in investor preferences, with no justification in the real economy, then inflation pressures will have changed, and some adjustment in monetary policy will normally be appropriate. a fourth contribution of the framework established by the 1989 act was, i think it is fair to say, an improvement in fiscal policy. again, i don ’ t want to overstate this point : there were a number of factors driving an improvement in new zealand ’ s previously rather poor record of fiscal performance, including some very determined ministers of finance. but the monetary policy framework played a useful part. this first became apparent in 1990 when the then - government introduced an expansionary budget not long before the general election that year. we judged that that degree of fiscal stimulus would require us to tighten monetary policy somewhat if inflation ( then running at over 5 per cent ) was to be brought down to the 0 to 2 per cent target by 1992 ; so we did. immediately, an editorial in new zealand ’ s largest daily paper noted that the budget had ‘ rekindled inflationary expectations. the ( reserve bank ) was bound to lift interest rates …. electors are frequently bribed to their ultimate cost. this time the independence of responsible monetary control quickly exposes a fiscal fraud. ’ 3 the main opposition party campaigned in the election on a commitment to get interest rates reduced, not by leaning on the central bank but by ‘ giving monetary policy some mates ’ through tighter fiscal policy and deregulation of the labour market. five years later, with several years of fiscal surplus behind it, the government undertook to reduce income taxes subject to several conditions, one of which was that the reserve bank was satisfied that such tax cuts would not require a significant tightening of monetary policy. to me, this is a good illustration of the benefit of having the precise specification of the objective of monetary policy a matter for formal and public agreement between government and bank. the government makes a public commitment to the agreed inflation objective. it implicitly accepts that, if its fiscal policy increases inflationary pressures, the bank will need to tighten monetary policy to ensure that the agreed objective is met. the bank is protected from political pressure to ease monetary policy as long as the inflation rate is, and looks likely to remain, above the bottom of the inflation target range. in contrast to these positive benefits from the 1989 act, some people have noted that in the early 1990s new zealand also saw quite a strong increase in unemployment and a downturn in output, and have suggested that the reserve bank must accept

peers. we believe it is time to review new zealand ’ s position and review more broadly our capital framework in light of international and domestic developments and our experience with the current regime. today i want to set the scene for the review of bank capital that the reserve bank will undertake over the coming year. i will explain the high level objective of the review, elaborate on the international and domestic context and set out principles that will guide the review. objective of the review the aim of the capital review is to identify the most appropriate regulatory framework for setting capital requirements for new zealand banks. consistent with the reserve bank ’ s legislative purposes, minimum capital requirements should promote the maintenance of a sound and efficient financial system. in broad terms, higher levels of capital will improve the soundness of the financial system as the likelihood of bank failures is reduced and the potential impact of credit cycles is moderated. 1 / 9 bis central bankers'speeches however, the capital regime may reduce the efficiency of financial intermediation if ratios are pushed too high or standards are made overly complex. capital is a more expensive form of funding for the banks and so higher capital ratios can potentially increase the overall cost of funding the system as well as improving its soundness. our aim is to agree a capital regime that ensures a very high level of confidence in the solvency of the banking system, while avoiding unnecessary economic inefficiency. in pursuing this objective, the capital review will look at the three key components of the regulatory capital regime : the definition of eligible capital instruments the measurement of risk, in particular the risk weights attached to credit exposures the minimum capital ratios and buffers these three factors are interdependent and the links between them must be carefully considered. the calibration of the capital ratios needs to be set in the context of the risk weights applying to exposures as well as the capacity of eligible capital instruments to absorb losses. also, the role of capital buffers versus hard minimum requirements needs to be considered. the capital review will examine how well the reserve bank ’ s current framework operates and consider potential improvements. the reserve bank will consult the banks and the public on its findings and on any proposed changes to the capital framework. outcomes of the review will be heavily influenced by the international regulatory context, the risk characteristics of the new zealand system and the reserve bank ’ s regulatory approach. i will start with the international context. how do our banks compare to international peers? this is not a straightforward question to answer, but