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Our approach to ensuring financial stability
Financial stability means having a resilient financial system that can withstand severe but plausible shocks and continue to provide the financial services we all rely on.
Why stability is important
The financial system has a critical role in supporting economic activity. Households and businesses need:
- services for savings and credit to pay for their consumption and investment
- payment systems to make it easy for them to transact here and overseas
- insurance to manage their risks.
Households and businesses need to be confident that banks, non-bank deposit takers and insurers will continue to provide these services. They also need to be able to rely on the payment and settlement systems to work as they expect.
The financial system is exposed to risks
Risks to financial stability come from a wide range of sources:
- overseas (external) — for example New Zealand’s financial system relies heavily on external funding making us vulnerable to disruption in overseas funding markets
- domestic (internal) risks — for example lending to our dairy industry and to highly indebted households
- vulnerability due to the small size of our financial system and its domination by a small number of banks with similar business models. If one of these banks failed or was in distress, it would be likely to impact the whole system
- emerging risks including misconduct, technology disruptions, cybercrime, insurance affordability and climate change.
The financial system is subject to market failures
Financial stability is a common resource that benefits us all. It is prone to the tragedy of the commons – the risk that it is abused and degraded by individual agents who do not have the right incentives to look after it.
For example, moral hazard – where financial institutions believe the taxpayer will bail them out if they suffer significant losses – limits the incentive for institutions to manage their risks appropriately and to internalise the social costs of a financial crisis.
This can be compounded by behavioural factors. Herd behaviour, myopia and irrational exuberance can create market momentum that drives the price of an asset or transaction away from its fundamental economic risk and return, and imposes costs on others.
Our role in maintaining financial stability
We aim to promote a sound and efficient financial system
As a full service central bank we are uniquely placed to fulfil our role in maintaining financial stability.
As well as regulating and supervising financial institutions, we develop and implement monetary policy, oversee payment and settlement systems, and are ready to use our markets functions to provide liquidity in exceptional circumstances.
We also help promote a vibrant and healthy financial ecosystem. This relies on the input of a wide range of stakeholders, as well as the consumers and businesses who rely on the financial system.
As a member of the Council of Financial Regulators, we work with Treasury, the Financial Markets Authority, the Commerce Commission and the Ministry of Business, Innovation and Employment to identify, manage and address issues, risks and gaps in the financial system, so that it is both safe and efficient.
Our regulatory and supervisory approach recognises there is an important role for both the regulator and the regulated in ensuring the financial stability regime is operating effectively as intended.
The 3 disciplinary pillars
There are 3 pillars of discipline influencing regulated entities (banks, non-bank deposit takers and insurance companies): market discipline, self-discipline and regulatory discipline.
- Market discipline refers to how market participants influence regulated entity's behaviour and risk-taking. They use their influence by changing the cost or amount of funding they are willing to give to a regulated entity based on financial and other information about that entity. This motivates regulated entities to manage their risks appropriately.
- Self-discipline refers to a regulated entity’s own processes and risk management frameworks. These are mainly the responsibility of its directors and senior managers.
- Regulatory discipline means the imposing of requirements on regulated entities. It is necessary to improve the effectiveness of market and self-discipline.
Our role as a regulator means setting robust requirements that are fit for purpose. This means they address risks and market failures at the source, taking into account the costs of regulation and supervision on our regulated entities and the wider economy.
We do not run a zero failure regime
Allowing financial institutions to fail provides incentives for self-discipline and market discipline to operate effectively.
Achieving financial stability does not mean eliminating all risks. This would create inefficiencies – for example, it could stifle new entrants to the system, and remove the incentives for growth, innovation and healthy risk-taking.
However, to allow individual institutions to fail we need a robust financial system that can continue to work even when individual entities are experiencing distress or failing.
Our role is dynamic
The financial system is constantly evolving, as are its risks and challenges. This means our requirements and expectations of regulated entities evolve as well. Our approach to financial stability is becoming more intensive and more intrusive in terms of both regulation and supervision.
For more information on the outlook see Geoff Bascand's speech titled The Reserve Bank is renewing its approach to financial stability.
Our approach to financial stability
The diagram below shows our approach: we monitor the financial system, enhance its resilience and manage the consequences of institutional distress or failure.
Monitor the financial system
We continuously monitor the financial system to identify and assess:
- Structural risks: ever-present risks related to the composition of the financial system, in terms of its institutions, and their assets and funding. New Zealand is exposed to external shocks, and standards must recognise these risks and shield the domestic system and economy.
- Emerging risks: these can be risks related to traditional areas of focus like credit or funding risks, or to new and emerging technologies, or to climate change. We are particularly focused on innovation that presents risks to the regulatory perimeter – whether institutions are operating inside or outside our supervisory and regulatory reach, and whether this is appropriate.
- Cyclical risks: the risk that boom-bust cycles are amplified by, and to the detriment of, the financial system, due to the procyclicality of credit and asset price growth.
We publish our assessment of risks in the 'Financial Stability Report' to raise awareness of risks and help institutions develop resilience and improve their self-discipline.
Our Bank Strength Dashboard promotes self- and market discipline by making a wide range of financial information about banks more accessible.
Thematic reviews help us and our regulated entities better understand specific risks.
Stress testing is where we subject individual financial institutions to stresses (such as a significant economic downturn and distressed funding markets) to help us understand how resilient the financial system is to big risks. Stress tests also help financial institutions understand risks and assess their risk management frameworks.
Enhance the resilience of the financial system
We make the financial system more resilient by setting strong baseline requirements to manage ongoing and identifiable sources of risk, for example:
- liquidity standards for banks ensure they can meet their cash-flow demands
- solvency standards for insurers ensure they can afford to pay claims
- capital requirements for banks and non-bank deposit takers allow them to absorb unexpected losses and continue lending to households and businesses.
We then adapt our regulatory and supervisory approach to reflect emerging and/or cyclical risks and the impact they could have on the financial system.
If cyclical risks become extreme for banks, we can use macroprudential tools like loan-to-value (LVR) ratios to improve the resilience of the balance sheets of both the bank and borrowers. We have other macroprudential tools for improving banks' capital and/or liquidity ratios.
Our regulatory requirements are complementary and they aim to support effective self-and market discipline by providing a basis for directors and the market to assess the wellbeing of individual institutions.
Manage distress or failure
Despite our efforts to monitor and enhance the resilience of the financial system, institutions may become distressed and even fail. When this happens, these events need to be managed to maintain critical payments and services and mitigate costs to depositors, investors and taxpayers.
The Government is proposing to introduce a deposit protection regime. In the event of failure of a deposit-taking institution, this would provide that deposits in the range of $30,000–$50,000 would be insured. It is consulting on the features this new bank crisis management regime should have.
We can provide liquidity (as the lender of last resort) when a cash shortfall threatens the viability of solvent banks and causes a significant tightening in credit supply.
Our supervisory approach
Our supervisory approach is intended to complement our regulatory approach in terms of its reach and its intensity. Our supervision:
- monitors and deepens our understanding of the financial system and the risks it faces
- enhances the resilience of the financial system by:
- verifying that self-discipline and market discipline are operating as intended
- verifying that regulated entities are complying with requirements
- enforcing requirements where regulated entities are not complying.
- manages the consequences of the distress or failure of institutions by:
- providing intelligence on balance sheets, operations and the risks facing institutions
- working closely with institutions on their recovery and resolution plans
- clearly setting out our intervention process.