Time to reform Reserve Bank goverance – the Bank does different things

Reader numbers tell me that anything on housing is more popular than things I write on Reserve Bank governance.  And, in fairness, the housing issues are probably more important.   But a good quality central bank, subject to best-practice governance models, matters too, and the governance issues are actually much easier to deal with. Any minister willing to pick them up would be pushing at an open door.  There would (and should) be debate around details, but no one would fight for the status quo.

This is last in my series of posts on the basic case for changing the Reserve Bank governance model adopted in 1989.  I haven’t set out to re-litigate the choices made in 1989.  At this point, doing so would only be of historical interest, and in any case I’ve tried to illustrate the quite rational and reasonable basis on which the 1989 choices were made.  But things are different now, and the governance model needs to be overhauled to reflect the way things are today.

As I noted on Tuesday, no other country does things the way we do (gives a single unelected official formal decision-making powers over both monetary policy and financial regulatory policy), even though many countries have reformed their systems since 1989.

As I noted on Wednesday, in no other area of policy in New Zealand are decisions made the way we allow Reserve Bank policy to be made.  Policy decisions (as distinct from the application of policy in individuals’ cases) are typically made by elected politicians, or by boards, not by single officials.

As I noted yesterday, back in the late 1980s monetary policy was seen by some as likely to be pretty straightforward and uncontroversial, involving little exercise of discretion. As one of my former colleagues put it, exaggerating to make the point, “with the right PTA, any bozo could be Governor”.  In fact, experience here and abroad suggests that considerable discretion is needed, and the choices have material implications for the short-term performance of the economy.  So it isn’t the sort of policy for which one might appropriately rely just on the talents and preferences of a single unelected individual, no matter how able.

And, if the conception of monetary policy has changed, so has the conception of the Bank itself.  The sort of organisation the Bank was seen as becoming materially influenced the governance model chosen.

In 1989, the Reserve Bank was seen as being en route to becoming a rather simple institution.  It would be primarily a monetary policy institution, with next to no financial risks on its quite small balance sheet.  Banking registration and supervision powers were put in the Act, but no one envisaged the Bank as being engaged in much active discretionary prudential supervision (and key failure management powers were, in any case, reserved to the Minister).

I’ve already talked about the changed conception of monetary policy, which meant that a PTA did not provide any simple or easy way to hold the single unelected decision-maker to account.  But the changes to the rest of the Bank, and their implications for governance and accountability, are probably even greater, and more important.  The Bank has been assigned by Parliament a much wider range of regulatory responsibilities (non-bank deposit-takers, insurance companies, AML, and the payment system (where it is bidding for still more powers)).  That alone represents a hugely greater weight on regulatory matters.  But in addition the Bank has chosen to use its existing statutory powers over banks in ways that involve much greater degrees of discretion.  The most obvious examples are the recent and proposed LVR restrictions, but there is also a lot of (not very transparent)  discretion involved in the approval processes for the capital models used by the big banks in calculating regulatory capital requirements.  Where considerable discretion is involved, the personal preferences of the decision-maker become important.    And that discretion can’t easily be constrained by something like a PTA  –  it is pretty much common ground that nothing like a PTA, that would materially constrain discretion, could be put in place for the financial stability policy responsibilities the Bank has.   The state of knowledge is just too limited[1].

Note that, for these purposes, I’m not questioning whether or not the Bank should have such powers, or should interpret them as it does.  I’m simply making the point that when so much discretion is involved it is inappropriate –  and not seen anywhere else –  to have a single unelected official making the decisions.  It is simply too risky.  It isn’t the way the New Zealand generally allows policy to be made.

New Zealand has pretty good quality institutions and systems of government and public sector governance.  The Reserve Bank governance model has become out of step with practice globally,  with that in the rest of the New Zealand public sector, and with what the Reserve Bank now actually does.  It really is Time to Reform the Governance of the Reserve Bank.

As things appeared in 1989

At the time Reserve Bank was thought of as being (in the process of becoming) a relatively simple institution.  Exchange control had gone in 1984, direct controls had been removed by early 1985, and government banking, tendering and registry functions were gradually being removed from the Bank.  No one in officialdom had much interest in foreign exchange intervention and the foreign reserves the Bank was allowed to hold were well-hedged.

The 1989 Act gave the Reserve Bank powers in a variety of areas, but the Bank was overwhelmingly seen as a monetary policy institution[2]  Many of the clauses of the Act were devoted to the registration of new banks, and the management of bank failures, but there was little or no sense that the Bank was likely to become a particularly active regulatory agency. People close to the work on the 1989 Act report that in detailed discussions around the drafting of the 1989 legislation, little or no attention was given to governance issues as they affected the regulatory responsibilities of the Bank.  Thus, although the governance arrangements (single decision-maker, complemented by the monitoring role of the Board) covered all the Bank’s responsibilities, it is clear that they were designed primarily with (the rather simple conception of) monetary policy in mind.

And, by contrast, how they are today:

The third aspect that has turned out materially differently than the designers of the 1989 legislation expected is the wider role of the Reserve Bank.

In the late 1980s, the Reserve Bank was envisaged primarily as a monetary policy institution, with a very limited – and well-hedged – balance sheet. Since then the Bank’s roles have expanded considerably, but there has been no material change in its (single unelected official) governance.   What are the changes in role?

The Bank has taken on substantial foreign exchange risk, including a more active foreign exchange intervention role. In crisis periods it has assumed substantial credit risk.  And whereas in 1989 the registry business was in steep decline, the Bank is now the owner and operator of New Zealand’s major securities clearing and settlement system.

But perhaps the most substantial changes have been in the supervisory and regulatory functions, which now take a much larger, and a more active, place.  Considerable amounts of regulator discretion are now being exercised, as to policy and the implementation of policy.  The change has accelerated in the last half-dozen years with:

  • The move to Basle II and then Basle III capital models (involving approval of risk models, and the exercise of detailed discretion and judgement on risk weights etc)
  • The introduction of the so-called macro-prudential (time-varying) approach to regulation of banks, including the 2013 residential mortgage LVR “speed limit” and the recent proposal for a ban on high LVR property investor lending in Auckland.  Regional differentiation in the way prudential policy is applied is yet another new step in regulator discretion.
  • The Reserve Bank becoming responsible for the regulation of non-bank deposit-taking institutions
  • The Reserve Bank becoming responsible for insurance supervision.
  • The Reserve Bank becoming responsible for implementing anti-money laundering etc legislation in respect of the financial institutions it regulates, and
  • The Reserve Bank’s bid (not yet successful) for more payment system powers.

It is common ground that there no framework in the Act for defining output-based performance standards for these functions and that for most of them it is simply not possible to do so.  That is not a criticism of the Reserve Bank, or of the roles Parliament has assigned, but simply a description of the difficulty all countries face in these areas.

So the Reserve Bank is now an organisation that, with the acquiescence of ministers and sometimes with the specific mandate of Parliament, has a wide range of functions and powers, but typically has rather ill-defined, and hard to measure, goals[3].   But that means it is very difficult to defend a conception of the Bank in which having a single (unelected) decision-maker provides for clear and decisive point of accountability across these multiple different functions and responsibilities.

[1] Although it has been pointed out that the UK Banking Act makes an effort in this regard.

[2] Section 8 of the Reserve Bank Act still states that monetary policy is the “primary function of the Bank”.

[3] In one or two areas there are memoranda of understanding with the Minister of Finance, but these documents have no legal status, and bind neither subsequent ministers nor subsequent governors.