Disclosure requirements: some anomalous laws

Parliamentary sovereignty is a key feature of our political and governance system. But sometimes parliaments end up producing rather anomalous results when we look from one piece of legislation to another.

Twenty years ago, the Reserve Bank moved to a system of prudential regulation of banks that was designed to rely heavily on public disclosure of key information on a regular basis. Disclosure was never envisaged as the only element of the regulatory regime. Basle 1 basic regulatory capital requirements were also in place, and were left in place as much at the request of the banks (who wanted to be seen as operating in an internationally-recognisable regime) as because of any conviction by the Reserve Bank that capital requirements were worthwhile. And the Bank and the Minister of Finance retained significant powers to intervene if a bank was getting into trouble, and was (or appeared to be approaching) insolvency.

But the proposition underpinning the disclosure framework was that investors (depositors, bond-holders) and others transacting with a bank should have all the information that the Reserve Bank had about a regulated bank. That seemed only fair and reasonable – after all, it was investors’ money that was at stake, not the Reserve Bank’s.  And if the Reserve Bank had private information that was not disclosed to depositors/investors that could, in the event of a subsequent failure, open the Reserve Bank up to charges (political and rhetorical, even if not legal) that it should have acted earlier, and thus prevented the losses investors/depositors subsequently experienced.  Private information might have supported the argument for government bailouts if things went wrong.

A lot of effort went in to devising the disclosure regime. In some areas it may have gone a little too far.  One example might have been requirements on banks to have Key Information Summary documents immediately available in every branch.  I suspect the number of these documents that were ever actually read was extremely small. The regime went to somewhat absurd lengths: someone who worked in the economics department of one local bank told me that their bank interpreted the regulations to mean that Key Information Summaries had to be available for perusal in the economics department (“branch”)  itself – a part of a bank not typically visited by the public.

Because so much weight was put on disclosure requirements, the law was written in a way that exposed those responsible for bank disclosure documents to significant penalties (including potential imprisonment) for breaches of the requirements. Don Brash has many stories to tell of the reaction of outraged directors (and puzzled ones in other jurisdictions). There had, perhaps, been a tendency for bank boards to be made up of people with gilded reputations, rather than much ability or willingness to ask hard questions about the conduct of the Bank. The prospect of such steep penalties certainly altered incentives, and behaviour.   Banks may, or may not, be safer, but directors have certainly gone to considerable lengths to minimise their own risks

In the last decade, the Reserve Bank has backed away from heavy reliance on the public disclosure aspect of the regulatory regime for banks. The disclosure requirements have themselves been watered down, and there are proposals for further reductions in the requirements in a recent Bank consultative document. This tendency seems unfortunate – despite inevitable complaints from banks about compliance costs. If anything, the focus globally in recent decades has been on more and more disclosure. Perhaps more concerning is the explicit shift the Reserve Bank has made to collecting private information about banks’ day-to-day activities and risks, information which is not available to investors and depositors.  The  Reserve Bank has been keen to promote the idea of its OBR tool being used in the event of a bank failure, so it remains the case that the regime is designed to be about depositors/investors being primarily at risk of losing money, not the Crown. And yet the Crown uses statutory powers to acquire information about these regulated institutions which depositors do not typically have access to.

But notwithstanding the diminished emphasis on disclosure, the Reserve Bank is still keen to remind people of the stiff penalties for breaches of disclosure requirements. In a speech only a couple of years ago, the head of the banking supervision department noted

Self-discipline is closely linked with sound governance. We have a strong tradition of director attestations, coupled with heavy penalties for non-compliance. For example, bank directors who fail to comply with disclosure obligations face fines of up to $200,000 or 18 months in prison.

Those are very stiff penalties for individuals, even if the scale of potential fines on the institutions themselves seems lighter (a maximum fine of $2 million –  banks typically have rather more than 10 times the equity of a typical director).

But, of course, banks are only one element of the financial system, and only one of the areas in which people are exposed to financial risk.  Another, in which people are typically quite risk averse, is superannuation schemes.   There is no prudential supervisory regime for superannuation schemes –  no government regulator actively scrutinises the business of schemes to minimise the risk of failure.  To a large extent, members of superannuation schemes are on their own.

However, there is a Superannuation Schemes Act, which is designed to provide some basic regulatory parameters and protections for members.  One key component of that regime is disclosure.  And that makes sense, how can members make good decisions, and help ensure that their money is safe, if they do not have access to information.

One of the key requirements is regarding scheme annual reports.  For members of superannuation schemes, the material in the Annual Report is akin to a disclosure statement for bank depositors.  But an important difference is that there is a quite a lot of public information available about banks, even if disclosure statements didn’t exist (credit rating information for example), whereas there is almost none about superannuation schemes.  The disclosures in the Annual Report are absolutely imperative.

There is an entire schedule to the Act which sets out minimum information that must be included in the Annual Reports.  That includes audited financial statements, disclosure of related party exposures, affirmations that contributions and payments have been made in accord with the rules of the relevant scheme.  And scheme trustees must also advise members of any amendments to the relevant trust deed since the previous Annual Report.  All of those seem pretty foundational.  You wouldn’t want to be in a scheme where the rules could be changed without you being aware of it.

Recall that breaches of disclosure requirements on banks could be met with both civil and criminal sanctions, with the latter including up to 18 months in prison.

And in the Superannuation Schemes Act?  Well, there, Parliament seemed to take a rather different approach.  Breaches of disclosure requirements are subject to a fine of up to $500.  No, there are no missing zeroes there, the maximum penalty is five hundred dollars.  I’m a trustee of a superannuation fund, and I was surprised to learn how light the potential criminal penalties are [1].  And yet people who are members of longstanding defined benefit pension schemes typically have far more money tied up in those schemes than most will have in any bank or other regulated financial institution.

I’m not quite sure why Parliament in 1989 had such a different approach to the importance of full  and honest legally-required disclosures than it had only a few years later when it came to consider the case of banks.

I’m not usually a fan of increased regulation, but if there is a good case for such disclosure laws at all, as there probably is with very long-lived commitments such as superannuation schemes, which often involve people in their declining years, then such slight penalties almost make a joke of the requirements.  Trustees might, for example, come to treat apparent breaches of such requirements as a matter of little account, even if the consequences for members of such breaches could have been serious.

I hesitate to encourage them, but this looks an issue for MBIE, in its policy role, and the FMA to take up.

[1] And apparently, and equally remarkably, there is apparently a two year statute of limitations on prosecuting such offences


As readers know, I have been putting a lot of weight on the unemployment rate. It isn’t a perfect measure of excess capacity, but it has lingered at uncomfortably high levels since the recession. Very uncomfortable for those who are unemployed, no doubt. But particularly when inflation has been persistently well below the agreed target midpoint, those unemployment numbers should also have been very disconcerting for people with responsibility for short-term economic management.

The Reserve Bank Governor began an OCR tightening cycle at the start of last year, and was still talking about further OCR increases as late as last December.

The red line in this chart is what the Reserve Bank thought was going to happen to the unemployment rate last March – the numbers from the March 2014 MPS projection. The blue line, by contrast, is what actually happened.

hlfs error

The first OCR increase was announced in March 2014. It takes a little while for monetary policy changes (even expected ones) to have much of an effect on the economy. By the September quarter of 2014, the unemployment rate had reached what now appears to have been a trough. Even by them, the unemployment rate hadn’t been falling as fast as the Reserve Bank expected. And since then, the divergence has grown materially. The Bank had expected the unemployment rate would be 4.9 per cent by now. In fact, SNZ tell us, it is 5.9 per cent. That is a difference of around 25000 people. And unemployment doesn’t just affect the people who are unemployed, but their spouses and families as well.

Is it all down to the Reserve Bank’s misjudgement? Probably not – and there is noise in the series – but monetary policy is our principal macroeconomic stabilisation tool. Mistakes on this scale, when there was no pressure to tighten in the first place, have to be sheeted home to those responsible. That is, very largely, the Governor.

Optimists have told stories about the unemployment rate holding up mainly because of rising participation rates. But participation rates have been rising in much of the OECD, and since September New Zealand’s participation rate has risen by only 0.2 percentage points.  It doesn’t explain the difference. The Reserve Bank seems to credit surprisingly high immigration with boosting unemployment, in defiance of all the evidence (and its own research) that shocks to population affect demand more than they do supply in the short-term.

The HLFS is a sample survey, and occassionally it does seem to give slightly rogue steers (notably the increase in the unemployment rate in 2012), but this time it doesn’t seem inconsistent with most of the rest of the labour market data, and in particular the absence of any resurgence in wage inflation. The uncomfortable truth seems to be that after rising more than 3 percentage points during the recession, the unemployment rate at 5.9 per cent is only about 0.5 percentage points below the average level for 2009 to 2012.

This is no small failing. Among all the OECD countries, the only ones whose current unemployment rates are higher, relative to pre-recession lows, are a group of countries in the euro-area with no ability to adjust monetary policy at all.

Sometimes a rise in unemployment is unavoidable. And forecasting is a mug’s game. But with what was always an anaemic recovery (by historical standards), with very weak price and wage inflation, and no external constraints (eg ZLB) on macroeconomic policy, there was no pressure on the Reserve Bank to tighten when it did. They could have held their hand, and let the numbers unemployed continue to fall. But they didn’t.

As I noted last week, I wonder how Graeme Wheeler explains this to the, now, 148000 unemployed people when he meets any of them? I really do.

In Fran O’Sullivan’s column in today’s Herald there is a report of the recent Minter Ellison Rudd Watts’ 2015 Corporate Governance Symposium in Auckland on Monday, attended by, inter alia, a number of “leading independent directors and chairs”. Participants were addressed by various independent directors, and O’Sullivan notes:

It was said that while the regulatory and social pressure on major organisations mounts, the 24-hour news cycle is shrinking to 24 minutes and accountability is increasing.

Where, the unemployed might wonder, is the accountability for the Governor?

Dairy: another day, another price slump

In the last 24 hours we’ve had two gloomy headline indicators out. The ANZ Commodity Price Index for July was out, with a record 11 per cent fall in the world prices of New Zealand export commodities. And the latest GDT auction saw another 10 per cent fall in whole milk powder prices, with portents of further falls to come.

Neither piece of news was that surprising on the day, but to say that is to risk underestimating the severity of what has been going on.

As the ANZ notes, the latest fall was the largest fall in the almost 30 year history of their series. What they didn’t mention is that it was the largest fall by a large margin. By an even larger margin it was the largest monthly fall in world dairy prices.

anz monthy changes

On the ANZ measure, the scale of the fall in commodity prices in the last year or so now matches what happened during the 2008/09 recession.

ANZ Commodity

For dairy prices themselves, the fall in the GDT index now materially exceeds the scale of the fall in 2008/09. Real dairy prices now appear to be around the lowest levels for 30 years – although not necessarily at levels wildly inconsistent with trends up to 2006.

ANZ commodity real USD dairy

The fall in commodity prices didn’t cause New Zealand’s recession in 2008/09. A drought didn’t help. Neither did lingering inflationary pressures that for a while made the Reserve Bank reluctant to cut the OCR. And, of course, there was the recession that engulfed the rest of the world, which in turn helped exaggerate the fall in commodity prices. So I’m not suggesting that the falls in New Zealand commodity prices necessarily mean we are now heading for negative GDP quarters, but the loss of national income is now large and the risks of some pretty bad outcomes must be rising. There are no forces operating in the other direction, to boost growth rates. The real exchange rate is only around 10 per cent below the average for the previous couple of years – as I pointed out the other day, that is a pretty modest adjustment by historical standards.

For a few years, I’ve been intrigued by how little growth there has been in real value-added in the agricultural sector. The terms of trade have been high, and in particular world dairy prices have been high, and yet over 10 years or so there has been almost no growth in what SNZ record as real value-added in the agricultural sector. Here is the most recent version of a chart I’ve run previously.

agriculture real GDP

Total factor productivity growth in agriculture has also been quite remarkably weak.

I’ve noted previously that some of this may have reflected the incentives of rising prices. It is well-known that dairy production processes have become much more input-intensive over the last decade or more.   Much of that is about supplementary feed, but it also includes irrigation and other more capital-intensive production models.  In principle, in the face of high product prices these additional inputs could improve the profitability of the agricultural sector, even though the real (constant price) value-added is not increased. If more inputs are being used to produce more outputs, and those outputs can be sold profitably, then it is just one of the ways in which farmers (and their suppliers) capture the benefits of the rising terms of trade.

I was never sure quite how persuasive that reassuring story was. But a reader has got in touch to point me to some papers which suggest that things might be nowhere near as rosy as that story suggests. A basic proposition of economics is that one should produce to the point where the marginal revenue from the additional production equals the marginal cost of doing so. Beyond that point, one starts losing money on every additional unit of production.

I don’t suppose anyone imagines that this model exactly describes how any single business actually operates.   But it is a tendency towards which economists typically, and implicitly, assume that firms in a competitive market will gravitate.  Why, for example, would one produce more if you were going to lose money on each new unit of production. And in the rural sector, where land is huge component of inputs, a farmer generating the highest rates of profit should be able to bid a higher price for land. Resources should gravitate to those best able to use them.

But there is no guarantee of this happening, especially over relatively short periods of time.

In their paper “The intensification of the NZ Dairy Industry – Ferrari cows being run on two-stroke fuel on a road to nowhere?”, presented at an agricultural economics conference last year, Peter Fraser and two co-authors (Warren Anderson, an academic at Massey, and Barrie Ridler,a Principal at Grazing Systems Limited) argue that many New Zealand dairy farmers have been applying anything but the principle of producing until marginal revenue equals marginal cost.  I spent quite a bit of time working with Peter during the 2008/09 dairy price crash – I knew about debt but he (at MAF) knew, and taught me, a lot about dairy. I have a lot of time for his (often-trenchantly-expressed) views.

Fraser et al argue that most of the farm models used by farmers and their advisors in New Zealand take an average cost approach rather than a marginal cost approach, which is inducing increases in production beyond the point of profit maximisation.

none of the mainstream dairy industry farming simulation models (e.g. the Whole Farm Model, Farmax, DairyMax, Udder) and performance measures (e.g. information derived from Dairy Base or Red Sky, benchmarks such as milksolids per hectare, average profit per hectare, gross farm returns, production at x percentile, etc.) are economic models or measures as none employ marginal analysis. As a result, none can profit maximise at a farm level and all are likely to lead to a production decision where marginal costs are greater than marginal revenue.

They argue that this misinformation has not been driven out by competitive processes partly because many dairy farmers are not necessarily setting out to be profit-maximisers.

The corollary is that if farmers are focused on accumulating assets then a ‘satisficing’ position of having sufficient cash flows to pay drawings and to service debt is likely to suffice. Critically, this can also explain why more resources are flowing into the dairy industry: farmers are willing to borrow (and banks willing to lend) in order to accumulate assets (and potentially realise [untaxed] capital gains, especially if converting a dry stock farm into a dairy farm, as this is akin to property development).

In short, a combination of systemic misinformation combined with farmer motives can go a fair way towards explaining why a $10 note may be left on the pavement after all.

One can debate whether this explanation for why is wholly persuasive (the more aggressive dairy developments in recent years, seem far removed from the traditional Waikato or Taranaki (satisficing?) family dairy farmer), but the fact that many farmers are not getting good marginal-based advice and analysis does seem reasonably clear.

Fraser et all go on to support their case with results from a Lincoln University model farm, suggesting that using more sophisticated models (using marginal analysis) profit maximisation would typically result from milking fewer cows (per hectare).

The argument appears to be that much of the growth in total milk production in New Zealand in recent years (perhaps 10-15 per cent of total production) is resulting from an average-cost led focus on boosting total production, rather than maximising profits. Even at the higher prices that were prevailing until recently, production volumes should probably have been lower (the authors also note the potential environmental benefits).

Quite how all this feeds into thinking about the current situation, and the likely response to falling payouts, I’m not sure.   Marginal revenue is plummeting, and even an average-cost based approach would presumably lead to some reduction in production. On the other hand, there is an awfully large stock of debt to service, and maintaining production levels remains sensible if (but only if, and only to the extent that) current payouts are covering short-run marginal costs.

Relatedly, a reader notes:

I would contend that the family farming structure adapts more readily to the pressure of a price slump. The corporates’ general means of survival is by committing more capital to sustain an existing production plan. Family farms shift more quickly into survival mode and if the household has a trained nurse or teacher sends her back to work to support the family household! The dairy industry in its drive to maximise total production has blithely discarded the flexibilities inherent in the cooperative based systems developed over the previous 150 years. It seems there may be a price to be paid for that negligence.

On which note, however, I have long been struck by the production response of the New Zealand dairy industry to the collapse of export prices in the Great Depression   If one didn’t price the farmer’s family labour, short-run variable marginal costs were presumably extremely low, and there was a great deal of debt to service.

dairy depression

I don’t claim expertise in this area, but I found the analysis stimulating and one reconciliation for those otherwise puzzling GDP data I showed earlier. It does look as though participants in the industry will need to think harder about how best to maximise returns, not just production. I like driving obscure and remote roads when we travel the country on family holidays, and I’m often prompted to wonder about the economics of collecting milk from the remote suppliers that linger in such places, and just how long that can go on.  On its own that is a small issue, but perhaps symptomatic of an industry not yet adequately focused on medium to long-term profit maximisation.   Industry structure issues often crop up in the context of discussions like this.  Co-operative structures or not should be a choice for farmers – and they are common internationally in the dairy sector – but direct government legislative interventions facilitated the existing, less than fully competitive, industry structure. So far, the gains to New Zealand from having done so are less than fully apparent.