Don Abel: The economy, uncertainty and institutional response
Speech by Mr Don Abel, Assistant Governor and Head of Operations of the Reserve Bank of
New Zealand, and Mr Steve Gordon, Head of Risk Assessment and Assurance of the
Reserve Bank of New Zealand, at the Oceania CACS 2012, Wellington, 10 September 2012.
* * *
The assistance of Bernard Hodgetts, Tim Ng and Mike Hannah in drafting this address is gratefully
acknowledged.
The events of the past decade have been extraordinary.
Prior to the Global Financial Crisis (GFC) a western-based consensus, built around
unfettered markets, in particular financial markets, allied with a commercial emphasis on the
maximisation of shareholder value, dominated the evolution of developed economies. For
many years this prescription seemed to work but some inherent flaws were revealed by the
sudden collapse of financial markets in 2007-08 and the subsequent fall-out that we are
continuing to experience today.
To remind ourselves of what happened is to provide a basis on which lessons can be drawn
to improve our collective futures. As risk managers you need to be aware of these lessons
that may directly affect your institutions and which you can reference to calibrate your
responses in these uncertain times.
From the early 2000s there was a build-up in a number of troubling factors.
First, from the early part of the decade onwards credit began expanding in numerous
countries at double-digit annual rates. Much of the credit growth was to households and
coincided with a rapid increase in house prices along with a significant increase in debt
burdens within the household sector. At the same time, there was a significant deterioration
in lending standards in many countries as financial institutions attempted to sustain the
growth in credit.
Second, financial risk management practices were adopted which, in hindsight, proved to be
quite ill founded and based on a naive understanding of the underlying risks. The packaging
of sub-prime loans into highly-rated residential mortgage backed securities in the United
States, in an attempt to reduce risk through diversification, is the best example. When the
United States housing market later weakened, investors holding these securities were
exposed to risks they (and the agencies that had rated them) never thought existed.
Third, underlying fiscal imbalances in many countries continued to worsen. Many
governments ignored the reality of longer term fiscal pressures associated with ageing
populations and growing income inequalities leading to increased health and social security
spending. Later decisions to support economies and financial systems in the wake of the
GFC would further stretch fiscal positions.
Fourth, global imbalances were also continuing to worsen. While the causes of these
imbalances are complex, the lack of fully flexible exchange rate regimes in some countries
was undoubtedly an aggravating factor. Large and growing current account deficit countries
in many western economies were mirrored by large and growing current account surpluses in
other countries such as China. These surpluses then formed the basis for much of the
financing of the debt-fuelled imbalances occurring in the western economies.
Surprisingly many of these phenomena were largely ignored by policy makers, until it was
too late to intervene. The financial institutions and rating agencies that were meant to monitor
and price for risk proved to be more interested in short term profits and management
bonuses. Governments were reluctant or unable to take the longer view in terms of their
fiscal positions. The regulators in western developed economies displayed a notable
reluctance to take action at an early point when it might have made a difference. In the end
the inevitable financial crash occurred and governments around the World were left to pick
up the pieces and the taxpayers the tab.
What the financial collapse revealed was a world economy that was "seriously imbalanced".
On the one side stood the western developed economies whose societies had expanded
debt, both private and public, to maintain and lift living standards. While, on the other, the
newly emerging economies, benefiting from globalisation and the low cost production of
manufactures, had recycled their earnings as savings to the western economies. For most of
the 2000s this apparently mutual beneficial relationship persisted, but eventually it unravelled
as a substantial part of the debt accumulated in the developed countries turned out to be
unserviceable.
The pressures of rapid growth in the developing countries were also becoming apparent. Oil
prices started to rise rapidly from a low of around $20 a barrel in 2001 to a peak of $140 just
prior to the GFC. Currently the price of oil is around $100 a barrel. This represents an
ongoing weight on economic activity that did not exist at the opening of the 2000s, despite
the fact that the World is in a period of low growth.
There was also strong growth in non-oil commodity demand and prices. Hard commodities,
like iron ore, coal and industrial metals were sucked into China and other East Asian
economies to fuel industrial development and urbanisation. While soft commodities, like dairy
products and meat, experienced substantial volume and price increases as the rapidly
growing middle classes in the emerging countries, with rising incomes, shifted their eating
preferences towards protein-based diets. The currencies of commodity producing nations
became in-demand, appreciating in value as capital flowed into them, creating problems for
import competing industries and, in some cases, exporters as well as the control of domestic
monetary conditions.
When the financial collapse occurred it was sudden, and sharp, and unprecedented in the
post-Second World War era. Global financial institutions, big names, were wounded, some
fatally, others less so. Some required bail-outs from governments. Financial markets were in
turmoil, unable to distinguish between potentially "good" names and potentially "bad" names
and, for a short period, the flow of money in the world economy practically stopped. Even
small financial markets like in New Zealand were caught in this maelstrom. In concert with
other governments around the World, we were forced to take action to safeguard our
domestic-based financial institutions.
The difference for New Zealand, though, was that the vast majority of the growth in financial
assets was held on the balance sheets of the four large Australian owned banks. Rather than
on-selling mortgages or transforming their risk through complex financial derivatives, New
Zealand's domestic banks had supplied plain-vanilla financial products and avoided an
excessive leveraging of their capital.
Furthermore, lending standards in New Zealand, at least within our banking system, had
generally remained sound. But within parts of our non-bank deposit taking sector - most
notably the finance companies - New Zealand experienced its own homegrown example of
poor risk management, leading to considerable financial loss for many people. High risk
loans made in areas like property development, financed from household deposits, proved to
be an unsustainable combination when property markets turned down from around 2007
onwards.
A lesson from the GFC for risk managers is that "innovative financial products" should be
treated with a great deal of scepticism. Understanding where the true risks lie and how they
could play out when economic fortunes change is paramount.
Another lesson is that poorly managed risks may take years to be realised. The build up of
risk on financial institutions' balance sheets, which was uncovered by the GFC, was created
over a number of preceding years.
The current situation
The New Zealand economy was not immune to the collapse in World financial markets. As
credit growth and commodity prices tumbled, our GDP shrunk through 2008 and in the first
half of 2009. But, by the second half of 2009, with commodity prices lifting again, modest
growth resumed in the order of 2% per annum. Banks, which had relied heavily on short-term
wholesale funding from offshore during the boom, found funding harder and more expensive
to obtain. The situation was gradually alleviated following the introduction of a government
guarantee for wholesale debt and as funding markets reopened in early 2010.
The downturn associated with the GFC, nevertheless, had more long-lasting effects for our
businesses and households as inflated property prices were punctured. As noted earlier,
many non-bank financial institutions failed with depositors suffering great loss. And, with a
high degree of uncertainty about the future, businesses and households preferred to be
conservative, reducing debt and spending and avoiding future commitments.
The government sector, on the other hand, faced a prospect of accumulating debt as tax
revenues fell and spending demands increased. In the space of five years from 2008 the
fiscal deficit as a percent of GDP moved from a positive 3% to a negative 4%.
In comparison, the shift to increasing household saving can be traced in Figure 1 with the
ratio of saving to disposable income changing from a substantially negative position in 2003
to a slightly positive one today.
Figure 1
Household saving to disposable income ratio
Source: Statistics NZ
Into this mix another completely unanticipated event fell. The Canterbury earthquakes,
centred on the second largest city in New Zealand - Christchurch - caused a catastrophic
loss of life, property and infrastructure.
To rebuild Christchurch will cost at the very least $20 billion. While the impetus to the
regional economy of Canterbury will be very large, this spending represents a replacement of
damaged buildings and infrastructure, not a net gain to national wealth. And, the extent to
which the cost is not covered by insurance, it results in a further need for fiscal consolidation
at the central government level and increased property rates at the local, Canterbury, body
level. In addition, overseas reinsurers are now acutely aware of natural disasters and the
cost of property insurance for all New Zealanders has risen across the country with
Christchurch and Wellington being especially impacted.
Medium term influences
As the governments of developed countries in the western hemisphere struggled to deal with
the consequences of the GFC, their spending and borrowing ballooned causing fiscal deficits
to rise at pace. The central banks in these countries also had a role to play by reducing
policy interest rates close to zero - "the lower bound" - and embarking on programmes that
substantially expanded their monetary bases (quantitative easing) in an attempt to push up
domestic demand while depreciating their currencies.
Despite these unprecedented interventions economic recovery in Europe, the United
Kingdom and the United States has remained stubbornly subdued. This can best be
illustrated by comparing the current path of the recovery in the United States with previous
recoveries in the post-war period (Figure 2).
Figure 2
Path of real GDP since end of recession
GDP Index GDP Index
Unemployment in many of these countries has lifted sharply and, of particular concern is the
high level being recorded amongst young people. In Greece and Spain, for example, the rate
of unemployment for those under 25 years of age has risen to around 50%. To put this in
perspective, the comparable number in New Zealand is 12% (Figure 3).
Unemployment rate: Under 25 (SA, %)
The social and political ramifications of these levels of unemployment in the Eurozone are
considerable and weigh heavily on the economic policies that governments are able to
pursue.
CPI inflation in the western economies, on the other hand, is largely stable at around 2% and
the far more pressing financial issue facing these countries has been the build-up in
sovereign debt. As can be seen from Figure 4 a number of European nations, the United
Kingdom and the United States all have levels of debt in excess of 50% of GDP.
The sovereign debt crisis has become critical in the Eurozone as the southern, peripheral
states of Greece, Portugal, Italy and Spain have struggled to implement domestic economic
austerity and structural reform policies aimed to placate financial markets and reduce their
debt and borrowing costs. Their individual ability to trade their way to stability and growth has
been circumscribed by membership of the Eurozone and consequent adoption of the Euro
currency. For at least the past year, the World has watched, in a combination of concern and
fascination, as Eurozone governments and the IMF have moved from one crisis meeting to
another in the hope of finding a solution that will maintain the integrity of the European bloc
but also the economies of the constituent sovereign states. At this point it is not at all clear
how the crisis will resolve. What is evident is that the Eurozone as a whole is falling into
recession with the weaker southern states pulling the stronger northern states down. While
countries within the European bloc undertake much of their trade with each other, lower
growth overall is having a dampening effect on World output more generally.
Sovereign debt
Austerity measures are also being pursued in the United Kingdom and the United States.
Tightened government spending in combination with restrained business sector investment
and household consumption and investment - housing - has meant these economies
respectively are not growing or growing only slowly. In the case of the United States the
situation is complicated by the November presidential election which has the effect of
postponing difficult decisions, in particular how to deal with the impending "fiscal cliff" of
expiring tax cuts and increased spending cuts. Together these two policy measures if fully
engaged would be likely to push the United States back into recession.
New Zealand's future, however, now resides firmly in the economies of Australia, China and
East Asia. This grouping (excluding Japan) today accounts for 49% of our trade compared
with 39% a decade ago. And it is this grouping that is experiencing growth rates of 5-6% per
annum. Our problem is that Australia is dependent on China while China and East Asia have
ties to the fortunes of the rest of the World. The question is to what extent will growth in the
Asian economies be affected by developments in the West?
China's high rate of growth, averaging close to 10% per annum over the past decade, has
been driven by exports and high levels of investment in infrastructure and housing.
Neighbouring East Asian economies have benefited by supplying intermediate goods to
Chinese manufacturers. There is no doubt that the low activity now being experienced by the
western developed economies will slow expansion in China and East Asia but this seems
more likely, perhaps optimistically, to be a relative deceleration rather than a plunge towards
outright recession. There is still a lot of scope for China to increase efficiency and
productivity as well as investment and its levels of urbanisation and consumption have the
potential to expand considerably. What can be assumed reasonably is that the prospects for
China over the next 4-5 years will be considerably better than for the Eurozone, United
Kingdom and United States.
Within New Zealand the path of recovery from the Canterbury earthquakes has been a
matter fraught with great difficulties and much heartache. Nobody anticipated the frequency
and severity of the aftershocks that accompanied the February 2011 event. The scale of the
disaster has been enormous and only now as the aftershocks seemed to have dissipated
does it appear that rebuilding can begin in earnest. The earlier forecasts of a relatively quick
recovery can be seen to have been quite unrealistic as the detail of land use planning,
sorting through insurance disputes, coordinating competing interests, providing logistical
support and resources has taken over. The path for rebuilding, based on the most recent
information available, suggests that activity will start to ramp up from the end of this year,
accelerating through 2013 and 2014 before reaching a peak in 2015.
Degrees of uncertainty
Right now the uncertainties faced by decision-makers are unusually diverse and numerous.
The World is in the process of transiting to a new order of economic reality, the dimensions
of which are difficult to map with any certainty. What is clear, nevertheless, is that choices for
policy makers, business leaders and householders can no longer be based on a simple
assumption of brisk growth resuming as before and that the economies of the western
hemisphere will be in a position to direct economic policy and growth ad infinitum.
With the rapid development of the Asian bloc and India, combined with a lack of access to
easily recoverable energy supplies as well as political instability in the Arab states, the World
is having to adjust to an environment of high and on-going energy costs. A new easily
exploitable resource might be discovered, with a consequent reduction in prices, but this
remains an uncertain prospect and definitely not one on which to base business decisions.
The western developed economies, in particular, face multiple challenges and the degree to
which these will be overcome in the next five years is far from clear. The volatility seen in
financial and equity markets is a symptom of this uncertainty currently most obvious in the
responses to the Eurozone crisis. Structures, previously thought inviolable, such as the Euro
currency, are now recognised to be vulnerable.
In the banking and finance sectors regulators are tightening standards, imposing new capital
requirements and introducing new macro-prudential tools to assist in maintaining the stability
of financial systems and the control of credit creation.
Fiscal policy is dominated by a desire to reduce sovereign debt by increasing government
savings. On the one side financial markets need to be reassured that governments are able
to act responsibly and implement sound, long term, economic policies to promote economic
growth, while, on the other, the voting public have to be convinced that the lengthy period of
restrained growth that typically accompanies structural reform and fiscal austerity is in their
best long term interest. In these highly uncertain times households themselves act to restrain
growth by increasing savings and reducing spending. Obtaining the right balance between
these factors will largely determine the direction of the western economies with a positive
outcome being sustained ultimately by the return of business and consumer confidence
leading to investment and productivity growth.
Similar forces can be seen at play in the New Zealand economy. The difference being that
the imbalances and structural issues here are not nearly as deep-seated as in many of the
western economies. Furthermore, New Zealand has been fortunate to be placed
geographically in the eastern part of the Pacific primarily selling soft commodities that are
now experiencing increasing demand from Asian trading partners who continue to
experience relatively good growth.
The Canterbury earthquakes have proved to be an additional test of resilience for the country
and although insurance will cover the majority of the cost of recovery, the process of
rebuilding will take much longer than originally thought and may well cost more than currently
forecast. The impact of these events on the provision and cost of insurance is now becoming
apparent and is reflective of a general review of the insurance cover for natural disasters
world-wide. The frequency and intensity of these types of events seems to be on a rising
trend creating further management challenges for private and public enterprises.
Institutional response
Institutional language is now coloured by words such as austerity, crisis, collapse, disaster
response, instability, volatility, vulnerability and, above all, uncertainty. The GFC exposed the
weaknesses of risk management to the World and especially the inadequacy of institutions
that allowed their risk management practices to be subverted by the drive for short term
profitability. Many of these institutions no longer exist and if they do, not in a form they would
have recognised prior to the GFC.
The irony is that despite its lack of strength in the decades building up to the GFC and its
ultimate failure, risk management remains absolutely critical to the success of institutions.
Furthermore, the incidence of risk means that the enterprise needs to take a long run view of
its business not a myopic, short run, approach. Which is a good thing if it helps to make the
business operating environment more stable.
The issues outlined earlier in this paper reveal the complexities that private and public
enterprises will need to navigate in the future. Possession of a metaphorical radar, capable of
identifying obstacles both near and far, should be second-nature to those leading and managing
the enterprise. In the current climate effective risk management aligns very closely to the theme
of your conference: "Embracing uncertainty and delivering value in turbulent times".
As risk professionals you must systematically identify the key areas of risk for your institution
and develop a built-in resilience and ability to respond to whatever happens. Anticipation and
not the "ambulance at the bottom of the cliff" is required. In Table 1 some key risks are set
out. Your challenge is to interpret these macro developments and translate them into tangible
business meaning.
Table 1
Areas of Focus
Risk Themes Key Points and Area of Focus
Global economic
•
High and volatile energy costs
and political
•
Sovereign debt and austerity issues
• Fragility and interconnectedness of the financial system
• Eurozone developments
•
Credit, funding and liquidity conditions
•
Rising influence of Asia
Domestic
•
Growth
landscape
•
Household and business spending
• Exchange rate developments
•
Property prices
•
Agriculture sector
Environmental
•
Natural disaster preparedness
•
Business continuity planning
Information
•
Significant dependency on technology
technology
• High impact risk area
Operational risk
• Change and uncertainty increase operational risk
•
Operational risk is pervasive and relates to many other risks that
materialise
The first group relate to global economic growth and relevant questions for decision-makers,
who have the ultimate responsibility to mitigate risks, are what does this mean for product
demand and prices, cost of production, transport and supply of goods and services? Actually
these questions are fundamental to how institutions are run. What is being suggested here is
that a bit more thought is given to how events might deviate from what is perceived to be
"normal"; what steps should be taken in settled times to ensure the future of the enterprise
and through doing so the wider role it plays in society.
In our globalised and wired environment the speed at which information is transmitted would
suggest that no one should be surprised at the consequences of a collapse of steel prices in
China or a deep liquidity crisis in european funding markets. The point in question is to what
extent have these types of events been imagined and planned for, sorting the "sheep from
the goats". Tools such as stress testing and scenario analysis, if rigorously deployed, can
provide valuable insight into the uncertain future and assist in preparing the institution to deal
with an existential crisis that may arise.
In terms of the Bank, as you would expect, considerable effort is placed on monitoring and
assessing all financial risks as these are of high relevance to monetary policy, our prudential
and supervisory responsibilities as well as the management of our $27 billion balance sheet.
The second area noted in Table 1, which is inextricably linked to the first, is the domestic
landscape. Growth has been modest and confidence somewhat repressed and there are no
imminent signs of a sudden or material positive change to this pattern. In this setting, where
there are limitations as well as opportunities, businesses will need to be astute in reading the
emerging trends and, in doing so, identifying the risks associated with fulfilling their particular
business objectives.
The next area of focus shown in Table 1 is described as environmental. The Canterbury
earthquakes served as an unwanted illustration of the power to literally shift the ground on
which institutions stood and planned their activities. The consequences are now playing out
across many levels, including the fact that the insurance industry was poorly prepared to deal
with such a cataclysmic event. Business continuity planning should be well within the frame
for risk professionals. Possessing a clear understanding of critical business processes and
having made the capital and human investment required to be able to continue operations in
the event of a disaster is simply good management.
In February 2011 the Bank established a small satellite office in Auckland so that the time
critical aspects of our business, such as the support of financial market liquidity and payment
systems, could continue if Wellington was shutdown in a regional disaster. Recently a small
internal flood on the Wellington site meant the building had to be evacuated and operations
were carried out successfully in Auckland for the best part of a day.
Information technology risk is an area that, no doubt, many of you will be very familiar with.
Reliance on technology is immense and consequently the risks inherent in the loss of
integrity or availability of systems is severe for most enterprises. Consumers and businesses
depend on these systems to operate effectively on a minute by minute, day by day, basis.
The potential business loss and reputational risks in not being able to deliver services are
considerable and it is surprising that some businesses continue to be parsimonious when it
comes to providing sound back-up systems. Of course when it all falls apart they come to
central government for help - which in my eyes is as good a measure of managerial
recklessness as any other.
The Bank acts as banker to the commercial banks, providing inter-bank settlement facilities
and related payment services, so we are acutely aware of our responsibilities in the
operation of the New Zealand financial system. Over the past decade we have invested
$13m in upgrading and improving our payments infrastructure. As you would expect, across
both the audit and corporate risk functions at the Bank, payment system assurance is given
considerable focus and is subject to close monitoring.
Operational risk is the final area over which a close watch should be maintained. This risk
relates to failures by staff and break-downs in processes, facilities and equipment in daily
activities. Operational risk is pervasive across all business processes and, in fact, can be the
root cause of a wide range of incidents that disrupt or impede the meeting of objectives. With
increasing change and complexity as well as uncertainty, operational risk inherently grows.
Mistakes and errors are more likely and institutions need sound policies to reduce both the
underlying likelihood and impact.
Operational risk management is quite process oriented and is therefore one area within
which businesses can focus on continuous improvement. Incident capture, causal analysis
and applying lessons learned from an operational risk event can serve to strengthen the
wider business environment. At the Bank we have a system called Proactive Problem
Management to serve this purpose. It has been in place for over a decade and it is not about
attributing blame but about improving how we do things. It entails line management reporting
of incidents and, with the assistance of the central risk management function, finding ways to
remediate the situation and, in some circumstances, identifying any wider systemic patterns
that may be of relevance.
Although the Bank's Head of Risk reports directly to me, he has an indirect reporting line to
the Governor and, with his team and me in attendance, meets with the Governor formally
once a month. He also has an independent meeting with the Chairman of the Board Audit
Committee at least once a year. He has ample opportunity to talk directly with the Governor
or the Chairman of the Board Audit Committee if he feels that is required. Currently we are
refreshing our risk model and have developed an embedded enterprise risk management
lead community through all of our business units. These people work with the Heads of
Departments to identify, assess and manage the business risks. The model is enterprise
driven in that it aligns risks to departmental objectives in a context of the over-riding
governing mandate for the Bank: the Reserve Bank Act. The model also includes major
projects and smaller initiatives and actions that relate to specific risks. By doing so it provides
an insight into active risk management mitigations that are underway giving a level of
validation as to how resource is being directed towards certain risk areas.
Conclusions
The first half of this paper outlined the extraordinary events that have buffeted the World
since the onset of the Global Financial Crisis. As noted earlier there was an inevitability
about the financial crash. From a debt perspective western economies had become seriously
bloated, and in the absence of any countering force, there was always going to be a day of
reckoning as banks in many developed countries fed an insatiable appetite for credit in the
pursuit of short term gain.
Better regulation and policy interventions in the future may help to stabilise markets by
aiming to reduce excessive and risk-laden decisions. But ultimately it is the people involved
in the key roles of institutions that largely determine the future of their enterprises.
Accountability, honesty, responsibility; these sorts of well founded values must be present in
the culture of institutions if they are to survive in a rapidly evolving and highly uncertain
environment.
Risk experts are integral to this process and need to hold true to professional and personal
values that instinctively drive judgement and consequent actions in the workplace. As skilled
practitioners you should know the points at which proposed courses of action are misaligned
to business goals in the broadest sense which include the enterprises' responsibilities to the
wider community.
In good institutions there will be sound frameworks and governance protocols to address
misalignments and the risk function has the important job of influencing and leading others to
make the right decisions.
Uncertainty is a part of life and, indeed, can make life exciting, if not overdone. But Reserve
Bank governors generally prefer "boring" and our Governor has been no exception, saying so
on a number of occasions. Unfortunately the past five years and the immediate future will
certainly not meet that preference.
By accepting uncertainty and looking for explanations of what is happening, you should be
able to assist your institutions towards strategies that respond to the unusual pressures that
we currently face.
Delivering value in these turbulent times should be second-nature to risk managers.