By Geof Mortlock*
The Government is currently undertaking a review of the Reserve Bank. That review is wide-ranging. It includes consideration of the governance arrangements for the Reserve Bank, the banking supervision arrangements and the framework for the protection of bank deposits.
The review has also opened up a more fundamental question: Should the Reserve Bank continue to be the prudential regulator of banks, insurers, non-bank deposit-takers (NBDTs) and payment system operators, or should this role pass to a new regulatory body?
In this article, I argue that a new financial regulatory body should be established, completely separate from the Reserve Bank. I believe this would provide the basis for a much-improved quality of financial regulation and supervision in New Zealand. It would avoid the conflicts of interest inherent in the Reserve Bank performing this function. It would enable all of the anti-money laundering regulation to be handled by one body, rather than being spread across three government agencies (i.e. the Reserve Bank, Financial Markets Authority and Department of Internal Affairs). It would reduce the excessive concentration of power that the Reserve Bank currently has. It would enable the Reserve Bank to focus on its core role of monetary policy, leaving prudential regulation to a separate agency with the culture and capacity to do the job properly. And it would avoid the risk of regulatory over-reach, such as when the Reserve Bank uses prudential policy for purposes well beyond financial stability.
The separation of the financial regulation function from the central bank has much precedent internationally. Indeed, it is the norm in much of the OECD. In many countries (e.g. Australia, Canada, France, Germany, Japan, South Korea, Sweden and Switzerland) the prudential supervision authority is completely separate from the central bank, often having been moved out of the central bank following a comprehensive review of regulatory institutional arrangements.
In New Zealand, there has never been a serious consideration of the benefits and costs of separating the prudential regulatory function from the Reserve Bank. Instead, prudential regulation of banks evolved within the Reserve Bank, growing from its historical role of regulating banks for monetary policy reasons. This was formalised in 1986 when the Reserve Bank Act was amended to formally establish prudential supervision of banks in the Reserve Bank. Many years later, in 2008, the Reserve Bank acquired responsibility for the prudential regulation (but – very oddly – not the supervision) of NBDTs, such as finance companies, building societies and credit unions. A few years later, in 2010, the Reserve Bank acquired responsibility for the prudential regulation and supervision of insurers, despite having very little expertise and no experience in insurance matters. Along the way, the Reserve Bank also became the regulator for anti-money laundering (AML) for banks, NBDTs and insurers. Yet, AML regulation for other categories of financial entities is handled by the Financial Markets Authority and Department of Internal Affairs – a very inefficient and costly arrangement.
New Zealand’s financial regulatory architecture has evolved in a piecemeal and muddled way. Changes have been made here and there in an ad hoc manner to respond to the pressures of the moment. Unlike most countries in the OECD, which have had periodic fundamental reviews of regulatory architecture in a considered and methodical manner, New Zealand has never done this.
It is worrying that, despite the failure of DFC in 1989, the virtual failure and government-funded rescue of BNZ in 1990, the failure of more than 50 finance companies in the period 2007 to 2011, and the failure of insurers, there has been no government enquiry into the adequacy of the Reserve Bank’s performance as prudential supervision authority, and no wider enquiry into financial system regulatory architecture. In contrast, Australia has had numerous such enquiries which have led to constructive and fundamental changes to the financial regulatory architecture in Australia.
More recent events in New Zealand also raise the fundamental question as to why there is not a substantial questioning of the competency and suitability of the Reserve Bank as prudential regulator. Several examples raise serious questions about whether the Reserve Bank is the appropriate agency to be the country’s prudential regulator. These include:
- the failure in 2017 of the Reserve Bank to promptly identify the non-compliance by Westpac with its internal capital model requirements – the Reserve Bank had failed to detect the breach of regulatory requirements for years before its eventual discovery;
- the Reserve Bank’s adoption of its eccentric and dangerous ‘open bank resolution’ policy, which, if implemented in a bank failure, could result in ordinary depositors being forced to take losses and could potentially trigger a destabilising run on the banking system;
- the Reserve Bank’s ongoing opposition to deposit insurance – largely for ideological reasons and a misguided view that it would undermine market discipline on banks;
- the Reserve Bank’s failure to comply with international standards on banking and insurance supervision, as revealed by the International Monetary Fund in 2017 when it conducted an assessment of New Zealand’s financial system;
- the very low scores that the Reserve Bank received in a survey of financial institutions in terms of its performance and conduct as regulator;
- the persistent resistance that the Reserve Bank has displayed in building a close, cooperative relationship with the Australians in planning for how a trans-Tasman banking crisis would be coordinated between them;
- the recent release of bank capital regulation proposals that would see banks in New Zealand being required to hold a very high level of capital compared to other countries, with potentially adverse consequences for borrowers’ access to credit, an increase in interest rates and adverse impacts on the economy – and all on the basis of shockingly flimsy analysis by the Reserve Bank; and
- the longstanding inadequacy of the Reserve Bank’s conduct as a regulator, including the inadequate quality of the cost/benefit analysis of its regulatory proposals, its arrogance in dealing with those who question its decisions and its lack of robust consultation practices.
I could go on. But you get the drift. The above examples paint a picture that is clear to see – of a central bank that fails in significant ways to perform the responsibilities of a professional, effective financial regulator. To make matters worse, the Reserve Bank governor portrays the Bank as a deity – the ‘god’ of the ‘financial forest’, none other than Tane Mahuta. He has spent more time publicly touting the Tane Mahuta metaphor than he has in explaining in a professional way the Reserve Bank’s role as financial regulator and accounting for its performance. At times, it feels a little like watching a Monty Python movie. New Zealand deserves better than this.
It is noteworthy that the only review ever undertaken of the Reserve Bank’s prudential supervisory regime since its inception in 1986 was the internal review conducted by the Reserve Bank itself in the early 1990s. That review was poorly structured, inadequately resourced and self-serving. It involved no external parties. Treasury had little, if any, input. The Reserve Bank Board played no substantive role in the review. It was largely driven by those in the Reserve Bank who had a philosophical bias against prudential regulation but fundamentally lacked any substantive understanding of the issues. The analysis in the review was superficial, ill-informed and driven far too much by half-baked ideology.
The review led to a hollowing out of the supervisory function, rendering the Reserve Bank even less effective as a supervisory authority than it had been in the preceding years. It brought about some constructive changes, such as the bank disclosure regime and director attestation framework, which were beneficial and sensible reforms, but left the Reserve Bank ill-equipped to identify and proactively respond to emerging stress in the banking system, and hopelessly under-resourced to deal with a banking crisis should one occur.
The review led, for some time, to the absurd outcome that the Reserve Bank supervision function should be based only on information that is publicly available and not privately accessed by the Bank. No other supervisor in the world operates on that basis - for good reason.
Sensibly, this naïve approach was progressively abandoned in later years and supervisory resources have been substantially increased. Nonetheless, many remnants of that mindset continue to this day and continue to undermine the effectiveness of prudential regulation. The Reserve Bank’s ideological and cultural DNA is simply incompatible with what is needed to perform the role of a financial regulator with the professionalism that is needed.
Reflecting this, the Reserve Bank continues to eschew any form of on-site assessment of banks or insurers. It has little in-depth understanding of bank and insurance risk management frameworks or a reliable ongoing means of verifying financial institutions’ financial position, including as to asset quality, the adequacy of loan loss provisioning and capital adequacy. By international standards, the Reserve Bank’s approach to bank and insurance supervision is lamentably under-developed. Indeed, drawing on my considerable experience in evaluating countries’ financial systems for the IMF and World Bank, I am confident in saying that many prudential regulators in emerging economies (i.e. those with around half of New Zealand’s per capita GDP) have considerably superior financial regulatory and supervisory authorities than the Reserve Bank. Using a cricket analogy, the Reserve Bank is about as much use as a financial regulator as is a cricket umpire who is nearly blind and who understands little about the game.
A fresh assessment of the financial sector regulatory architecture is well overdue. An assessment should be undertaken by Treasury, supplemented with independent experts selected and appointed by the Minister of Finance, to evaluate the benefits and costs of three regulatory architecture options:
- Retaining the prudential and supervisory function in the Reserve Bank, but under much-strengthened governance, accountability and transparency arrangements. This would entail undertaking a capability assessment of the Reserve Bank – much as is shortly to occur in respect of the Australian Prudential Regulation Authority, as announced recently by the Australian Government.
- Establishing an agency to conduct prudential regulation and supervision, with its own statute, governance and accountability arrangements, but where it is under the overview of the Reserve Bank, much like the former arrangement in the United Kingdom and the model recently established in South Africa.
- Establishing a completely separate government agency – a New Zealand Prudential Regulation Authority – under its own statute and governance and accountability arrangements, and completely unconnected with the Reserve Bank.
Of these options, I favour the third one – the creation of a new government agency, a Prudential Regulation Authority, that is completely separate from the Reserve Bank. This is the Australian and Canadian model, and one that is prevalent in many countries in the OECD. In my assessment, there are several persuasive reasons for separating the prudential regulatory and supervisory function from the Reserve Bank:
- It would reduce the concentration of excessive power in one agency. Currently, the Reserve Bank has a much wider range of powers compared to most central banks in comparable countries. A narrower span of functions would reduce this concentration of power and assist in the promotion of a less arrogant but more effective regulatory agency.
- It would enable the Prudential Regulation Authority to focus on the job at hand, without senior management being distracted by other tasks, particularly monetary policy, and without the hinderance of an unsupportive organisational culture, rooted in deep scepticism of the value of prudential regulation.
- It would enable a senior management team to be appointed with the skills, knowledge and experience to perform the role effectively – i.e. people with deep knowledge of banking, insurance and regulatory issues. The current senior management team – and its predecessors – fundamentally lack the skills, knowledge and experience required for the role, with few exceptions. Mostly, the Reserve Bank is dominated by macroeconomists. For all their talents, they know little about banking and even less about insurance, and still less about technical regulatory issues. They are not sufficiently qualified to do the job entrusted to them.
- It would enable the Prudential Regulation Authority to build the depth of knowledge and skills in its staff to perform the functions required of them. Currently, although the Reserve Bank has some able people in the supervisory area, it lacks the depth and breadth of ability that APRA or other OECD country regulators bring to the job – even allowing for obvious differences in size. This greatly hinders their effectiveness. For example, the Reserve Bank staff lack the data, skills, systems and knowledge needed to conduct in-depth reviews of bank and insurer risk management systems. Similarly, if the Reserve Bank were tasked with conducting an asset quality review of a bank or an asset and actuarial review of an insurer to assess its capital position it would lack the capacity to do this. In short, the Reserve Bank lacks the ability to do the job entrusted to it. A properly structured Prudential Regulation Authority would be much better equipped to do the job, led by senior management with the right blend of skills and knowledge, and with a supportive mindset committed to the mandate of the Prudential Regulation Authority, and undistracted by other responsibilities.
- Separation of the prudential regulation function from the Reserve Bank would also reduce the risk of regulatory over-reach and misuse of regulatory tools. For example, the Reserve Bank’s conduct of macro-prudential policy creates a risk of it being used for purposes that relate more to monetary policy than to prudential policy. A reasonably persuasive argument can be made that the Reserve Bank has used macro-prudential policy principally for reasons that relate to price stability (i,e, reducing inflationary pressures emanating from house prices) and housing affordability concerns (which is not part of its remit), than for legitimate financial stability reasons. There is a potential conflict of interest in a central bank having the macro-prudential policy tool at its disposal. It creates a risk of regulatory over-reach. In contrast, a prudential regulatory authority is much more likely to limit the use of macro-prudential policy to a narrower set of financial stability goals.
- Separation of prudential regulation from the Reserve Bank would reduce internal conflicts of interest. For example, the Reserve Bank regulates payment and settlement systems and yet also operates payment and settlement systems. This raises an obvious conflict of interest. It is questionable that the entity that owns and operates key parts of the payment and settlement systems should also be charged with regulating and supervising them. It is a bit like the referee of a rugby game also being a player on the field and writing the rules of the game. A far more satisfactory arrangement would be for the regulatory and supervisory functions to be vested in a separate agency.
Taking into account these factors, among others, a strong case can be argued for separation of the prudential regulatory and supervisory functions from the Reserve Bank, as has been done in so many other countries.
A further argument for the creation of a separate regulatory agency is that it would be well placed to assume the role of AML regulator for all entities subject to AML regulation. This could replace the current structure under which AML regulation is spread across three government agencies by consolidating the function into just one agency. It would be more effective and efficient. It would likely cost less than the current arrangement. It would promote a more consistent approach to AML regulation across the relevant sectors. And it would be more consistent with prevailing international practice, where the tendency is for one regulatory agency to perform AML regulation.
What of the arguments for retaining the prudential function in the Reserve Bank? The argument generally advanced by the Reserve Bank in favour of retaining supervision is the alleged synergy between the prudential function and the other functions of the Reserve Bank. For example, it has been argued by some in the Reserve Bank that the Bank is better equipped to perform the supervisory function because of its payment system operation, exchange settlement function and monetary policy operations. This argument is fragile at best and largely illusory. The insights gained by the Reserve Bank from these other functions have little bearing on its role as prudential regulator and supervisor. Interaction between the different departments within the Reserve Bank in my time at the Bank was very limited and had no effect on prudential policy decisions. It might have increased in more recent times, but I very much doubt that there is any substantive input from these other parts of the Reserve Bank to the supervision function.
If one looks at our near neighbour – Australia - the separation of supervision from the Reserve Bank Australia (RBA) had no deleterious effect on the effectiveness bank regulation and supervision. If anything, it enhanced it by enabling APRA to focus on its key functions without the distraction of the other functions of the RBA. To the extent that central bank insights have a useful role to play in informing prudential supervision, they can be harnessed efficiently and effectively through well-structured coordination between the supervision authority and the central bank, as happens regularly in Australia through the Council of Financial Regulators and bilaterally between APRA and the RBA.
Another argument offered for keeping bank regulation in the Reserve Bank is that it complements the central bank’s role as lender of last resort. This argument also fails upon scrutiny. A central bank only provides liquidity support to a bank in a last resort capacity if it is satisfied on the bank’s capital adequacy and that it has sufficient collateral to cover the credit and market risks involved in any lending. These assessments do not rely on the central bank being the prudential regulator. In many other countries, including Australia, the central bank looks to the prudential regulator for information and assurance on capital soundness. The central bank might undertake their own due diligence in some situations. They typically undertake separate initiatives to check for suitable collateral, which is not something that falls within the standard scope of a prudential regulation role in any case. In other words, the function of lender of last resort does not in any way rely on the central bank being the prudential supervisor. Just ask the central banks in Australia, Canada and many other OECD countries.
I therefore believe that the Government should undertake a rigorous assessment of the regulatory architecture in New Zealand. This should be led by Treasury with international experts brought in to assist and provide additional objectivity and expertise. It should include a capability assessment of the Reserve Bank and an assessment of the alternative regulatory architecture options.
I believe that New Zealand would be best served by a fundamental change to financial regulatory architecture, with the establishment of a new regulatory agency completely separate from the Reserve Bank. This new agency would have its own Act of Parliament, with a clearly specified mandate focused on financial stability and the protection of depositors and policyholders. It would be subject to robust governance, transparency and accountability. And, refreshingly, the new agency would be a mere mortal – not a tree god or indeed any kind of god. Let’s leave Tane Mahuta in the forest, where he belongs. He has no place on The Terrace in Wellington.
*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant 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.