Mr. Brash asks how central banks can best help banking systems remain
strong in a world of open capital markets Address by the Governor of the Reserve Bank of
New Zealand, Dr. Donald Brash, to the Asian Pacific Bankers Club Annual Conference in
Auckland on 13/3/98.
Introduction
I appreciate your invitation to address you this morning and I join with others in
welcoming you all to New Zealand. This country can not be regarded as truly Asian, but we are
increasingly integrated into the Asian region, through trade, through immigration, through
political and diplomatic linkages, through cultural exchanges, and in my own case through
marriage!
Whereas when I went through school almost the only foreign language learnt in
New Zealand schools was French, now more New Zealand students learn Japanese than learn
any other foreign language, with many students also studying Mandarin and Indonesian.
Whereas when I went through school the United Kingdom took roughly half of
New Zealand's exports, now the British market takes only some 7 per cent of our exports, with
Japan taking 16 per cent, China/Hong Kong taking 6 per cent, and Korea (in 1997) taking 5 per
cent. Seven of our largest 10 export markets are now in this region.
Whereas when I went through school almost all immigrants to New Zealand came
from the United Kingdom, Australia or the Pacific Islands, in the last few years a great many
immigrants have come from East Asia - especially from China/Hong Kong, Taiwan, and Korea.
And New Zealand has gained enormously from these immigrants, who have tended to be
hard-working, thrifty, enthusiastic about education, and enterprising. They have enriched our
culture and helped our economy.
Whereas when I went to school New Zealanders seeking international experience
inevitably travelled to the United Kingdom and Europe, typically by means of a ship which
travelled via the Panama Canal and lots and lots of ocean, today many New Zealanders seek
overseas experience in the countries of Asia and, even when travelling to Europe, travel via
several Asian countries.
This year and next, the Reserve Bank of New Zealand holds the Chair of
SEANZA, a grouping of 20 central banks in the Asian region originally formed in the
mid-1950s, and we were a founding member of EMEAP, an 11-country group of East Asian
central banks. (Indeed, we hosted two of the three EMEAP working groups in New Zealand last
month.) And of course next year New Zealand will host the APEC Leaders' meeting here in
Auckland.
So we are increasingly a part of the Asian region, and have a vital stake in the
prosperity of the region.
And in that regard, everybody in this room, and indeed almost everybody in this
country, is very much aware of the stresses and strains which several of the countries in the
region have been going through in the last few months. Even countries which have not
experienced severe turbulence in their currency markets in some cases face very considerable
pressures on their banking systems, so that it is no exaggeration to say that most of the people in
the region live in countries where banking systems are under real strain.
Oceans of ink have been spilt in analysing the causes of these strains, and this
analysis will no doubt continue for a long time to come. Most detached observers seem to agree
that the underlying problems had nothing to do with the real or imagined activities of foreign
speculators but a great deal to do with more fundamental factors, factors which clearly varied
from country to country, but which included politically-directed lending by banks, the end of a
real estate bubble, sharply increased real exchange rates in a pegged exchange rate situation, a
lack of transparency in financial markets, and, dare I say it to this audience, some poor quality
credit analysis by some of the banks and other financial institutions.
I do not propose to offer my own analysis of the causes of 'the Asian crisis' this
morning. I was originally invited to speak about 'the role of central banks, the New Zealand
experience'. But instead I want to tailor my remarks more specifically to the theme of your
conference, 'Open Markets - the implication for Banks in the Asian Pacific Region'. So for this
reason I want to focus this morning on a question, namely 'In a world of open capital markets,
how can central banks best help banking systems remain strong?' Not surprisingly, my remarks
will be heavily conditioned by our own experience in New Zealand.
While we are all conscious of the strains currently besetting the banking systems
in many Asian countries, not all of you will be aware that we in New Zealand had our own
banking system problems less than 10 years ago. As a result of these problems, our largest bank
would almost certainly have failed had the government, as majority shareholder, not been
willing on two occasions to provide a substantial capital injection. One very major financial
institution (not a bank, but certainly a quasi-bank, and an institution which was in the process of
applying for a banking licence) did fail, one of the largest failures in New Zealand's history.
Another bank would have failed had its private sector shareholder not been in a position to inject
very large amounts of additional capital, and even after that was done the institution was
eventually wound up. At no point did it look likely that the whole banking system might fail, but
we certainly had major problems with some of the largest participants in the system.
What lessons did we learn from that experience? There were of course a whole
host of factors which caused these difficulties. One important factor was the sheer inexperience
of many of our bankers: they had been accustomed to a highly protected environment, and were
ill-prepared to deal with the demands of a deregulated environment. Nevertheless, I think there
were four important lessons. While every country has to make judgements and decisions in the
light of its own particular circumstances - and certainly no two countries are exactly alike - some
of the things we learnt may have relevance to other countries also.
Lessons from New Zealand: encourage banks to behave prudently
First, it is important that banks are given every incentive to behave prudently.
This may seem a self-evident statement, but it is astonishing how frequently the importance of
this principle is ignored. In New Zealand's case, we diminished this incentive to behave
prudently by allowing the view to go unchallenged that banks were effectively 'sovereign risk',
or at least 'too big to fail'. This meant that bank creditors felt little need to assess the
creditworthiness of the banks with which they deposited funds - banks were, it was widely
believed, effectively guaranteed by government. Bank boards and managements may have felt
similarly protected against the possibility of failure, and made loans with a disregard for risk
which was, in some cases, breath-taking. This so-called 'moral hazard problem' may have been
particularly severe in the case of two of the three institutions which got into serious difficulties
in the late 1980s, both of them owned wholly or in part by government. There was little or no
direction of their lending by government, but the management of both institutions certainly
embarked upon lending transactions in the newly liberalised environment which rapidly got
them into serious difficulties.
In some Asian countries, it is possible that the incentive for banks to behave
prudently was seriously eroded not only by the impression that most large financial institutions
would not be allowed to fail but also by the extent to which governments directed the lending
activities of the banks themselves. After all, if governments are going to become extensively
involved in directing where banks should and should not lend, it is not unreasonable if the banks
and their creditors assume that governments will 'see them right' if things go wrong. Bank
management certainly has little incentive to carefully assess credit risk if, at the end of the day,
the decision on whether or not to lend will be made by the bank's board under the influence or
direction of higher political authority.
At the moment, there is a great deal of international attention focused on how this
problem of poor credit decisions in the banking sector can be dealt with. Most of the attention is
on how official banking supervision and banking regulation can be improved, and made more
independent of political influence. Certainly, freeing banks from political interference in their
credit decisions is very desirable, and better banking supervision is one possible way to reduce
the risks of future problems in the banking system.
But as some of you perhaps know, we in New Zealand are not persuaded that
improving the quality of official banking supervision is the only way to proceed, or indeed even
necessarily the best way to proceed in all circumstances. When we reviewed what we were doing
in banking supervision in the early 1990s, we became concerned. At that time, we were
conducting banking supervision along conventional Basle Committee lines. We were gathering
very large amounts of confidential information from banks on a quarterly (sometimes a monthly)
basis. We were laying down a large number of rules and limits designed to ensure that banks
behaved prudently.
Several things prompted us to review that approach, and one of them was a worry
about the risks which we were incurring on behalf of taxpayers. What would happen if, despite
our banking supervision, a bank were to get into difficulties? Might depositors argue that they
wanted full compensation, since while they had had no knowledge of the bank's financial
condition we in the Reserve Bank were not only fully aware of that condition but were also
responsible for laying down the rules and limits by which the bank had been obliged to operate?
We consoled ourselves with the thought that our banking supervision was so good
that no banks would fail under our watchful eye. But then we looked abroad - at the United
States, at Japan, at Scandinavia, at the United Kingdom, at Australia, and indeed even at New
Zealand itself. We found banks going down in significant numbers, despite some extremely
professional and politically-independent banking supervision. We could not be confident that
traditional banking supervision would prevent bank failure, and we could be confident that, by
being the sole recipient of detailed financial information on banks and the main arbiter of what
constituted prudent banking behaviour, there was a major risk that we would be held liable,
politically and morally if not legally, for any losses incurred by depositors.
Then we became aware of anecdotal evidence that our banking supervision was
reducing the incentive for bank directors to make their own decisions about crucial aspects of
their bank's operations. In other words, because the Reserve Bank was laying down maximum
individual credit limits, and limits on open foreign exchange positions, and guidelines for
internal controls, some bank directors were assuming that they were necessarily behaving
prudently provided they were operating within those limits and guidelines. They stopped
addressing the risks which their own banks were facing and simply complied with the general
limits and guidelines. To the extent that that was true - and as I say we found some evidence that
it was true in some banks - we concluded that our banking supervision might actually be
increasing the risk of bank failure, by reducing the incentive for bank directors and bank
managers to make their own careful assessment of risk.
So we retain a system of official banking supervision, and we take it very
seriously. But we retain only a few absolute rules within that framework, principally that all
banks must at least meet the Basle capital adequacy rules, and rely mainly on a requirement that
banks disclose to the public a substantial amount of financial information quarterly. In addition,
all bank directors must sign off these quarterly statements, at the same time attesting to the fact
that the internal controls of their banks are appropriate to the nature of their banking business,
and that those controls are being properly applied. We in the Reserve Bank do not attempt to tell
banks what those controls should look like, but directors signing those quarterly statements
without making a careful assessment of the adequacy of internal controls are exposing
themselves to very considerable legal risk in the event that their bank gets into difficulty.
We have also gone out of our way on a number of occasions to make it clear to
the public that neither the Reserve Bank nor the government of New Zealand is guaranteeing
individual banks, and we published a booklet designed to assist the general public to interpret
banks' financial information.
None of these actions is a guarantee against imprudent bank behaviour, but we
believe that we have gone a considerable distance towards ensuring that banks face strong
incentives to behave prudently. No bank operating in New Zealand is now owned by
government, none is guaranteed by government, none is obliged to lend to particular sectors or
companies, and our supervision is based heavily on mandatory public disclosure and director
attestations. As Alan Greenspan said last year, 'Regulation by government unavoidably involves
some element of perverse incentives. If private market participants believe that government is
protecting their interests, their own efforts to do so will diminish.'1
We have tried to minimise
those perverse incentives.
Of course, to some extent this approach only works where there is a clear
framework of company law which makes it clear that company directors and managers have
unambiguous responsibilities. Having agreed accounting rules is important. Having a vigorous
media, with probing financial journalists, is also of great value, so that when a bank is forced to
disclose to the public a deteriorating financial position, or a breach of one of the few rules we
retain, there is at least a reasonable chance of that being picked up and sensibly analysed by the
media. Not all countries are so lucky.
So far at least, we are well satisfied by the way in which the new system is
working. (A few months after the new system first came into operation, at the beginning of
1996, one bank was obliged to disclose the fact that it had had a credit exposure to its
shareholder bank which considerably exceeded the limit which we had stipulated for such
exposure. The attention focused on this issue by the media, and indeed by other banks, created
strong incentives for the bank never to repeat that mistake - quite probably stronger incentives
than any threat of central bank sanction could have created.)
Lessons from New Zealand: beware of government ownership of banks
The second lesson from the New Zealand experience in the late 1980s is that the
ownership of banks is an important issue. For us, the issue was in part government ownership of
banks and in part foreign ownership of banks. The government-owned financial institutions
almost without exception suffered various degrees of financial difficulty - sometimes because
their managers had undertaken imprudent lending, and sometimes because they had been obliged
to invest in large amounts of government securities at sub-market interest rates. The large
foreign-owned banks suffered to a much more limited extent from the bad debts and losses
which the government-owned banks experienced.
There have been various reasons given for this difference, but the most plausible
is that the large foreign-owned banks were under the watchful eye of experienced parent banks,
and were therefore much less able to stray into some of the riskier propositions which tempted
the government-owned institutions, especially in the years immediately after the banking sector
was liberalised in the mid-eighties. (The newly-arrived foreign-owned banks, however, often did
succumb to the temptation of lending on risky propositions, perhaps because, being quite small
both in absolute terms and in relation to their overseas parents, they were subject to much less
intensive parental scrutiny.)
More recently, New Zealand has been running a very large balance of payments
deficit, probably amounting to more than 7 per cent of GDP at the present time. As in some
Asian countries, this balance of payments deficit has been experienced at a time when the
government itself is running a fiscal surplus. In other words, it has been the private sector which
has been borrowing heavily from overseas, not the public sector. And while some of this
borrowing has been done by the corporate sector directly, much of it has been done by the
banking sector. Comparable levels of overseas borrowing by some Asian banks have been
sufficient to make foreign lenders very nervous, and yet similar nervousness has not been at all
evident in New Zealand. Why? I can only conclude that the foreign lenders take considerable
comfort from the fact that most of the banks operating in New Zealand now are in fact
wholly-owned by foreign banks, or are indeed branches of foreign banks. Those parents are
seen as being financially strong, and fully able to back the operations of their New Zealand
subsidiaries or branches. (It may also be relevant that, overwhelmingly, the overseas borrowing
being undertaken by New Zealand banks carries no foreign exchange risk for the banks
themselves.)
In some countries, there is political reluctance to allow foreign institutions
unrestricted entry into local banking sectors. I would have to say that, as a country where all but
one of our 19 banks are owned and controlled overseas, we have seen absolutely no
disadvantages from this situation, and many advantages. We have a financially stable banking
sector, with vigorously competing and highly innovative banks, all of them subject to the
monetary policy influence of the central bank. I have no doubt at all that the banking sector is
considerably more stable than would have been the case had all the banks been
domestically-owned, whether in the private sector or in the public sector.
Lessons from New Zealand: keep prices stable
The third lesson from our experience has been the crucial importance of keeping
prices stable. By the late 1980s, New Zealand had experienced nearly 20 years during which
inflation had been above 10 per cent almost without a break. Interest rates after adjustment for
tax and inflation were often strongly negative, and there was as a consequence a strong incentive
to invest in real estate and shares, using as much borrowed money as could be obtained. This
was undoubtedly an important contributor to the severe difficulties which both the corporate
sector and some parts of the banking sector experienced when monetary policy was tightened in
order to reduce inflation. Interest rates went up and asset prices went down, and several banks
incurred very large losses as a consequence.
Asian countries have an enviable record of combining very rapid rates of
economic growth with rates of inflation which, by the standards of many other countries, have
been low or moderate. But it is also true that in many Asian countries relatively low consumer
price inflation has been accompanied by a huge escalation in asset prices. There is no single
explanation for this phenomenon and, as New Zealand has itself discovered over recent years,
with quite a strong increase in the price of both residential and rural property, it is often
extraordinarily difficult to restrain asset price inflation even when inflation in consumer prices is
low.
But it is at least possible that asset price inflation in Japan in the late 1980s - the
reversal of which has done so much damage to bank balance sheets in that country - was a
consequence of monetary policy being kept too easy for too long, whether to appease the United
States after the Plaza Accord or for some other reason I know not. Similarly, it may well be that
if central banks in some other Asian countries had not been so preoccupied with trying to avoid
the appreciation of their currencies against the US dollar as capital flowed into these economies
in recent years, their interest rates would have been higher and asset price inflation
commensurately reduced. And of course if asset price inflation had been less, the
over-investment in certain kinds of real estate would presumably have been less and, with that,
the subsequent fall in asset prices would have been less also.
Lessons from New Zealand: avoid pegging the exchange rate
And that brings me on rather naturally to the final lesson from New Zealand
experience, and that is the danger of pegging the exchange rate unless you are prepared to go all
the way to a currency board, as Hong Kong has done, and have the political and banking sector
strength to endure the economic, political, and social pain which is inevitably associated with a
currency board arrangement from time to time.
In New Zealand, we had a pegged exchange rate until March 1985. Prior to that
date, it was not uncommon for companies to borrow overseas, often at interest rates which were
very much lower than those within the high inflation New Zealand economy. Some companies
made rather spectacular losses when the New Zealand dollar was devalued from time to time, or
when, even when pegged, the New Zealand dollar depreciated against the currency in which the
loan was denominated. (Borrowing in Swiss francs was particularly popular, and particularly
painful, for some companies.) But the losses were probably fairly moderate in comparison to the
loss which the government itself incurred on behalf of taxpayers in 1984. In that year, the New
Zealand dollar was devalued by 20 per cent after a foreign exchange crisis which had certain
similarities to some of those in Asia more recently and the government, which had written very
large volumes of forward exchange contracts with companies trying to protect their positions,
incurred losses of many hundreds of millions of dollars.
Since March 1985, the New Zealand dollar has been freely floating, and indeed I
suspect we may be the only central bank that can claim not to have intervened directly in the
foreign exchange market for more than 13 years. (I say 'directly' because from time to time we
did adjust monetary policy when we felt that movements in the exchange rate seemed likely to
threaten our single goal of low inflation.) One of the benefits of this has been that, though many
companies and banks have borrowed overseas, none of this borrowing was undertaken in the
belief that there was no currency risk involved. Overseas interest rates were frequently much
lower than those in New Zealand, but after factoring in the exchange rate risk, the incentive to
borrow offshore in foreign currency was substantially reduced.
As a consequence, when, after a period of strong New Zealand dollar appreciation
between early 1993 and early 1997, the New Zealand dollar fell by some 18 per cent against the
US dollar, there were very few companies unhappy about that fall - and indeed plenty of
exporters who were delighted. Even fewer of our banks were caught out by the depreciation, and
to the best of my knowledge none incurred losses as a consequence of the move. Because they
knew that the New Zealand dollar was freely floating, they were careful to avoid taking on
unhedged positions in foreign currency.
Conclusion
In conclusion, in a world of open capital markets, the challenges facing banks are
very considerable. Central banks can not prevent all banks from getting into trouble, and nor
should they try to do so. But central banks do have a responsibility in all our countries to
promote the stability of the banking sector. In my own view, they can best do that by creating
strong incentives for banks to behave prudently; by discouraging government ownership of
banks, and removing barriers to the foreign ownership of banks; by keeping the focus of
monetary policy on price stability; and by not creating the impression that borrowing in foreign
currency is a riskless activity. We learnt those lessons the hard way.