World's toughest capital requirements in New Zealand may squeeze credit

New Zealand is planning some of the toughest bank capital standards worldwide to ensure lenders can weather a downturn. The risk is that the caution may squeeze access to credit.

The nation's four largest lenders will have to hold capital equal to at least 18% of risk-weighted assets by the end of a seven-year period that starts in July 2022. The smaller banks will need a minimum capital of 16%, which is double that of European lenders and significantly higher than in Australia. The current minimum regulatory capital required for all New Zealand banks is 10.5%.

Meeting the high requirements will likely force New Zealand banks to cut riskier exposure, such as loans to smaller businesses, and require billions of dollars in extra funding. The nation's four biggest banks, units of Australian majors — Australia and New Zealand Banking Group Ltd., Commonwealth Bank of Australia, National Australia Bank Ltd. and Westpac Banking Corp. — would need NZ$5.4 billion of extra capital to maintain the status quo with riskier customers, according to Martien Lubberink, associate professor at the School of Accounting and Commercial Law at Victoria University of Wellington.

The new capital requirements announced by the Reserve Bank of New Zealand, or RBNZ, in June will reduce risk appetite and "slow the rate of new lending," Geof Mortlock, head of Mortlock Consultants Ltd., told S&P Global Market Intelligence in an email. "This will bite especially hard if and when NZ enters a recession — as is just a matter of time."

While central banks across the world are seeking to better insulate their financial systems from economic shocks from rare events such as COVID-19, New Zealand, a geographically isolated nation with a population of less than 5 million, is seeking to be extra cautious. "Capital requirements of New Zealand banks should be conservative relative to those of international peers, reflecting the risks inherent in the New Zealand financial system and the reserve bank's regulatory approach," the central bank said in December 2019 when the proposal was first announced after a two-year consultation process.

Extra cautious

The central bank believes the changes are necessary to make banks more resilient to economic shocks and to ensure that the frequency of bank failures "are so small that the chances of a large bank in New Zealand failing should be no more than once every 200 years."

The RBNZ should have balanced "sensibly calibrated" capital requirements with prudential requirements for governance and risk management, in line with other countries such as Australia, the U.S., Singapore and Japan, Mortlock said, pointing at internal capital adequacy assessment process, or ICAAP, arrangements and recovery plans required by the authorities in most developed economies.

The central bank's model "places far too much emphasis on capital and far too little on risk mitigation. The consequence will be one that is expensive for New Zealand, given that banks will be less well-placed to lend to New Zealand businesses and households than they would under a conventional set of requirements," Mortlock said.

The Australian Prudential Regulation Authority requires the nation's four major banks to hold a common equity Tier 1 ratio of at least 10.5% of risk-weighted assets to allow them to be regarded as "unquestionably strong" by international standards. The EU currently requires banks to hold a total amount of capital to be equal to at least 8% of risk-weighted assets. The European Banking Authority said in December 2020 it would implement the final Basel III reforms that will increase the current Tier 1 minimum required capital by an average of 15.4% for all banks by 2028.

Based on RBNZ data, all banks in New Zealand, except Westpac, will have to enhance their capital ratios, some more than others. Westpac New Zealand's total capital ratio was 18.2% as of March 31. ANZ Bank New Zealand Ltd.Australia and New Zealand Banking Group Ltd. - ANZ New Zealand, Bank of New Zealand and ASB Bank Ltd. reported total capital ratios at 15.9%, 16% and 14.8%, respectively.

Commonwealth Bank, or CBA, said in 2019 its unit ASB Bank will require an additional NZ$3 billion in Tier 1 capital by July 1, 2027. CBA said it is well placed to meet the changes but noted that a significant increase in capital "ultimately increases the cost of providing loans to customers." National Australia Bank said the capital changes represent a CET1 capital increase of N$3 billion to NZ$4 billion for unit Bank of New Zealand by July 1, 2027, based on its balance sheet as at Sept. 30, 2019.

Risk aversion

The banks' possible shift away from higher risk-weighted lending would "lower the denominator" and thus increase the capital ratios, said Victoria University's Lubberink. The central bank should prioritize on operational risks such as cyberthreat, anti-money laundering and systems instead of credit risks that were brought "largely under control" after the global financial crisis of 2008, the associate professor said. "New Zealand banks at the time were well-capitalized, and they still are."

Given that banks will need to conserve capital, the new requirements may also prompt them to consider selling more capital-intensive businesses. Westpac and Bank of New Zealand both announced that they will sell their life insurance arms, which will help boost their total capital ratios.

While the requirements are likely to limit credit availability once implemented, they would further help fortify banks' balance sheets, said Matthew Barry, senior industry analyst at market research firm IBISWorld. "The overall impact to lending and availability of credit will play out over the medium term as the banks adapt to the changes," Barry said.

Smaller lenders may face challenges in raising capital and may need to rely on retained earnings at a time when low interest rates have crimped margins.

"There are a few levers the banks can pull to meet these new capital requirements including issuing more qualifying equity, seeking to enhance earnings and reducing dividend payout ratios to increase organic capital generation," said Barry.