Opinion: How the RBNZ's new bank funding policy will stabilise interest rates, currency swings

By Roger J Kerr The news snippets from last week's RBNZ Financial Stability report and associated appearances before the Parliamentary Finance and Expenditure Select Committee have wide-reaching implications for borrowers and investors alike. New Zealand is seemingly leading the world again in finding new ways to better control bank credit expansion (thus inflation) so that the burden does not so heavily fall on just high interest rates/high exchange rate to slow things up and control inflation. It also seems that the RBNZ have been taking note of our continuous bleating over recent years that the collateral damage to the productive economy from the high interest rate/high exchange rate monetary settings has been too great i.e. the medicine has just about killed the patient. Monetary policy in New Zealand has for a long time badly needed some mates. It appears that one has been created. The new RBNZ liquidity and funding rules on the banks are now firmed-up, with 65% of bank liabilities required to be funded from sources greater than one year (Core Funding Ratio). The ratio will increase to 75% in stages over time (not stated when as yet). Any registered bank that fails to comply with these funding rules under the RBNZ's prudential supervision regime may find their banking licence under review. The banks have been aware for some time that these liquidity and funding rules would be imposed on them and have been re-positioning their respective funding books so that they comply. What it means is that they will be no longer be able to fund heavily off short-term offshore CP markets at low margins - they are forced to lengthen the term of their wholesale and retail funding arrangements. They pay higher credit spreads for offshore term funding and the local retail deposit war is also resulting in cost of funds well above BKBM and swap base rates. As could be expected, the banks will find every way they can to pass these extra costs onto unsuspecting corporate and household borrowers. Unfortunately the end-borrowers are the ones paying the cost of this mismanagement of funding risk by the banks over recent years. The RBNZ obviously had no confidence that the banks would self-regulate themselves with prudent funding risk management policies/limits and could not be trusted to their own devices to withstand another credit meltdown. As I have stated previously, many corporate borrowers in New Zealand could teach the major banks a thing or two about funding and liquidity risk management policies. The new Core Funding Ratio on the banks in New Zealand will be watched by banks and central banks around the world, as the influential "Economist" magazine recognised in an article on the subject last week. The case for a few large and locally owned banks to emerge to take business away from the Australasian big-4 incumbents grows every day. What does all this mean for the track of 90-day and swaps rates over the next 12 to 24 months? In my view, the increased bank and thus end-borrower credit spreads (or lending margins) now prevailing allows the RBNZ to set base OCR and 90-day BKBM market rates at lower levels than previously. Up until 12 moths ago "neutral" monetary policy settings were considered to be an OCR around 6.00% to 6.50%. The new order with the Core Funding Ratio imposed on the banks and higher bank credit spreads means that "neutral" is now closer to 5.00% to 5.50%. Those borrowers with facilities priced-off 90-day BKBM will have a major advantage over those priced-off the bank's cost of funds. In other words, the banks' actual overall cost of funds is going to be well above BKBM and swap rates. To have the same impact on borrowing and spending behaviour in the economy, the RBNZ will not have to lift OCR base rates as high as previously. The RBNZ can now pull a few more levers on controlling credit growth in the economy than just relying on the OCR interest rate sledgehammer. Presumably they can also lift and reduce the 75% minimum at any time if they think it will assist their monetary policy control of inflation. These bank funding regulations, together with a tighter fiscal policy from the Government, will combine to take the onus and pressure off interest rate changes to control inflation in New Zealand. More long-term stability in interest rates will reduce the wild swings of the Kiwi dollar and be beneficial for the economy as export industries invest and grow with more confidence. Well done Dr. Bollard! Yes, we do give bouquets when they are earned, as well as the normal brickbats! ____________ * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com