Three unanswered questions hang over the Reserve Bank capital proposals.

First, do the benefits of the proposals exceed the costs?

If you believe the Reserve Bank, they probably do. If you believe the New Zealand Bankers’ Association and other critics, the adverse impacts of the Reserve Bank’s proposals on borrowers, savers and the wider economy will dwarf the benefits.

According to the central bank, higher levels of bank capital are needed to avert banking failure. For the critics, the proposals involve gold plating an already robust financial system, and they will force up interest rates, limit the availability of credit, and stall an already slowing economy.

Who is right?

At present, it is impossible for most of us to tell. On the Reserve Bank’s own admission (and despite working on this proposal for more than two years), the regulator has still not undertaken a full cost-benefit analysis.

This is a substandard approach to public policy formation. And the omission has severely undermined the public consultation process. The lack of a fully articulated cost-benefit analysis means submitters have been unable to probe and critique the assumptions that should have underpinned the regulator’s assessment of the advantages and disadvantages of its radical regulatory proposal.

The second question is: “Has the Reserve Bank been consulting with an open mind?”

As a regulatory decision-maker the Bank is legally obliged to remain impartial. If the Bank fails in this, it is guilty of ‘predetermination’ and has breached what the law calls natural justice.

It should be inconceivable that an institution as august as our Reserve Bank could be guilty of such a transgression. Yet, from the outset of the consultation period, the Reserve Bank has actively tried to influence public debate on its proposals. A recent example is Governor Orr’s media release accompanying the Reserve Bank’s Financial Stability Report on 29 May 2019. The release stated: “Increasing financial institutions’ capital positions is central to ensuring that they can withstand severe shocks.” Yet the question of whether banks should be required to hold new capital is the very issue on which the Reserve Bank is consulting.

Perhaps even more blatantly, earlier this month a Reserve Bank media statement announced: “We think the costs of [increasing banks’ capital] are outweighed by the benefits – someone’s cost is for society’s broader benefit.”

Ironically, the media statement accompanied the release of a document summarising the submissions the Bank has received on its capital proposals (and which the Bank is supposed to be “considering”). It is hard to conceive of a sentence that could more clearly convey a predetermined view.

The third question is whether the Reserve Bank properly understands its statutory objectives.

Compared with the first two questions, this issue may seem a bit arcane. But in exercising its prudential regulatory powers, the Reserve Bank’s statutory duty is to maintain a ‘sound and efficient’ financial system. It is easy to understand the ‘soundness’ objective. A sound financial system is one in which the risk of systemic banking failure is low. But how low?

That is where the ‘efficiency’ limb comes in. Like other forms of safety, it is possible to have too much soundness – to require banks to hold so much capital that the costs (in the form of higher interest rates for borrowers and reduced availability of credit) exceed the benefits (of a reduced risk of banking failure).

Excessive soundness can be unsound – or in economics-speak, inefficient. Consequently, the Reserve Bank’s efficiency objective operates in tandem with its soundness objective to restrain any tendency the Bank might otherwise have to over-regulate.

Unfortunately, the Reserve Bank does not appear to have followed this tandem approach in developing its proposal to double banks’ capital. Instead, the ‘risk appetite framework’ the Reserve Bank mentions in its consultation documents describes a soundness-first-and-efficiency-second approach.

The Bank’s framework suggests it may have misunderstood its statutory objectives; in other words, that it has misdirected itself in law. If it has, the Bank’s decision-making processes would be susceptible to legal challenge.

But in a real sense, this is the lesser of the two problems with the framework the central bank has adopted. The more important problem is that the Bank’s framework may have encouraged it to over-regulate. And this concern brings us back to the first question: where is the cost-benefit assessment supporting the Reserve Bank’s proposals?

Fortunately, the Reserve Bank acceded to the calls from its critics and, nearly four months after commencing its consultation process, agreed that it would undertake a proper cost-benefit analysis to “help inform and describe final decisions in the review.”

More recently, the Bank has confirmed it will appoint three independent experts to ‘audit’ its cost-benefit analysis. Both these moves are welcome. However, they are not as satisfactory as enabling all interested parties to comment on and critique the Bank’s analysis. And the Bank’s approach invokes a slightly uneasy sense that it wants to keep its cards close to its chest.

Over the coming months, the Reserve Bank has an opportunity to answer all the outstanding questions relating to its bank capital proposals.  It should take the time to do so – and before it makes any final decisions.

The simplest, most straightforward and most reassuring way would be to reopen the consultation process once it has undertaken its cost-benefit analysis. That would allow all interested parties to evaluate its reasoning. And it should leave no unanswered questions.