By Geof Mortlock*
In his ongoing battle against the Australian banks, Reserve Bank governor Adrian Orr recently expressed concern that some directors of banks in New Zealand also sit on the boards of their parent banks. He questioned in whose interests they were working – the foreign parent shareholders or the shareholder of the subsidiary bank in New Zealand. Although he did not explicitly target this comment at the four large Australian banks operating in New Zealand, it seemed clear that they were the banks to which his comment was referring. One could easily be forgiven for thinking that this was yet another example of Mr Orr’s apparent antagonistic attitude towards the Australian banks. However, putting that observation to one side, let’s look at what he was saying and assess it.
It is true that some banks operating in New Zealand as subsidiaries have directors on their boards who also serve as directors on the parent bank boards. This has long been the case. And the Reserve Bank has long allowed it to be so. Rightly, in my view. We are not alone in that regard. It is very common globally for subsidiaries of foreign banks to include directors who also sit on the parent bank board. This can be found in many countries in which foreign banks have a presence, including virtually every OECD jurisdiction. Moreover, it is not unique to banking. Globally, and in New Zealand, it is commonly the case that some of the directors of a subsidiary of a foreign parent company are also on the board of that parent company.
There is a very good reason why this practice is so common. It recognises that a subsidiary – whether a bank or any other kind of company – is part of a global, interconnected group. The parent entity needs to ensure that there is a whole-of-group approach to business strategy, risk appetite, risk management and operational management. That is to be expected. Indeed, it would be very troubling if a parent entity did not manage the group’s affairs on a globally integrated basis, given the potential for risk events in one part of the group to adversely impact the group as a whole. In banking, that is why we see such an emphasis on global group risk management, where risk appetite, risk management, stress testing, capital strategy, recovery planning, business continuity and the like are generally managed both at a global group level (recognising the inter-connectedness of entities within the group) and, separately, at the level of each subsidiary in the group.
Having some overlap in board membership is an important element in achieving a whole-of-group, cohesive and integrated approach to risk management. It provides the opportunity for directors who sit on the subsidiary board to seek to ensure that the decisions made in the parent board are not inconsistent with the interests of the subsidiary. In that regard, it therefore offers some degree of protection to the New Zealand banking system. It also provides a further channel by which a parent entity can ensure that group policies and practices are being properly applied at subsidiary level.
Internationally, banking regulators in home jurisdictions strongly encourage – and indeed often require – a parent bank or holding company of a global banking group to demonstrate comprehensive governance and management of risks across the global group on a consolidated group basis. They do so because they recognise the need for a cohesive, consistent approach to risk management policies and practices across the global group in order to reduce the risk of one part of the group triggering or exacerbating problems in another part. For example, the Australian Prudential Regulation Authority (APRA) requires banks in Australia to apply prescribed risk management requirements at the parent bank level and the parent’s global group. In that context, internationally, banking regulators have been supportive of – and routinely allow – an overlap in the membership of boards between a parent entity and subsidiaries. For example, Australia allows an independent director on a foreign parent board to also be an independent director on the bank board in Australia, including to be its chairman.
NZ subsidiaries benefit from improved risk diversification
As a host country, where the biggest banks in New Zealand are foreign owned, New Zealand derives major benefits from a whole-of-group, integrated approach to the management of the banks’ risks. The foreign banks operating here – including the large Australian ones – are stronger because of the risk management policies and practices applied to the New Zealand subsidiaries by the parent banks in Australia. The subsidiaries benefit from improved risk diversification that arises from being part of a large global group. They also benefit from the parent bank’s depth of risk management skills, knowledge and experience that can be expected from a large global group.
New Zealand also derives banking system efficiencies from having large Australian and other foreign banks operating in New Zealand, including economies of scale and scope, and reduced operational costs, that tend to arise from being part of a global banking group. To date, New Zealand’s interests have been very well served by the foreign banks operating here. Indeed, it is no accident that the few bank failures or near-failures that New Zealand has experienced occurred in New Zealand owned banks. To a substantial degree, that reflected the poorer quality of governance and risk management practices in those banks compared to their foreign-owned competitors.
I would argue that, in the majority of situations, there is a strong complementarity of interests between the parent and subsidiary banks. The financial soundness of the subsidiary to a large degree depends on the financial soundness of the parent. However, this is not to say that conflicts of interest cannot arise between a foreign parent bank and the subsidiary bank in New Zealand. On occasions, that can happen. For example, conflicts of interest can arise in a situation where the parent bank is in financial stress and seeks a repatriation of capital from the subsidiary, or a lay-off of risk from the parent to the subsidiary or obtaining funding from the subsidiary. Tensions can arise in the global allocation of capital between subsidiaries within a group. And there may be instances where the parent and subsidiary have divergences in their respective preferred risk appetite.
However, the answer to these potential concerns is not – as Adrian Orr seems to suggest – to require directors of the banks in New Zealand to resign as directors of the parent banks. That would be an odd and very counter-productive approach. It would be inconsistent with international practice and the Reserve Bank’s long-established governance requirements for banks. It would fly in the face of the fact that – in the overwhelming majority of situations – there is a complementarity of interest between parent bank and subsidiary, and that conflicts, while they can arise, are comparatively rare. In short, to pursue Adrian Orr’s idea would be throwing the baby out with the bath water. It would not be consistent with New Zealand’s best interests.
The solution to any conflict issue lies elsewhere. And, indeed, the Reserve Bank already has some of the key solutions in place. For example, the Reserve Bank requires at least half of the directors of a bank in New Zealand to be independent (i.e. non-executive and otherwise independent of the bank). It requires the chairman of the board to be independent. It contemplates the possibility that the chairman might also be a director (but not an executive) of a parent entity, and enables such a person to be chairman provided that the parent company directorship is the only respect in which the director would fail the normal tests for independence. The Reserve Bank also states that it will need to be satisfied that the chairman’s experience and background is such that they could be expected, when acting as a director of the holding company, to adequately contribute the subsidiary’s perspective to the way that the group as a whole is run.
A further protection against conflicts of interest is dealt with sensibly by the Reserve Bank’s longstanding requirement that the director must act in the interests of the bank in New Zealand. It specifically rules out a bank having a constitution which enables a director to act in the best interests of a holding company even though this might not be in the interests of the subsidiary (as permitted under section 131(2) of the Companies Act 1993).
These measures address the concern that Adrian Orr has raised. Other prudential requirements also address the concern, such as the limit on credit exposures that a bank may have to a parent entity and other connected parties. Repatriation of capital from the subsidiary to the parent is ruled out to the extent that it causes a breach of the Reserve Bank’s capital requirements for banks in New Zealand. In addition, the Reserve Bank has ample legal powers available to intervene if a bank board in New Zealand were to act in a manner detrimental to the interests of the bank and its depositors. Furthermore, the director attestations required under the Reserve Bank disclosure regime for banks also provide important safeguards that help to address whatever concerns Mr Orr might have. Among other matters, the directors are required to sign legally binding attestations as to whether the bank in question has systems in place to monitor and control the banking group's material risks and whether those systems are being properly applied; and whether the bank has complied with its conditions of registration over the period covered by the disclosure statement.
I therefore take the view that an overlap in directors between a parent bank and the bank subsidiary in New Zealand is a sound practice that brings benefits to the governance and management of risks of the bank in New Zealand. Complementarities of interest between parent and subsidiary will greatly outweigh the occasions on which conflicts might arise. To the extent that potential conflicts of interest might occasionally arise, these are dealt with in the existing requirements applied by the Reserve Bank. If any further protections are needed – and I am not convinced there are – then a targeted solution should be sought, rather than Mr Orr’s counterproductive suggestion that a director of a bank in New Zealand may not also be a director of the parent bank. Targeted solutions would seek to address the conflict situation specifically by, for example, requiring a director to oppose, in parent board deliberations, any initiative by the parent bank that would be contrary to the interests of the New Zealand bank or, in extremis, to resign from the parent board if the director is unable to give reasonable effect to opposition to such an initiative. However, I do not think such measures are needed. They are already addressed by the existing requirement to act in the interests of the bank in New Zealand.
The elephant in the room
However, there is a broader issue here. The elephant in the room. And that elephant is the governor’s persistent antagonism towards Australian banks and the Reserve Bank’s associated autarkic approach to banking regulation. Whereas most banking regulators globally are trying to build closer cooperation and coordination between home and host regulatory authorities in the regulation of banks, to try to find sensible whole-of group solutions, the Reserve Bank persists in its bunker-like, defensive, autarkic policy stance. It does so, ostensibly, because it says it is acting in New Zealand’s best interests. But I believe that their approach is counterproductive to our interests.
This bunker-like autarkic approach manifests in several ways.
The Reserve Bank’s ill-considered bank capital proposal is one glaring example. The unjustified and as yet still un-costed proposed hike in bank capital ratios, which is presented by Mr Orr as being in New Zealand’s best interests, is likely to prove quite the contrary. If implemented, it will impose potentially very significant long-term costs on New Zealand’s economy in terms of reduced appetite by banks to lend and higher lending costs. In my view, this will particularly harm the many thousands of our small to medium-sized businesses; they are the ones most vulnerable to the impact of higher bank capital ratios. I believe the economic costs of the huge hike in capital ratios would significantly exceed the little benefit it would bring in lowering the probability of bank default (from an already extremely low level). As others have said, it would be one of the most expensive insurance policies we have ever been asked to pay.
A more sensible approach would be for the Reserve Bank to introduce recovery planning requirements for banks to require them to establish the means by which they would seek to restore themselves to a sound financial position, and to do so in close coordination with the parent banks – i.e. seek a whole-of-group approach. If any further loss absorption buffer is then found to be necessary, there are much less expensive options than the Reserve Bank is proposing, such as a requirement for the large banks to have a tranche of contractual ‘bail-in’ debt, as is increasingly being required of systemically important banks in many countries. The adoption of a professional approach to banking supervision, rather than the half-hearted, under-resourced approach adopted by the Reserve Bank, would provide a further safeguard in protecting New Zealand’s financial system. Adopting a more comprehensive approach to bank risk management, such as APRA did with its risk management requirements some years ago, would also be a much less expensive and more effective way of managing New Zealand’s financial system risks than the unjustified hike in capital ratios proposed by Mr Orr.
Another example of the Reserve Bank’s go-it-alone, bunker mentality is their half-baked and frankly quite dangerous ‘Open Bank Resolution’ policy – the proposal to apply a ‘haircut’ in a capricious manner (and, in my opinion, with questionable legal foundation) to depositors and other creditors, and with no thought given to any ex post ‘no creditor worse off’ compensation. It has persisted with this policy while also opposing the establishment of deposit insurance. If ever a government in New Zealand were silly enough to follow the Reserve Bank’s advice on this, and applied the Reserve Bank’s recommended haircut, it would pose a significant risk of contagious runs on banks and severely damage confidence in the banking system. Deposit insurance helps to mitigate this risk, but only to a degree. And deposit insurance is only being introduced because the Government, supported by Treasury and others, has accepted that it is a sensible and necessary part of a bank failure management policy. The Reserve Bank has been irresponsible, reckless, incompetent and obstructive at every turn on this matter.
A more sensible and orthodox approach to dealing with a bank failure would be to take a whole-of-group approach, under which the New Zealand and Australian authorities would work closely together to develop resolution plans that are designed to resolve the parent bank and New Zealand bank in one package. This would be far less expensive for New Zealand than the isolationist approach being pursued by the Reserve Bank, especially if it involved a tranche of contractual bail-in debt that could be applied while keeping the group intact. We would still need to have a back-up arrangement to cater for a situation where the Australian-led resolution would not meet New Zealand’s interests, but this could be done in far less costly ways than the Reserve Bank has done with its bank outsourcing requirements.
The outsourcing requirements are yet another example of the Reserve Bank’s bunker mentality. They reflect an almost paranoid obsession within the Reserve Bank that the Australian authorities would cut off parent bank functionality support to the New Zealand operations in a banking crisis. This is a very unlikely outcome given that cutting off functionality support to the New Zealand operations would almost certainly backfire on the Australian parent banks, making their rescue by the Australian authorities in a banking crisis all the more expensive. Again, a whole-of-group resolution framework, built on cooperation, coordination and trust between the Australian and New Zealand authorities, would largely avoid the need for expensive outsourcing requirements.
In summary, what we need from the Reserve Bank, and from its governor in particular, is a much more intelligent, thoughtful and professional approach to banking regulation and supervision. The autarkic bunker mentality needs to be abandoned. A sensible cross-border policy framework needs to be introduced. Sadly, what we are getting is a constant stream of half-baked proposals that have not been adequately thought through and have not been subject to any robust cost-benefit analysis. And – even more sadly - we are being entertained each week by off-the-cuff and ill-considered commentary from the Reserve Bank governor on policy issues that warrant a far more professional and thorough approach.
One can only hope – perhaps in vain – that the Minister of Finance will finally take an active interest in these matters and impose on the Reserve Bank and its governor the kind of discipline and accountability that is so badly lacking. So too with the Reserve Bank Board, which is missing in action. But these issues are for another article.
*Geof Mortlock is an international financial consultant based in Wellington who undertakes extensive assignments for the International Monetary Fund, World Bank and other organisations globally, dealing with a wide range of financial sector policy issues. He formerly worked at senior levels in the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.