Mr. Brash looks at the implications of the global financial marketplace for
New Zealand Address by the Governor of the Reserve Bank of New Zealand, Dr. Donald
Brash, to the Single Financial Services Market Conference in Wellington, on 19/11/97.
Introduction
It's a great pleasure to be here today to share some thoughts with you on the
global financial marketplace, and its implications for New Zealand. We have recently had a
dramatic example of how events in one country can spread rapidly. The recent share market
collapse that began in Hong Kong and spread to equity markets around the world, including
New Zealand, illustrates just how integrated global financial markets have become. Designing
and implementing an effective financial policy in pursuit of national goals, in a world of highly
integrated capital markets, is one of the most topical and challenging tasks in central banking
today.
To keep my presentation today within manageable bounds, and reflecting my
professional interest, I will constrain my comments to one of the important functions of a central
bank, namely, the preservation of stability in the financial system. Our focus at the Reserve
Bank is on promoting the maintenance of a sound and efficient financial system in New Zealand.
This focus involves establishing a policy environment to counteract the possibility of contagious
spread of financial distress, and in particular is aimed at encouraging prudent bank behaviour.
I will begin by sketching out some of the key trends in global finance, and will
then describe the international regulatory response to these developments. Along the way, I will
tease out the implications for New Zealand, and test our approach to banking supervision against
these global developments. I will conclude with some crystal ball gazing.
Trends in the global financial marketplace
Let me begin then with some observations on the rapidly changing global
financial marketplace.
It is now a commonplace that barriers between countries and financial markets, at
least in developed countries, have largely disappeared, and this fact, together with new
technologies, new financial instruments and new funding techniques, means that financial
intermediation is increasingly global.
Fundamental to this trend has been the way in which advances in computer and
communications technology have reduced the costs of cross-border transactions by lowering the
costs of collecting and analysing data, undertaking transactions, clearing and settling payments
and monitoring financial flows. And the cost reductions have been very dramatic. A recent
article in The Economist noted that "the cost of a three-minute telephone call between London
and New York has fallen from US$300 (in 1996 dollars) in 1930 to US$1 today". The same
article stated that "the cost of computer processing power has been falling by an average of
30 percent a year in real terms over the past couple of decades". Such trends allow both the users
of financial services and financial institutions themselves to look to global solutions to meet
their financial needs. Funds can now be raised and invested, currencies exchanged, and financial
risk positions changed around the world at almost anytime.
Contributing to the globalisation of finance has been the rapid trend towards
financial market liberalisation. This has seen country after country freeing up their financial
system. In that process, exchange controls (that had been intended to isolate domestic markets
from global influences) have been dismantled. In the increasingly integrated global capital
market that has resulted, global financial firms with often complex financial and corporate
structures have emerged as dominant players. These firms are to be found operating around the
globe -- relatively low transaction costs and the application of new technologies allow such
firms to be active players in whichever of the world's financial markets they want to participate
in. Distinctions between different types of financial institutions are breaking down as a result of
the growth of these conglomerate structures, the relaxation in regulatory constraints, and the way
in which derivatives can be used to transform the risk characteristics of institutions' portfolios.
A related development is that the risk management practices of global financial
firms are becoming increasingly centralised as competitive pressures drive financial
organisations seeking the highest risk-adjusted returns for shareholders. With the processing
power of modern computers, it is now possible for the risk and return characteristics of large and
complex portfolios to be managed centrally and, if not real time, at least on an intra-day basis.
Virtually all large bank holding companies are now operated and managed as integrated units.
This trend towards centralised risk management raises some fundamental policy issues as to how
best to regulate and supervise such large and complex banking organisations.
Product innovation has gone hand in hand with liberalisation. One of the more
significant developments has been the emergence of derivatives such as financial futures, swaps
and options. The total risk of more traditional financial products has been broken into
component parts and repackaged into synthetic products that have risk profiles similar to other
financial instruments. The synthetic products can then be sold to those domestic and global
investors willing and able to bear the associated risks. Such products are now used extensively
throughout the world to help firms manage the exposure to interest rate and exchange rate
movements that occur in liberalised financial markets. And innovation is ongoing, as is evident
with the increasing application of derivatives to credit risk.
The rapid globalisation of finance is well illustrated by the phenomenal growth in
cross-border financial activity. An April 1995 survey by the Bank for International Settlements
estimated that an average of US$1.2 trillion flowed through the world's foreign exchange
markets each day, up 45% on three years earlier. Estimated turnover of over-the-counter
derivatives on an average day was US$880 billion, 70% of which involved transactions with
counterparties in different countries. An article in Institutional Investor in August 1997 provides
another illustration of the magnitude of cross-border finance -- "nearly US$150 billion of net
new private capital poured into the main Latin American and Asian economies in 1996, almost
double the 1995 level". These numbers are enormous however you want to look at them.
New sources of systemic risk
The globalisation of finance, the liberalisation of financial markets and rapid
technological change have opened up new opportunities in commerce for achieving economies
of scale, and facilitating the international rationalisation of production and distribution. The
resulting benefits include productivity growth and improving living standards. Innovations like
derivatives improve the efficiency of financial markets. New technology allows sophisticated
management information and control systems, and the application of complex analytical models
to help institutions manage risks more effectively.
But while considerable benefits flow from such developments, they also
inevitably bring with them new risks. One of the most important from a central banker's
perspective is the introduction of new sources of risk to the stability of the financial system:
• Liberalisation and globalisation bring competition, which squeezes out the rents created by
previously protected markets. This produces efficiency gains but it also means that financial
institutions in the new environment have less of a buffer of protected profits and are
therefore more vulnerable to distress caused by either mismanagement or misfortune.
•
Derivatives bring new risks in that they can expose financial institutions to greater leverage,
thereby allowing for shocks to be amplified. In addition, they increase the linkages between
national financial markets, which means that adverse events are quickly transmitted from one
market to another.
• Furthermore, market participants can now react very rapidly to a problem in a particular
country, or even a perceived problem. Capital can move rapidly and in large volumes. Again,
a disturbance in one country can now flow rapidly to other countries with the result that
other countries' financial systems, and the international financial system more generally, are
arguably more exposed to disturbance than before globalisation.
In the light of these increased risks, it is worth recalling that there have been
relatively frequent episodes of national financial instability over the past couple of decades.
Since 1980, over two-thirds of IMF member countries have experienced at least one serious
banking-sector difficulty. And, in more than 65 emerging country cases, bank losses nearly or
completely exhausted the banking system's capital. In more than a dozen countries in the
emerging markets of Asia, Latin America and Eastern Europe, financial collapses have required
budgetary expenditure of more than 10% of GDP to resolve. Some industrial countries have also
experienced major financial problems over the same period. The list includes the United States,
Japan, France, Sweden, Finland, Norway and Spain. In Sweden, for example, 18% of bank loans
were lost between 1990 and 1993 with two of the largest banks being bailed out by the state.
These and more recent episodes of bank distress, such as Mexico and Thailand, suggest that
there is no evidence that financial sector fragility is reducing with time.
While New Zealand has not experienced bank problems of the magnitude that I
have just described, there have nevertheless been occasions of serious bank distress. In 1989-90,
the Bank of New Zealand (which was government-owned at the time) had to be re-capitalised
twice by the Government, at a total cost of about 3% of government expenditure. NZI Bank
would certainly have failed had it not been re-capitalised by its parent in Scotland. A very
significant non-bank financial institution, the DFC, was placed in statutory management in 1989
when it became insolvent.
A national financial crisis can not only have a severely adverse impact on the
economy of the country directly concerned, it may also threaten the stability of the international
financial system. A recent example was Mexico in early 1995. A build up of short-term US
dollar-linked debt, combined with the devaluation of the peso and a sharp rise in interest rates,
undermined the solvency of most of the Mexican banking system and resulted in a liquidity
crisis. International investors shifted their claims away not just from Mexico, but also from other
countries where similar weaknesses were suspected.
Instability in the international financial system can arise not only from the
transmission of a national problem but also from a breakdown in the normal functioning of
critical financial interconnections between countries. What I have in mind here are the payments
and settlements processes that link national financial systems. This is not a new source of risk,
and the best known illustration of the problem was the failure of Bankhaus Herstatt in 1974.
This small German bank was active in the foreign exchange market. It defaulted after receiving
Deutsche Marks from international banks but before the matching US dollar leg was processed
later in the day. This left its counterparties exposed to the full value of the Deutsche Marks
delivered. This event severely disrupted CHIPS, the main clearing system for US dollars, led to
a collapse in trading in the US dollar/Deutsche Mark market and even resulted in disorder in the
inter-bank money markets. The circumstance that led to Herstatt risk is still present today,
namely the time lapse between the payment and receipt of currencies in foreign exchange
transactions. What is different now is the exponential growth that has occurred in foreign
exchange transactions since 1974. In the late 1990s, if a major international bank were unable to
meet its obligations in settling an average day's foreign exchange transactions, it would have
serious ramifications for the stability of the international financial system, as well for domestic
financial markets.
Globalisation of finance to date has been most marked in wholesale business. But
technology in the form of the Internet is now beginning to allow for retail products to be
advertised and sold from anywhere in the world, and paid for electronically by anyone in any
other country. There seems little doubt that, when our next conference on financial services is
held, this trend to the globalisation of retail financial services will be an important theme.
In any event, there is no doubt that finance is now global. Nor is there any doubt
that new sources of systemic risk have emerged from the liberalisation of financial markets,
from the increased size and greater complexity of institutions, from the greater complexity of
some of the new financial instruments, from the greater volume and speed of transactions, and
from the increased involvement in the global financial system of national banking systems which
are themselves suffering considerable strains. It is probably fair to conclude that, while the threat
of serious disruption to the international financial system remains relatively small, should
serious disruption occur it could have disastrous consequences for living standards around the
world.
Regulatory response
Faced with these new sources of risk, the objective of safeguarding the soundness
of financial systems has become a top policy priority both nationally and internationally.
Most obviously, the trend towards large and complex global financial institutions,
centralised risk management and the blurring of boundaries between different types of financial
institutions is leading to a change in regulatory structures.
Generalising somewhat, the traditional approach to regulating the financial
industry was for there to be a bank regulator, a securities industry regulator, an insurance
industry regulator and so on. This decentralised approach to regulation was seen as being
appropriate when institutions were clearly delineated and decision-making was decentralised.
However, in today's world of conglomerate financial institutions where decision-making and
risk management are centralised, the traditional regulatory approach is seen as being inadequate
by many countries. Exposure of a bank to potential risk, for instance, cannot be evaluated
independently of the condition and management policies of any conglomerate to which the bank
belongs.
Whereas efforts have been made in some countries to co-ordinate and exchange
information between different kinds of supervisors, in other countries the supervisory structure
has been changed so that all financial institutions are supervised by one "umbrella-type"
supervisory body. Recent developments in this direction have been seen in Australia, with the
Australian Government adopting the recommendations of the Wallis Inquiry. This will see the
establishment of the Australian Prudential Regulation Authority to oversee all financial
institutions in Australia. Similarly, the new United Kingdom Government has decided to
establish a new "super-regulator" that will bring together nine financial regulators in one
organisation.
New Zealand's regulatory approach
Given that the banking industry in New Zealand has always been dominated by
foreign-owned banks, particularly from Australia and the United Kingdom, any development
that makes supervision of the parent bank more effective is welcomed by us. From the Reserve
Bank's perspective, though, we have not seen a pressing need to change our regulatory structures
in a similar way. The reasons for this are two-fold.
First, we take a rather different approach to promoting financial system stability,
an approach which relies less on direct regulation and more on the use of market disciplines and
the internal incentives for banks to behave prudently (I will return to this shortly).
Secondly, we see our present regulatory structure as being effective. Over recent
years, our regulatory structure has been closely aligned to a public policy approach that
recognises that open and competitive financial markets are desirable. Within this, all of the key
areas where private sector failure may occur have been covered in a way that meets our
circumstances. Hence, the Reserve Bank is responsible for the maintenance of the financial
system's soundness and efficiency, with our attention focused on the banking sector, where any
systemic problems, if they were to occur, would arise. The Commerce Commission has
responsibility for protecting the consumer against exploitation and unfair trading. And the
Securities Commission is focused on improving the efficiency and fairness of the markets for
securities (widely defined) of entities that raise funds in New Zealand. This approach recognises
that in New Zealand systemic issues are central in the supervision of banks, whereas in non-bank
financial services consumer-protection issues are more important.
There has been a strong presumption in economic policy development in New
Zealand over the last decade or so that market forces generally produce better outcomes than
those arising from bureaucratic rules and regulations. Our approach to banking supervision
reflects this.
We start with the presumption that financial markets contain powerful and
flexible disciplinary mechanisms for rewarding good bank performance and penalising
imprudent bank behaviour. Given the widespread public belief in most countries that
"governments never allow banks to fail", we do not argue that market forces alone will do the
job, but we do see the disciplines of the market as being the dominant and most effective means
for promoting a robust financial system. There are three key elements in our market-based
approach to banking supervision.
• The first is to ensure that the marketplace has sufficient and reliable information on banks on
which to base financial assessments and decisions. This is achieved through a public
disclosure regime which requires banks to publish a comprehensive range of financial,
corporate and risk-related information for the bank and its banking group at quarterly
intervals.
• The second important element is to promote market discipline by ensuring that government
policy supports, or at least does not impede, the development of active inter-bank markets,
the diversification of funding instruments and sources, the development of institutional
investors and the entry of sophisticated foreign players to the financial market. The rationale
is that professional players are the market's strongest disciplinary force.
• The third key element has been to strengthen the incentives for the directors and
management of banks to manage their banks' affairs in a sound and responsible manner. An
important aspect of this is a requirement for the directors of banks to attest to the accuracy of
the information in the quarterly disclosure statements, to the fact that their banks have
satisfactory risk management policies and to the fact that these are being properly applied.
This approach, of harnessing market forces and using improved internal
governance to promote financial system soundness, is gaining some support in the international
supervisory community, and among academics. This can be highlighted by recent comments
from three prominent and highly respected individuals.
•
"As financial transactions become increasingly rapid and complex, I believe we have no
choice but to harness market forces, as best we can, to reinforce our supervisory objectives.
The appeal of market-led discipline lies not only in its cost effectiveness and flexibility, but
also in its limited intrusiveness and its greater adaptability to changing financial
environments. Measures to enhance market discipline involve providing private investors the
incentives and the means to reward good bank performance and penalise poor performance.
Expanded risk management disclosures by financial institutions is a significant step in this
direction." Alan Greenspan, May 1997.1
• "For major banks in industrial countries ..... there needs to be a shift of emphasis towards the
re-inforcement of internal managerial risk-control mechanisms, and a recasting of the nature
and functions of external regulation, away from generalised rule-setting and towards
establishing incentives/sanctions which reinforce such internal control mechanisms." Charles
Goodhart, June 1997.2
• "Much recent thinking has focused on incentive-compatible regulation -- using the market's
own internal forces -- as the promising next step for strengthening the financial system. It is
banks' shareholders and management that have the strongest interest to measure risk
accurately." Andrew Crockett, September 1997.3
To illustrate the evolution that is taking place in supervision, let me cite one
example. In a recent initiative by the Basle Committee on Banking Supervision to amend the
Capital Accord to include market risk, a greater role has been given to banks' own internal
models in the measurement of market risk. This reflects a move away from regulation that relies
on detailed rules to an approach that places more emphasis on the adequacy of internal risk
control mechanisms. Such an approach recognises that it is bank directors and management that
have the strongest interest and ability to measure risk accurately, and that an internally-generated
measure of risk should be better than one derived from that imposed by supervisors. The
ongoing challenge to regulators is to ensure that incentive structures are conducive to this
outcome.
My own perspective is that a paradigm shift in supervision towards harnessing
market forces will make a more significant contribution to promoting sound and efficient
financial systems than simply changing regulatory structures within the same external regulation
paradigm.
Although it is far too early to make conclusive assessments of the success or
otherwise of our new supervisory approach (which has now been in operation for nearly two
years), I am satisfied that it is encouraging prudent behaviour by banks in New Zealand, and
thereby is reducing the likelihood of financial system instability in the future. Moreover, I am
confident that it is doing this at lower efficiency, compliance and taxpayer costs than other
supervisory options might be expected to achieve.
Payments system reform
So far, I have discussed the regulatory response to the globalisation of finance in
terms of the health of the individual institutions that make up the financial system. Of equal
significance to financial stability in this new environment is how resilient payment and
settlement systems are, both domestically and internationally.
In common with most central banks around the world, we have been devoting
considerable attention to payments system reform. Our main focus to date has been developing a
real time gross settlement system for large-value transactions between banks. Until quite
recently, the standard form of settlement was end-of-day net settlement: all payments and
receipts between banks were allowed to accumulate during the day, to be settled by transfer of
the very much smaller net amount at the end of the day. The risk of this form of settlement is
that it usually requires participants to grant unsecured and unlimited credit to other participants
during the period until final settlement occurs. Credit extended to a single counterparty can in
some cases exceed a bank's entire capital. One important solution which has been implemented
in some countries, and which we have as a high priority to implement within the next few
months in New Zealand, is the replacement of this traditional end-of-day settlement arrangement
with an RTGS system. Individual transactions under RTGS are settled one-by-one during the
day rather than being allowed to accumulate, thereby removing the very large exposures that can
build up between banks. Once implemented, RTGS will be a significant milestone in the
reduction of domestic payment system risks.
Another important initiative that we are promoting to reduce systemic risk is to
make bilateral and multilateral netting arrangements for certain transactions legally binding.
With legally enforceable netting arrangements in place, the various "gross" obligations to make
payments can be offset against one another, and it is only the net amounts due which are called
into question in the event of a bank failure.
Our attention is also being actively focused on dealing with settlement risk in
cross-border foreign exchange transactions. As already noted, the value of foreign exchange
deals that are now being settled is so substantial that the resulting settlement risks can be of a
size to cause systemic concern for both national and international financial systems. This risk,
mentioned earlier in my presentation, is often referred to as Herstatt risk. As in New Zealand,
much international attention is currently being focused on this problem.
Co-operation amongst supervisors
My final comments on the response of regulators to global financial trends
concern the co-operation among supervisors and international agencies to address the potential
for systemic disruption.
These efforts have gained momentum over the last decade as the inherent tension
between nationally-based regulatory structures and an increasingly globalised financial sector
has become apparent. Co-operation among bank supervisors under the auspices of the Basle
Committee on Banking Supervision has produced a number of important agreements on the
supervision of banks, including minimum capital standards and minimum standards governing
the supervision of banks' cross-border establishments. Similarly other supervisors, such as the
International Organisation of Securities Commissions (IOSCO) and the International
Association of Insurance Supervisors (IAIS), have pursued co-operation in their areas of
responsibility. And in the early 1990s, in recognition of the emergence and growth of financial
conglomerates, banking, securities and insurance supervisors from G-10 countries began to work
together to identify problems that conglomerates can cause and to consider ways to overcome
them.
The Mexican crisis in 1995 in particular, and the widespread incidence and high
cost of banking problems more generally, have prompted calls for concerted international action
to promote the soundness of financial systems. These calls have strengthened over the last
couple of years with the G-7 countries calling for "the adoption of strong prudential standards in
emerging countries" and encouraging the international financial institutions to "increase their
efforts to promote effective supervisory structures in these economies". The Basle Committee on
Banking Supervision has been at the forefront of this effort over the past year with the release of
its Core Principles for Effective Banking Supervision. These principles have quickly become the
focal point for the increased efforts to strengthen financial sectors around the world. Also aiming
at more effective bank supervision, the IMF is making the evaluation of financial supervision
and regulation part of its annual country reviews, and the World Bank is emphasising the
strengthening of financial infrastructure as an important part of its structural assistance
programmes.
A comment on the international supervisory response
While the international regulatory response has many positive elements, to me it
has not always been appropriately focused. Often following a crisis, there are calls to
"strengthen supervision". For various reasons, I feel that these calls, or the ways in which they
have been answered, have not always been well directed. Let me briefly elaborate on why I think
this.
At both the national and the international levels, the nature of the policy response
to a crisis needs to be based on a careful analysis of the "problem". It is certainly clear from the
record that there have been significant weaknesses in some countries' banking systems, and that
these weaknesses have both contributed to the emergence and severity of financial crises and
complicated the task of resolving them. However, I am somewhat sceptical of the general
proposition that "poor supervision" has been the primary cause of these weaknesses. There has
been a tendency to give supervision the "blame" for problems which have originated elsewhere,
and/or to seek supervisory remedies for problems which might well be better solved in other
ways. I would note further that "supervision" (in its general sense) has sometimes been part of
the "problem" rather than part of the "solution" -- particularly when it has involved excessive
forbearance by the regulatory authorities, and/or excessive reliance on the public safety net. I
think it important that we supervisors should be appropriately modest about what we can
achieve, and supervision should not be seen as an assured remedy for all potential problems.
Establishing price stability and a sustainable fiscal position are also critical
elements in the pursuit of sound financial systems. While weakness in the financial system can
have macroeconomic implications, the reverse is also undoubtedly true -- unsound
macroeconomic policies can have long-lasting effects that lead to weakness in financial systems.
Excessive credit creation and inflation are obvious examples. Some observers have suggested
that virtually every major financial system problem in the last two or three decades was caused,
directly or indirectly, by unsound macroeconomic policies.
Some of the international regulatory responses also do not sufficiently recognise
that the objectives of bank supervision, and the infrastructure within which supervision takes
place (for example, the quality of company law, accounting standards, and external auditors), are
not the same in all countries. To have any chance of being successful, international initiatives
will need to be flexible enough to suit this wide variety of national circumstances.
For emerging countries where the banking infrastructure may not be well
developed, it may well be sensible to actively pursue financial stability through improving the
quality of prescriptive rules. In this regard, the initiative by the Basle Committee to establish an
international standard of core principles for effective supervision may be helpful.
But regulators in many developed countries are finding that the complexity of
banking, the blurring of functional dividing lines amongst financial institutions, globalisation,
and the speed of portfolio adjustment are making external regulation based on standard rules less
effective and less feasible. This is resulting in an increasing emphasis being placed on internal
risk management processes and in harnessing market disciplines to promote prudent banking
behaviour.
What this suggests to me is that the regulatory approach followed by a particular
country will need to fully reflect its own circumstances. Attempting to apply a "one-size-fits-all"
approach to all countries is likely to be ineffective, and may even be counterproductive.
The Future
So, what do I see as being the likely issues of the future? What is certain is that
the future will surprise us! But some things seem likely.
Innovation in the financial sector will continue, as will the integration of the
world's financial markets. Using market disciplines to strengthen the financial system also seems
likely to grow in relative importance.
New Zealand's approach to promoting financial system stability is entirely
consistent with the global trends that I have described and, in particular, with the
"incentive-compatible" approach to regulation. It seems absolutely appropriate for our
circumstances. There will inevitably need to be refinements made to our regulatory approach
from time to time, but I believe that the principles on which it has been established, and its basic
design, are soundly based and will remain so for the foreseeable future.
At some point in the future the "special" status of banks in the New Zealand
supervisory approach may need to be reassessed. This might be prompted by the continued
gradual breaking down of the traditional distinction between banks and non-banks in financial
intermediation, or perhaps by banking services being provided in New Zealand by institutions
not physically located here. It may also be prompted by a risk-proofing of payments an