Dr. Brash looks at banking soundness and the role of the market with
respect to New Zealand's banking industry Address by the Governor of the Reserve Bank of
New Zealand, Dr. Donald T. Brash, to the IMF conference on banking soundness and monetary
policy in a world of global capital markets held in Washington on 30/1/97.
My address this morning is on "Banking Soundness and the Role of the Market".
As most of you will already know, this is a subject of particular relevance to New Zealand,
given that we have adopted a banking supervision approach which places considerable emphasis
on the role of the market in promoting a sound financial system. In my speech today I will be
outlining the key features of our new approach to banking supervision and the reasons why we
have gone in this direction. Although much of my address will focus on the New Zealand
experience, I will attempt to draw some general conclusions about the role market disciplines
can play in promoting a sound and efficient financial system - conclusions that may have
relevance for the design of banking supervision arrangements in other countries. Before I outline
the new approach to banking supervision in New Zealand, I think it would be useful to give you
a little background on the supervisory structure which operated at the time that the Reserve Bank
of New Zealand conducted its review of banking supervision.
Background to New Zealand's Banking Supervision Arrangements
New Zealand first adopted a formalised approach to banking supervision in 1987.
For most of the period from then until the end of 1995 New Zealand's approach to banking
supervision was relatively orthodox. It involved:
minimum capital requirements (based on the Basle Capital Accord);
limits on the amount which banks could lend to individual customers and related
parties;
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 involve any form of on-site examination of banks.
These distinguishing features continue to apply under the new supervisory
framework.
In late 1991 we commenced a major review of our banking supervision
arrangements. The review was motivated by a number of concerns.
Probably the main reason for commencing the review was a concern that
conventional approaches to banking supervision generally make insufficient use of market
disciplines as a means of promoting a sound and efficient financial system. We believed that
there was considerable scope to use market disciplines to promote systemic stability. In
particular, we wished to provide the market with a greater capacity to hold the directors and
management to account for the sound management of their bank. And we wanted to improve the
market's ability to make well informed decisions as to which banks they would do business
with. As I note later in this address, we concluded that the introduction of a well focused and
comprehensive disclosure regime would go a long way towards achieving these objectives.
Another factor which led us to review our banking supervision arrangements was
a concern at the compliance costs and regulatory distortions which can be associated with
conventional approaches to banking supervision. This concern reflects our view that banking
supervisors tend to have strong incentives to promote a stable financial system, without always
having appropriate regard to the compliance costs and regulatory distortions to which
supervision and prudential regulation can give rise.
We were also concerned at the taxpayer risk involved in the traditional approach
to banking supervision. Although this risk is present regardless of the form banking supervision
takes, it is likely to be greater where the banking supervisor, and only the banking supervisor,
has regular access to financial information on a bank. It is also likely to be greater the more
intensive the supervision process is. We wanted to explore ways of reducing the risk of the
government being called upon to rescue a bank in distress.
Finally, 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, even supervision which includes on-site examinations, can
minimise the incidence of bank distress and failure. This is evidenced by the fact that countries
with intensive supervisory regimes have not been immune from serious episodes of financial
distress. Indeed, we were concerned that banking supervision could even be increasing the risk
of bank failure or distress, by potentially reducing the incentives for bank directors and
managers to make their own considered judgements about what constitutes prudent behaviour.
The New Approach to Banking Supervision in New Zealand
In the light of these concerns, and following a lengthy period of review, we
concluded that the concerns we had identified could be substantially addressed by placing
greater reliance on market disciplines through public disclosure by banks, increasing the
accountability of bank directors and management, and reducing the extent of prudential
regulation. The new banking supervision arrangements, which came into force on 1 January
1996, reflect these conclusions.
The new approach differs from the former regime in two main areas. First, a new
disclosure regime applicable to all banks operating in New Zealand has been introduced. The
disclosure regime is designed to substantially strengthen the market disciplines on banks and
sharpen the incentives for the directors and management of banks to manage their banks' affairs
in a sound and responsible manner. I will outline the main features of the disclosure
arrangements shortly.
The second major change involved a reduction in the extent of prudential
regulation of banks. The main changes included:
the removal of the former limit on the amount which banks may lend to their
customers;
the removal of the limit on banks' open foreign exchange exposures;
the removal of the Reserve Bank's guidelines on internal controls and the
associated audit requirements; and
the removal of the need for banks to privately report their financial position and
risk exposures to the Reserve Bank.
We were satisfied that the introduction of the new disclosure regime obviated the
need for many of the former prudential controls on banks.
Undoubtedly the feature of the new approach that has attracted most attention is
the disclosure regime. Let me briefly outline its main features.
Under the new arrangements, all banks operating in New Zealand must publish a
disclosure statement each quarter. The disclosure statements are in two forms: a brief Key
Information Summary, which is aimed at the ordinary depositor; and a more comprehensive
General Disclosure Statement, which is aimed principally at the professional analyst.
The Key Information Summary contains a short summary of key information on a
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
peak exposure concentration, peak exposures to related parties, asset quality,
shareholder guarantees (if any) and profitability.
The Key Information Summary must be displayed prominently in, and be
available on demand from, every bank branch.
The General Disclosure Statement contains wider-ranging and much more
detailed information on a bank and its banking group, including:
corporate information and some information on parent banks (where applicable);
comprehensive financial statements (including a five year summary of key
financial data); credit rating information (including any changes to the rating in
the two years preceding a bank's most recent disclosure statement balance date);
detailed information on capital adequacy, asset quality and various risk exposures
(including exposure concentration and related party exposures); information on
funds management and securitisation activities, risk management systems, and a
summary of the prudential regulations imposed on the bank in question by the
Reserve Bank of New Zealand; information on the bank's exposure to market
risk, both peak and end of period (and in respect of the full banking book).
The disclosure statements issued by banks are subject to full external audit at the
end of year and a limited scope audit review at the half year. Disclosure statements issued at the
other quarters in the year are not required to be audited.
One of the most important features of the disclosure framework is the role it
accords bank directors. Each director is required to sign their bank's disclosure statements (or
authorise someone to sign on his or her behalf) and to make certain attestations in the disclosure
statements, including:
whether the bank is complying with the prudential requirements imposed on it by
the Reserve Bank; whether the bank has systems in place to adequately monitor
and control its banking risks and whether those systems are being properly
applied; whether the bank's exposure to related parties is contrary to the interests
of the bank; and whether the disclosure statement contains all the required
disclosures and is 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 arrangements are expected to bring a number of important benefits
to the New Zealand financial system:
We are confident that the disclosure arrangements are playing an important role in
strengthening market disciplines on banks. Under the new arrangements the market has
considerably greater information on a bank's financial performance and risk positions than was
previously the case. And the information is available more frequently and in a more timely
manner. The market therefore has greater scope to react to developments affecting a bank's
financial condition - rewarding those banks which are well managed and penalising those which
appear to be less well managed. The strongest banks are likely to benefit from that strength by
operating at lower costs; weaker banks are likely to be under pressure to strengthen their
position. Over the longer term we believe that stronger market disciplines will make a major
contribution to the soundness of New Zealand's financial system.
Another benefit which we expect to see from the disclosure regime is a growing
emphasis on the important role which bank directors play in overseeing the prudent management
of their banks. The disclosure framework reinforces and provides a sharper focus on the duties
of bank directors. In particular, it sharpens the focus on directors' duties to ensure that their bank
has the necessary systems in place to identify, monitor and manage adequately the bank's
various business risks, and to ensure that those systems are being properly applied at all times.
The disclosure requirements are also likely to increase the accountability of bank
directors and, indirectly, the accountability of various levels of management within the banks.
As a result of the disclosure arrangements, we would expect to see directors taking greater care
than might otherwise have been the case to ensure that they are adequately discharging their
obligations. In so doing, it is likely that directors will take steps to ensure that there are
appropriate accountability mechanisms within the management hierarchy.
Over time, we expect that the increased accountability of bank directors will lead
to an improvement in the quality of bank boards. Shareholders now face stronger incentives to
ensure that the directors of their banks have the appropriate skills, experience, integrity and
judgement to fulfil the duties expected of them.
Another important benefit which we hope will flow from the disclosure regime is
a reduction in the risk that the taxpayer will be called upon to rescue a bank. As a result of the
disclosure arrangements we hope that there will be a stronger public perception that the
management and directors of a bank have the sole responsibility for the management of their
bank's affairs. Moreover, the public now has access to much the same information on banks as
does the Reserve Bank, thereby eliminating the monopoly of information which supervisors
generally tend to have in respect of a bank's financial condition. Both of these factors should
assist in enabling future governments to resist the inevitable pressures to rescue a bank in
distress or to insulate creditors from losses - at least to some extent.
Although the new supervisory framework places great emphasis on the role that
market disciplines can play in promoting systemic stability, it is important to note that the
Reserve Bank of New Zealand has not abandoned its responsibilities for the financial system.
We recognise that, for the time being at least, systemic stability is best served by a combination
of market disciplines and banking supervision. In particular, we see value in:
retaining some control over which entities may call themselves banks in New
Zealand;
the Reserve Bank maintaining a sound understanding of the state of the financial
system; and
the Reserve Bank retaining a capacity to respond to financial distress or bank
failure, where this threatens financial system stability.
In this context, a number of the Reserve Bank's core functions have been
retained.
The Reserve Bank continues to have responsibility for registering new banks.
Banks continue to be subject to minimum capital requirements (in line with the
Basle Capital Accord) and a limit on lending to related parties. 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 additional cost to banks.
The Reserve Bank continues to monitor banks on a quarterly basis. However,
monitoring is now 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 contain information which is more
comprehensive and more reliable than the information previously provided privately to the
Reserve Bank.
The Reserve Bank also continues to consult with the senior management of banks.
Formal prudential consultations are held annually, and generally focus on the strategic direction
of the banks, major changes in their operations and other high level issues. In addition, as
Governor of the Reserve Bank of New Zealand, I meet with the chief executives of the larger
banks on a regular basis to discuss a broad range of issues, including issues relating to the
banking industry and to the wider economy.
And, 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.
As with the former supervision arrangements, the objective underlying the above
responsibilities is the promotion of a sound and efficient financial system. Depositor protection
does not feature in the Reserve Bank's objectives.
Reactions to the New Approach to Banking Supervision
All in all, I believe that the new approach has been relatively well accepted. 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, both at home
and abroad. I think it would be useful to mention some of these.
One of the observations made has been that New Zealand is "free riding" on the
efforts of the home supervisors. We firmly reject this notion. We believe that the new
supervisory framework is at least as effective at promoting prudent banking practices as are the
more traditional approaches to banking supervision. And we are satisfied that the new
framework enables the Reserve Bank of New Zealand to fulfil its duties as a host supervisor
within the terms of the Basle Concordat. In that regard, under the new approach to banking
supervision, the Reserve Bank of New Zealand remains well informed about the activities and
financial condition of all banks operating in New Zealand, and well placed to respond to
incipient financial distress where appropriate. Indeed, as I have already noted, the disclosure
regime provides the Reserve Bank (and the public) with information which is generally more
comprehensive than the information previously received by the Reserve Bank.
But 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. The most a host supervisor can realistically achieve is to promote prudent
banking practices in the local operations of the banks within its jurisdiction.
In the context of the above point, some commentators have suggested that the
Reserve Bank of New Zealand is not well placed to anticipate emerging financial distress in the
absence of conducting on-site examinations of banks or otherwise obtaining private information
from banks. Although I acknowledge that on-site examinations do increase the information
available to banking supervisors, I am not at all convinced that the information obtained from
such examinations enables the supervisors to reliably anticipate incipient financial distress. In
modern banking, risk positions can and do change rapidly. A week in politics might be a long
time, but in banking it is a very long time indeed! This is becoming increasingly the case. The
information obtained from on-site examinations, or from any other sources for that matter, can
only provide a snapshot of a bank's risk positions at a particular point in time, and even then
generally only in respect of a subset of the bank's business. For these reasons I believe any such
information is of limited usefulness in assessing the dynamics of a bank's risk positions or in
anticipating financial distress.
I acknowledge, of course, that publicly disclosed information also has these
limitations. But at least public disclosure brings with it the incentives for the sound management
of banking risks. I am not at all sure that the private disclosure of information to a banking
supervisor - whether on-site or off-site - creates these types of incentives.
A further concern we have with on-site examinations or the off-site collection of
detailed private information on banks, at least in the New Zealand context, is the risk that these
approaches can blur the lines of responsibility for the management of banks. If the banking
supervisor has responsibility for regular on-site examinations, it presumably follows that the
supervisor also has responsibility for encouraging or requiring a bank to modify its risk positions
or make other adjustments to its balance sheet where the supervisor has concerns in relation to
the bank's risk profile. This has the potential to erode the incentives for the directors and
management of banks to take ultimate responsibility for the management of banking risks,
effectively passing some of this responsibility to the banking supervisor. It also has the potential
to create public perceptions that the responsibility for managing banking risks is effectively
shared between a bank's directors and the banking supervisors. In turn, this makes it very
difficult indeed for a government to eschew responsibility for rescuing a bank in difficulty.
I acknowledge that any system of banking supervision - even one that relies
principally on public disclosure - will inevitably create public expectations that the supervisory
authority takes some responsibility for the management of banking risks. And I acknowledge
that any system of banking supervision creates a risk for the taxpayer in the event that a bank
gets into difficulty. However, in order to minimise these risks, the Reserve Bank of New
Zealand prefers to keep the spotlight clearly focused on the directors and management of a bank,
rather than risk a further blurring of their accountability. We believe that the avoidance of
having an on-site examination role or otherwise regularly obtaining private information from
banks assists in this regard and reinforces market disciplines on banks.
Another observation frequently made is that New Zealand would not have
adopted the new framework had a substantial part of its banking system been domestically
owned. It is my firmly-held conviction that we would have adopted this approach even if all or
most of our banks had been locally-owned. I say this because we believe that the regime is
actually more likely to promote prudent banking behaviour than do the more traditional
approaches, but with a lower likelihood of moral hazard and regulatory distortion. 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.
Indeed, as I see it, many of the changes we have implemented in New Zealand would be of equal
relevance to those jurisdictions in which the core of the banking system is domestically owned.
Another criticism made of the New Zealand approach is that comprehensive and
frequent disclosure can, in some circumstances, exacerbate financial system distress, rather than
promote systemic stability. I acknowledge that, in some circumstances, disclosure could
exacerbate a bank's difficulties. For example, where a bank is required to disclose a loss or a
severe deterioration in asset quality, this could lead to a sharp adverse reaction by the market,
possibly causing the bank in question to come under liquidity pressure. Of course, this
possibility exists with even the barest disclosure requirements - such as with the release of an
annual report or a six monthly interim disclosure. And the risks of adverse market reaction are
present even in the absence of disclosure requirements - for example, as a result of market
speculation as to a bank's financial condition. Indeed, in some circumstances the disclosure of
comprehensive information might actually reduce the risk of the market reacting adversely to
misinformation or to an absence of information. In any case, where a bank knows in advance
that it will be making adverse disclosures, it would generally have the opportunity to take steps
to reduce the risk of an adverse market reaction. These steps would include the disclosure of the
remedial measures being taken to address the bank's difficulties.
Of course, the risk of a severe market reaction to an adverse disclosure creates the
very incentives for banks to ensure that they manage their affairs in such a way that there will be
no adverse developments to disclose. In the longer term, therefore, the risk of adverse market
reaction could be expected to promote a sounder financial system.
One of the criticisms often made of public disclosure by banks is that the vast
majority of depositors will not read banks' disclosure statements. On this assumption, some
observers suggest that disclosure is of very limited effectiveness. We do not agree. It is certainly
true that most depositors are unlikely to read the disclosure statements. But the disclosure regime
in New Zealand is not predicated on the assumption of wide readership by the ordinary
depositor. The source of market disciplines does not lie in wide public readership. Rather, the
efficacy of the disclosure regime rests on the assumption that the disclosure statements will be
read by the agents of depositors, such as the financial news media, financial analysts and
investment advisers, and by wholesale creditors and fellow bankers. It is the risk of adverse
reactions by these types of disclosure users that creates the incentives for bank directors and
management to manage their banks' affairs in such a way as to avoid the need to make adverse
disclosures.
Although the disclosure regime does not rely on the mass readership of disclosure
statements by depositors, the Reserve Bank of New Zealand is encouraging depositors to take a
greater interest in their banks' disclosures. Over much of last year we actively promoted
publicity about the new disclosure arrangements. And we prepared a "user's guide" to assist
depositors (and their agents) to understand the disclosures being made by banks. The user's
guide is now available in every bank branch in the country. While it is unlikely to be a "best
seller", it is encouraging to note that there has, in fact, been a surprising degree of interest in it
from the public. We hope that, over time, an increasing proportion of depositors will take a
keener interest in their banks' financial condition.
Another observation made about the new framework is 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, during the review process, 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 management 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 had 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 on
market disclosure and director attestations, will improve that situation.
Early Indications of the Effects of the Disclosure Regime
Although it is far too early to make conclusive assessments of the success or
otherwise of the new supervisory approach, there have been some encouraging signs that the
disclosure requirements are meeting a number of their objectives. I will briefly highlight a few
of these.
We have been encouraged by the fact that the financial news media in New
Zealand have taken a close interest in the new bank disclosure regime. The quarterly disclosure
statements have received quite detailed scrutiny from the news media, resulting in greater and
more focused public exposure of banks' financial results and risk positions. We hope that this
type of media attention will sharpen the incentives for banks' directors and management to
manage their banks' affairs prudently.
A good example of the news media's interest in banks' disclosure statements was
the media's interest in one bank's disclosure of its non-compliance with a Reserve Bank
prudential requirement. We were surprised at the intensity of the media's interest in this
disclosure - as, I suspect, were the management and directors of the bank in question. Hopefully,
this type of media attention, and the attendant adverse publicity to which it inevitably gives rise,
will encourage banks to ensure that they comply with Reserve Bank requirements in the future. I
am inclined to think that the threat of adverse publicity is likely to be a more effective discipline
on banks than are many of the standard supervisory sanctions for breaches of regulatory
requirements.
Interestingly, the disclosure regime seems to be strengthening the extent to which
banks scrutinise each other's financial performance and risk positions. We are aware that banks
are making considerable use of the disclosure statements to monitor each other. The additional
and more frequent information now available could be expected to assist banks in managing
their inter-bank exposure positions and in assessing the extent and nature of the business they
conduct with each other. We believe that the banking industry itself is one of the most potent
sources of market disciplines on individual banks.
Anecdotal feedback suggests that the obligations now placed on bank directors are
causing the directors of some banks to exercise greater scrutiny of their banks' risk positions. In
turn, this seems to be focusing greater attention on the systems they have in place for identifying
and managing risks. Moreover, it seems that some banks are taking steps to increase the
accountability of various levels of management within their banks. We are also aware that some
banks have engaged external consultants to review aspects of their risk management systems. It
seems that part of the motivation for conducting these reviews lies in the disclosure requirements
- particularly the director attestation as to the adequacy of a bank's risk management systems.
These are all pleasing developments. We hope that they auger well for the success
of the new arrangements. I am confident they will. But we are under no illusion that the new
arrangements provide guarantees of financial system stability. Of course they do not. No system
of banking supervision can do that. The most we are entitled to believe is that the disclosure
regime will significantly reduce the likelihood of financial system instability in the future - at
lower regulatory, compliance and taxpayer costs than other supervisory options might be
expected to achieve.
General Observations on Incorporating Market Disciplines into Banking Supervision
Before I conclude this address, I should probably make some comments about the
extent to which market disciplines could be better incorporated into the supervisory frameworks
in other countries.
I should first of all make it clear that the Reserve Bank of New Zealand is not
promoting the New Zealand supervisory model as the ideal model for other countries to adopt.
We make no such claims. The model we have adopted meets our particular needs, but it might
not necessarily be suitable for other countries. Clearly, each country needs to make its own
judgement as to what type of supervisory framework is best suited to its unique requirements.
That judgement will inevitably depend on many considerations, including:
the objectives which banking supervision is expected to meet, and whether those
objectives include depositor protection;
the existence or otherwise of deposit insurance arrangements;
the structure of the banking system; and
the infrastructure within which banking operates, such as banking law and
accounting standards.
Having said this, I do believe that market disciplines can play a substantial role in
most financial systems. In particular, I think policy makers in many countries could usefully
give careful thought to the merits of introducing comprehensive and well focused disclosure
requirements for banks. Similarly, I believe there would be much to gain from the adoption of
policies designed to strengthen the responsibilities of bank directors, so that the ultimate
responsibility for the management of banking risks lies squarely in the boardroom, rather than
being awkwardly balanced between the banking supervisor and the bank director.
But it is fair to say that the effectiveness of market disciplines will much depend
on the structure of the regulatory arrangements in place and the nature of the infrastructure
within which the banking system operates. In particular, the following factors would seem to
play an important role in determining the effectiveness of using disclosure as a mechanism for
promoting systemic stability.
Market disciplines are more likely to be effective where governments do not
insulate depositors from losses - whether explicitly in the form of deposit insurance or through
implicit depositor protection. Understandably, deposit