open foreign exchange positions, and guidelines for internal controls, some bank directors were assuming that they were necessarily behaving prudently provided they were operating within those limits and guidelines. they stopped addressing the risks which their own banks were facing and simply complied with the general limits and guidelines. to the extent that that was true – and we found some evidence that it was true in some banks – we concluded that our banking supervision might actually be increasing the risk of bank failure, by reducing the incentive for bank directors and bank managers to make their own careful assessment of risk. the outcome of our review was to substantially strengthen disciplines on the directors and managers of banks to operate their banks prudently, and to strengthen the ability of the marketplace to discipline banks. we also retain a system of supervisory discipline, which we take very seriously. but we retain only a few absolute rules within that framework, principally that all banks must at least meet the basel capital adequacy rules. we rely mainly on a requirement that banks disclose to the public a substantial amount of financial and risk information quarterly. in addition, all bank directors must sign off these quarterly statements, at the same time attesting to the fact that the internal controls of their banks are appropriate to the nature of their banking business, and that those controls are being properly applied. we in the reserve bank do not attempt to tell banks what those controls should look like, but directors signing those quarterly statements without making a careful assessment of the adequacy of internal controls are exposing themselves to very considerable legal risk in the event that their bank gets into difficulty. we have also gone out of our way on a number of occasions to make it clear to the public that neither the reserve bank nor the government of new zealand is guaranteeing individual banks, and we published a booklet designed to assist the general public to interpret banks ’ financial information. none of these actions is a guarantee against imprudent bank behaviour of course, but we believe that we have gone a considerable distance towards ensuring that banks face strong incentives to behave prudently. no bank operating in new zealand is now owned by government, none is guaranteed by government, none is obliged to lend to particular sectors or companies, and our supervision is based heavily on mandatory public disclosure and director attestations. three years ago, alan greenspan commented that ‘ regulation by government unavoidably involves some element of perverse incentives. if private market participants believe that government is protecting their interests, their own efforts

the private sector which has been borrowing heavily from overseas, not the public sector. and while some of this borrowing has been done by the corporate sector directly, much of it has been done by the banking sector. comparable levels of overseas borrowing by banks in other countries have been sufficient to make foreign lenders very nervous ( for example, in some asian countries in recent years ), and yet similar nervousness has not been at all evident in new zealand. why? i can only conclude that the foreign lenders take considerable comfort from the fact that most of the banks operating in new zealand now are in fact wholly - owned by foreign banks, or are indeed branches of foreign banks. those parents are seen as being financially strong, and fully able to back the operations of their new zealand subsidiaries or branches. ( it may also be relevant that, overwhelmingly, the overseas borrowing being undertaken by new zealand banks carries no foreign exchange risk for the banks themselves. ) in some countries, there is political reluctance to allow foreign institutions unrestricted entry into local banking sectors. i would have to say that, as a country where all but one of our 17 banks are owned and controlled overseas, we have seen absolutely no disadvantages from this situation, and many advantages. we have a financially stable banking sector, with vigorously competing and highly innovative banks, all of them subject to the monetary policy influence of the central bank. i have no doubt at all that the banking sector is considerably more stable than would have been the case had all the banks been domestically - owned, whether in the private sector or in the public sector. monetary policy lessons from new zealand lesson 3 : keep prices stable the third lesson from our experience has been the crucial importance for financial system stability of keeping prices stable. i am sure that for this audience the assignment of monetary policy to the objective of keeping prices stable is not extraordinary, as evidenced by price stability being the primary objective of the single monetary policy of the eurosystem. but let me comment on the link between price stability and financial system stability. by the late eighties, new zealand had experienced nearly 20 years during which consumer price inflation had been above 10 per cent almost without a break. interest rates after adjustment for tax and inflation were often strongly negative, and there was as a consequence a strong incentive to invest in real estate and shares, using as much borrowed money as could be obtained. this was undoubtedly an important contributor to the severe difficulties which both the corporate sector and some parts of the banking sector experienced when