You may be a bit mystified by the public dispute between the Reserve Bank and the trading banks over the need, or not, for increasing the capital of the trading banks. Everyone starts off assuming you understand what is going on and also avoids mentioning that the main concern is not about ‘normal’ times, but about the abnormality of a financial crash. (Which is something we do not discuss, a bit like the Victorians not mentioning sex, even though babies kept turning up.)

How banks work is an intricate issue. Allow me to oversimplify. Banks make loans. The loans are funded by deposits (including those from offshore). However, at any time, the depositors may choose to withdraw their deposits. That is going on all the time, but usually the withdrawals are about matched by new deposits. After all, what are you going to do with your deposits when you have taken them out? Frequently you put them in another bank and there is a complicated process by which the trading banks deal with a mismatch.

However sometimes, as occurred immediately after the Global Financial Crisis, the depositors do not trust any of the trading banks so they ‘deposit’ in the Reserve Bank by holding one of its banknotes. This mucks up the trading banks, because they cannot easily go to those who borrowed from them and ask for their money back to fund the withdrawing depositors. Imagine your bank asking you to pay back your mortgage in a hurry.

What has been described in the previous paragraph is called a ‘run’ on the bank or banks. Over the years we have evolved various mechanisms to deal with runs and the day-to-day mismatching of flows. The New Zealand system coped with the runs caused by the GFC. I will not go through the details; bankers tell me we were damned lucky – I hope we will be the next time too.

In order to simplify thus far, I have not mentioned that there are actually two major sources of funding of banks’ loans. As well as deposits there is also the capital of the banks’ shareholders. I am simplifying but they are sort of ‘deposits’ with the following differences.

First, you cannot withdraw them; if you want your money back you can only sell your shares to someone else. Second, shareholders do not receive interest but they get a dividend from the profits the banks make. The return is (usually) higher than the rate of interest, because, third, the shareholders take on risk. If anything goes wrong – I’ll explain how – the shareholders are the first to lose their capital. So they need a higher return to induce them to contribute to the banks’ capital rather than deposit their savings.

Trading banks need these capital reserves as a cushion because their profits fluctuate and because of short term volatility – it is expensive to cover the mismatch by relying on the Reserve Bank or other trading banks. But banks also make investment mistakes when borrowers cannot repay their loans. Such costs not only cut back profits but they may reduce the banks’ capital.

Banks are always making bad loans; inevitably, given that they have to make judgements about the ability of borrowers to repay. They build in a margin in their charges for bad debts. But sometimes those bad debts are overwhelming; depleting the bank’s capital.

It is even possible for the bad debts to exceed the bank’s capital. Such failures have occurred in New Zealand on four occasions in 130-odd years. In the 1890s, at the end of the Long Depression, the Bank of New Zealand, the Colonial Bank and the National Bank of New Zealand all got into extreme difficulties, as did the Bank of New Zealand in 1990, only 30 years ago.

Often they involved a taxpayer bailout. If that does not work properly, the spreading turmoil in financial markets may impact badly on the economy. Fortunately, that has not happened here, but the collapse of the City Bank of Glasgow in 1878 precipitated the world into the two-decade ‘Long Depression’. Much the same thing happened during the GFC, but it was shorter.

In a way, the above banking experience underestimates the vulnerability of a financial system, even if we ignore runs. Finance companies are kinds of banks, except they do not have the privilege of going to the Reserve Bank when they are in trouble in the way that a trading bank can. You will recall that lots of finance companies collapsed about the time of the GFC – the collapse of South Canterbury Finance was only the most spectacular – but there have been many earlier instances. So, even if we ignore the many parallel overseas experiences, there are New Zealand examples of bank-like failures.

I hasten to add that nobody expects our trading banks to collapse regularly, and they go to a lot of trouble to avoid it. But it would be prudent to think about the possibility, and to expect at least one major banking failure in, say, the next 130 or even 35 years.

The larger the capital a trading bank holds the less likely it is to fail. But the higher the proportion, relative to its size, the lower the return to shareholders. So there is a tradeoff between prudence and profitability.

That is what the dispute about the adequacy of bank capital is about. The Reserve Bank wants greater capital adequacy to reduce the danger of bank failure; the trading banks want a lower proportion because it keeps their profit rate higher. Moreover, they doubt they can raise the extra capital, which could cause a credit contraction impacting on the health of the economy. It is a matter of judgement which is ‘correct’. However, I have noticed that most of those studies commissioned by the trading banks pay little attention to the possibility of bank failure; I leave you to decide why.

A bank failure is a serious problem even if the contagion does not spread to other banks when depositors, fearful that it will affect them, start a run on sound ones. In particular, if the bank’s capital does not cover the loss, the depositors may lose whole or part of their savings – as they did when the finance companies collapsed. So the depositors will be more comfortable with their trading banks having relatively higher capital reserves.

But depositors will end up with slightly lower interest rates as a consequence of better capital adequacy . (There are other possibilities such as lower profitability or higher lending rates; simplicity requires pursuing the most likely outcome.) What is happening is that depositors are suffering lower returns as a tradeoff for more secure returns, ‘paying’ a kind of insurance levy.

It would be easy for the Reserve Bank to turn a blind eye and mop up any mess in the future. (One of the consequences of a financial collapse is that the government (taxpayer) can end up bailing out depositors.) But the RBNZ seems to be most concerned with is maintaining prudent stability in the trading bank system. The trading banks would prefer the RBNZ did not interfere with them.

I cannot tell what the outcome of the dispute will be. It involves a tradeoff which is typically resolved by the balance of power. Whether the Reserve Bank is the more powerful and gets its way – perhaps with a lower capital adequacy target than it is currently promoting – or the trading banks get their preferred outcome, we must await on the sidelines. Or to put the power ‘game’ another way, it may be whether depositors make a lower return immediately or lose a chunk of their savings in the long run.