Reforming the governance of the Reserve Bank

The Green Party leader, James Shaw, has just put out a press release highlighting the Reserve Bank’s persistent forecasting errors, which have had the effect of keeping the number of people unemployed higher than it would otherwise have been in recent years.  James Shaw uses that record to reinforce the argument that too much power is vested in a single unelected individual, the Governor, and that the governance model of the Reserve Bank should be reformed, as (for example) The Treasury has previously argued.

As I have noted previously, the Bank’s serious forecasting errors are not primarily the fault of the single decision-maker model.  There was, unfortunately, widespread support at the Bank last year for the OCR increases, and it would have been hard even for a more independent committee to have resisted the push for the early increases.  But the succession of policy mistakes (eg having twice had to reverse OCR increases in the last five years) does reinforce the more fundamental arguments for a better, and more conventional, governance structure for the Reserve Bank.  It is not governed the way most central banks are, or the way most New Zealand government agencies are.  Even among central banks, only the Bank of Canada puts the legal authority to set the policy rate with the Governor alone, and the Bank of Canada Governor has a much less extensive range of powers than Graeme Wheeler (and his predecessors) have had.

I outlined my own case for governance reform here.

The Reserve Bank itself has been working on the issue.  I lodged an OIA request some time ago for

copies of any papers done by the Reserve Bank on statutory governance issues in the last two years  (i.e. since 1 July 2013).  To be specific, I am requesting:

  • any papers (draft or otherwise) provided to Treasury or the Minister of Finance on these issues
  • any papers provided to the Governor or the Governing Committee on these issues
  • any internal working or discussion papers on governance issues
  • any file notes or other records of discussions on these issues between the Governor, and the Secretary to the Treasury and/or the Minister of Finance.

The Bank has just extended my request for another month, telling me that they have found 9786 records or documents they need to check.  I suspect that means the initial search wasn’t very well-targeted, but there should be a few interesting documents to emerge in a month or so.  It will be interesting to see what model of change the Bank would prefer, if and when change comes, and their assessment of the pros and cons of the various approaches to dealing with the governance of the wide range of issues the Bank is given responsibility for.

It is a shame that the current government appears unwilling to address the issue.  It is one of those areas where change will almost certainly come, to bring Reserve Bank governance into line with modern public sector practice and the current responsibilities of the Bank.  It won’t surprise readers that I’m not a natural supporter of many Green Party issues, but I give them considerable credit for continuing to chip away at this issue.

Dairy lending and the Minister of Finance

I saw this Bernard Hickey piece yesterday afternoon, and have been mulling on it since.

Finance Minister Bill English has admitted the Government and Reserve Bank are in discussions with banks to ensure they don’t prematurely force dairy farmers into mortgagee sales that could trigger a dangerous spiral lower in land values.

If accurately reported (which it may not be), it is somewhat disconcerting.  What bothers me is the notion that the Minister of Finance (and perhaps the Governor of the Reserve Bank, although there is no confirmation of any involvement by the Bank) thinks he knows better than banks how to run their own businesses. Ministers of Finance often aren’t very good at presiding over the government’s own businesses – Solid Energy or Kiwirail anyone?

During the 2008/09 recession I did quite a lot of work at Treasury on dairy debt. Debt, and dairy land prices, had run up extremely rapidly in the previous few years, and there was concern about what the fall in commodity prices, and the seizing up in international funding markets, might mean for the dairy sector as a whole, and for those who financed them. I reminded the perennial optimists that the long-term real average dairy payout had been around $4.50 and that it would seem unwise to be planning (whatever one might hope for) on anything much higher in the medium-term future.

During that period, I took to describing dairy debt as “New Zealand’s subprime”. My point here was not that large losses were inevitable (in fact, in that episode NPLs did pick up quite notably, although not in a systemically-threatening way), but that the nature of the risk exposures were not generally well understood. At the time, banks were very dependent on wholesale market funding, and few offshore investors appreciated just how large New Zealand banks’ exposures to farms were (I recall checking out the US flow of funds data and finding that in an economy 100 times our size, farm debt in the US was only around 10 times that in New Zealand).

It was also never entirely clear that the Australian parents really appreciated the scale of the dairy debt boom, and competitive credit-supply war, their New Zealand subsidiaries had gotten into. And, of course, the market in agricultural land was not the most liquid in the world – like many markets there was reasonable liquidity in booms, and almost none in busts.   That illiquidity meant that it was very difficult for anyone to know the true value of the collateral underpinning dairy debt. As it was, dairy land prices fell very sharply (and never subsequently fully recovered the boom time peaks) even with very few forced sales. One of the risks of lending secured on farm land was that if one lender got very worried and starting a round of forced sales, it would seriously undermine the market value of the collateral other banks were holding. They all knew that – and they also knew about the goodwill in the rural community that had been burned off in the period of financial stress in the 1980s. And that created an incentive for what I describe as “hand-holding” – each tacitly agreeing (probably not in ways that create legal difficulties) to approach forced sales very very cautiously. That might seem a good outcome in some respects, albeit at the expense of transparency. In 2009 perhaps, with hindsight, it was: the downturn in dairy prices proved short-lived, and the recovery in the payout bought time for banks to manage out of their worst exposures.

But we didn’t know then, and we don’t know now, how long the low payouts will last for, and what either a market-clearing or equilibrium price for dairy land is. And when I say “we”, I include experts, stray bloggers, and the Minister of Finance and the Governor of the Reserve Bank. Uncertainty is a key feature of economic life, and one that people in positions of power too readily underestimate. There is probably a selection bias – people without a strong self-belief (and belief in their own views) tend not to end up at the top of politics. In some dimensions, the current position seems more worrying than the 2009 episode. Not much new debt has been taken on in recent years, and there hasn’t been a recent spiralling-up in land values. That suggests little risk of a systemic threat to the health of the banking system (but as I have noted previously it is not clear that the minimum risk weights the Reserve Bank requires on dairy exposures are really high enough). But, on the other hand, whatever is dragging milk prices so deeply down now is not the side-effect of a global liquidity crisis, the direct effects of which were reversed pretty quickly. Global commodity prices have now been trending down for several years, and there is little obvious reason to expect the trend to be reversed – although no doubt there will be plenty of volatility.

Perhaps there is nothing more to this story than a natural politician’s desire to sound sympathetic to business owners who find themselves in difficult conditions. I hope so.  But the Minister of Finance and the Governor of the Reserve Bank hold a lot of power over banks, and the fact that those statutory powers exist suggests it is even more important that the Governor and Minister avoid putting pressure on banks to make decisions that might suit a politician, but might not be in the interests of bank shareholders. Banks aren’t popular, but they are legitimate and important businesses, who are expected to make a return and act in the best long-term interests of shareholders. Plenty of times some discerning forbearance may have helped through a key customer in difficult times, but forbearance – whether by bank or regulator – can also be a recipe for worse problems, and bigger losses, down the track. The risks of that are much greater when people with no financial stake weigh in to try to tilt the attitudes of lenders. Neither the Minister nor the Governor has the information to make those calls well regarding dairy debt. In the Governor’s case, it is little more than a year since he gave this relentlessly optimistic speech, and I’m sure that without too much difficulty I could find similar examples from the Minister of Finance – it is, after all what ministers do.

Here is a link to my own piece on dairy debt from a couple of months ago.