A new approach to banking supervision
Governor of the Reserve Bank of New Zealand
to the Centre for the Study of Financial Innovation
Thank you for inviting me to speak to you today.
The subject of my address today is the new approach which New Zealand has adopted to the supervision of its banking system. As some of you may be aware, this has attracted considerable interest around the world, not least for the emphasis it places on market disciplines as a means of promoting a robust banking system.
Before I outline the new approach to banking supervision, I think it would be useful to put the supervision reforms into a broader context.
As you probably know, New Zealand is no stranger to financial innovation. Over the last decade or so, the New Zealand financial sector has undergone a sweeping set of reforms. Briefly, these have included:
- the removal of all controls on interest rates
- the removal of exchange control and the floating of the New Zealand dollar;
- the abolition of government security ratios and regulatory lending constraints;
- the privatisation of all state-owned financial institutions and the removal of government guarantees of savings bank deposits; and
- a number of other measures to promote a more contestable and competitively neutral financial sector.
These reforms have played an important part in the broader restructuring of the New Zealand economy. And they have resulted in New Zealand having one of the least regulated financial sectors in the world.
It is not surprising, given this background, that sooner or later, banking supervision policy would be reassessed. Indeed, the recent reforms to banking supervision very much complement the general pattern of financial sector liberalisation in New Zealand.
In order to understand the new approach to banking supervision in New Zealand, it is helpful to know a little of our former supervision framework.
For most of the period from 1987 to 1995, New Zealand's approach to banking supervision was relatively orthodox. It involved:
- minimum capital requirements (based on the Basle Capital Accord);
- a limit on the amount which banks could lend to connected persons (such as major shareholders) and individual customers;
- a limit on banks' open foreign exchange positions;
- off-site monitoring of banks, using information provided privately to the Reserve Bank;
- annual consultations with the senior management of banks; and
- a range of powers to enable the Reserve Bank to respond to bank distress or failure.
However, the former system of banking supervision differed in some important respects from the approaches adopted in many other countries. In particular, New Zealand's supervisory framework:
- did not involve the licensing or supervision of deposit-taking or the business of banking - only those entities wishing to use the word "bank" in their name were subject to supervision;
- did not feature deposit insurance;
- did not seek to protect depositors per se - instead, it sought to protect the financial system as a whole; and
- did not comprise any form of on-site examination of banks.
These distinguishing features continue to apply under the new supervisory framework.
So, why did we review our approach to banking supervision? The review was motivated by a number of concerns. I will briefly outline the more important of these.
- First, the Reserve Bank was concerned at the compliance and efficiency costs associated with conventional approaches to banking supervision. This concern probably reflects the reality that banking supervisors tend to have strong incentives to promote a stable financial system, without always having appropriate regard to the compliance and efficiency costs to which supervision and prudential regulation can give rise.
- Second, we were concerned at the taxpayer risk involved in the traditional approach (which of course is partly based on the supervisor, and only the supervisor, having access to detailed prudential information on banks).
- Third, we recognised that conventional banking supervision can only go so far in promoting a sound banking system. There are inherent limitations in the extent to which prudential regulation and supervision can minimise the incidence of bank distress and failure. Indeed, we were concerned that banking supervision could even be increasing the risk of bank failure, by reducing the incentives for bank directors and managers to monitor their own operations, and to make their own considered judgements about what constitutes prudent behaviour.
- And, we believed that market disciplines were being under-utilised as a means of promoting stability in the financial system.
After a lengthy period of review and consultation, the new banking supervision arrangements came into force on 1 January this year. The new arrangements seek to address the concerns just outlined, by increasing the role of market disciplines in New Zealand's financial system.
Under the new approach, New Zealand's banking supervision objectives remain essentially unchanged. Supervision seeks to maintain a sound and efficient banking system and to minimise damage to the system that could result from a bank failure. We remain of the view that it is unnecessary and inappropriate to protect depositors or to provide deposit insurance. However, the way the Reserve Bank seeks to meet those objectives has indeed changed.
Probably the most important feature of the new banking supervision framework is the public disclosure regime under which all banks in New Zealand now operate. This requires all banks to publish quarterly disclosure statements, containing comprehensive financial and risk-related information.
The disclosure framework has a number of features. I will not mention them all, but some are worth highlighting.
- An important feature of the new framework is the quarterly Key Information Summary. This is aimed principally at depositors and contains a short summary of key information on the bank, including:
- the bank's credit rating (or a statement that the bank has no credit rating);
- the bank's capital ratios, measured using the Basle framework; and
- information on exposure concentration, asset quality, shareholder guarantees (if any) and profitability.
- The Key Information Summary must be displayed prominently in every bank branch. We are hopeful that it will provide depositors and others with more focused and timely information than has previously been the case.
- Banks must also publish a larger disclosure document quarterly, which is aimed principally at professional analysts and the financial news media. It contains detailed information on the bank and its banking group, including:
- comprehensive financial statements;
- detailed information on capital adequacy, exposure concentration, lending to controlling shareholders and asset quality; and
- information on the bank's exposure to market risk.
- The disclosure statements must be externally audited twice a year, although the half year audit is only required to be of a limited review nature.
- Perhaps one of the most important features of the disclosure framework is the role it accords bank directors. The directors are required to make certain attestations in the disclosure statements, including whether:
- the bank is complying with the conditions of registration applied by the Reserve Bank to the bank;
- the bank has systems in place to adequately monitor and control its banking risks and whether these systems are being properly applied; and
- the bank's exposure to controlling shareholders is contrary to the interests of the bank.
- In addition, the directors (or their appointed agents) must sign the disclosure statements as being not false or misleading. Directors face severe criminal and civil penalties (including up to three years' jail and personal liability for creditors' losses) if a disclosure statement is held to be false or misleading.
The disclosure regime has enabled the Reserve Bank to remove a number of prudential regulations. These include the limits on banks' lending to individual customers and on open foreign exchange positions, and the Reserve Bank's former external audit requirements in relation to banks' control systems. We believe that the market disciplines created by enhanced disclosure have obviated the need for these types of regulation.
While the emphasis on market disciplines through disclosure lies at the core of the new approach, it is important to note that the Reserve Bank continues to have responsibility for supervising the banking system. In that regard, a number of the Bank's core functions have not been significantly altered.
- The Reserve Bank continues to have responsibility for registering new banks. The registration process is designed to promote a competitive banking system, while ensuring that all registered banks have appropriate standing and are able to conduct their business in a sound manner.
- Banks continue to be subject to certain conditions of registration, including minimum capital requirements and limits on lending to major shareholders (in the case of banks incorporated in New Zealand). Although we believe that disclosure alone would ensure that banks would maintain capital at least equivalent to the 8% minimum, we consider that retention of the minimum capital requirements reinforces the credibility of the new supervisory framework, at no cost to banks.
- To the extent practicable, all regulatory requirements imposed on banks are applied evenly, in a standardised way. And all such requirements will be publicly disclosed, so as to facilitate market monitoring of a bank's compliance with the requirements, and to increase the transparency of these requirements.
- The Reserve Bank will continue to monitor banks on a quarterly basis. However, monitoring will be conducted principally using banks' public disclosure statements, in contrast to the former system of monitoring on the basis of information provided privately to the Reserve Bank. In most respects, banks' disclosure statements will contain information which is as comprehensive - and in some cases more so - as the information previously provided privately to the Reserve Bank.
- The Reserve Bank will also continue to consult with the senior management of banks, generally once a year. These consultations provide an opportunity for the Reserve Bank to keep itself apprised of each bank's strategic direction and developments in the banking industry.
- Importantly, the Reserve Bank retains a wide-ranging capacity to respond to financial distress or bank failure where a bank's financial condition poses a serious threat to the stability of the banking system. This includes the power to appoint an investigator to review a bank, the ability to give directions to a bank and the power to recommend that a bank be placed into statutory management.
We believe the new approach to banking supervision offers some important advantages over the former system.
- First, disclosure considerably strengthens the incentives for bank managers and directors to identify, monitor and manage their own business risks.
- Second, disclosure places market pressures on banks to behave prudently. Those banks which are the strongest are likely to benefit from that strength by operating at lower costs; weaker banks are likely to be under pressure to strengthen their position.
- Third, disclosure reinforces the perception that the management and directors of a bank have the sole responsibility for the management of the bank's affairs, and eliminates the monopoly of information which supervisors tend to have in respect of a bank's financial condition. Both of these factors help government to resist inevitable pressures to rescue a bank in distress, to some extent at least.
In contrast, substantial reliance on conventional supervision can create serious impediments to financial market innovation and efficiency, can reduce the incentives for banks' directors and managers to take responsibility for the management of their banks, and can increase the risk of moral hazard.
Before concluding this address, I think it would be useful to make a few comments on some of the reactions we have had to the banking supervision changes.
All in all, I believe that the new approach has been relatively well accepted, both in New Zealand and internationally. But it has taken time for that acceptance to be achieved. It is fair to say that, during the review process, reservations about the new approach were expressed from a number of quarters.
One of the observations made has been that New Zealand is "free riding" on the efforts of the home supervisors - ie the supervisors of the parent banks of the banks operating in New Zealand. We firmly reject this notion. It is certainly true that any host supervisor will - inevitably - rely to some extent on the global supervision of the home supervisor. After all, this is an intrinsic part of the Basle Concordat. No matter what supervisory arrangements a host supervisor puts in place, the host supervisor is very limited in the extent to which it can meaningfully influence the financial soundness of an international bank, particularly where the local operation is a branch of the overseas bank. But it can ensure that the local operation is adequately supervised within these constraints. Indeed, this is the host supervisor's obligation under the Basle Concordat. I have no doubt that the New Zealand supervisory framework is just as effective - and probably more so - at promoting sound management practices in the New Zealand operations of international banks, as the more conventional supervisory approaches.
Another observation frequently made is that New Zealand would not have adopted the new supervisory framework had a substantial part of its banking system been domestically owned. I cannot prove that our approach would have been politically feasible with a different ownership structure. But it is my firmly-held conviction that we would be adopting this approach even if most of our banks had been locally-owned, because we believe, quite strongly, that the regime is actually more likely to promote prudent banking behaviour than the conventional approach. In this context, I should note that, at the time we commenced our review of banking supervision, in late 1991, a significant part of the New Zealand banking system was still domestically owned.
Some observers have suggested that our approach places an excessive emphasis on the role of bank directors - that we are asking too much of them. To illustrate this point, some months ago, I had a visit from the chief executive of one major international bank with an operation in New Zealand. He had come to protest strongly at the requirement that bank directors would have to sign the disclosure statements every quarter, and attest to the appropriateness of their risk control systems. When I asked why, he said "... bank directors understand absolutely nothing about banking...". This comment is quite unfair about many bank directors, of course, but there is an uncomfortable element of truth in it in some cases. The blame for this situation almost certainly lies in part on a supervision regime which has assumed too much of the responsibility for the viability of banks. We very much hope that a regime which will continue to have some key regulations, but which is based primarily around market disclosure and director attestations, will improve that situation.
Another area of concern was the effect our disclosure regime might have on the parent banks of the banks operating in New Zealand. Some banks were concerned that quarterly disclosure in New Zealand might effectively force parent banks to also issue quarterly disclosure statements. We are not actually aware of any such pressures, although of course it is still early days under the disclosure framework. But I must say that we would feel no discomfort if parent banks do come under pressure to issue quarterly statements in their home countries. From a supervisor's perspective, and from the perspective of depositors and others, more frequent and higher quality financial disclosures by parent banks would be thoroughly welcome.
Overall, I am confident that the new supervisory framework - with its partnership between supervision and market disciplines - will serve New Zealand well in the future. I have no doubt that it will make a significant contribution to the ongoing soundness and efficiency of New Zealand's financial system.