New Zealand’s banks are set to become safer and that’s something we should all celebrate.

Under a proposal tabled by the Reserve Bank of New Zealand in December, banks here may soon be required to operate above the biggest and best quality safety net of any banking system in the world.  This is a bold move by the regulator.  But it’s the right one and here’s why.

Banks play a vital role in our economy.  When you think about how we get paid and how we pay for things, how tax is collected, how benefits are distributed, or how investment is funded, it really is hard to overstate their importance.  A strong and resilient banking system is therefore in all our interests.

Now when it comes to bank safety, capital will always be at the heart of every discussion.

That’s because capital is the money which is used as the first line of defence in absorbing losses.  It’s therefore imperative that banks have enough of it to ride out whatever tough times may eventuate.  More specifically though, capital is the owner’s stake in a bank.  So it also acts a strong deterrent to the bank taking on unreasonable risks in the first place.

The difficulty, though, is knowing just how much capital is enough.  In essence, balancing the safety of the system with allowing banks to earn a profit, and thereby encouraging them to continue to perform their important role in the economy.

The most obvious limitation to unearthing a definitive answer on this is that you must be able to precisely predict the future.  Something this author has struggled with since birth.  But not so for the Basel committee in Europe which has established a one-size-fits-all international standard which stipulates exactly the amounts and types of capital banks should theoretically hold.  Of course, the committee’s proficiency in crystal ball gazing will only be revealed in the full passage of time.

But what I find hard to swallow is the flack the Reserve Bank has recently received for simply suggesting that New Zealand should decide on its own set of rules which reflect our own set of unique circumstances.

You don’t need to look much further than how large and how similar each of New Zealand’s “Big 4” banks (ANZ, ASB, BNZ, and Westpac) are to understand how unique our situation really is.  At over 80% of all bank lending, these four banks clearly dominate the landscape.  But it’s not until you consider how similar they are to one another, that you realise that as one goes so goes the economy.

Once you recognise this, it becomes much clearer why the Reserve Bank is taking the stance it is.

It understands that the New Zealand economy simply could not withstand the failure of one of these banks.  That’s because, as soon as one gets into trouble, that trouble would either very quickly spread or, even more likely, already be evident across the other three major banks.  In essence, one failure would bring down our entire banking system.

That’s why capital rules, like those suggested by the Basel Committee, which focus just as much on how bank failures should be managed once they occur as they do avoiding them in the first place, really aren’t appropriate for us here in New Zealand.

However, that’s not where the uniqueness our banking system ends.

To have a vast majority of our banking services provided by foreign-owned entities really is quite exceptional.  In effect, this introduces a tangled web of moral hazard that acts to amplify the previously mentioned concentration risks.

In banking, there are incentives to take risks and rewards today at the cost of potential instability in the future.  This is further exacerbated, in this case, by the limited liability (i.e. the capital invested) of the Australian parent banks.  Here they stand to benefit entirely from the rewards of taking risk today whilst not being required to share in what would be unimaginable costs should those risks prove to have been too large tomorrow.

It’s important to recognise here that New Zealand’s “Big 4” are some of the most profitable banks in the developed world.  That is to say, they generate some of the highest profits in relation to the amount of capital their Australian parents have invested in them.

Using simple arithmetic, if we hold last year’s profits constant, the new capital requirements would pull down profitability to broadly in line with global peers.  I admit, this is almost certainly oversimplifying things.  But equally, making a series of assumptions to build in what might happen would also distort what is purposefully a simplistic observation. 

The point of all this is, we are dealing with a highly complex and unique situation.  This makes it very hard to have certainty about the multitude of interrelated variables at play.  It seems to me at least, the Reserve Bank understands these challenges and while they might not have all the answers, they are likely to be some of the best placed to opine on them.

With that, I will leave you with the one thing that is for certain.  The cost from setting the minimum level of capital required for our banks too low is countless times greater than a cost from setting them too high.