
Alan Bollard: The role of banks in the economy improving the
performance of the New Zealand banking system after the global
financial crisis
Speech by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, to the New Zealand
Shareholders Association Annual Meeting, Tauranga, 6 August 2011.
* * *
This speech was written by Dr Alan Bollard, Chris Hunt and Bernard Hodgetts, with thanks to Don Abel,
Toby Fiennes, Michael Reddell and Grant Spencer for useful comments.
1 Introduction
The New Zealand financial system has been significantly tested in recent years by the effects
of the global financial crisis, volatile global commodity prices, the end of a domestic housing
boom, and the resulting slowdown in domestic economic activity between 2007 and 2009.
Over the past year, even with the economic recovery underway, the financial system has
faced further challenges from the series of earthquakes in the Canterbury region and from
ongoing fragility in the global financial markets due to sovereign debt concerns.
Unlike the case in many countries, New Zealand's banking system has remained relatively
resilient over this period. Banks dominate the New Zealand financial system to an extent
seen in few other economies, accounting for around 80 percent of the total assets of the
financial system. Moreover, four banks - the Australian-owned subsidiaries and their
branches domiciled in New Zealand - account for nearly 90 percent of the banking sector, or
just over 70 percent of the financial system as a whole. It is these institutions that provide the
lion's share of financial services and products to the New Zealand economy, and therefore
are of key systemic importance.
What explains the New Zealand banking system experience relative to other jurisdictions
where banks failed, or required government recapitalisation? Briefly, our banks stuck to their
knitting over the boom, engaging in very profitable lending to households and the rural sector in
the main, without recourse to the sort of exotic financial innovation witnessed elsewhere. As
prudential supervisor of the banks we certainly witnessed some decline in lending standards
over this time, and what we considered misplaced exuberance around lending to some
sectors, particularly later in the cycle. However, New Zealand's conservative application of the
regulatory capital regime (under both the original Basel I and the new Basel II frameworks)
helped to promote sound risk management and the banks appear to have steered clear of the
dubious lending practices evident in parts of the non-bank sector.
Nevertheless, one point needs to be made clearly. When the crisis did hit, the banks did
require public sector support. The Government implemented both retail and wholesale
funding guarantees to preserve confidence in the banking system, while the Reserve Bank
expanded its liquidity facilities in order to ensure that banks remained liquid and well-funded.
The financial crisis revealed a major limitation in the banks' business model that lay behind
the rapid expansion in credit during the lead-up to the financial crisis - a tendency to fuel
much of that lending primarily through short-term wholesale funding from offshore. However,
unlike banks in the Northern Hemisphere, the banks' own capital buffers proved sufficient to
absorb the rise in non-performing loans and accompanying decline in profitability that
followed from the economic slowdown.
Banks play an important role in supporting economic growth and it is worth reflecting on the
lessons that have been learnt from the global financial crisis and the experience of the
New Zealand financial system over recent years. Under the Reserve Bank Act, the
Reserve Bank has a legislative mandate to promote the "soundness and efficiency" of the
financial system. In thinking about ways to make the financial system safer and more
resilient, consistent with the aims of global regulatory reforms, we need to take both these
dimensions of financial system performance into account. More stringent regulations may
well make the financial system safer but possibly at the expense of the efficiency and cost at
which it provides services to businesses and consumers.
2 What role do banks play in the economy?
Any modern financial system contributes to economic development and the improvement in
living standards by providing various services to the rest of the economy. These include
clearing and settlement systems to facilitate trade, channelling financial resources between
savers and borrowers, and various products to deal with risk and uncertainty.
In principle, these various functions can be provided by banks or other financial institutions or
directly through capital markets. Banks and other financial intermediaries exist because they
are an efficient response to the fact that information is costly. Banks specialise in assessing
the credit worthiness of borrowers and providing an ongoing monitoring function to ensure
borrowers meet their obligations. They are rewarded for these services by the spread
between the rates they offer to the accumulated pool of savers, and the rates they offer to
potential borrowers. This process is known as "maturity transformation" and is at the heart of
modern banking. Banks offer a repository for savings, and then transform them into
longlived (illiquid) assets - housing loans and lending to businesses. In addition, banks play a
role in providing payment and settlement services which are necessary for households,
business and other financial institutions to settle day-to-day transactions.
As a country becomes more developed, one typically sees the capital markets playing a
greater role in supplying financial products and services relative to that supplied by the
banks. In many advanced economies, for example, raising business debt through securities
rivals or exceeds that provided though the banking system. Unusually, New Zealand has a
large banking sector, while the role played by the capital markets and non-bank financial
institutions is small.
Table 1 compares New Zealand to five other economies whose banking systems also tend to
dominate their financial systems, using data immediately prior to the financial crisis as
compiled by the IMF.1 Table 2 compares the New Zealand and Australian financial systems.
The following points emerge:

Relative to the financial system as a whole, the New Zealand banking system is
large in common with the other countries included in the table. New Zealand's
banking system is larger than Australia on this metric.

In relation to the size of the economy however, the New Zealand and Australian
banking systems are of roughly equal size, and much smaller than the other
countries identified by the IMF.

New Zealand's financial system is much smaller than in the other economies
included in Table 1. On the eve of the crisis Iceland's financial system was 4 times
as large as New Zealand's. New Zealand's financial system is also smaller than
Australia's largely reflecting Australia's compulsory superannuation and the large
funds management business.

The New Zealand banking system is not as internationally active as the countries in
the IMF sample as measured by gross foreign assets and liabilities. However, our
banking system's negative net foreign asset position in 2007 was similar to Ireland's,
but smaller than Iceland's. (The rest of the world's net claims on the New Zealand
banking sector is also reflected in figure 1 below).
 New Zealand has a relatively highly concentrated banking system, even compared
with those countries with large banking systems. The big four Australian-owned
banks command a larger role in the New Zealand financial system, compared to
their parents in Australia.
Table 1:
Bank-dominated financial systems before the crisis - a comparison
Hong New
Iceland Ireland Switzerland Singapore
Kong Zealand
Financial sector size and growth
Financial sector assets 1071 1129 873 931 876 242
(% of GDP, 2007)
Financial sector assets 218 711 706 574 836 212
(% of GDP, 2001)
Financial sector structure
Bank assets (% of total 72 76 66 71 91 75
financial assets)*
Banking sector 79 34 67 55 31 68
concentration* (share of
the largest 3 banks)
Banking sector
Bank loans 69 48 41 25 26 78
(% of total bank assets)*
Bank assets 876 894 664 641 789 184
(% of GDP, 2007)
Bank assets 121 468 518 474 784 152
(% of GDP, 2001)
Bank foreign assets 367 574 451 386 447 8
(% of GDP, 2007)
Bank foreign liabilities 491 618 223 230 442 62
(% of GDP, 2007)
Bank net foreign assets -124 -44 228 156 5 -54
(% of GDP, 2007)
Table 2
Financial system structure - comparison with Australia
(as at December 2010) New Zealand Australia
Total financial system assets $474 bn AU$4.6 tr
as a percent of GDP 244% 340%
Number of banks 20 54
Foreign branches 10 33
Locally incorporated 10 21
Domestically owned 3 12
Total bank assets $380 bn AU$2.7 tr
as a percent of total financial system assets 80% 58%
as a percent of GDP 195% 197%
Big-4 banks' assets
as a percent of total bank assets 89% 77%
as a percent of total financial system assets 71% 43%
Stock market capitalisation (2009)
as a percent of GDP 25% 180%
Sources: RBNZ, APRA, RBA, World Bank.
The dominant role of banks within the New Zealand economy can also be examined by
looking at financial claims between the different sectors of the economy - financial
corporates, non-financial corporates, households, government and the rest of the world. As
can be seen from figure 1, banks dominate the flows between the financial sector and the
rest of the economy.
Figure 1
Financial claims between registered banks and other sectors,
December 2009 (percent of GDP)
New Zealand has a very "plain vanilla" banking system with a large proportion of assets
being loans to households and businesses. Relatively few of its assets are held in the form of
trading securities. New Zealand's banks largely fund themselves "on balance sheet" rather
than through the securitisation channel common in some other countries. The banks have
little in the way of funds under management, nor do we allow them to conduct much
insurance business. Reflecting New Zealand's history of current account deficits, the banking
system has a reliance on foreign wholesale markets, particularly the short-term funding
markets.
Given these trends and our relatively underdeveloped capital markets, the question can be
asked whether the structure of our financial system is optimal for the economic growth
outcomes we would like to achieve. The answer is by no means clear. The failure of any one
of our larger banks could have serious repercussions for the rest of the economy. Moreover,
there may be efficiency concerns if the banks are perceived by their customers and investors
to be "too-big-to-fail" and hence gain a competitive advantage over other banks and other
non-bank financial institutions or financial markets.
New Zealand firms could well benefit from greater capital market development to help them
grow and reach the scale necessary to compete on the world stage - a point made by the
Capital Markets Taskforce and more recently the Savings Working Group. Larger capital
markets might help to stimulate greater competition in the financial system by providing a
substitute for bank funding of both small and large businesses. However, it is not clear
whether our underdeveloped capital markets are more a symptom of low national savings or
a direct cause of relatively low growth outcomes over the past two decades. Finally it may
well be that because of the large number of small businesses in New Zealand, relationship
lending through a bank-based system is actually an optimal arrangement.
3 Banks and financial (in)stability - making the system safer
Transforming short term deposits into longer term lending - one of the most important
functions that banks perform for the rest of the economy - is also what makes financial
systems prone to fragility. This process exposes banks to illiquidity or possibly insolvency
given the possibility of bank runs from depositors and creditors, or deterioration in lending
quality. Banks' own practices and financial regulation have an important bearing in reducing
or amplifying this risk. For example, banks have choices around how much debt they use to
fund their lending (leverage), while the quality of that lending is influenced by a number of
governance-related factors. These include the control that creditors and shareholders exert
over bank managers, as well as the internal risk management systems of the bank.
Regulations also set boundaries on what banks are able to do.
Given the interconnections between a bank and the rest of the economy, the effects of a
bank in stress or failure can potentially spill over to the wider financial and economic system
when financial savings cannot be accessed, the credit intermediation process is disrupted or
the transactional role via the payments and settlement systems is undermined. The extent of
such contagion will depend on the "systemic importance" of the bank, which will be roughly
related to its size, the nature of its exposures, interlinkages with other banks and so forth.
Governments are naturally reluctant to see such important institutions fail since economic
crises that are accompanied by major banking crises are typically far worse than usual
business cycle slowdowns. However, as we have seen from the experience of Ireland and
Iceland, supporting stressed banks can create major fiscal problems, particularly if the
banking system is very large relative to the size of the economy. A banking crisis can evolve
into a sovereign debt crisis, which itself can have cross-border contagion effects.
As mentioned at the outset, the New Zealand banking sector did not experience the sorts of
problems that affected the US or European banking systems. Despite a tightening in lending
conditions and standards, which had a significant effect on some businesses, our banking
system was largely able to maintain the confidence of depositors and creditors. However, it
did still require a backstop of government support. In the aftermath of the crisis we are
aligning our prudential initiatives with global efforts focussed on redesigning the regulatory
safety net. This improvement in the soundness of our banking system centres on the
implementation of stronger microprudential standards; the development of a new
macroprudential framework; and improved failure resolution management.
(i) Microprudential standards
Microprudential settings in New Zealand were largely appropriate heading into the crisis.
Both before and after the implementation of Basel II, our capital requirements ensured locally
incorporated banks held high quality (Tier 1) capital that excluded hybrid debt/equity
instruments in order to absorb potential losses. The larger banks that were accredited to use
their own internal models to calculate capital requirements under the Basel II guidelines were
also strongly encouraged to use risk parameters that "looked through" the boom-bust cycle.
Basel II largely appears to have served us quite well, although the banks' initial modelling of
capital requirements for both housing and rural lending was not sufficiently conservative, a
point highlighted by the sharp fall in farm prices and earnings in 2008-09. In response, the
Reserve Bank has initiated a number of adjustments, most recently a tightening in the area
of capital requirements for farm lending.
Over the course of the crisis the Reserve Bank introduced a Prudential Liquidity policy to
ensure that bank lending is largely funded by stable (retail and long-term wholesale) funding
and to ensure that banks have sufficient liquid assets to withstand short-term market
disruptions. Banks are now also able to issue covered bonds to help diversify and lengthen
their wholesale funding. Banks should now have more robust liquidity structures, reducing
their need to call on emergency liquidity facilities with the Reserve Bank during periods of
funding market volatility.
The Reserve Bank will be reviewing its capital adequacy framework in view of guidelines
from the Basel Committee now widely known as "Basel III". In addition there may be minor
developments to our liquidity policy. We are broadly supportive of Basel III, but will
implement it in a manner that is appropriate for our financial system. We don't believe our
banking system requires the sort of radical overhaul that is being discussed as necessary in
some other countries, given the relative resilience of our banks over the course of the crisis.
The Reserve Bank's supervisory approach for banks has also changed, with a shift from a
high reliance on market disclosures, to one that uses more private reporting. This will enable
the Reserve Bank to utilise more detailed and timely information from internal reports that
banks themselves use to manage risk.
(ii) Macroprudential framework
Microprudential policies are typically aimed at building the resilience of individual institutions,
while a macroprudential approach focuses on system-wide risks and vulnerabilities and a
range of instruments or tools that might be used to build greater financial system resilience to
the risks associated with the extremes of the credit cycle. Examples include countercyclical
capital requirements, liquidity ratios or caps on loan-to-value ratios for housing lending.
Some of these tools may also have the ability to directly dampen the credit cycle.
We have been considering a number of potential instruments for these purposes including
credit-based measures and capital and liquidity buffers. Our examination of the costs and
benefits of these tools suggests we should keep our expectations modest in terms of the
effectiveness of any one tool particularly as instruments to help control the flow of credit.
However, we have concluded that our Core Funding Ratio - part of the Prudential Liquidity
policy - could help to dampen periods of excessive credit growth in some circumstances by
making the marginal cost of funding more expensive than it would be were it not in place.
(iii) Failure resolution management
One important lesson from the crisis was that few countries had an adequate framework for
resolving the failure of a systemically important bank or financial institution in an orderly
fashion. Moreover, the existing resolution tools did not address the cross-border
complications that occur with globally active banks. Improving the resolution framework is an
important component of efforts to address the systemic risks posed by the largest and most
interconnected of the international banks.
New Zealand's largest banks are not of global systemic importance and nor are their
Australian parents. However, distress in any one of our larger banks in New Zealand could
have a potentially large negative effect on the New Zealand economy and could expose the
government to large fiscal risks in the event of a bailout. The recently announced Open Bank
Resolution (OBR) policy is a failure resolution option that aims to preserve the continuity of
banking services to retail customers and businesses, while placing the cost of a bank failure
primarily on the bank's shareholders and creditors rather than the taxpayer. Under OBR, the
creditors of a distressed bank, including its depositors, would face a "haircut" of their funds
based on initial estimates of the shortfall in the bank's capital position. Access to their
remaining funds would be supported via a government guarantee. This would allow the
affected bank to remain open for business while the longer-term options were worked
through.
We believe OBR would help address the "too-big-to-fail" problem posed by our largest banks.
Currently we are not contemplating additional loss absorbency or capital surcharges for the
largest New Zealand banks, measures that are currently being planned for the largest 30 or
so global banks.
4 Making the financial system more efficient - the role of banks
The banks' role as financial intermediaries has a major bearing on how efficiently the
economy allocates its resources between competing uses. In considering efficiency, we are
interested in whether lending activity helps resources flow to their "best use" or whether
some sectors get too little or too much credit relative to what is needed for the economy to
perform at its best. We are also interested in whether lending and other financial activities
are provided in a cost effective manner from the point of view of consumers and the degree
to which the banks improve and innovate their financial products and services over time.
All else equal, a well-managed bank acting prudently and operating in a reasonably
competitive market will be making credit available at an appropriate price to creditworthy
borrowers. However, in concentrated banking systems dominated by a handful of large
banks, competition may be lacking. Households and firms may end up paying more to
access credit (and other bank services) than in a more competitive system.
Financial sector efficiency can also be compromised by boom-bust cycles, which is why
there has been a resurgence of interest in how we might avoid or reduce these. During
booms, lending standards may fall significantly and lenders may underprice risk, with too
much credit being allocated to any one sector (such as the rural sector or property
development). In turn, when the boom turns to bust, the over-allocation of credit may be
revealed when physical and human resources become underemployed.
International evidence suggests what might be more important for competition and efficiency
is how "contestable" the banking system (or individual banking product markets) is, rather
than simply how many banks operate (i.e. market structure). Contestability is influenced by
both the actions of incumbent banks, and by various formal and informal barriers to entry and
exit.
Cross country comparisons undertaken by the OECD suggest formal regulatory barriers to
entry and exit to the New Zealand financial system are low by international standards.2.
While banks seeking registration must meet minimum qualitative and quantitative criteria so
that their entry to the market is consistent with the soundness and efficiency objective, the
Reserve Bank does not impose quotas of any kind nor do we restrict foreign ownership.
However, the costs associated with establishing a new retail branch network in New Zealand
appear to be high given the small scale of the market. Notwithstanding the success of
Kiwibank in the retail market, the fact remains that it is difficult for new players to enter the
New Zealand market and assume a competitive position other than through direct acquisition
of an existing bank or by specialising in a narrow market segment.
In terms of informal barriers to entry, one such barrier may come about from the practical
difficulties customers face switching between banks. Shifting one's banking activities from
bank A to bank B is usually a more involved process than shifting between cellphone
providers or electricity companies. The customer inertia that this creates makes it difficult for
new entrants to gain critical mass even if they price their offerings keenly. Encouragingly,
some of these barriers may have eased recently through technical innovations at the
payment systems level orchestrated by Payments New Zealand (PNZ). More switching
implies greater incentives for banks to compete and innovate.
Figure 2
Post tax return on equity - OECD comparison
(average 2002-2007)
Source: OECD, Australian Prudential Regulatory Authority,
RBNZ calculations.
Although some of the smaller banks have succeeded in "nipping at the heels" of the larger
banks and stimulating competition in some markets, overtaking the market share of the
larger banks has proven a very tall order. It is likely that the "franchise" or brand value of the
large New Zealand banks is an important factor that gives established banks an advantage.
Customers do appear to place considerable weight on the "brand" of the financial institutions
with which they bank and the larger banks have considerable investment built-up in their
brands, both tangible and intangible.
What does all this imply about the efficiency of the New Zealand banking system? Efficiency
is very difficult to measure in absolute terms, but two commonly used indicators include the
return on equity and operating costs as a share of income. Profitability is a gauge of the
economic rents that banks are able to earn, while operating costs tell us something about the
efficiency with which services are delivered.
In the decade preceding the global financial crisis, the New Zealand banking system's return
on equity (RoE) appears to have been among the highest of the OECD group of countries
coming second in a sample of 22 countries for the period 2002 to 2007. Rates of return in
New Zealand were ahead of those in Australian banks, which were third highest in the
comparison. Operating costs were second lowest in the sample while loan loss provisions
were also towards the lower end.
While we are acutely aware of the accounting issues that can make these comparisons
misleading, taking the comparison at face value would suggest the New Zealand banks (and
their Australian parents) were among the world's most cost-efficient, and also among the
most profitable. This was at least partly due to their relatively strong asset quality. From a
financial stability perspective, the relative strength of the Australasian banks could be seen
as a desirable feature. A leaner banking system would have had fewer financial buffers to
draw on and therefore would be potentially more exposed to the sorts of risks that arose
following the global financial crisis.
However, the question can be asked why the banks' rates of return were not at levels that on
average were more typical of other countries. The result could be seen as evidence that
competition and contestability in the banking sector were lacking enabling the banks to earn
higher profits than would otherwise be the case. However, alternative explanations are also
plausible.
One relevant factor is that the sample period covers a major domestic credit boom. A
comparison over a longer period would be likely to reveal rates of return more in line with the
banks' international counterparts. There have certainly been periods when New Zealand
bank profits have been weaker most notably in the early 1990s following the commercial
property downturn.
Another potential explanation relates to the higher cost of capital facing New Zealand.
Riskfree interest rates have been consistently higher in New Zealand than in most other
countries, and this could account for part of the higher observed rate of return in New
Zealand. Moreover, the degree of support that the major New Zealand banks receive from
their Australian parents allows them to maintain lower capital levels than would otherwise be
the case to maintain their credit ratings. Nevertheless, the capital ratios of New Zealand
subsidiary banks are similar to those of the Australian parents, and it remains an open
question why the Australasian banking system as a whole has been relatively profitable.
Some work we have done comparing the margins that banks charge on some financial
products like residential mortgages suggest that the New Zealand banks have not earned
interest margins that are particularly high relative to other countries. This would support the
view that strong profitability was due to low operating costs rather than undue market power
being exercised over customers. However, a comparison across the full range of financial
products is difficult due to a lack of comprehensive data and other country differences.
Clearly, operating conditions for the banks have changed profoundly since the financial
crisis. It is still too early to be definitive about how this will affect financial performance over
the years ahead. In terms of bank shareholders, regulatory changes designed to create safer
banks might be expected to lower required rates of return over time. However, a host of other
structural changes will also have a bearing on returns. In the past three years, bank balance
sheets have shown little growth, with households and businesses choosing to curtail debt
and save more. If this trend endures, banks will have less opportunity to generate higher
profits through balance sheet expansion. A combination of higher risk aversion, global
regulatory changes and sovereign debt issues have led to a rise in the cost of debt funding
for banks although where these costs are likely to settle in the longer run is uncertain. The
higher funding costs have encouraged some large corporates to raise funds directly in the
capital markets in lieu of the banks and it will be interesting to see whether this trend
continues. The banks' ability to recover higher funding costs from customers will depend
partly on the strength of loan demand as well as competitive pressures from other parts of
the financial sector.
All things considered, it seems unlikely that the rates of return in banking enjoyed over the
past decade can be sustained in the future.
5 Conclusion
The global financial crisis has focussed policymaker's attention on making their banking and
financial systems safer and more resilient to shocks. While New Zealand's bank-dominated
financial system stood up well during the crisis and does not require the extensive overhaul
required in some countries, we have continued to develop our prudential policies with the aim
of improving the resilience of individual institutions and the financial system as a whole.
Ensuring that core banking services can continue if any one of our large banks comes under
duress, and that the cost of bank failure falls squarely on the shoulders of shareholders and
creditors, is another plank in our regulatory reform agenda. Notwithstanding the importance
of financial system resilience, we also need to understand more about the efficiency of the
financial system when assessing its performance and contribution to the economy.