Written by Daniel Song
New residential mortgage interest rates have climbed from roughly 3.6% to 6.1% between 2019 and today (RBNZ, 2025). Business loan interest rates have climbed from roughly 4.1% to 6.0% in the same period (RBNZ, 2025). The Reserve Bank of New Zealand’s (RBNZ) capital requirement policy, announced in 2019, may have something to do with it.
The nation’s four biggest banks were required to increase their equity to meet the new minimum of 18% of their risk-weighted assets (a bank’s loans and other assets weighted according to risk to determine the minimum amount of capital it must hold) from the previous 10.5% minimum (Gibson, 2025; RBNZ, 2019; RBNZ, 2025). For smaller banks, the minimum became 16% (also previously 10.5%) (RBNZ, 2022). Both changes would take place incrementally between 2022 and 2029.
Global Context
This regulation placed New Zealand’s capital requirement higher than most of the world. Australia requires up to 10.25% for its major banks at a minimum (Reserve Bank of Australia, 2022). The European Central Bank requires 15.8% (European Central Bank, 2024). American and Canadian banks face requirements of up to 14%, with the exception of Deutsche Bank USA Corp, which faces 18.4% (Dobby, 2025; Federal Reserve Bank, 2024). UK banks face up to 21% (Bank of England, 2025).
This raises the question of whether New Zealand, home to fewer than 5 million, should really be seeking to be extra cautious.
The Basel Framework
The Basel Framework is the primary global standard for banking prudential regulation (central banks’ legislative power to supervise banks) (Banking (Prudential Supervision) Act, 1989). The Basel Committee on Banking Supervision is a supervisory authority committee established by G10 countries in 1974. Although New Zealand is not one of its 45 members, our capital adequacy rules are largely based on this internationally agreed framework.
There are two frameworks that contemporary central banks use most widely: Basel II and Basel III. Basel III emerged from the 2008 financial crisis with a clear mission to prevent banks from gambling with insufficient capital buffers (Tian, 2017). This was captured by requiring banks to hold more high-quality capital and introducing leverage ratios (a measurement of the relationship between a company’s debt and assets) to prevent excessive risk-taking (Tian, 2017).
The economic rationale behind Basel III is that “without enough loss-absorbing capacity, asset prices are pressured to drop in a deleveraging process, leading to massive contraction of liquidity and credit availability, as happened in the financial crisis of 2007–2008” (Tian, 2017). Long story short, Basel III is more stringent because it is more capital-intensive. This means bank owners have greater skin in the game when it comes to running their banks.
RBNZ has taken the more lenient model of the Basel II framework, with additional Basel III features such as a higher capital requirement for larger banks (RBNZ, 2022). Yet paradoxically, while claiming to follow a lenient Basel II approach, New Zealand has ended up with some of the world’s “toughest” capital requirements (Sanglap & Khan, 2021).
The Cost-Benefit Calculation
Several reports have shown that the efficacy of the capital ratio regulation is measured by balancing the benefits and the costs of higher capital ratio requirements. This is usually termed the theoretically-optimal capital ratio, or k* (Bank for International Settlements, 2019).
One macroeconomic benefit was to soften the recession’s aftermath on the economy. In this respect, one study showed a positive relationship between the bank capital ratio’s impact on the post-crisis economy (Bank for International Settlements, 2019). The higher the capital ratio, the higher the GDP growth following banking crises.
Another macroeconomic aim was to lower the probability of a recession. Studies generally show a reduction in the crisis probability of between 0.03% and 1.7%. One report was, however, critical that the overall economic benefit is not significant (de Bandt, et al., 2021). Some scholars argue that some studies do not include the possibility that banks with greater capital were simply healthier to begin with (Cochrane, 2017). This meant the beneficial impact of the capital ratio may have been exaggerated. Usually, there is a relatively steep initial reduction in crisis probabilities followed by a flattened impact (Bank for International Settlements, 2019). Increasing the capital ratio from 9% to 10% reduced the crisis probability much less than increasing the capital ratio from 1% to 2%. The RBNZ calculated a reduction from 1% to 0.5% (RBNZ, 2019).
Research shows that higher capital requirements have minimal negative effects on GDP during normal economic times. The primary impact on the public comes through more expensive borrowing costs (Bank for International Settlements, 2019). Banks typically pass through some of their increased funding costs to borrowers in the form of higher loan rates, and this transmission mechanism has been acknowledged by the RBNZ. Arguably, to the public, the more relevant costs are the immediate and tangible loan interests rather than the long-term GDP impact (RBNZ, 2019).
When calculating the financial impact of higher capital requirements, economists account for the Modigliani-Miller (MM) offset (Chen, 2024). This is the extent to which banks’ funding costs are reduced when they become safer due to higher capital levels. The RBNZ assumed a 50% MM offset, which aligns with the mid-range of academic estimates. This offset determines how much of the theoretical funding cost increase actually gets passed through to borrowers (Bank of England, 2015).
However, it appears that the RBNZ underassessed the cost to the public through higher loan costs. The RBNZ considered the cost of higher payments by borrowers to be offset by the benefit of the banks accruing more capital from it. At the end, the RBNZ considered this cost as a transfer payment that is cancelled out in the cost-benefit analysis (RBNZ, 2019). One critic points out that this is erroneous as the RBNZ’s capital benefit does not always directly benefit the borrowers (Scott, et al., 2019). The borrowers incur an opportunity cost. For example, a household paying more on mortgage rate cost ends up with smaller savings to spend elsewhere. The RBNZ’s use of transfer payment may have underassessed the overall economic impact of the additional cost.
RBNZ’s approach also shows greater rigidity in assessing risks compared to the Australian Prudential Regulation Authority (APRA). The RBNZ requires banks to calculate risk-weighted assets using either internal ratings-based (IRB) models (banks’ self-calculated risk-weighted assets) or 85% of the outcome from the standardised approach (Risk.net, n.d.; RBNZ, 2022). The RBNZ then chooses whichever is higher. This mechanism, known as the output floor, ensures that banks cannot report excessively low capital requirements based on internal models alone. If banks’ self-assessment of the risk-weighted assets is lower than the 85% rating of the standardised measurement, the RBNZ prefers the higher measurement.
On the other hand, APRA allows approved banks to rely more fully on their IRB models, resulting in capital ratios that more closely reflect each bank’s individual risk profile (Reserve Bank of Australia, 2022). Overall, the RBNZ’s model can be rigidly stringent on some banks.
While the RBNZ shows some flexibility, such as adjusting the countercyclical capital buffer, this is a common practice among other jurisdictions, such as Canada and Australia, and does not make the RBNZ uniquely flexible (Office of the Superintendent of Financial Institutions, 2023; Reserve Bank of Australia, 2022; Reserve Bank of New Zealand, 2022).
Other conceptual problems seem to have been neglected by the RBNZ (Scott, et al., 2019). First, not all bank subsidiaries may benefit from the assumed MM offset because parent companies may not alter their allocation rules. Secondly, some sectors may face a higher borrowing cost due to higher risk weighting, such as the agricultural and small business sectors. Lastly, business competition may favour larger corporations that are able to access cheaper funding from overseas directly.
Conclusion
RBNZ’s good intentions behind the economic policy may have been overshadowed by neglect. It has underestimated the policy’s economic cost and failed to assess some crucial systemic repercussions. The overall benefit of reducing banking crisis probability and making the economy more resilient after the crisis may not be proportionate to the cost incurred by the public.
As one proposal, the RBNZ can take a more flexible approach, like the Australian Prudential Regulation Authority (Australian Prudential Regulation Authority, 2020). By relying on IRB models, banks will only have to hold capital commensurate with their actual risk profile.
References
Australian Prudential Regulation Authority. (2020). Capital explained. https://www.apra.gov.au/capital-explained
Australian Prudential Regulation Authority. (2020). Removing additional tier 1 capital from the prudential framework. https://www.apra.gov.au/removing-additional-tier-1-capital-from-prudential-framework
Bank for International Settlements. (2019). The costs and benefits of bank capital—A review of the literature (Working Paper No. 37). https://www.bis.org/bcbs/publ/wp37.htm
Bank of England. (2025). Banking sector regulatory capital: 2024 Q4. https://www.bankofengland.co.uk/statistics/banking-sector-regulatory-capital/2024/2024-q4#:~:text=The%20Common%20Equity%20Tier%201,%C2%A3460bn%20to%20%C2%A3468bn
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