Capital Adequacy – What Is It & How Will it Affect the Market?

Capital adequacy is the Reserve bank telling banks that in tough financial times the capital they are holding on their balance sheet could be insufficient to weather a major economic event, such as we saw during the Global Financial Crisis.

Adrian Orr is pushing that this needs to happen and the Reserve bank are currently taking feedback on their proposal, so let’s talk about what could happen if this does go ahead.

The impact on interest rates will all depend on how much additional capital the RBNZ requires and how this will impact the banks’ cost base. We know banks are preparing to go to the market and raise capital but we don’t know how much additional capital they will be required to raise, the increase in interest cost to the bank or how this will impact their cost base. We also don’t know whether they will pass this additional cost on. They probably will, banks are always looking to increase their margin, but we don’t know if some banks will act competitively and loosen borrowing criteria to gain market share.

In my opinion, this can all be seen as a bit of a storm in a teacup. Rates are sitting around 4-5 % and I can’t see how this would increase significantly. Historically research shows interest rates have sat below 5% historically and spikes have been closely correlated to large increases in the population growth rate. This growth rate is currently declining, so all other factors remaining equal, there is evidence to suggest interest rates will remain below 5% for the foreseeable future.

Putting this all together, while no one wants the bank to increase rates, I don’t see this as a reason to pause making investment decisions – quite the opposite. I think in the medium to long term banks will get flexible with their serviceability criteria and this will grow demand and lift prices. Until then I will keep building my portfolio so when the next boom comes I can maximize my capital growth.

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