By Geof Mortlock*
The Treasury and Reserve Bank recently released a consultation document on the second part of the review of the Reserve Bank Act: Safeguarding the future of our financial system: The role of the Reserve Bank and how it should be governed. The consultation document covers a wide range of issues relating to the review of the Reserve Bank Act, focusing on the Reserve Bank’s financial sector regulatory functions.
This is the first of a series of articles commenting on various aspects of the review. This article discusses what the Reserve Bank’s objectives of prudential regulation should be. Future articles may discuss, among other matters:
- the perimeter for prudential regulation;
- the case for and against depositor protection;
- the case for and against separating prudential supervision from the Reserve Bank; and
- the Reserve Bank’s institutional governance and decision-making framework.
Why do objectives matter?
A good starting point for assessing what the nature of financial sector regulation should be is to first define the objectives – i.e. what should the Reserve Bank be tasked with achieving in regulating banks, insurers and non-bank deposit-takers (NBDTs)?
Establishing clear and well-designed objectives is important. Without clearly identifying the objectives, it is impossible to know what one is seeking to achieve, let alone how best to achieve it and how to measure success or failure. Get the objectives right, and one at least charts the course for achieving worthwhile outcomes. Get the objectives wrong, and you might end up creating more problems than you solve. This is true not just in financial regulation, but in all aspects of life. In a very different field of endeavour, Yogi Berra, the renowned United States baseball player and coach, summed it up this way: “If you don’t know where you are going, you’ll end up someplace else.”
What are the current statutory objectives for the Reserve Bank?
The Reserve Bank’s prudential regulation objectives vary depending on the type of financial institution being regulated and supervised. In the case of banks, the objectives are to:
- promote the maintenance of a sound and efficient financial system; or
- avoid significant damage to the financial system that could result from the failure of a registered bank.
In the case of insurers, the objectives are slightly different, being to:
- promote the maintenance of a sound and efficient insurance sector; and
- promote public confidence in the insurance sector.
In the case of Non-Bank Deposit-Takers (NBDTs), the objectives are much the same as for banks, being to:
- promote the maintenance of a sound and efficient financial system; and
- avoid significant damage to the financial system that could result from the failure of an NBDT.
Are these objectives appropriate?
Well-defined regulatory objectives should have a number of attributes:
- Objectives should be linked closely to the reasons for regulating.
- Objectives should be realistic and achievable, given the regulatory powers available.
- Objectives should be non-conflicting.
- Objectives should be measurable (at least in broad terms).
Let’s assess the Reserve Bank’s statutory objectives against these criteria.
Do the Reserve Bank’s objectives relate to the reasons for regulating financial institutions?
The establishment of appropriate objectives for prudential regulation should relate to the reasons for regulating. So, what are the reasons for prudentially regulating banks, insurers and non-bank deposit-taking institutions? There is plenty of room for debate on this, but generally the reasons for justifying some form of prudential regulation relate to one or more of the following:
- The important role that financial institutions play in the economy and society. Banks and insurers play key roles in the financial system and economy. Banks intermediate funds between depositors and borrowers, facilitate credit allocation, enable payments and settlements, and manage customers’ risks. Insurers provide a key risk management tool for businesses and households, enabling economic activity that might otherwise not occur. It is therefore important to have a well-functioning financial system; it is critical to the functioning of our economy. Prudential regulation can help to foster this by reinforcing sound governance and risk management in financial institutions. It can help to focus the management of financial institutions on long-term financial soundness, rather than short-term profit at the expense of managing long-term risks (which has proved to be a key risk factor in many financial institutions globally).
- The systemic and economic costs of financial institution failure. When financial institutions fail, especially large and complex institutions such as the big banks, they have potentially severe impacts on the stability of the financial system and real economy. The failure of systemically important banks, or the multiple failure of medium-sized banks, can have serious and long-lasting effects on the financial system and economy, including through loss of savings, reduced capacity and appetite for lending, disruption to payment and settlement systems, interruption to the process of intermediation of funds between borrowers and lenders, and flow-on effects to economic activity. The failure of a large bank can potentially trigger the distress or failure of other banks – the so-called ‘contagion’ effect, and thereby destabilise the wider financial system.
There have been many examples around the world over the last 100 years of major financial instability and severe economic cost arising from large or multiple bank failures. New Zealand has not been immune from that, as in the late 1980s and early 1990s, when the failure of DFC, the near failure of BNZ and the distress of several other banks doubtless contributed to the depth and duration of the recession over that period.
Insurance failures do not to pose the same risk of systemic instability or economic impact as do bank failures. Nonetheless, insurer failures can have significant adverse impacts on economic activity, particularly in the case of insurers with dominance in particular niche insurance markets, as was apparent in the HIH Insurance failure in Australia in 2001. The failure of the large insurers in New Zealand would undoubtedly have significant impacts on the economy through a range of channels.
Prudential regulation and supervision seek to strengthen the management of risks in financial institutions and promote stronger buffers to absorb losses, with a view to reducing the probability and severity of institutional failure. Bank and insurance resolution policies seek to manage a failed financial institution in ways that minimise these adverse impacts.
- Fiscal costs of financial crises. A further rationale offered for prudential regulation and effective resolution policies is to reduce the fiscal costs associated with bank and institution failures. The costs can be large, as seen in many countries globally. These costs add to sovereign debt and represent an opportunity cost in the use of government funding by reducing the scope for governments to spend taxpayer dollars in other areas. Prudential regulation can help to reduce these costs by lowering the probability and extent of institutional failures, while resolution policies seek to minimise fiscal support.
- Depositor and policyholder protection. The failure of a bank or insurer can have devastating effects on depositors and policyholders. While one can argue that large depositors and policyholders should be able to look after themselves, this is not the case for ordinary ‘mum and dad’ depositors and policyholders. They lack access to the information needed to assess a financial institution’s financial position. Even if they had access to the information, they would not have the ability to understand it. Prudential regulation is often justified on the grounds of protecting small depositors and policyholders. In many countries this is reinforced through deposit insurance and policyholder compensation schemes. The presence of these schemes, and the liability they impose on the banking and insurance sectors, provides further justification for some form of prudential regulation.
The Reserve Bank’s current objectives align broadly to the reasons for prudential regulation. However, they are not as closely linked as they could and should be. For example:
- there is no reference in the objectives to financial stability (although it could be inferred, to some degree, from the reference to ‘soundness’), unlike in the case in many countries, where financial stability tends to be a core objective;
- the term ‘soundness’ is vague and could take on a wide range of meaning – it is so broad in concept as to be almost meaningless;
- there is no reference to the promotion of sound risk management at the individual institution level – the Reserve Bank’s objectives are only focused at the level of the financial system;
- there is no reference to protecting depositors or policyholders – unlike the case in many countries; and
- there is no reference to avoiding damage to the economy or to fiscal costs in a resolution context.
Further, the reference to ‘efficiency’ in the Reserve Bank’s objectives is rather problematic. It is not defined and hence could mean just about anything. If the term is retained, more specificity is needed, either in the law or in a policy statement that elaborates on the what efficiency, in this context, means. Moreover, as noted below, efficiency objectives are difficult to achieve using just prudential regulatory powers. Prudential regulation is, by its nature, designed to promote sound governance and risk management. It is much less well suited to promoting efficiency, other than indirectly. If efficiency has any meaning in a prudential regulation context, it is as a counter-balance to the pursuit of soundness – i.e. to avoid excessive or misguided regulation that creates excessive entry costs, excessive compliance burdens or undesirable distortions to financial sector behaviour and innovation. Broader efficiency goals in the financial sector are more likely to be achieved through competition policy and other forms of intervention, but do not sit well with the role of a prudential regulator.
Are the Reserve Bank’s statutory objectives realistic and achievable?
Objectives should be realistic and achievable using the regulatory tools available to the agency in question. In the case of the Reserve Bank’s objectives, ‘soundness’ is achievable within the limits of prudential regulation, but achievability can only be assessed once the term ‘soundness’ has been defined. Moreover, the soundness of a financial system is dependent on many factors that are outside the control of the Reserve Bank.
The efficiency objective – inadequately defined as it is – is only partially within the control of the Reserve Bank, given the limits of prudential powers. Moreover, there is a potential conflict between the pursuit of a sound (e.g. resilient and stable) financial system, on the one hand, and an efficient financial system, on the other. Financial soundness could doubtless be augmented tremendously through the adoption of very high bank capital ratios and very tight restrictions on risk-taking, but that would almost certainly have a very negative impact on the efficiency of the financial system in terms of costs to customers, reduced incentives and scope for innovation, and reduced competitiveness in the financial system. Yet there is nothing in any of the Acts under which the Reserve Bank operates that deals with this conflict. And the Reserve Bank has said little of use over the years in explaining how they manage the conflict.
Accordingly, I would argue that the objectives do not match up well to the achievability criterion.
Are the objectives measurable?
Regulatory objectives should desirably be capable of measurement. This is necessary if real accountability is to be attached to performance of the regulator against objectives.
The Reserve Bank’s statutory objectives, as currently expressed, are not readily measurable. This is partly because they are too vaguely expressed as concepts in the law. The law makes no attempt to define what ‘soundness’ and ‘efficiency’ mean. Likewise, there is no guidance in the law as to what ‘damage to the financial system’ means. And as for ‘confidence in the insurance sector’ what does this mean? Confidence by whom and confidence in what? More clarity is needed. But what is also needed is a document – such as a ‘Policy Objectives Statement’ – issued by the Minister of Finance that breathes life into the statutory terms – i.e. a parallel to the Policy Targets Agreement for monetary policy.
What should be the objectives of prudential regulation?
It takes more than a short article to define appropriate regulatory objectives for the Reserve Bank. The consultation process will hopefully lead to a better formulation than is currently in the law – objectives that better relate to the reasons for regulation, are achievable, are non-conflicting and are measurable. As a starting point in that process, my suggestion is that the objectives might sensibly relate to:
- promoting prudent risk management in financial institutions;
- promoting a resilient, stable financial system;
- promoting depositor/policyholder confidence in the financial system/insurance sector; and
- resolving failing financial institutions in ways that maintain financial system stability, protect insured depositors, minimise adverse impacts on the economy and, subject to these objectives, seek to minimise fiscal risk.
The law might also appropriately require the Reserve Bank, in the pursuit of these objectives, to seek to minimise adverse impacts on the efficiency of the financial system and avoid excessive compliance costs for financial institutions.
There is a need for more than just high-level objectives in the law. There should also be a more specific set of policy objectives specified by the Minister of Finance from time to time (in consultation with the Reserve Bank) – a Statement of Policy Objectives issued by the Minister. These would be a parallel to the Policy Targets Agreement for monetary policy, but expressed in mainly qualitative terms rather than quantitative policy targets. A Statement of Policy Objectives would appropriately be accompanied by performance metrics, set by the Minister, against which the Reserve Bank would be assessed annually. However, that brings me to another theme – the accountability of the Reserve Bank. A topic for another day.
*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant who undertakes work 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 at the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.