Reserve Bank Governor Alan Bollard warns Aussie banks to accept lower profits from New Zealand subsidiaries

By Gareth Vaughan

Reserve Bank Governor Alan Bollard has told the Australian owners of New Zealand's major banks not to expect profits in the future at the same levels they've enjoyed over the past decade due to post global financial crisis (GFC) regulatory changes and ongoing deleveraging by customers.

Bollard's comments, in a speech to the Shareholders' Association's annual meeting in Tauranga today, come a day after PricewaterhouseCoopers pointed out the New Zealand banks were "a drag" on their respective group's profitability and said it expected significant pressure to come from shareholders to improve returns.

PwC noted that New Zealand's major banks delivered an annualised 12.9% RoE in the first-half of their respective financial years, which is down 4.4% from three years earlier and below the 16.7% average delivered by their Australian parents. Nonetheless, New Zealand's big four banks produced a combined NZ$1.26 billion interim profit, up NZ$312 million, or 33%, from NZ$952 million in the same period of the previous year.

And in their first half-year ANZ, ASB and BNZ paid their Australian parents a combined dividend of NZ$583 million, down from NZ$843 million in the same period of the previous year. Westpac, which is preserving capital as some banking operations are transferred to Westpac NZ from its Australian parent, paid no dividend in either period.

Bollard pointed out that in the decade preceding the GFC, New Zealand's banks produced strong profits. From 2002 to 2007 he said the country's banking system produced a RoE second at about 18%  - behind only the Slovak Republic - out of a sample of 22 OECD countries.

"Rates of return in New Zealand were ahead of those in Australian banks, which were third highest in the comparison," Bollard said. "Operating costs were second lowest in the sample while loan provisions were also towards the lower end."

"While we are acutely aware of the accounting issues that can make these comparisons misleading, taking the comparison at face value would suggest the New Zealand banks (and their Australian parents) were among the world's most cost-efficient, and also among the most profitable," Bollard added.

Aussie dominance near complete

He noted that the four Australian owned banks - ANZ, ASB, BNZ and Westpac - dominate the New Zealand financial system to an extent seen in few other economies, accounting for nearly 90% of the banking sector, or just over 70% of the financial system as a whole.

"It is these institutions that provide the lion's share of financial services and products to the New Zealand economy, and therefore are of key systemic importance."

Even though New Zealand's banks largely stuck to their knitting during the last boom, avoiding the "sort of exotic financial innovation witnessed elsewhere," Bollard said operating conditions for the banks had changed profoundly since the GFC and regulatory changes designed to create safer banks "might be expected to lower required rates of return over time."

The regulatory changes include the introduction last year of the core funding ratio (CFR), which sets out that banks must secure at least 70% of their funding from retail deposits or wholesale sources such as bonds with durations of at least one year. The central bank lifted the CFR to 70% from 65% on July 1 and will increase it again, to 75%, on July 1 next year. And in his speech Bollard said there could be "minor developments" to the liquidity policy.

Bollard also said the Reserve Bank will be reviewing its capital adequacy framework in view of Basel Committee guidelines now known as Basel III. Currently banks must have a total capital ratio of no less than 8%, and a tier one capital ratio - comprising the proprietors' contribution to the bank - of no less than 4%. See more on the Reserve Bank's capital adequacy framework here.

The Reserve Bank is also in the process of implementing an Open Bank Resolution (OBR) policy, which Bollard describes as a failure resolution policy that aims to preserve the continuity of banking services to retail customers and businesses, while placing the cost of a bank failure primarily on the bank's shareholders and creditors rather than the taxpayer. See more on the OBR policy here.

'Radical overhaul not needed'

Nonetheless, Bollard said the Reserve Bank didn't believe New Zealand's banking system needs the sort of radical overhaul being discussed as necessary in some other countries, given the relative resilience of local banks over the course of the GFC. However, he said the central bank's supervisory approach had changed, with a shift from a high reliance on market disclosures to one that uses more private reporting.

"This will enable the Reserve Bank to utilise more detailed and timely information from internal reports that banks themselves use to manage risk."

Meanwhile, he pointed out that bank balance sheets had shown little growth over the past three years, with both households and businesses opting to reduce debt and save more.

"If this trend endures, banks will have less opportunity to generate higher profits through balance sheet expansion," Bollard said.

"A combination of higher risk aversion, global regulatory changes and sovereign debt issues have led to a rise in the cost of debt funding for banks although where these costs are likely to settle in the longer run is uncertain. The higher funding costs have encouraged some large corporates to raise funds directly in the capital markets in lieu of the banks and it will be interesting to see whether this trend continues," Bollard added.

"The banks’ ability to recover higher funding costs from customers will depend partly on the strength of loan demand as well as competitive pressures from other parts of the financial sector."

"All things considered, it seems unlikely that the rates of return in banking enjoyed over the past decade can be sustained in the future."