bonds in late-2015. These bonds were already on issue and no capital was raised from the listing (but total capitalisation increased materially in that month, as shown in the chart); ● excluding these bonds, bank capital issues contributed nearly half of the market’s growth over that period of time; and ● in contrast, there have been no new bank capital issues since the commencement of the RBNZ’s current capital review process, illustrating the adverse effect the consultation process has had on the further development of the market The long term health of the local capital market will be a determinant of the duration and severity of any future banking crisis, and therefore the RBNZ should consider effect on the local market as a factor in its policy decisions (given its responsibility for promoting the maintenance of a sound and efficient financial system). Composition of capital The RBNZ’s proposed increase in total capital requirements is not significantly different from other jurisdictions, however the proposed changes do differ materially in relation to the composition of capital. To alleviate bank concerns around the flow-on impact of increased capital requirements, RBNZ could reconsider the composition of total capital, with potential higher weightings to Additional Tier 1 and Tier 2, which would result in lower overall cost of capital. Redemption features in preference shares We also strongly recommend that RBNZ reconsiders a redemption mechanism in relation to perpetual preference shares. We do not believe that such a feature weakens the capital qualities of this class of capital for the following reasons: ● protections could be placed around the redemption similar to current call options – ie, the redemption would be subject to RBNZ approval and only permitted if the instrument is replaced with a capital instrument of the same or better quality (unless the bank can demonstrate that its capital position is sufficiently above the minimum capital requirements after repayment); ● with the above requirements in place, such preference share funding would fundamentally be perpetual in nature, with the periodic redemptions allowing for a recycling of the underlying investors and pricing; ● further protection could include incorporating a replacement issue with any RBNZ redemption application, as this is a relatively common feature across both financial and non-financial subordinated regimes; and

5 ● we note that whilst pre-GFC preference shares were not redeemable (as defined in the Companies Act), these issues effectively incorporated an equivalent feature via buy-out provisions within the wider banking group. Accordingly, we believe that perpetual preference shares include the ability for redemption at the option of the issuer after five years, subject to the redemption requirements of the current regime. We believe that this feature is critically important for the saleability of such instruments to the market, and its absence would have wider “level playing field” ramifications. Summary ● Tier 2 capital should be maintained in bank capital requirements, as it meets the RBNZ’s objectives and provides numerous advantages with minimal disadvantages ● The RBNZ should note the demonstrated importance of the bank capital sector to the local debt market, and that Tier 2 instruments represent the primary contributor to this growth ● In finalising the form of Tier 2 capital, RBNZ should look to continue well established security structures for “long term” subordinated funding, with the traditional 5+5 year structure an appropriate starting point ● Consideration should be given to appropriate incentives to encourage banks to list either or both equity/debt capital locally If you have any questions regarding the feedback provided in this letter, please feel free to contact either of the undersigned. Yours sincerely Forsyth Barr Limited

Shaun Roberts Matt Sturmer Director, Head of DCM Senior Analyst, Fixed Interest Cc Brent Stephen