By Gareth Vaughan
Former BNZ chairman Kerry McDonald is giving the Reserve Bank both barrels for its hands-off, "naive" and "not fit for purpose" regulation of New Zealand banks, and for "consistently ignoring" the interests of bank customers.
In a submission sent to Finance Minister Grant Robertson and provided to media including interest.co.nz, McDonald lays into the Reserve Bank, saying it's "unacceptably complacent, weak and ineffective" as a bank regulator. Robertson is overseeing a review of the Reserve Bank Act.
Ultimately McDonald wants the Financial Markets Authority (FMA) to take over bank regulation leaving the Reserve Bank with its central bank, including monetary policy, responsibilities. This would mimic the Australian model where the Reserve Bank of Australia sets monetary policy and the Australian Prudential Regulation Authority (APRA) is the prudential regulator of banks. (Interestingly the New Zealand Bankers' Association floated the idea of splitting the Reserve Bank's monetary and prudential responsibilities in a 2013 submission to the Productivity Commission).
To take on its new role the FMA should be "appropriately empowered, resourced and held to account," McDonald writes, with the interests of depositors "the highest priority."
The key problem McDonald sees with the Reserve Bank is this; "The RBNZ does not know whether the banks which it has licensed to operate in New Zealand are abiding by the terms of their banking licences. The banks are simply required to attest that they are but there is no review, examination or audit process, which is naive in the extreme! This is not tiddlywinks!"
'An industry that routinely demonstrates that it cannot be trusted'
McDonald also argues the Reserve Bank's Open Bank Resolution (OBR) bank failure tool - if used - would exposure bank customers, especially depositors, to an unacceptable level of risk. He says the Reserve Bank "consistently ignores" the interests of bank customers, notably depositors, and relies on "attestation from an industry that routinely demonstrates that it cannot be trusted."
McDonald also highlights issues aired by the International Monetary Fund (IMF) in last year's Financial Sector Assessment Program (FSAP) report on New Zealand. The IMF criticised the Reserve Bank's idiosyncratic light handed regulatory approach, which I detailed here, and said political will and increased resources would be required for beefed up banking supervision.
The IMF judged the Reserve Bank "materially non-compliant" in 13 of 29 international bank regulatory and supervision framework standards, or Basel core principles. The Reserve Bank played this down, saying it came as no surprise, but that it would closely examine the IMF recommendations.
McDonald describes the Reserve Bank's response to the IMF report as "naive, complacent and entirely unacceptable," reflecting a culture "unacceptable in a bank regulator."
"For this and other reasons I consider it inappropriate and anomalous that RBNZ is both the central bank and the regulator of the NZ banking system. The two functions are quite different and require different skills and capabilities. I therefore recommend that the Financial Markets Authority be designated as the bank regulator and that appropriate arrangement be made for it to develop the requisite 'fit for purpose' policies and capability; and take over the function ASAP. It is after all the 'financial markets authority' and this separation is common globally, including in Australia," McDonald writes.
He notes a key difference between Australian and New Zealand bank regulation is that APRA actively enquires, probes, tests, challenges and identifies issues. In contrast the Reserve Bank does none of this. It doesn't even do on-site inspections.
"So everything looks fine - but the reality is they simply do not know! They simply rely on attestation, in circumstances in which it is simply not credible!" McDonald writes.
An emphasis on self and market discipline
The Reserve Bank believes its hands-off three-pillar regulatory oversight regime focused on self, market and regulatory discipline, with an emphasis on self and market discipline, has served New Zealand well. The regulator is currently reviewing its directors' attestation regime. It says it will detail the findings of the review and outline its proposed response this year.
McDonald notes that New Zealand's big four banks - ANZ, ASB, BNZ and Westpac - are all Australian owned with parential representatives on the New Zealand subsidiaries' boards. Additionally they organise/control many of the senior executive appointments, their systems and processes and policies, and most importantly influence how the New Zealand offshoots respond to a crisis.
"It is of particular importance that the New Zealand boards of the New Zealand licensed banks are required to make all important decisions in relation to and in the best interest of the New Zealand bank, and are expressly not allowed to act in the interests of a holding company - such as the parent bank. But the RBNZ simply does not know if this is being complied with - again a critical issue. It simply - again and naively relies on attestation without audit or other serious testing or enquiry," McDonald writes.
McDonald is a fan of the "BEAR" measures being introduced in Australia to strengthen the responsibility and accountability of Australian bank executives and directors.
'They have deliberately put the bank customers, especially depositors, in a position of high exposure'
On the OBR McDonald argues it entails a serious moral hazard for the Reserve Bank.
"They have deliberately put the bank customers, especially depositors, in a position of high exposure, which they then should, at the very least mitigate by effective regulation - but they don't."
Asked by interest.co.nz to elaborate on this point McDonald said; "As with APRA there should be a much greater priority to protecting depositors - that must be explicit. And the more effective the regulation the better depositors - and everyone else - will be protected."
In his submission McDonald goes on to point out customers have no influence on the appointment of bank directors to ensure they are competent and make astute decisions, especially in the areas of risk they deal with "when the banks have a disturbing history of accepting higher levels of risk to increase profits and executive remuneration."
"The RBNZ consistently ignores the interests of customers, which will often differ from those of the bank, as is highlighted by many of the recent performance failures of banks as they seek to increase profits by inappropriate/illegal means," says McDonald.
He notes APRA, in contrast, aims to ensure the risks undertaken by the institutions it supervises are clearly identified and well managed and that the likelihood of financial losses to consumers are minimised. By doing this APRA strives to act to protect the interests of depositors and to promote the stability of the Australian financial system.
As a former insider with 17 years experience as a bank director in New Zealand and 12 years in bank governance in Australia, McDonald's views deserve serious consideration.
His strong criticism of the Reserve Bank's light touch oversight of New Zealand's banks aligns with some of the criticisms I too have made of the central bank and prudential regulator. For example, after the IMF review when I asked if the Reserve Bank was little more than an ambulance at the bottom of the cliff, when I argued less dogma and more flexibility was needed in the Reserve Bank's risk management strategy, and questioned its staunch opposition to deposit insurance.
It's also frustrating the Reserve Bank - and Commerce Commission - don't have the ability to tackle excessively high credit card interest rates as the Reserve Bank of Australia does. And when insurer Youi was in the gun it was disappointing the Reserve Bank, as prudential regulator of insurers, was only able or willing to say the outrageous sales tactics exposed by Diana Clement's articles raised "important and serious" issues.
In terms of the ability of the big four New Zealand banks to be run as standalone operations separate from their Australian parents in a crisis, McDonald may not be giving enough credit to the Reserve Bank's outsourcing policy. Being bolstered, this policy is expected to cost New Zealand banks about $550 million, or 2.8% of their cumulative after-tax profits over five years, and is not popular in the big end of banking town.
And on macro-prudential policy - notably through the introduction of the LVR restrictions - the Reserve Bank has been ahead of APRA.
Off the back of the IMF review, the ongoing Reserve Bank review of bank capital adequacy requirements, Robertson's review of the Reserve Bank Act, and March's arrival of Adrian Orr as Governor, there is some hope for a change of attitude at the Reserve Bank.
And I believe attitude is the key issue. Rather than loading an already stretched FMA up with such a big, new responsibility, I'd prefer to see what admittedly would need to be a sea change in attitude at the Reserve Bank. This would undoubtedly require more fresh blood at Reserve Bank HQ than just Orr.
When announcing Orr's appointment Robertson said Orr has the skills to successfully lead the Reserve Bank through a period of change. Let's hope the Finance Minister has more change in mind than just making Reserve Bank monetary policy have a focus on employment as well as inflation. Because it would be nice to have a bank regulator that relied on more than just directors' attestations to know whether things are hunky dory at our banks.
If this is to happen Robertson may need to forsake a dividend or two from the Reserve Bank to allow it to beef up its current funding agreement with the Finance Minister, which currently provides annual funding increases of only about 1% until 2020.
The Reserve Bank receives no direct taxpayer funding through the Parliamentary appropriation process. Its main source of income is the return on investments it holds, which are funded by the issue of currency and by the central bank's $2.8 billion of equity.
Under the Reserve Bank Act, the Minister of Finance and the Reserve Bank Governor have a five-year funding agreement specifying the amount of the Reserve Bank's income to be used to meet operating expenses in each of those years. The size of the dividend paid to the Crown is determined by the Minister of Finance each August on the recommendation of the Reserve Bank. Last year the dividend was $140 million.
As the IMF pointed out; "The RBNZ operates under specific resource constraints and numbers are insufficient [it has about 240 staff]. Strengthening the regulatory discipline pillar will require increased resources, including technical capacity to develop prudential requirements and guidelines, deepen the analysis that supports the supervisory ratings, and to develop a supervision policy that reflects a balance between risk and efficiency costs of supervision."
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