If your doctor thinks you may be suffering from a serious illness but the test results suggest you are in the clear, that will seem like good news.

But your prognosis will depend on whether your doctor has tested for the right thing. A false negative is worse than useless.

Earlier this month, Reserve Bank governor Adrian Orr would have been pleased to publish the results from the panel of experts tasked with testing the Reserve Bank’s bank capital proposal. Announced in December last year, the proposal is to more than double banks’ high-quality (Tier 1) capital, from 8% to 16%, to reduce the risk of a banking failure to one-in-200 years.

After a barrage of criticism claiming the Reserve Bank’s proposals were flawed, the Reserve Bank will have been relieved to hear the independent reviewers generally supported the direction proposed in the capital review (even if one of the experts – Berkeley, University of California’s Professor Ross Levine – expressed some fundamental reservations about aspects of the Reserve Bank’s approach).

But can the Reserve Bank really breathe a sigh of relief? More importantly, can those who use the banking system – as either borrowers or depositors – feel confident the Reserve Bank has got it right? And can Finance Minister Grant Robertson, who must surely have been poised to intervene, step back and let the Reserve Bank have its way?

Unfortunately, several reasons suggest the Reserve Bank did not get the clean bill of health it thinks it did.

Still no proper cost-benefit analysis

The first stems from limitations the Reserve Bank imposed on the panel of experts. Whether it makes sense for the Reserve Bank to double bank capital depends on whether the benefits of the proposal to the overall welfare of New Zealanders exceed the costs.

While the Reserve Bank has adopted a ‘net-benefits’ framework for its analysis, despite working on its proposal for more than two years, it has still not undertaken a full cost-benefit analysis. And the Reserve Bank instructed the experts not to undertake their own modelling.

This omission is a serious flaw. As the Reserve Bank acknowledges, because the level of a bank’s capital will affect the interest rate it charges on its loans, higher capital requirements will make it more expensive for New Zealanders to borrow. The Reserve Bank estimates that for every 1% rise in bank Tier 1 capital, lending rates will rise by 8.1 basis points. The doubling of banks’ Tier 1 capital could see lending rates increase by 0.5 percentage points or more.

These estimates relate to average lending rates. It is likely some sectors – especially capital-intensive sectors – will face higher borrowing costs. Sectors affected will include high loan-to-value borrowers (including first-time borrowers), the rural sector and small to medium-sized enterprises.

The Reserve Bank also acknowledges the proposals will have an adverse impact on GDP. According to the bank, every 1% rise in bank Tier 1 capital could lead to an eight-basis-point decline in GDP. On these numbers, the capital proposal could see a decline in steady state GDP of 0.32% or more.

The actual effects on lending rates and GDP could vary from these estimates depending on the assumptions made. The Reserve Bank’s panel of experts suggested the bank may have overestimated some of the effects. Meanwhile, some in the banking sector say the Reserve Bank has underestimated the effects. Either way, the effects of the Reserve Bank’s proposals will be significant.

Treasury guidelines provide that the government expects cost-benefit analysis should be undertaken “before a substantive regulatory change is formally proposed.” Given the potential for the capital proposals to harm both borrowers and the wider economy, the Reserve Bank should have undertaken a full cost-benefit analysis before coming out with its proposals. And it should have allowed it to be stress-tested by the panel of experts.

The central bank’s failure to do this means the expert review is seriously compromised. It may think public welfare will improve from reducing the risk of banking failure but the harm to the economy may mean the cure is worse than the disease. Proceeding with the proposals remains a prosperity-threatening gamble that will affect all New Zealanders.

Predetermination

To address criticism about the lack of a proper cost-benefit analysis, in April the Reserve Bank said it would undertake a full cost-benefit analysis to “inform and describe the final decision.” However, the bank’s approach to its capital proposals suggests it has a pre-conceived notion of the “correct” level of capital the banks should hold. This is apparent from the bank’s persistent advocacy of its proposal during the public consultation process. And, as has become widely reported this month, the bank has been harshly critical of anyone who has dared to challenge its views. This is astonishing conduct from a government agency.

Against this background, an ex post cost-benefit analysis is susceptible to challenge on the grounds of pre-determination. The cost-benefit assessment is needed as part of the policy formulation process, not to describe final decisions. And an ex post analysis will not have the benefit of testing and challenge through the public consultation process. Indeed, in releasing the views of the panel of experts, the Reserve Bank announced its cost-benefit assessment “will be published alongside the final decision in December,” suggesting there will be no further opportunity for feedback.

This is no way to implement an important public policy decision.

Until the Reserve Bank has completed a proper cost-benefit analysis and submitted it for evaluation and consultation, neither the bank, the minister of finance, nor the wider public will know what impact the proposals will have on New Zealand’s overall welfare. 

Until then, the views of the panel of experts are a false negative.

Roger Partridge chairs The New Zealand Initiative  (www.nzinitiative.org.nz).