By Geof Mortlock*
The Government is currently undertaking a review of the Reserve Bank. That review is wide-ranging. It includes consideration of the governance arrangements for the Reserve Bank, the banking supervision arrangements and the framework for the protection of bank deposits.
The review has also opened up a more fundamental question: Should the Reserve Bank continue to be the prudential regulator of banks, insurers, non-bank deposit-takers (NBDTs) and payment system operators, or should this role pass to a new regulatory body?
In this article, I argue that a new financial regulatory body should be established, completely separate from the Reserve Bank. I believe this would provide the basis for a much-improved quality of financial regulation and supervision in New Zealand. It would avoid the conflicts of interest inherent in the Reserve Bank performing this function. It would enable all of the anti-money laundering regulation to be handled by one body, rather than being spread across three government agencies (i.e. the Reserve Bank, Financial Markets Authority and Department of Internal Affairs). It would reduce the excessive concentration of power that the Reserve Bank currently has. It would enable the Reserve Bank to focus on its core role of monetary policy, leaving prudential regulation to a separate agency with the culture and capacity to do the job properly. And it would avoid the risk of regulatory over-reach, such as when the Reserve Bank uses prudential policy for purposes well beyond financial stability.
The separation of the financial regulation function from the central bank has much precedent internationally. Indeed, it is the norm in much of the OECD. In many countries (e.g. Australia, Canada, France, Germany, Japan, South Korea, Sweden and Switzerland) the prudential supervision authority is completely separate from the central bank, often having been moved out of the central bank following a comprehensive review of regulatory institutional arrangements.
In New Zealand, there has never been a serious consideration of the benefits and costs of separating the prudential regulatory function from the Reserve Bank. Instead, prudential regulation of banks evolved within the Reserve Bank, growing from its historical role of regulating banks for monetary policy reasons. This was formalised in 1986 when the Reserve Bank Act was amended to formally establish prudential supervision of banks in the Reserve Bank. Many years later, in 2008, the Reserve Bank acquired responsibility for the prudential regulation (but – very oddly – not the supervision) of NBDTs, such as finance companies, building societies and credit unions. A few years later, in 2010, the Reserve Bank acquired responsibility for the prudential regulation and supervision of insurers, despite having very little expertise and no experience in insurance matters. Along the way, the Reserve Bank also became the regulator for anti-money laundering (AML) for banks, NBDTs and insurers. Yet, AML regulation for other categories of financial entities is handled by the Financial Markets Authority and Department of Internal Affairs – a very inefficient and costly arrangement.
New Zealand’s financial regulatory architecture has evolved in a piecemeal and muddled way. Changes have been made here and there in an ad hoc manner to respond to the pressures of the moment. Unlike most countries in the OECD, which have had periodic fundamental reviews of regulatory architecture in a considered and methodical manner, New Zealand has never done this.
It is worrying that, despite the failure of DFC in 1989, the virtual failure and government-funded rescue of BNZ in 1990, the failure of more than 50 finance companies in the period 2007 to 2011, and the failure of insurers, there has been no government enquiry into the adequacy of the Reserve Bank’s performance as prudential supervision authority, and no wider enquiry into financial system regulatory architecture. In contrast, Australia has had numerous such enquiries which have led to constructive and fundamental changes to the financial regulatory architecture in Australia.
More recent events in New Zealand also raise the fundamental question as to why there is not a substantial questioning of the competency and suitability of the Reserve Bank as prudential regulator. Several examples raise serious questions about whether the Reserve Bank is the appropriate agency to be the country’s prudential regulator. These include:
I could go on. But you get the drift. The above examples paint a picture that is clear to see – of a central bank that fails in significant ways to perform the responsibilities of a professional, effective financial regulator. To make matters worse, the Reserve Bank governor portrays the Bank as a deity – the ‘god’ of the ‘financial forest’, none other than Tane Mahuta. He has spent more time publicly touting the Tane Mahuta metaphor than he has in explaining in a professional way the Reserve Bank’s role as financial regulator and accounting for its performance. At times, it feels a little like watching a Monty Python movie. New Zealand deserves better than this.
It is noteworthy that the only review ever undertaken of the Reserve Bank’s prudential supervisory regime since its inception in 1986 was the internal review conducted by the Reserve Bank itself in the early 1990s. That review was poorly structured, inadequately resourced and self-serving. It involved no external parties. Treasury had little, if any, input. The Reserve Bank Board played no substantive role in the review. It was largely driven by those in the Reserve Bank who had a philosophical bias against prudential regulation but fundamentally lacked any substantive understanding of the issues. The analysis in the review was superficial, ill-informed and driven far too much by half-baked ideology.
The review led to a hollowing out of the supervisory function, rendering the Reserve Bank even less effective as a supervisory authority than it had been in the preceding years. It brought about some constructive changes, such as the bank disclosure regime and director attestation framework, which were beneficial and sensible reforms, but left the Reserve Bank ill-equipped to identify and proactively respond to emerging stress in the banking system, and hopelessly under-resourced to deal with a banking crisis should one occur.
The review led, for some time, to the absurd outcome that the Reserve Bank supervision function should be based only on information that is publicly available and not privately accessed by the Bank. No other supervisor in the world operates on that basis – for good reason.
Sensibly, this naïve approach was progressively abandoned in later years and supervisory resources have been substantially increased. Nonetheless, many remnants of that mindset continue to this day and continue to undermine the effectiveness of prudential regulation. The Reserve Bank’s ideological and cultural DNA is simply incompatible with what is needed to perform the role of a financial regulator with the professionalism that is needed.
Reflecting this, the Reserve Bank continues to eschew any form of on-site assessment of banks or insurers. It has little in-depth understanding of bank and insurance risk management frameworks or a reliable ongoing means of verifying financial institutions’ financial position, including as to asset quality, the adequacy of loan loss provisioning and capital adequacy. By international standards, the Reserve Bank’s approach to bank and insurance supervision is lamentably under-developed. Indeed, drawing on my considerable experience in evaluating countries’ financial systems for the IMF and World Bank, I am confident in saying that many prudential regulators in emerging economies (i.e. those with around half of New Zealand’s per capita GDP) have considerably superior financial regulatory and supervisory authorities than the Reserve Bank. Using a cricket analogy, the Reserve Bank is about as much use as a financial regulator as is a cricket umpire who is nearly blind and who understands little about the game.
A fresh assessment of the financial sector regulatory architecture is well overdue. An assessment should be undertaken by Treasury, supplemented with independent experts selected and appointed by the Minister of Finance, to evaluate the benefits and costs of three regulatory architecture options:
Of these options, I favour the third one – the creation of a new government agency, a Prudential Regulation Authority, that is completely separate from the Reserve Bank. This is the Australian and Canadian model, and one that is prevalent in many countries in the OECD. In my assessment, there are several persuasive reasons for separating the prudential regulatory and supervisory function from the Reserve Bank:
Taking into account these factors, among others, a strong case can be argued for separation of the prudential regulatory and supervisory functions from the Reserve Bank, as has been done in so many other countries.
A further argument for the creation of a separate regulatory agency is that it would be well placed to assume the role of AML regulator for all entities subject to AML regulation. This could replace the current structure under which AML regulation is spread across three government agencies by consolidating the function into just one agency. It would be more effective and efficient. It would likely cost less than the current arrangement. It would promote a more consistent approach to AML regulation across the relevant sectors. And it would be more consistent with prevailing international practice, where the tendency is for one regulatory agency to perform AML regulation.
What of the arguments for retaining the prudential function in the Reserve Bank? The argument generally advanced by the Reserve Bank in favour of retaining supervision is the alleged synergy between the prudential function and the other functions of the Reserve Bank. For example, it has been argued by some in the Reserve Bank that the Bank is better equipped to perform the supervisory function because of its payment system operation, exchange settlement function and monetary policy operations. This argument is fragile at best and largely illusory. The insights gained by the Reserve Bank from these other functions have little bearing on its role as prudential regulator and supervisor. Interaction between the different departments within the Reserve Bank in my time at the Bank was very limited and had no effect on prudential policy decisions. It might have increased in more recent times, but I very much doubt that there is any substantive input from these other parts of the Reserve Bank to the supervision function.
If one looks at our near neighbour – Australia – the separation of supervision from the Reserve Bank Australia (RBA) had no deleterious effect on the effectiveness bank regulation and supervision. If anything, it enhanced it by enabling APRA to focus on its key functions without the distraction of the other functions of the RBA. To the extent that central bank insights have a useful role to play in informing prudential supervision, they can be harnessed efficiently and effectively through well-structured coordination between the supervision authority and the central bank, as happens regularly in Australia through the Council of Financial Regulators and bilaterally between APRA and the RBA.
Another argument offered for keeping bank regulation in the Reserve Bank is that it complements the central bank’s role as lender of last resort. This argument also fails upon scrutiny. A central bank only provides liquidity support to a bank in a last resort capacity if it is satisfied on the bank’s capital adequacy and that it has sufficient collateral to cover the credit and market risks involved in any lending. These assessments do not rely on the central bank being the prudential regulator. In many other countries, including Australia, the central bank looks to the prudential regulator for information and assurance on capital soundness. The central bank might undertake their own due diligence in some situations. They typically undertake separate initiatives to check for suitable collateral, which is not something that falls within the standard scope of a prudential regulation role in any case. In other words, the function of lender of last resort does not in any way rely on the central bank being the prudential supervisor. Just ask the central banks in Australia, Canada and many other OECD countries.
I therefore believe that the Government should undertake a rigorous assessment of the regulatory architecture in New Zealand. This should be led by Treasury with international experts brought in to assist and provide additional objectivity and expertise. It should include a capability assessment of the Reserve Bank and an assessment of the alternative regulatory architecture options.
I believe that New Zealand would be best served by a fundamental change to financial regulatory architecture, with the establishment of a new regulatory agency completely separate from the Reserve Bank. This new agency would have its own Act of Parliament, with a clearly specified mandate focused on financial stability and the protection of depositors and policyholders. It would be subject to robust governance, transparency and accountability. And, refreshingly, the new agency would be a mere mortal – not a tree god or indeed any kind of god. Let’s leave Tane Mahuta in the forest, where he belongs. He has no place on The Terrace in Wellington.
*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant who undertakes extensive assignments for the International Monetary Fund, World Bank and other organisations globally, dealing with a wide range of financial sector policy issues. He formerly worked at senior levels in the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.