RBNZ tightens liquidity guidelines for banks; may push up lending rates (Update 1)

By Bernard Hickey The Reserve Bank of New Zealand has announced a new prudential liquidity policy for banks that will force them to lengthen the term of their funding and include more domestic 'term deposit' funding rather than wholesale foreign funding. (Updated with comments from interview with Acting Reserve Bank Governor Grant Spencer) The bank acknowledged this could potentially lift lending rates by 10-20 basis points over the medium term, but said it would help strengthen the Reserve Bank's monetary policy power in an upturn because banks would be less able to race out and borrow heavily on offshore wholesale markets to fund another housing boom. This was a factor in very strong bank lending growth to households at relatively low interest rates through 2006 and 2007 when the Reserve Bank was lifting the Official Cash Rate to slow the economy. This rush for cheap and often short term foreign funding left the banks vulnerable to a freeze on financial markets similar to that seen for a few weeks after the collpase of Lehman Bros in September last year. The central bank is focusing its policy on banks meeting a 'Core Funding Ratio' (CFR), which means the banks will have to make sure at least 75% of its lending is funded by wholesale term debt of longer than a year, retail funding (term deposits, and tier one capital (government bonds and other very safe securities). Reserve Bank Acting Governor Grant Spencer told interest.co.nz in an interview that the banking system currently had a CFR of around 70%, which was improved from around 65% before the Global Financial crisis hit in mid 2008. Spencer, who is standing in for Governor Alan Bollard while he is on duty at a Bank for International (BIS) annual meeting in Basle, said the banks would have a couple of years to improve their CFRs and would not have to rush out to raise local or longer term funding. "We're trying to give them stretch targets, but we're not trying to be too stretchy," Spencer said. The new measures were unlikely to have a significant impact on retail interest rates, given many of the banks were already heading in the right direction, competing hard for local term deposits. "They're not going to have to rush out to obtain more funds," he said. The new measures would strengthen the Reserve Bank's monetary policy hand in any upturn, he said. "If these (prudential liquidity) measures had been in place during the previous boom it would have been less of a factor," he said, referring to the banks' desire to raise cheap foreign funds during a housing boom. The bank's Questions and Answers document on the policy said some banks already met the requirement, but others would have to adjust over the next year or two. The bank did not identify those banks who were not up to scratch yet.

Some banks already meet or exceed this benchmark, and it is possible that others would be aiming to achieve similar long-term funding ratios as financial markets stabilise over the next year or two. The policy signals to banks what the Reserve Bank judges to be best for the stability of New Zealand's financial system over the longer term. The policy is likely to have more impact in a cyclical upturn, reining back any tendency by the banks to revert to the short term offshore funding markets to support a rapid credit expansion.

Spencer said the policy sets various balance sheet requirements and disclosure obligations for banks around their internal liquidity management. "The purpose of the policy is to ensure that banks maintain strong liquidity positions, making them more resilient to both short term and long- lasting funding shocks," Spencer said. "The vulnerability of the banks to liquidity shocks has been our main concern for the stability of the New Zealand financial system during the international financial crisis," he said. "While the funding markets have shown encouraging signs of improvement in recent months, we want to ensure that the New Zealand banking system is better protected against any future shocks of this sort." Spencer noted that, in light of the current pressures faced by banks, the new prudential liquidity requirements will be phased in over a two-year period. "Some banks will be little affected as they are already close to the new policy requirements. Others will need to continue lengthening the maturity of their funding in a gradual and measured way," he said. The full 22 page policy document is here and the Q&A document is here. The Q&A document makes clear the bank had settled for a slightly easier policy than one raised early in the consultation process.

The consultation document proposed a 70% CFR target; why are you now tightening this further to 75%? The method of calculating the CFR in the consultation paper has changed in the final policy. The new CFR of 75% equates roughly to a CFR of 65% as originally proposed. So this is in fact an easing of the original proposal, which has been made in response to banks' concerns about the feasibility of meeting the requirements, and also to points they made about maintaining a buffer above the regulatory minimum for their internal management purposes.

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