Grant Spencer: Banking regulation - where to from here?
Speech by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to
KangaNews New Zealand Debt Capital Markets Summit, Auckland, 2 August 2017.
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Background
I began my present job as Head of Financial Stability at the Reserve Bank in April 2007. That
month saw the first straw in the wind of the US sub-prime crisis - the failure of a real estate trust
called "New Century Financial". Over the next three years the Reserve Bank was kept very busy
attempting to protect the New Zealand banking system and economy from the ravages of the
global financial crisis (GFC).
In the aftermath of the GFC from 2010 onwards, we saw a step up in banking regulation globally,
epitomised by the G20-sponsored Basel III reforms, Financial Stability Board initiatives, and the
Dodd-Frank Act in the USA. The reforms sought to reduce risk-taking by banks, increase capital
and liquidity buffers, and improve resolution regimes so that government bail-outs could be more
avoidable in the future.
While the Australian and New Zealand banks were less directly affected by the GFC than their
Northern Hemisphere counterparts, they were severely tested, particularly when shut out of
international funding markets for several months following Lehman Brothers' collapse. It was
inevitable and appropriate that the tightening of banking regulation would be felt in this part of the
world. The New Zealand banking system is highly integrated with international markets and
needs to maintain a strong reputation if it is to continue its lead role in intermediating New
Zealand's financial dealings with the rest of the world.
As the post-GFC reforms rolled out internationally, the Reserve Bank endeavoured to tailor the
reforms to suit the specific characteristics of the New Zealand financial system and our
regulatory philosophy. We did not adopt certain policies such as the leverage ratio and
compensation policies, but in broad terms have adopted most of the components of Basel III.
That said, some of these policies may be better suited to the major banking systems of the US
and Europe, than to New Zealand's relatively vanilla banking system. This raises the question of
how closely we need to follow international standards in order to realise the undoubted benefits of
international recognition.
We are currently reviewing our regulatory experience over the post-GFC period and thinking how
we might shape the New Zealand framework going forward. Two particular catalysts in this
regard are the recent IMF Financial Sector Assessment Program (FSAP) report, and our recently
initiated review of bank capital adequacy.
To guide our planning we need to revisit the objectives of the regime, our regulatory philosophy,
the experience to date with the post-GFC reforms, and the trade-offs involved in deviating from
international norms.
Today I will summarise these guiding principles and discuss how they are likely to influence key
regulatory initiatives over the coming years. While I will focus my remarks on banking regulation,
the principles and key themes apply more broadly to the other financial sectors that the Reserve
bank regulates. I will comment specifically on our upcoming review of the insurance regime.
Objectives and regulatory philosophy
The Reserve Bank's mandate is to promote the maintenance of a sound and efficient financial
system. While we see soundness as the primary goal of prudential regulation, the secondary
goal of efficiency has an important influence on our approach. When setting prudential
requirements we need to be mindful of inefficiencies that can be created if they needlessly or
disproportionately add to the cost of financial intermediation, stifle innovation or disadvantage
some institutions over others.
Broadly speaking, our regulatory interventions aim to improve soundness and safety while as far
as possible minimising the efficiency costs of those interventions. We focus our attention on
areas where there is strong justification for regulation based on clear market failure and where
the benefits to society of regulation are expected to well exceed the costs.
The main source of market failure in banking is negative externalities - which occur when banks
do not fully take into account the wider effects of their commercial decisions. For example, the
combined effect of mortgage credit expansion on house prices and housing risk is not factored
into the risk assessments of individual banks. Nor do bank owners and creditors take into
account the systemic costs of failure that can be well in excess of private capital losses. As the
GFC demonstrated, governments may feel compelled to commit public funds to rescue failing
banks in order to limit the systemic damage from such events. The presence of externalities
means that, in the absence of prudential regulation, banks may take on greater risk than is
appropriate from the point of view of the broader economy and society.
The prudential framework reinforces incentives for banks and their creditors to understand and
manage the risks they take. In some areas, incentives alone are insufficient and we have
imposed direct regulatory requirements. Our approach is built on three pillars: self; market and
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regulatory discipline.
The self-discipline pillar aims to support institutions' internal risk management and governance,
and has been at the heart of the Reserve Bank's approach to banking supervision for close to
three decades. The primary responsibility for prudent risk management lies with the directors
and senior management of banks. Giving boards and management the right incentives to act
prudently is the first priority of our regulatory framework.
The market discipline pillar seeks to reinforce incentives for prudent behaviour by requiring the
disclosure of financial and risk-related information by banks and also through our own
publications (such as our Financial Stability Reports). The aim is to increase market
participants' understanding of risks in the individual institutions and the wider financial system,
enabling investors to differentiate between institutions and thereby apply market discipline to
those institutions.
The third pillar of regulatory discipline, which has grown in prominence since the GFC, involves
the application of prudential standards intended to reduce various aspects of risk in bank balance
sheets, for example via minimum capital and liquidity requirements. While the Basel Committee
has promoted global prudential standards, the approaches of different countries span a wide
spectrum. At the intensive end are regulators with long lists of prescriptive prudential
requirements and supervisory guidance, with extensive compliance monitoring. At the other end
of the spectrum are regulators who choose to be less prescriptive, and instead rely on setting
higher, more conservative buffers or limits on a narrower set of key variables.
Our preference is the latter. A less activist approach to regulatory discipline is more consistent
with our emphasis on self- and market discipline. Those disciplines can be eroded if institutions
feel that the responsibility for risk management has been taken over by the regulator. A less
prescriptive approach is also less likely to impose excessive compliance and efficiency costs.
This more permissive view has guided our approach to loan-to-value ratio (LVR) limits, for
example, where we have set broad speed limits on high-LVR mortgage lending rather than
outright restrictions.
How close should New Zealand stick to international norms?
In shaping our regulatory approach - with its emphasis on self- and market discipline and being
at the more permissive end of the spectrum - we must consider the potential costs of deviating
too far from international norms. This is especially important to consider as we seek to tailor the
sometimes complex international regulatory environment to New Zealand's relatively vanilla
banking system.
The integration of our banking system with international financial markets means that the
adoption of the key elements of the Basel framework is desirable; a strong degree of
commonality between New Zealand's banking regulations and those of the major countries
enhances our financial system's international credibility. Thus, while there might be efficiency
gains from a more streamlined regime that is free of unnecessary complexity, there would also
be efficiency losses if the New Zealand regime ceased to be recognised as broadly in line with
international standards. This could result in a higher risk premium in bank funding costs and
potentially reduced access to international capital markets.
As you might expect, much of the "demand" for adopting Basel regulations in New Zealand
comes from the four major Australian-owned banks, who generally seek to have a regulatory
framework that is closely aligned with the Australian Prudential Regulation Authority's (APRA)
requirements. The FSAP report acknowledged the Reserve Bank's close cooperation with APRA
and recommended that we strengthen this relationship further. We will continue to develop the
relationship with APRA but both sides are well aware of the differences in our circumstances and
our different regulatory approaches.
Over recent years we adopted most of the key Basel initiatives even when some have been less
than ideally suited to New Zealand circumstances. At the same time the Reserve Bank has
taken on additional compliance oversight roles, some of which require specialised skill sets. Two
examples are the oversight of banks' internal capital models and the non-objection process for
bank capital instruments. Such activities do not sit very well with the regulatory philosophy that I
have described. Nor are they easily handled with the limited resources of a small Central Bank.
Such an approach has however been consistent with maintaining recognition of the New Zealand
regulatory regime by international investors and rating agencies.
The IMF takes the view that our framework needs to be brought more into line with the
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international orthodoxy. The recent FSAP report on New Zealand found the Reserve Bank's
prudential framework to be less than fully compliant with the Basel Core Principles in many
areas. This assessment relates more to the Reserve Bank's intensity of supervision than to its
adoption of Basel standards per se. The IMF recommends that the Reserve Bank take on
significantly more resources in order to: more proactively engage with the banks; issue more
comprehensive rules and guidance on key prudential matters; and more frequently verify and
enforce compliance.
Can we retain our regulatory approach and still achieve the benefits of international recognition? I
believe we can. Notwithstanding the views of the IMF, compliance with the international prudential
frameworks is not always a black and white choice; the Basel framework sets minimum
standards for key prudential requirements but often offers a menu of choices within those
standards, for countries to tailor to their specific circumstances. Further, while Basel Committee
members such as APRA are more bound to comply with the Basel standards, a small country
like New Zealand implicitly has a greater degree of freedom.
In summary, our objectives are to retain our regulatory philosophy with relative emphasis on
governance and market discipline. We want to streamline and simplify the current regulatory
regime in a number of areas but at the same time heed the IMF's advice about improving the
effectiveness of our supervisory model. Underpinning this, we need to maintain the high
international reputation of the New Zealand financial system.
I now turn to how these broad objectives might influence the shape of the Bank's current
regulatory initiatives.
Supervisory model
As I mentioned, the FSAP report recommends that we issue more guidance, and be more
prescriptive in many of our banking and insurance requirements. The IMF also says we should
seek more assurance of compliance via direct on-site verification and validation. The report
recommends a significant increase in resourcing to support such changes. The IMF
acknowledge that their recommendations imply a departure from the current balance in the three
pillars approach and philosophy. However they also take the view that the Reserve Bank needs
to increase resourcing in order to effectively implement its current low-intensity model.
The Reserve Bank's preferred approach is to improve the effectiveness of the supervision model
through a combination of simpler regulations, some increase in resourcing, and streamlining
approval processes.
We will continue to emphasise the quality of banks' decision making processes, with director
accountability for compliance through the attestation regime. In this context, current Reserve
Bank "non-objection" regimes run the risk of weakening internal incentives for banks to "get it
right first time". We will look at these processes closely in the context of our current review of
the attestation regime and other governance arrangements which underpin the self-discipline
pillar. The review will also consider whether the attestation regime needs to be supported with
supervisory guidance and/or verification.
With regard to the broader question of improving verification, we believe the best approach could
be through increased use of thematic reviews. These reviews are conducted by our supervisors,
and hone in on industry-wide areas of supervisory interest. Recent reviews in banking have
looked at outsourcing arrangements and problem loan identification. In the insurance sector we
have recently reviewed disclosure compliance. Such thematic reviews achieve the combined
purpose of compliance assessment, an improved understanding of risks by the supervisors, and
the sharing of best practice across the industry. We are also looking to make greater use of
targeted reviews by external experts in cases where serious non-compliance becomes apparent
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at particular institutions.
Capital review
In a speech in March I outlined the principles that would guide the current review of the capital
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adequacy framework for locally incorporated banks. The two overarching principles were
conservatism and simplicity. Regarding the latter, we do not believe that New Zealand's relatively
vanilla banking system warrants a high degree of complexity in its capital regime. We are leaning
towards simplifying both the allowable capital instruments and the methods for measuring risk,
though we are in the consultative phase and far from making any decisions.
On the allowable capital instruments, many of you will have read our "numerator" consultation
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paper and we are keen to receive your submissions (the consultation closes on 8 September).
It proposes that we remove contingent debt instruments from regulatory capital, which were
introduced to the framework in 2013 as part of Basel III. Several factors lean us in this direction.
There is an inevitable interaction between capital regulations and tax law, and an inherent tension
with both sets of regulations when an instrument has both debt and equity characteristics. Debt
status brings about tax benefits whereas equity characteristics can see an instrument accepted
as loss-absorbing capital from the Reserve Bank's perspective. Banks often seek to structure
financial instruments to maximise the regulatory capital value of the instrument, while reducing
their tax liability. In our experience this often leads to complexity in instrument design, greyness
around their true loss-absorbing capacity, and high compliance costs.
Further, it is questionable whether contingent debt has added any real economic value in terms
of improving the risk-return options available to issuers and investors. Two thirds of the
contingent debt issued since 2013 has been by Australian-owned banks to their parents, with the
remainder largely issued to retail investors. The former may be driven mainly by the tax
treatment, while retail investors receive an interest premium over deposits but may not
appreciate the underlying conversion or write-down risk. In this context, we are concerned that
contingent debt may be a financial innovation that is born more of regulatory arbitrage than of
market need.
On the risk measurement side, we will be taking stock of the current framework, particularly
around the internal risk models used by the four largest banks since 2008. Our experience, and
that of other regulators, is that it can be very difficult to assess whether these models provide
objective measures of the underlying risks banks face. In theory, internal models allow banks to
more accurately manage their risks, and thereby more efficiently align capital with those risks.
On the other hand, internal models add complexity to the regulatory framework that may not be
warranted in some risk areas, and the banks' assigned risk weights are often lower than would
be prescribed by standardised models. While deliberations are on-going, the Basel Committee
has signalled its intent to make some major changes to the risk measurement framework, in
particular a greater use of floors to ensure modelled outcomes do not deviate excessively from
standardised measures. We expect to release a consultation paper looking at these risk
measurement issues once the "numerator" consultation is complete, around mid-September.
We also intend reviewing the capital ratios themselves. The key relevant principle here will be
conservatism relative to international peers. New Zealand's relatively high risk profile supports
such an approach, as does the Reserve Bank's non-prescriptive regulatory philosophy. We are
also conscious that the international minimum standards are not calibrated to deal with some of
the issues we face in New Zealand, including high industry and portfolio concentration. An
interesting issue to address in this part of the review will be the future role and management of
conservation buffers, including the counter-cyclical buffer, relative to the minimum capital
requirements. We plan to progress these issues later in the year and in early 2018.
The dashboard
Market discipline is a key part of the Reserve Bank's regulatory philosophy. We know market
discipline works best when it is supported by the timely and transparent disclosure of financial
information. In this rapidly advancing digital age, we have an opportunity to improve the
effectiveness of disclosure regimes - the "Dashboard" is an important step in this direction. It will
be located on the Reserve Bank's website and will provide market participants and the general
public with more timely and comparable quarterly data on New Zealand incorporated banks. The
information will cover capital, liquidity and asset quality as well as profitability and balance sheet
positions. It will replace existing (off quarter) disclosure statements and make information more
easily available and comparable. The information will be available at different levels of granularity
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to meet the needs of different users.
We see the current Dashboard project as an important step in an on-going effort to support and
enhance more effective and efficient disclosure for banks, insurers and other financial
institutions. We are working closely with the banks and want to make sure we get it right. We
expect to have the first Dashboard published in the first quarter of 2018.
Looking further ahead, we see scope for ongoing advances in effective disclosure and private
data management for supervised institutions. Advances in digital services and data management
tools are likely to offer a range of new opportunities for assessing and managing the prudential
performance and compliance of banks, non-banks and insurers alike. I expect technology will
also offer increasing scope for automation in many of these processes. We anticipate greater
use of "Big Data" in our supervisory assessments and in providing warning signs of crises or
market concerns. But the day of full "robo-supervision" may still be some way off!
Macro-prudential policy
Macro-prudential is a relatively new policy area that we have so far implemented through LVR
speed limits, applied in 2013, and modified in 2015 and in October last year. The objectives of the
macro-prudential policy framework are set out in the 2013 Memorandum of Understanding
between the Governor and the Minister of Finance, which also outlines the instruments we can
use to respond to emerging systemic risks.
Macro-prudential policies have been adopted by many countries in recent years as the underlying
issues have been global in nature. The very low level of inflation and interest rates in most
countries since the GFC has led to rapid increases in leverage and an escalation of systemic
risk in property markets, particularly housing. Macro-prudential policies in New Zealand and
elsewhere have been aimed at moderating systemic risk by directly limiting housing-related
credit risk on banks' balance sheets.
These instruments are more prescriptive than our baseline micro-prudential tools. They target a
specific and significant systemic risk in the form of a leveraged and highly stretched housing
market. In a booming housing market, such as we have seen in recent years, we believe the
adverse externalities from rapid mortgage credit growth become accentuated, warranting the
imposition of temporary macro-prudential measures such as the LVR speed limits.
The Bank currently has a consultation paper out on debt-to-income (DTI) limits. We regard a DTI
instrument as complementary to the LVR speed limits. Limits on DTIs reduce the likelihood of a
mortgage borrower defaulting, in response to interest rate or unemployment shocks, while lower
LVRs help to reduce the risk of banks facing losses arising from a default. They are not just two
types of hammer hitting the same nail. Of course, banks already investigate borrowers'
repayment capacity when deciding whether to grant a loan as part of prudent banking practice. At
times, however, high volumes of high-DTI lending can contribute to a build-up of risk across the
financial system which individual banks may not take fully into account. This is why the IMF and
the Reserve Bank believe it is appropriate to have this tool in the macro-prudential toolkit, even
though we would not wish to use it while the Auckland and national housing markets continue to
moderate.
Thinking more broadly about the macro-prudential framework, we will seek to achieve more
broad-based support by ensuring that the policy framework is understood by stakeholders,
including the public. It should be positioned consistently with our macro-financial monitoring and
our micro-prudential policy and supervision. Policy adjustments should follow a systematic and
well-articulated process in response to emerging systemic risks. It is important to be clear what
macro-prudential policy can and cannot achieve. For example, while macro-prudential policies
can help reduce housing-related risk in the banking system, they cannot control house price
inflation.
These broad macro-prudential framework issues will be jointly examined next year by the
Reserve Bank and Treasury when the Bank's Memorandum of Understanding with the Minister of
Finance comes up for review.
IPSA review
My comments today have focussed on the future of banking regulation. However, many of the
issues around banking are also relevant for the Reserve Bank's oversight of insurance
companies. Certainly our regulatory philosophy applies to insurers (and non-bank deposit takers)
just as it does to banks. This includes our key principles of simplicity and conservatism. We will
be applying these in the upcoming review of the Insurance Prudential Supervision Act (IPSA),
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which has now been in place for close to seven years.
We are undertaking the review in recognition of the experience we have gained operating under
the legislation, and developments in international standards and guidance. The review aims to
ensure a cost-effective supervisory approach that promotes the soundness and efficiency of,
and confidence in, the insurance sector.
It is a comprehensive review and the range of issues is wide. It includes the legislative scope
(who is required to be licensed), the treatment of overseas insurance business, governance
requirements and distress management mechanisms. Earlier this year we published an issues
paper, which sought submissions on the scope of the review and areas which the review should
prioritise. We are currently reviewing the submissions, and thank those who provided feedback.
The FSAP report on insurance will be an important input to our thinking. While recognising the
relative youth of our supervisory regime, and the Reserve Bank's three pillar supervisory
philosophy, the IMF assessors made a wide ranging set of recommendations. As in the banking
area, we are particularly interested in the FSAP findings that could enhance the oversight
framework within the existing three pillars approach. These include the development of clearer
and more enforceable prudential requirements, enhancements to verification and improvements
to disclosure and market conduct requirements.
Conclusion
Today I have provided some of our thinking on the Reserve Bank's objectives for financial
regulation and how these are expected to shape our framework over the coming years. Of
primary importance is to maintain the high international reputation of the New Zealand financial
system. However we seek also to reinforce our regulatory approach based on the less-intensive
supervisory model and simple-yet-conservative prudential requirements. We believe this
approach continues to suit New Zealand's small and relatively vanilla financial system.
We will continue to place emphasis on getting the right incentives in place for prudent institutional
governance, supported by effective market discipline that increasingly makes use of technology
advances. The greater use of thematic and external reviews will enhance our approach to
supervision, while maintaining an appropriate balance between the three pillars of the prudential
framework. We will also explore how the macro-prudential framework can be made more robust
through a well-signalled and understood policy process.
1
For a more detailed discussion of the three pillars approach, and how it applies across the different sectors we
regulate, see Fiennes (2016), New Zealand's evolving approach to prudential supervision.
2
See the Financial System Stability Assessment report. The Reserve Bank has published a Bulletin article
summarising the IMF's recommendations, see Hunt (2017), Outcomes of the 2016 New Zealand Financial
Sector Assessment Programme.
3
Under Section 95 of the Reserve Bank of New Zealand Act, the Reserve Bank can require a registered bank to
provide the Reserve Bank with a report prepared by a party approved by the Reserve Bank on the corporate,
financial, prudential or other matters of the registered bank.
4
Spencer (2017), Review of bank capital requirements. A consultation paper outlining the intended scope of the
review is available on the Review of the capital adequacy framework for registered banks page.
5
See the news release for the Review of the capital adequacy framework for registered banks consultation.
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6 Further information on the Dashboard is available on the Dashboard approach to quarterly disclosure
consultation page.
See the news release for the review of the Insurance Prudential Supervision Act and links therein for the Terms
of Reference and Issues Paper.