RBNZ eyes introduction of NZ version of Basel III from 2013, says banks holding additional capital is 'easily justified'

By Gareth Vaughan

The Reserve Bank has confirmed it wants New Zealand banks to meet new international capital requirements known as Basel III from 2013 rather than these being phased in over six years as mooted internationally, says it will retain existing local standards where the Basel III proposals are less conservative, and believes local banks are "relatively well positioned" to deal with holding additional capital.

The Reserve Bank says this in a consultation paper entitled Implementation of Basel III capital adequacy requirements in New Zealand released today.

 “Capital provides a buffer to reduce the risk of a bank becoming insolvent as a result of unexpected losses, for example arising from a severe economic downturn," Reserve Bank Deputy Governor Grant Spencer said. "Robust bank capital requirements are therefore a critical part of a sound and efficient financial system.”

The Basel capital adequacy standards will apply to all locally incorporated New Zealand banks.

Basel III is a set of reform measures, developed by the Basel Committee on Banking Supervision and endorsed by G20 leaders, designed to strengthen the regulation, supervision and risk management of the banking sector in the wake of the global financial crisis. It aims to improve the banking sector's ability to absorb shocks arising from financial and economic stress, improve risk management and governance, and strengthen banks' transparency and disclosures.

The Reserve Bank says its main principles in putting its Basel III plan for New Zealand together are;

* The adoption of the Basel III standards as a starting point, except where the standards aren't appropriate for New Zealand circumstances.

* Where the Basel III standards are less conservative than New Zealand's existing standards, retain those existing standards.

* Regard given to international consistency and comparability - especially consistency with Australia which is the home of the parents of New Zealand's big four banks - subject to the previous two principles.

Big banks may fight it

The Reserve Bank's plans for the implementation of the new international capital requirements are, however, likely to face some push-back from the big banks.

Mike Smith, CEO of Australia's ANZ Banking Group which owns both the ANZ and National banks in New Zealand, recently said banks from countries with "strong banking systems" such as India, China, Australia, and Canada should team up to fight against Basel III, because the international banking reform process has been "hijacked" by ill-conceived policies seeking global conformity and what's relevant for France, the USA and UK isn't necessarily relevant elsewhere.

Some banks have argued that higher capital requirements may force them to restrict lending growth and increase their profit margins to compensate, while bank critics say their profits are strong enough to increase capital levels and keep their current lending levels, although returns on equity and dividends may have to fall.

However, the Reserve Bank says locally incorporated New Zealand banks should be reasonably well positioned to meet its proposals, but more information from the banks will provide greater clarity. It has called for submissions by January 27 next year and is asking banks to complete and submit a quantitative impact assessment.

'Pretty much there already'

Westpac New Zealand CEO George Frazis told interest.co.nz last week that New Zealand banks were "pretty much there already" in terms of meeting what was likely to come out of Basel III.  Frazis said Westpac's capital ratios and liquidity were "really strong" and noted the bank was well positioned for the step up in the core funding ratio to 75% from 70% next July given its core funding ratio, which sets out that banks must source at least 70% of their funding from retail deposits and wholesale sources with durations of at least a year, was at 80%.

The adoption of Basel III will see the Reserve Bank's current Tier 1 minimum capital requirement increase to 6% from 4% with the quality also increasing because a larger portion of common equity will be required with the criteria for inclusion in Tier 1 capital tightened. However, the total minimum capital requirement remains unchanged at 8%.

That said, a 2.5% "conservation buffer" is proposed to be added to the tier one and total capital ratios. It's designed to ensure banks keep a capital buffer over their minimum requirements that can be used to absorb losses during periods of financial and economic stress.

"While banks will be able to draw on this buffer during such periods of stress, constraints on earnings distributions will be applied as their capital ratios get closer to the minimum requirement excluding the buffer," the Reserve Bank says.

A "countercyclical" buffer of common equity will also be introduced which is designed to protect the banking sector from periods of "extraordinary excess" aggregate credit growth. This will be introduced and implemented according to national circumstances. The adoption of Basel III will also see the quality of Tier 2 capital improve, the Reserve Bank says, with the criteria for the inclusion in Tier 2 capital tightened.

What is capital?

The central bank defines capital as a measure of how much a bank's assets exceed the amount of money it owes depositors and other ordinary creditors. It is divided into two categories, called "Tier 1 capital" and Tier 2 capital". Total capital is the sum of both.

Tier 1 capital represents the shareholders' funds in the bank, - their share of the bank's assets after all of the bank's debts have been repaid to creditors.

Tier 2 capital generally has a lower capacity to absorb losses than Tier 1 capital. One of the more important forms of Tier 2 capital is "subordinated debt" such as money the bank owes to creditors, but that in a winding up can only be repaid after the bank has repaid the money it owes to depositors and other ordinary creditors.

Capital is expressed as a percentage of the banking group's total “risk weighted exposures”. Risk weighted exposures are a measure of the banking group’s exposure to credit risk, market risk and operational risk. Capital as a percentage of risk weighted exposures is known as the capital ratio. Use of the capital ratio enables a banking group's capital position to be compared with those of other banks.  See more on the Reserve Bank's website.

'Cost-benefit analysis justifies plans for banks holding more capital'

The Reserve Bank says its initial cost-benefit analysis of the Basel III capital ratios suggests tightening existing requirements to the Basel III standards is "easily" justified.

"Our analysis took into account the key benefit of of higher capital requirements - a reduction in the expected cost of a banking crisis including fiscal cost, and the potential costs of higher capital requirements including the impact on bank lending rates."

It aims to introduce its New Zealand version of Basel III from January 1, 2013, instead of the six year phase in recommended by global overseer the Basel Committee on Banking Supervision, unless there are "compelling reasons" for a phased approach.

The central bank also plans to consult with the banks on any Basel III related changes to its disclosure requirements next year.

(Update adds comments from George Frazis).