higher capital better for banking system and nz notes from an address delivered to business nz ceo forum in auckland on 30 november 2018 by adrian orr, governor 2 the terrace, po box 2498, wellington 6140, new zealand telephone 64 4 472 2029 online at www. rbnz. govt. nz the reserve bank is tasked with ensuring the banking system is both sound and efficient. to achieve our task we have a range of tools ( see table 1 ). the most important tool in our kit is ensuring banks hold sufficient capital ( equity ) to be able to absorb unanticipated events. the level of capital reflects the bank owners ’ commitment – or skin in the game - to ensure they can operate in all business conditions, bringing public confidence. given its importance, we have been undertaking a review of the optimal level of capital for the new zealand system. we conclude that more capital is better. we are sharing our work with the banking sector and public, and expect to hear one side of the story loud and clear, that capital costs banks. we need to hear a broader perspective than that, to best reflect new zealand ’ s risk appetite. what have we done in practice? the reserve bank needs to ensure there is sufficient capital in the banking “ system ” to match the public ’ s “ risk tolerance ”. this is because it is the new zealand public – both current and future citizens - who would bear the social brunt of a banking mess we know one thing for sure, the public ’ s risk tolerance will be less than bank owners ’ risk tolerance. how do we know this? surely the more capital a bank has the safer it is and the more it can lend. why don ’ t banks hold as much capital as they can? first, there is cost associated with holding capital, being what the capital could earn if it was invested elsewhere. second, bank owners can earn a greater return on their investment by using less of their own money and borrowing more - leverage. and, the most a bank owner can lose is their capital. the wider public loses a lot more ( see figure 2 ). hence, we need to impose capital standards on banks that matches the public ’ s risk tolerance. we have been reassessing the capital level in the banking sector that minimises the cost to society of a bank failure, while ensuring the banking system remains profitable. ref # 7821869 v2. 0 the stylised diagram in figure 3 highlights where we

oil and commodity prices which have also been buffeting the economy ) and taking into account the underlying structure of the euro area economy. one question that could arise here is whether the massive injections of liquidity into the banking system come at the price of either an inappropriate monetary policy stance or a less than optimal signalling of it. in practice, this is very unlikely to be the case. indeed, since the beginning of the financial turmoil in august 2007, the ecb has repeatedly emphasised that the policy stance is defined in terms of the interest rate at which financial intermediaries can obtain liquidity, rather than by fixing the quantity of liquidity which is provided. as early as 1970, william poole's classical analysis of the instrument - choice problem taught us that using the interest rate as policy instrument is desirable when short - term uncertainty stemming from instability in the money multiplier or from money demand shocks is high relative to the uncertainty stemming from aggregate demand shocks. the provision of liquidity then becomes an endogenous variable as it is steered in order to stabilise the money market rate at its desired level. in this framework, the sometimes substantial liquidity injections by the eurosystem should be seen as simply offsetting the sudden and sharp declines in the money multiplier induced by the financial crisis. as far as our monetary policy decisions are concerned, they depend on our medium - term assessment of the risks to price stability and are based on our two - pillar strategy, which enables us to cross - check developments in the money, credit and financial markets with the signals provided by economic analysis. given existing upward inflationary pressures from oil and other commodity prices and the associated likelihood of second - round effects, euro area monetary policy was until recently faced with predominantly upward risks to price stability. however, as the financial crisis intensified further, financial conditions for the private nonfinancial sector have tightened – independently of monetary policy – and the supply of credit from financial institutions might be reduced. as a result, expectations regarding economic activity have rapidly deteriorated over the last two months and the upward inflationary pressures have eased, partly as a result of lower commodity prices but also because of the change in the outlook for domestic economic activity. therefore, the coordinated interest rate cut of 50bp last week was also the appropriate response for the euro area to the materialisation of previously identified downside risks to growth and the associated decline in the upward risks to price stability. for the near future, we will continue