donald t brash : central banks and financial system stability in an uncertain world address by dr donald t brash, governor of the reserve bank of new zealand, to belgian financial forum, antwerp region, brussels, on 6 june 2000. * * * introduction i am very pleased to be here in antwerp this evening, and to have the opportunity of sharing with you some of the reserve bank of new zealand ’ s views on promoting financial system stability. everybody in this room is confronted with uncertainty in their daily interface with financial markets. for those of us who are central bankers or bank supervisors, the task is to guide the dynamic, complex and unpredictable processes in financial markets towards outcomes that meet the policy preferences of our country. for the reserve bank of new zealand, our task is to deliver price stability and a sound and efficient financial system within a liberal economic policy paradigm. the uncertain world that we operate in can be highlighted by the relatively frequent and unpredictable episodes of financial instability experienced over the past couple of decades. since 1980, over two - thirds of imf member countries have experienced at least one serious banking - sector difficulty. in some countries, bank losses nearly or completely exhausted the banking system ’ s capital. in some countries, financial collapses have required significant fiscal expenditure to resolve. and, as we all know, national financial crises have been transmitted to other countries, threatening not only the economic well - being of those countries but also the stability of the international financial system as a whole. oceans of ink have been spilt in analysing the causes of these crises. most detached observers seem to agree that the underlying problems can be traced to certain fundamental weaknesses, weaknesses which clearly varied from country to country, but which have included poor quality credit analysis by banks and other financial institutions, politically - directed lending by banks, the end of an asset price bubble ( typically real estate ), sharply increased real exchange rates in a pegged exchange rate situation, distorted incentives in financial markets, and a lack of transparency in financial markets. the widespread incidence and significant economic cost of financial sector problems have prompted calls for concerted international action to promote the soundness of financial systems. these calls have strengthened considerably over the last couple of years. the basel committee has been at the forefront of this effort with the release of the core principles and proposals for a new capital accord. the imf is making evaluation of financial supervision and regulation part of its annual country reviews, and the world bank is emphasising the strengthening of financial infrastructure as

systemic and through - the - cycle view of prudential regulation. this reduces the risk of spillover from the financial sector to the real economy. soundness is not easily translated into a single, quantifiable benchmark against which performance can be monitored. the academic literature and various countries ’ prudential reforms since the gfc suggest there is a wide range of views on the optimal quantity and quality of capital for a banking system. indeed, the literature generally suggests that ‘ optimal ’ capital is not only higher than regulatory minimums, but can also span quite a wide range. the literature is therefore helpful in pointing to the direction that regulatory capital should travel, but not the destination. we are naturally cautious in how we think about risk to the banking sector. we operate in the uncertain : the origin of the next crisis is unknown. and as alluded to earlier, a banking crisis would have significant costs for ordinary new zealanders that would persist for years, in terms of economic output, public debt, employment and welfare. there is a good argument that there are soundness and efficiency gains to be made by requiring banks to hold more capital – within reason. more capital would help deliver both greater certainty, and higher expected output ( before and after a crisis ). this is illustrated by figure 5, where the level of financial stability is measured on the x axis and the expected output is measured on the y axis. at some point more certainty comes at a cost, though this may be justifiable if we desire greater certainty. however based on the literature and the views of other regulators it would seem that we are a long way from that trade off. some will argue that certainty comes at a price – that share capital is a more expensive form of funding than debt. there is a debate as to how high that price really is. and we need to weigh those private costs against the social costs of a crisis. figure 5 a framework for thinking about our policy goal output financial stability low high the question remains, how much certainty do we want, how risky do we want our financial system to be in the long - term? goldilocks returns with the same question what level of financial stability is too risky, too safe, or just right? to answer this we need to think about our risk tolerance for crises. stress tests one input into informing the reserve bank ’ s risk tolerance is stress testing. we ask banks to consider what would happen in the event of a severe but plausible hypothetical scenario