The Chairman of the Reserve Bank Board, Dr Arthur Grimes, briefed me on his meeting with you on 6 July regarding the joint trans-Tasman banking report. On the basis of his briefing, I am providing you with some talking points that you could draw on in your next discussion with Peter Costello.
I believe that it is important to emphasise the significant benefits for both parties of the 'enhanced home-host' banking supervision model for New Zealand and Australia, as discussed in the report. These benefits were not adequately highlighted in the working group's joint report due to the significant distraction caused by some team members' focus on specific, and short-term, commercial considerations for banks.
Putting those distractions aside, the Reserve Bank is not alone in considering the advancement of home-host and crisis management issues both necessary and of significant mutual benefit. [...] (Section 105(8) Reserve Bank of New Zealand Act) and was highlighted in the recent Financial Sector Assessment Programme.
It is also important to emphasise the very significant difficulties involved with an 'APRA supervises' or 'joint supervision' model. The separation of supervision and regulation from failure management responsibilities is very risky, especially so when jurisdictional boundaries are crossed and there is a separation of taxpayer from shareholder.
Australia has noted the growing relative importance of the New Zealand component of their banks balance sheets, as a reason for their interest in further integration of supervision and regulation. This New Zealand ‘component' is currently less than 15 percent of the four largest Australian bank group assets.
In contrast, foreign banks make up 98 percent of the New Zealand banking system. As such, it is extremely important that New Zealand retains an ability to regulate, supervise, and manage a banking crisis effectively, and to consider any changes that would undermine this ability very cautiously.
I provide a separate background paper on the causes, frequency, magnitude and implications of banking crises, as well as the effectiveness of regulatory responses in minimising such economic damage.
The benefits of an enhanced home-host banking supervision and regulation framework
- The enhanced home-host framework discussed in the joint report provides both countries crisis management that can work, while ensuring that the day-to-day supervisory issues are managed efficiently.
- APRA and the RBA agree with us that a coordinated crisis management is critical for effective bank failure management where there is such a high level of trans-Tasman banking interdependency.
- The enhanced home/host model allows resolution in this area faster than with more complicated 'APRA as supervisor' or 'joint supervision' models. These alternatives get into complex issues around insolvency, taxation, competition law, and other hard conflicting policy areas. This would make crisis resolution very slow without improving the efficiency of the industry.
Other key advances under the enhanced home-host model approach include the following.
Help Finance Ministers
- The model clearly lays out respective responsibilities and roles for liquidity provision in different kinds of crises, and addressed financial burden sharing.
Help depositors and others
- On failure management the focus will be on decision-making protocols that work, ensuring disputes between regulators, depositors and shareholders are minimised, and that essential technical services don't breakdown.
- These protocols will ensure that New Zealand and Australia are not in a position whereby rational, independent, national decisions are made that leave depositors and the financial system in either or both countries worse off; e.g. an asset grab at the time of bank failure.
Integration of disclosure requirements
- The RBNZ will review its disclosure requirements to ensure that they effectively dovetail with Australia Stock Exchange, securities and prudential disclosure requirements. This will further reduce compliance costs on Australian-owned banks in New Zealand.
Close gaps in the effective reach of Australian supervision
- The RBNZ will make two significant changes to its supervisory model that will strengthen the effective reach of APRA's supervisory rules. Upon their introduction, the Australian banks operating in New Zealand will mostly be subject to the same rules as their parent.
- [...] (Section 105(8) Reserve Bank of New Zealand Act)
- [...] (Section 105(8) Reserve Bank of New Zealand Act)
Greater coordination of supervisory process
- Both countries will be able to coordinate onsite inspections.
- Any special third party reports on bank activities will also be consulted on between regulators and coordinated if desired.
- Any actions against banks will also be consulted on and coordinated if necessary.
- These actions will result in less compliance costs on banks and better supervisory outcomes.
Implementation of Basel II with minimal compliance cost
- The Reserve Bank is committed to a consultative approach with APRA and the banks to reduce compliance costs to a minimum.
- If a different approach means unwarranted costs for the banks, the RBNZ will act on this.
- The Reserve Bank will take a case-by-case approach to banks when considering outsourcing arrangements.
- The RBNZ's will focus only on the resource and people requirements that are absolutely necessary in a failure management situation.
In summary, the Reserve Bank is committed to making progress in these areas due to their necessity and the significant benefits that will accrue to both countries.
Dr A E Bollard
ac. John Whitehead
Bank regulation and crisis management
- Banks continue to increase their financial leverage globally and fail at a frequent rate. Some of the increase in bank leverage is a response to increased regulation and the implicit taxpayer guarantee this brings.
- Bank failures continue to be very expensive for developed and developing economies.
- Bank failure management techniques can constrain the costs of a bank failure considerably if effective powers, purposes and capacity are in place.
- Cross-jurisdictional failure management is more complex, with competing priorities and conflicts of interest prevalent. These conflicts arise during times of stress and urgency.
Banks are the cornerstone of the New Zealand financial system. However, banks that operate in New Zealand, as elsewhere, are potentially fragile because of the high degree of leverage they operate under. The wider New Zealand economy is also vulnerable due to its high reliance on foreign savings for investment and private sector indebtedness. Moreover, 98 percent of our system assets are foreign owned, and it is vitally important that New Zealand retains its ability to regulate, supervise, and manage a banking crisis effectively.
A bank's financial leverage is sustainable as long as its reputation for sound management is sustained. The maintenance of a sound reputation comes from a combination of self, market and regulatory incentives. However, 'survival on reputation' is a double-edged sword.
Banks are one of the few industries in which the 'fear of failure' can lead to its demise. Hence, the financial risks must be identified and owned by those taking them, information must be disclosed for investors and depositors, and there should be no belief by all concerned that some kind of implicit guarantee exists.
Governments around the world have tried to address bank financial fragility through various forms of implicit or explicit guarantees, and a raft of regulatory requirements. Despite this, banks continue to fail at a frequent rate and banks continue to take on an increasing leverage.
The Reserve Bank approach has been to enforce clear ownership responsibilities and penalties, reduce any perception of government guarantees, and have credible and effective failure management policies. Credible and effective failure management implies having the legal powers and purpose for the swift action that is needed in a bank failure situation, as well as the capacity to manage a financial crisis. These powers and purpose must not lead to an increase the chance of the crisis occurring in the first place.
International comparisons show that crisis management structures that are well designed, prepared, and aligned with sovereign incentives can be very effective.
Frequency and costs of bank crises
- Bank crises are frequent: Since the mid-1970s there have been nearly 120 systemic bank crises (more than once for some countries), and another 50 or so near-crises in 45 countries. Thus, more than one half of all countries in nearly all parts of the world have experienced serious banking crises in recent memory. Many of the countries that did not suffer such crises are emerging economies that do not have a functioning banking system.
- The costs of these crises have been high: An IMF found 54 banking crises between 1975 and 1997 reported that GDP during the crises averaged nearly 12 percent below trend output and that it took these countries, on average, three years to recover.
- Crises in developed countries are not rare: Table 1 provides an indication of the costs of some recent crises. It is worth noting also, that there are many 'near misses' that are not captured in the research, because of government involvement, possibly financial, implicit guarantees and so on have headed off the crisis.
- The cost of the crisis is related to how well it was resolved domestically: Countries that have been able to undertake prompt corrective action have generally faired best by a significant margin.
Table 1: Fiscal costs of some recent crises in developed countries (in percent of GDP)