Professor Ross Levine

An American banking expert brought in by the Reserve Bank as part of a team to double-check its new capital raising requirements for banks has suggested that how bank executives are paid may play a much bigger role in defining bank stability than the Reserve Bank imagined.

His report will put more pressure on the Government to monitor — and possibly regulate – bank executives’ pay.

The Reserve Bank has proposed that to cope with a one-in-two-hundred-years financial crisis, the banks should increase a segment of their equity by between 20 and 60 per cent.

The Bank says this represents about 70 per cent of the banking sector’s expected profits over the five-year transition period.

The banks have responded to this by arguing that rural customers, in particular, will have to foot the bill.

The Reserve Bank brought in three international experts to evaluate its proposals to raise the capital requirements.

Two of the experts, Dr James Cummings from Macquarie University in Australia and Professor David Miles of Imperial College, London, believe that the Bank has overstated the margin required by equity investors in banks and hence the impact on interest rates may also have been overstated.

Professor Ross Levine, from the University of California, Berkely, on the other hand, argues that the Bank’s proposals will raise the costs of banking.

But he then offers some “outside the square” thinking on impacts the Bank may not have considered.

Levine argues that when major decision-makers within banks—e.g., large, influential owners, directors, executives—have more of their personal wealth invested in banks as common equity, they have more to lose from their banks misallocating assets, i.e., they have more “skin-in-the-game.”

“Thus, to the extent that capital regulations induce such major decision-makers to have more of their personal wealth at risk, they would tend to have stronger incentives to manage their banks prudently, potentially reducing the probability of bank failure,” he says.

And he says that when bank executives are paid top-ups to their salaries based on the Bank’s return on equity, then that can increase risk-taking activity by the executives in contrast to those who are paid only straight salaries.

 “If executives receive bonuses based on return on equity (ROE) and increasing capital regulations reduces ROE by increasing equity, executives may now have stronger incentives to increase risk-taking in search of higher returns,” he says.

And he believes that the strength (or otherwise0 of bank boards plays a crucial role in ensuring bank stability.

“With stronger governance, bank behaviour is governed more by the incentives of owners; while with weaker governance, the incentives of executives exert a more powerful influence over bank behaviour.

“Thus, for a strong governance bank, the response to capital reforms will depend more on ownership and who is providing the additional capital.

“For a weak governance bank, the response to capital regulations depends more on executives and their compensation packages.”

Levine says that the Reserve Bank reforms could incorporate more information on how the proposed capital regulatory reforms could alter the incentives of decision-makers within banks and hence bank stability and efficiency.

“Such an approach might also illuminate other changes that would enhance the effectiveness of bank capital regulatory reform, including altering the compensation contracts of executives so that they are penalised for excessive risk-taking and not simply rewarded when risk-taking succeeds.”

And he says that Government guarantees perversely encourage more risk-taking by banks.

“The Government subsidises banks in the form of implicit guarantees on bank debts, which currently tilts the financial system in favour of highly-levered banks with excessive risk-taking incentives and away from other financial service providers.

“To the extent that capital regulations reduce this subsidy for banks, the regulations will increase the cost of banking in New Zealand.

“The overall impact on the economy, therefore, depends on the degree to which new financial institutions can arise and compete with incumbent banks in financing households and firms.”

He says the RBNZ might also consider that reducing the subsidy provided to banks by increasing bank regulatory capital requirements might ultimately enhance the efficiency of the overall financial system in New Zealand by allowing greater competition across different types of financial services providers, e.g., banks, nonbanks, markets, etc.

“That said, the potential growth of these other entities should trigger an evaluation of questions concerning the oversight and regulation of these nonbank financial services providers.”

However, another of the experts, Professor David Miles,  said that one of the reasons the Reserve Bank was proposing higher capital requirements for the banks – higher than in most other countries – was that the Bank preferred a light-handed regulation of the banking sector.

“The RBNZ has probably not over-estimated the appropriate level of bank capital,” he said.

“The RBNZ has adopted a principle of being conservative as regards bank capital to offset possible risks from its light-handed approach to supervision.

“That is a choice and one partly based on the view that having very large resources devoted to intrusive oversight of banks is not the most efficient road to go down.”

Reserve Bank Deputy Governor, Geoff Bascand, said  the Bank was are continuing its  work on some technical suggestions made by the experts, “as well as finalising our decisions and ultimate review.”\.

Meanwhile, the  Bank is continuing its stakeholder outreach programme, which includes general public focus groups and engagement with wider industry groups on the potential costs and benefits.

“Along with the external expert reports and submissions received, these inputs will help us to make robust, well-calibrated policies and decisions that best represent society’s interests,” said Bascand.

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