Renewing the RBNZ's approach to
financial stability
A speech delivered to 15th Financial Markets Law Conference in Auckland
On 26 June 2019 (2:10pm)
By Geoff Bascand, Deputy Governor & Head of Operations
2 The Terrace, PO Box 2498, Wellington 6140, New Zealand
Telephone 64 4 472 2029 Online at www.rbnz.govt.nz
Renewing the RBNZ's approach to financial stability
Good afternoon, it's good to be here today. I'm going to talk about the Reserve Bank's role in
ensuring financial stability and how our approach to prudential regulation and supervision is
evolving in line with our own, and society's, risk tolerance.1
You'll hear me talk about how the Bank's approach is expanding and becoming more
intensive, so that we are more active in addressing vulnerabilities in the financial sector. This
is in response to our own experience, and a publicly identified need in formal reviews of our
approach.2 We are building our capabilities to undertake deeper analysis of risks to the
financial system and shift to a more intensive supervisory model.
It's a busy time at the Bank as we also undertake with Treasury a fundamental review of the
statutory framework for delivering financial stability. The government has announced
inprinciple decisions to modernise how the Reserve Bank is governed and its objectives,
powers and regulatory perimeter. These decisions strengthen our financial stability focus
and set the foundations for enhanced performance, capability and accountability of our
financial stability functions. Our 'soundness and efficiency' objective is to be replaced with an
explicit financial stability objective. The single decision-maker model is to be replaced with a
governance board responsible for financial policy. And the artificial distinction between
banks and non-bank deposit takers is set to be removed.
Meanwhile, we are reviewing key aspects of the regulatory system, for example upgrading
the capital framework for banks and commencing a review of insurance legislation and
solvency standards, while the government has declared its intention to introduce deposit
insurance.
These significant developments raise the question: how do the different parts of our financial
stability regime fit together?
Answering that question is not easy - financial stability is complex and we use a large
number of tools to promote it. And there is no single, quantifiable numerical target like the
inflation target for monetary policy. Hopefully on conclusion of my speech you will have a
greater understanding of the Reserve Bank's role and where we are heading in terms of how
the components of our regulatory and supervisory regime fit together.
First I'll outline why financial stability is important, the risks to the financial system and the
market failures that create the need for regulation and supervision.
Next I'll set out the Bank's role, alongside regulated entities and other agencies, in
supporting a dynamic and sustainable financial system and economy.
Finally I'll focus on the Bank's approach to financial stability, and the outlook in terms of
regulation, supervision, strategy and the ongoing modernisation of the Reserve Bank, before
covering off some recent announcements that will change the way we work.
1
I am very grateful to Piers Ovenden for considerable assistance in the preparation of this speech,
along with valuable comments from other Reserve Bank colleagues.
2
For example the IMF's FSAP recommendations.
Part 1 - Why we regulate and supervise
Financial stability is important
The financial system has a critical role in supporting economic activity. Households and
businesses need avenues for saving and credit to fund consumption and investment,
payment systems to facilitate local and international transactions, and insurance to manage
their risks.
In order to facilitate economic growth, the public need to be confident that banks, non-bank
deposit takers (NBDTs) and insurers can and will continue to provide these services, and
that the payment and settlement systems will work as expected. The continued and reliable
provision of financial services to the economy is a pre-condition for ensuring that the
financial system makes its maximum contribution to the prosperity and wellbeing of all New
Zealanders.
Financial stability means having a resilient financial system that can withstand severe but
plausible shocks and continue to provide the financial services we all rely on. It is something
we tend to take for granted - financial crises have been uncommon in this country. But
evidence from a wide range of countries over many decades shows us that when they do
happen, crises are damaging with long-lasting effects. They impact businesses and
households, with reduced economic activity and lost output. They result in increased
unemployment and costs for taxpayers. Not only that, recovery can take over a decade and
is often halting in nature.
Put another way, financial instability creates inefficiency and waste on a large scale.
Reducing the likelihood and severity of these episodes is therefore at the heart of our
mission. Our aim is for New Zealand to have a dynamic and efficient financial system that
contributes to a sustainable and productive economy.
The financial system is exposed to risks...
Risks to financial stability come from a wide range of sources. External - New Zealand's
financial system is heavily reliant on external funding, which makes us vulnerable to
dislocation in overseas funding markets. Domestic - risks related to lending to our dairy
industry and to our already highly indebted households. And our most recent Financial
Stability Report notes the risks from technology disruptions, misconduct and cybercrime,
insurance affordability and climate change.
We also have to consider the vulnerabilities of our financial system. It is relatively small, and
is dominated by a handful of institutions that have similar underlying business models. That
means the distress or failure of one of the major institutions is likely to have significant
implications for the system as a whole.
And we have to remain alert to new risks. History tells us that there are a wide variety of
triggers for financial instability. Every financial crisis is different.
...and is subject to market failures
Financial stability is a common resource that benefits us all. But because it is a common
resource, it is also prone to the tragedy of the commons - the risk that it is abused and
degraded by individual agents who do not have the right incentives to look after it, or at least
to internalise the cost that instability imposes on others. Viewed through this lens,
maintaining financial stability depends on market participants being willing and able to
identify, price, allocate and manage their risks appropriately.3
Information asymmetries - where one party to a transaction knows more than the other -
exacerbate this free-riding problem. Small retail savers are likely to find it difficult to detect
and price for higher risk-taking at a financial institution, although wholesale investors will
exert discipline. In addition there are factors that limit the incentive for financial institutions to
internalise the costs to society of a financial crisis. For example, moral hazard can result if
institutions believe the taxpayer will bail them out in the event of a crisis. The larger the scale
of this distortion, the greater the risk to financial stability and the greater the risk to other
regulated entities, investors, depositors and ultimately taxpayers.
These structural market failures tend to be reinforced by behavioural factors. It is well
recognised that individually rational people make decisions on the basis of other people's
credit and risk assessments.4 This herd behaviour can create market momentum that drives
the price away from the underlying risks and returns. In the absence of objective information
about the fundamental economic value of an asset or trade, this reinforces the mis-pricing of
risk.
Alongside herd behaviour, add myopic decision making and irrational exuberance and we
are well on our way to boom-bust cycles. If asset prices rise, people borrow more and invest
more heavily in that asset class. For a time, this becomes a self-fulfilling prophecy. However
this also increases the risk of contagion and fire sale dynamics once market sentiment turns.
As I said, financial stability is complex.
Part 2 - The Reserve Bank's role
The importance of financial stability as a common resource and the risks and market failures
that it is prone to, create the need for prudential regulation and supervision. Nonetheless
there is an important role for both the regulator and the regulated in ensuring that the
financial stability regime is operating effectively as intended.
The three pillars remain relevant...
The three, inter-dependent, pillars of self-, market- and regulatory discipline remain relevant
to our role as prudential regulator. Our regulatory actions do not occur in a vacuum, and
there is an important role for regulated entities and market participants in supporting financial
stability.
Market discipline refers to the influence that market participants have on a regulated entity's
behaviour and risk-taking, where influence is exerted by market participants changing the
cost or amount of funding they are willing to provide based on financial and other information
about the entity. In a functioning market this creates an incentive for regulated entities to
manage their risks appropriately. Transparency initiatives, such as the Financial Strength
Dashboard and mandatory disclosure statements support market discipline5.
Self-discipline refers to a regulated entity's own processes and risk management
frameworks, the responsibility for which lie primarily with its directors and senior managers. It
remains the starting point of the Reserve Bank's supervisory philosophy. However as the
conduct and culture review, the Reserve Bank's attestation review, and various regulatory
incidents demonstrate, we cannot assume that it is operating as intended and that
selfdiscipline is effective.
Even when market and self-discipline are effective, they are not enough on their own
because of market failures.6 Regulatory discipline - the imposition of requirements on
regulated entities - is necessary to improve the effectiveness of market and self-discipline,
and to minimise the costs of that could be visited on the financial stability commons. Our role
as regulator means setting robust requirements that are fit for purpose - that address risks
and market failures at source, taking into account the costs of regulation and of supervision
on our regulated entities and the wider economy.
Setting rigorous but not too stringent requirements is our challenge, informed by research,
experience and feedback.7 We need to understand New Zealanders' appetite for risk,
analyse the costs and benefits of regulatory requirements, and have processes for
decisionmaking that provide confidence that in high quality decisions being made.
...and we do not run a zero failure regime
Achieving financial stability does not mean eliminating all risks. This would create
inefficiencies of its own - it would potentially stifle new entrants, and remove the incentives
for growth, innovation and healthy risk-taking. So we do not run a zero failure regime.
Allowing institutions to fail provides the incentives for self- and market-discipline to operate
effectively.
However, in order to allow individual institutions to fail we need a robust financial system that
can continue to function even when individual entities are experiencing distress or failure. In
those situations the Bank is tasked with minimising the impact of distress or failure of an
institution on the financial system and the economy.
Our role is dynamic
By necessity our role is a dynamic. The financial system is constantly evolving, as are the
risks and challenges. This means that establishing baseline standards is not a set-and-forget
exercise. Our requirements and expectations of regulated entities continue to evolve. While
it is impossible to predict the future, it is incumbent upon us, when we do impose
requirements and set expectations, to think about their effect, and how they might be
adapted, in different states of the world.
We monitor the financial system...
We continuously monitor the financial system in order to identify and assess:
•
Structural risks: ever-present risks related to the composition of the financial
system, in terms of its institutions, and their assets and funding. New Zealand is
exposed to external shocks and standards must recognise these risks and shield the
domestic system and economy.
•
Emerging risks: risks related to traditional areas of focus like credit or funding risks,
or to new and emerging technologies or to climate change. We are particularly
focused on innovation that presents risks to the regulatory perimeter - whether
institutions are operating inside or outside our supervisory and regulatory reach, and
whether this is appropriate.
•
Cyclical risks: the risk that boom-bust cycles are amplified by, and to the detriment
of, the financial system, due to the procyclicality of credit and asset price growth,
when the failure of participants to account for the broader economic and social costs
of their actions is exaggerated.
We publish our assessment of risks in the Financial Stability Report both to increase
awareness and so that institutions can adapt and develop resilience, and improve their
selfdiscipline.
Supervision has a key role to play both in helping us understand risks to individual
institutions, and question whether banks are managing those risks adequately. Our thematic
reviews, where we delve into the detail of specific issues, help us and our regulated entities
better understand specific risks. Our periodic stress testing, where we subject individual
institutions to a significant yet plausible downturn in the economy and distressed funding
markets, help us to understand the system's resilience to macro risks.
Identify and monitor risks;
Financial
support effective self and
stability
market discipline
Monitor the financial
system
approach
Enhance the resilience Establish rigorous
of the financial system
baseline
requirements, and
adapt as necessary
Manage distress or
failure
Minimise the costs of
institutional distress or
failure
...enhance the resilience of the financial system...
We enhance the resilience of the financial system by establishing rigorous baseline
requirements and ensuring these are complied with through supervision. Our baseline
requirements address enduring and identifiable sources of risk to the financial system, with
the aim of achieving resilience to most probable shocks or adverse events. We then adapt
our regulatory and supervisory approach to reflect newly emerging and/or cyclical risks and
the impact they could have on the financial system.
For example, we require banks to meet prescribed capital and liquidity ratios to minimise the
risk of insolvency due to sudden losses or a disruption in funding markets (We have been
consulting on whether baseline requirements should be set to ensure solvency of the
banking system in all but the rarest occasions (a 1:200 year event) or only sufficient for
something more frequent). If cyclical risks become excessively heightened we can enhance
resilience by increasing capital and/or liquidity ratios. We can tighten loan-to-value ratio
(LVR) restrictions if we are concerned about banks' lending standards and the growth of
household credit together with the risk of a correction in the housing market.
Our regulatory requirements aim to support effective self and market discipline by providing
a basis for directors and the market to assess the well-being of individual institutions. Again,
supervision has a key role to play, in verifying that regulated entities are complying with
regulations and that self and market discipline are operating as intended.
...and manage the impact of distress or failure
Prevention is best, and most of our effort is focused there. Nevertheless, despite our efforts
to monitor and enhance the resilience of the financial system, institutions may become
distressed and even fail. This means we need to be well placed, in terms of information and
regulatory tools, to manage these events if and when they do occur.
Supervision is crucial in helping us understand the balance sheets, operations and the risks
facing institutions. This means working closely with firms on their recovery and resolution
plans and having a clearly articulated ladder of supervisory intervention.
The Reserve Bank also stands ready to act as the lender of last resort in situations where a
liquidity shortfall threatens the viability of solvent banks and causes a significant tightening in
credit supply.
And a new element of our resolution framework is being proposed. The government has
stated its intention to introduce a deposit protection regime that, in the event of failure of a
deposit taking institution, would provide that deposits in the range of $30,000- $50,000 were
insured. While protecting bank customers and taxpayers, this could make it easier to close
down a failing institution, sharpen incentives on wholesale investors to exert market
discipline, and help reduce the likelihood of financial instability through 'runs' on banks.
The Reserve Bank is uniquely placed...
As a full service central bank we are uniquely placed to fulfil our role in maintaining financial
stability. That means that, alongside our regulatory and supervisory function, we undertake
monetary policy, we oversee payment and settlement systems, and we stand ready to use
our markets functions to provide liquidity in exceptional circumstances.
We also have a role in promoting a vibrant and healthy financial ecosystem. This relies on
the input of a wide range of stakeholders, regulators and regulated, as well as the
consumers and businesses who rely on the financial system. As a member of the Council of
Financial Regulators, we work with Treasury, the FMA, the Commerce Commission and the
Ministry of Business, Innovation and Employment to identify, manage and address issues,
risks and gaps in the financial system, so that it is both safe and efficient.
We welcome the ten year review of New Zealand's capital markets by the FMA and NZX.8
Capital markets are a key component of a sound and efficient financial system - they
diversify the funding sources that businesses rely on, and they perform a crucial function in
regulated entities identifying, pricing, allocating and managing risk appropriately. That is
more likely to occur when capital markets are liquid and accurately capture the fundamental
value of assets.
Part 3 - Our approach to financial stability
Our approach to financial stability is expanding and becoming more intensive, in terms of
both regulation and supervision. How do we operationalise our financial stability role, and
what aspects of this role are changing?
Our regulatory approach
We choose the appropriate regulatory tool to address the identified risk to financial stability,
bearing in mind efficiency costs, the level of effective self and market discipline, and the
regulatory framework as a whole. Our requirements are complementary, with some
substitutability at the margin - we view them as a package. And as I mentioned earlier, our
baseline settings are not set-and-forget, we adapt them as risks and the resilience of the
financial system evolve.
We are bolstering the regulatory pillar through a wide range of initiatives. Most notably we
are consulting on a material increase in bank capital requirements. Bank capital is a crucially
important component of the regulatory framework for banks. 'Skin in the game' reinforces
self-discipline - the responsibility on boards and senior managers to manage and disclose
risks appropriately. Our proposals reflect our experience and the evidence on the
consequences of financial crises.
However, capital is not a complete mitigant. Our other initiatives reflect that banks can fail for
many reasons. And it is not efficient to require banks to hold more and more capital in order
to address all the different sources of risk. That's why we have a range of policies that aim to
address potential problems at source. For example, liquidity standards are important in
ensuring banks can meet their cash flow demands; outsourcing requirements are needed so
that banks can continue to operate in a situation where a key service provider fails; and
macroprudential interventions may be necessary during periods of excessive credit and
asset price growth.
Other regulatory initiatives include new legislation to grant us more extensive powers to
supervise FMIs. Given our dependence on payment and settlement systems, their
lightweight regulation and supervision is a crucial vulnerability. We are working with banks
and other stakeholders on a new mortgage bond standard, which will provide banks with an
additional funding source, as well as provide banks and investors with a new tradeable
instrument. It will also create a larger pool of standardised and transparent securities that the
Reserve Bank can lend against as lender of last resort. Phase 2 of the review of the Reserve
Bank of New Zealand Act is looking in more detail at our macroprudential and crisis
management tools.
The table below illustrates how our prudential banking tools work together to deliver financial
stability. Each of our policies contributes to financial stability by addressing a separate risk,
with its own transmission channel. Some are more targeted at prevention (limiting the
likelihood of a financial crisis) while others are more targeted at management (mitigating the
impact of a crisis if it does occur).
Purpose Relevant tools Impact on financial system resilience Impact on wider economy
More resilient households and banks
Macroprudential policy Borrower restrictions reduce potential severity of an economic
(LVRs) downturn
Reduce risk that the Reduced losses in a severe economic
financial system amplifies a downturn
Prevention
severe economic downturn Lowers incentives on banks to
Capital and liquidity deleverage in a downturn; supports
Crisis
instruments higher credit supply and economic
Supervision,
(CCyB/SCR) activity
Capital buffers
Prudential policy
oversight
Banks remain solvent through the Maintains market confidence
Liquidity policy
Maintain baseline resilience economic cycle and lowers risk of sudden increases in
and
of the financial system funding costs for households,
Governance and local
businesses and the economy
incorporation
Collateral standards
disclosure
Banks remain functioning parts Maintains availability of credit and
Manage and limit impact of of financial system banking services necessary for
Outsourcing
distress or failure economic activity
Open Bank Resolution
Management
Mitigates costs for creditors9 and
taxpayers
Crisis
Minimum capital Losses absorbed first by shareholders
There may, at the margin, be some substitutability between our different regulatory tools and
settings. However, as I've said, our regulatory tools are intended to be complementary. For
example, even if we have higher bank capital ratios, LVRs will continue to have a role to play
if there is excessive credit growth in household balance sheets.
Our supervisory approach - a tougher stance
While a robust regulatory approach gives us confidence in the financial system and its
stability, it does not imply a lower level of supervisory intensity or that we can shirk our
supervisory role. Our supervisory approach is intended to complement our regulatory
approach in terms of its reach, and its intensity.
Supervision plays a key role in monitoring, and deepening our understanding of, the financial
system and the risks it faces; in enhancing resilience by verifying that our requirements are
operating as intended, and enforcing them as necessary. Supervision provides us with the
necessary intelligence to manage the consequences of distress or failure of individual
institutions.
Effective self-discipline is the starting point of our supervisory philosophy. Firms must want
to achieve good outcomes for their customers and owners, not because regulators wish
them to. We aim to leverage the incentives on directors, senior managers and shareholders
to improve the soundness of institutions, and by extension the resilience of the system as a
whole, as efficiently as possible.
However, our experience over the last decade has been that regulations have not always
been well applied or complied with, and that tells us that we cannot rely solely on
selfdiscipline. Crucially, it is not just the fact of non-compliance that concerns us - regulated
entities have not been as proactive as we would have liked in identifying and remedying
issues before the risks become more significant.
Last year's conduct and culture review (run jointly with the FMA) highlighted specific
shortcomings in governance and risk management at banks and insurers, notably in relation
to sales incentives. The court judgement on CBLI's liquidation stated that "aspects of CBLI's
management had indicated a lack of commercial probity". And "a lack of candour in dealing
with the company's auditors and the regulator". More recently we revoked ANZ's
accreditation to model its own operational risk capital requirement because of persistent
failures in its controls and attestation process. It is clear that institutional self-discipline has
been lacking.
There is therefore a strong case for further increasing the intensity of our supervisory model
in line with the recommendations from the IMF's Financial Sector Assessment Program
(FSAP) assessment of New Zealand.10 This applies even if, on paper, individual regulated
entities appear to be sound. Banks should expect our more intensive supervisory approach
to apply even if capital requirements are increased as a result of the ongoing Capital
Review.
Regulated entities can expect our supervision to be more intrusive, in seeking evidence that
attestations are merited and verifying compliance, and that we will intervene and enforce our
requirements. We will be more pro-active in holding directors and managers to account,
particularly in areas where we have already identified shortcomings.
Our regulated population can expect us to continue with our thematic reviews in order to
enhance self-discipline and our own understanding of risks. In the near future there will be a
thematic review on banks' liquidity standards and another on the appointed actuary regime
in the insurance sector. We will continue to periodically stress test the banking system.
We are working towards more transparency about how our supervisory response would
escalate if institutions come under stress. As part of the Capital Review we have sought
feedback on the proposed supervisory consequences for banks if they breach their capital
buffers. The starting principle is that our response will vary depending on the extent to which
a bank needs to use its capital buffers to absorb losses. A minor breach of the proposed
capital buffers would result in increased monitoring and potentially a formal request for the
bank to submit a capital plan detailing how it planned to remedy the breach and by when.
More significant breaches could result in increasingly restrictive supervisory actions and
requirements.
Figure: Stylised escalated supervisory response
We continue to boost core supervisory capability in order to deliver on our supervisory
approach. This means more skilled resource but it also means building and maintaining the
necessary monitoring and supervisory frameworks, and it means being analytically strong,
suitably sceptical, and willing to act. Being clear and up-front on our supervisory approach -
on our greater willingness to intervene and to enforce our requirements - is desirable not
only in terms of transparency but also accountability. Setting out our approach publicly,
which we will do in more detail in coming months, will help build confidence and commitment
to our enhanced supervisory model.
A more intensive approach also means working more closely with industry. We are
committed to establishing a 'best regulator-regulated' relationship; to open, knowledgeable
and constructive discussions, recognising that that there can be a divergence of views and
interests.
Modernising the financial stability framework
Our Statement of Intent (released yesterday) outlines how we are implementing our financial
stability approach within the Bank. Our vision of 'great team, best central bank' means we
use and maintain rigorous and up-to-date frameworks for regulatory policy development and
supervisory decisions. In doing so we take into account the best theory and evidence
available. We act as responsible steward of the rules and policies which we create and apply
to regulated entities. We consult openly and are committed to communicating our approach
in a timely and accessible manner. We work hard to raise awareness across our regulated
populations about our objectives, priorities and expectations. We foster co-operation and
mutual trust among our domestic co-regulators, wider stakeholders and global peers.
Earlier this week the government announced the 'in-principle' decisions to (a) replace the
Reserve Bank's 'soundness' and 'efficiency' objective with a high-level financial stability
objective, (b) establish a new governance board for the Reserve Bank with statutory
responsibility for financial policy, (c) merge New Zealand's two existing prudential regimes
for regulating banks and non-bank deposit takers into a single regime, and (d) introduce a
deposit insurance scheme. Further changes are being consulted on in the documents just
released by Treasury.
The Governor is scheduled to talk on 11 July about the government's review and what that
means for the future of the Reserve Bank and the prosperity and wellbeing of New
Zealanders.
Financial stability objective
The new financial stability objective is consistent with how the Reserve Bank has interpreted
its responsibilities to date and with our increasingly intensive approach to regulation and
supervision. Financial stability - the soundness or resilience of the financial system - relates
directly to the existing purpose of our prudential philosophy and is consistent with our intent
to have a dynamic regulatory framework; a framework with rigorous and adaptable baseline
standards and a more searching approach to supervision.
'Financial stability' has the advantage of clarity, providing a sharp focus for the Reserve
Bank, but potentially downplays the importance of efficiency and dynamism that are equally
relevant to our over-arching purpose: contributing to a sustainable and productive economy
and the prosperity and wellbeing of New Zealanders. Aspects of efficiency - regulatory
efficiency and promoting innovation and competition - are expected to be recognised
through sub-objectives that are also being consulted on. Increased transparency and
accountability for decision-making will also serve to ensure good regulatory decisions are
made.
RBNZ Governance board
The Reserve Bank will have a new governance board, with statutory responsibility for
financial policy. The board will be accountable for all prudential decisions, including
regulation, supervision and enforcement, as well as crisis management. It is expected that
the board will be able to delegate powers and the exercise of day-to-day functions and
powers to the Governor, and in turn Reserve Bank staff (supported by internal committees
as at present). The board will set our risk appetite and scrutinise management's efforts to
implement it.
The new governance structure supports our vision and objectives of being a transparent and
accountable organisation. Not only will the new board bring diversity of perspectives and
experience to key decisions, it will set our strategic direction (our risk appetite, our policy
frameworks) and explain its decisions and regulatory outcomes to a broad audience, from
the Minister of Finance and Treasury, through to regulated entities and the general public. It
will also create more robust accountability by creating a clearer distinction between
governance and management functions, and establishing a delegation framework.
ADI perimeter
The government's decision to merge our regimes for regulating banks and non-bank deposit
takers into a single regime for deposit takers will create a simpler, more unified regime, more
clearly aligned with our financial stability objective. It will minimise duplication and treat
simila