will the next Reserve Bank governor relax capital requirements for banks?

Adrian Orr has so far not spoken about the reasons for his recent and unexpected resignation as Reserve Bank governor, but the sudden departure caused understandable speculation.

One suggestion has been that Orr was at odds with the government over his requirement that the Australian-owned New Zealand banks hold high levels of capital compared to other countries.

Whether this was indeed a reason for Orr’s resignation we can’t say. But it does raise important questions about Reserve Bank – and government – policies.

Set by the Reserve Bank, capital requirements specify the amount of equity banks need to have to cover future losses. Since 2022, banks have been required to hold enough equity to be able to survive a 1-in-200-year event.

But holding onto this much capital is expensive for banks. The higher requirements have led to higher interest rates – making it more expensive for people and businesses to borrow.

The government has long criticised the current capital requirements. Last August, Finance Minister Nicola Willis said she was open to making the Reserve Bank ease its regulation of banks – if a strong enough case could be made that it would improve competition and efficiency without undermining the stability of the financial system.

Making lending attractive again

The 2022 capital requirements meant the “big four” banks (ANZ, Westpac, ASB and BNZ) had to increase equity from 10.5% to 18% of their risk-weighted assets over the next seven years. Smaller banks had to increase their equity to 16%.

The new requirements were met with some resistance. This was due, in part, to concerns about how the move would affect bank customers.

To meet higher capital requirements, banks focused on lending that generated higher returns. They also charged higher interest rates to compensate for the increased levels of capital required for the loans.

Financial analytics company S&P Global described the rules as the toughest bank capital requirements in the world and noted the risk of reduced access to credit, particularly for smaller businesses.

Calls for change

Even before Orr’s resignation, members of the coalition government had called for changes to the capital requirements.

In January, ACT leader David Seymour sought information from the Ministry for Regulation on the issue.

Seymour has said going back to the former levels of bank capital would support economic growth by enabling more lending to business at more affordable interest rates.

In its study on the banking sector, the Commerce Commission also suggested revising bank capital requirements to address competition issues.

The 2022 capital requirements have influenced the type of lending banks do and the interest rates they have applied.

The more capital banks have to hold against a loan, the higher the interest rate required to cover that cost. This means home loans are more expensive under the current rules. If the requirements reduced (and nothing else changes) home loan interest rates would reduce.

At the same time. other types of lending – such as business loans – would become more attractive if capital requirements drop and banks have to have less equity on hand.

With a limited pool of funds available to lend, this may mean banks make fewer home loans and more personal and business loans.

Careful consideration needed

In the end, there is no guarantee a new Reserve Bank governor will reduce the capital requirements. And, under the current rules, the governor is the one who gets to make that call.

While the government has some say in the appointment process, the Reserve Bank board is responsible for recommending the next appointee.

Whoever finally takes the post will have to weigh up the benefits of any rule changes with the potential risks – including what the uncertainty of frequent rule changes do to the wider economy.

They will also need to take into account why Orr pushed for the higher capital requirements to begin with. He worried that in the event of a global financial disaster, the four major Australian-owned banks might abandon New Zealand customers.

Having the higher levels of capital forced the banks to have a greater financial cushion against losses and reduced the risk of bank failure. And ultimately, no government wants a bank to fail, with the personal and economic costs that would entail.