Explainer: What's a bank's 'capital stack' - and why does it matter to me?

When you take out a home loan or a business loan, you probably don’t think much about the rules that banks must follow behind the scenes. But bank capital rules aren’t just a technical issue for bankers, they affect every Kiwi who wants to buy a home, run a farm or a business.

That’s because the Reserve Bank of New Zealand’s (RBNZ) decisions on how much capital banks must hold have an impact on the cost of providing loans.

This has a flow on effect to households, businesses and the broader economy.

What Is bank capital?

Think of a bank like a family that keeps money aside for emergencies. A family may have available different money that they could access depending on how bad the emergency was. The first stash they might use is cash in their transactional bank account – it is there ready to use. After that they access the money they were putting aside in their savings account, and then their ‘just in case’ protection might be a loan top-up secured against their home.

Banks are similar in that they also have different forms of money, known as capital, available if times got tough. The different forms make up the ‘capital stack’. The first is CET1 (Common Equity Tier 1) - that’s the bank owner’s money. Once that was exhausted, or close to it, Additional tier 1, also known as AT1, is next. Tier 2 (T2) is the last form, the ‘just in case’ protection.

CET1 is the most expensive form of bank capital and T2 the least. The more expensive the capital, the higher the cost for banks. Part of that cost is passed on to borrowers through interest rates.

Why are NZ’s rules so tough?

In 2019, the RBNZ decided that New Zealand banks should hold much more capital than banks in most other countries. An estimated extra $20 billion by 2028, just in case of a rare crisis, a 1-in-200-year event. This made the banking system safer, but it also increased costs for banks. ANZ analysis showed these rules would add about 40 basis points to the cost of providing loans to our customers.

What’s changing now?

The RBNZ is reviewing the decisions they made in 2019, including how they compare to other countries capital requirements. They are deciding not just how much capital banks should hold but also how much of each form of capital. It’s looking at two options: Option 1 lifts the top, most expensive layer (CET1) from 10% today to 14% and slightly reduces the overall stack - a bigger ‘transactional account balance’, less of the cheaper backups. Option 2 sets CET1 at 12% and adds more of the cheaper safety gear (T2 plus something called loss absorbing capital (LAC), a backstop used in a crisis). All up, protection would be at about 21%.

Both options require more capital than banks must have today.

Is there an alternative?

Yes. ANZ believes there is a more efficient and balanced approach. Our recommended option would reduce the cost of providing credit to New Zealanders by around 11 basis points compared to the 2019 plan.

Instead of relying heavily on the most expensive type of capital (CET1), we recommend following Australia’s model, which uses a more efficient mix of capital types.

Our proposal includes:

· A CET1 requirement of 10.5% (including regulatory buffers)

· A total capital requirement of 13.75%

· A total Loss Absorbing Capacity (LAC) requirement of 18.25%

Banks would still hold more capital overall than what was required under the 2019 rules, but it would be structured in a way that’s more cost-effective.

We’re already about halfway through adding the extra capital under the 2019 rules. For ANZ that has equated to an increased requirement of $5.4 billion to 1 July 2025. Stopping the capital impost will take pressure off interest rates in future.

Our recommendation supports the Finance and Expenditure Committee’s call to ease the capital burden on banks. It’s a practical solution that brings New Zealand’s banking rules closer in line with international standards, in particular Australian standards.

We estimate this option could be put in place quicker than the other options being considered and would reduce the cost of borrowing by around 11 basis points compared to the 2019 plan. That’s an average, the impact on loans that attract a higher risk-weighting (typically business and agriculture lending) would be bigger than those that don’t (like home loans).

Why this matters for businesses and farmers

Business and agricultural loans are usually seen as riskier than home loans, so banks are required to hold more capital against them.

ANZ’s recommended approach would lower the amount of expensive CET1 capital that banks must hold across all loans. The expected impact for the productive sectors of the economy is at least double what it is for housing.

As an example, you can see the impact on how much capital banks are required to hold against a loan under the different options in the table below.