Ten years on

It is the season for books and articles reflecting on financial crises of a decade or so ago, the aftermath, and whatever risks might –  or might not –  be building today.  The collapse of Lehmans –  and the wise decision of the US authorities not to bail it out –  was 10 years ago this month, and although the US crisis had been underway for at least by a year by then, the Lehmans moment seems set to take a place in historical memory around the Great Recession rather parallel to the sharp falls in US share prices in October 1929 (the ‘Wall St crash’) and the Great Depression.  Not in any real sense the cause of what followed, but the emblematic moment in public consciousness nonetheless.

I’ve just been reading the big new book, Crashed: How a decade of financial crises changed the world, by esteemed economic historian Adam Tooze.  I might come back to it in a separate post, but for now would simply caution people that it is less good than his earlier books (around the Nazi economy, and the economic history of the West after World War One running into the Great Depression) had led me to hope.

But on a smaller scale, I picked up the Listener the other day and noticed on the front cover ’10 years after the GFC, former Reserve Bank governor Alan Bollard warns of new risks’.  Conveniently, I see that the article is freely available online.  The sub-heading tantalises potential readers

Former New Zealand Reserve Bank governor Alan Bollard warns that, although lessons were learnt from the global financial crisis, new risks have emerged that could trigger a repeat contagion..

Alan Bollard writes well, and often quite interestingly.  Extremely unusually (and in my view quite inappropriately), he actually published a book on his perceptions of the previous crisis in 2010, while still very fully-employed as Governor, a senior public servant.  There were quite severe limitations as to who, or what, he could be critical of (as I was reminded last night rereading my diaries of some crisis events I was closely involved in, and the Bollard published perspective on those events).     The Bank’s early reluctance to take seriously the emerging issues, as they might impinge on New Zealand, is not, for example, something you find documented in the book.

He must be in a somewhat similarly difficult position now.  He is Executive Director of the APEC secretariat, that grouping of Asian and Pacific (loosely defined) countries and territories, that includes China, Russia, the United States, Indonesia and so on.  I dare say Xi Jinping and Donald Trump won’t be watching nervously to see what Alan Bollard is saying, but the Executive Director knows that there are quite severe limits to what public servants can say while in office.

And, thus, much of the Listener article is a bit of a, perhaps slightly rose-tinted, rehash of some of the policy responses here and abroad (I will come back to deposit guarantee schemes on the tenth anniversary, next month).  There is some loose descriptive stuff on various developments in parts of the APEC region.  There was the suggestion that some countries (actually “much of the region”) in Asia is “anxiously worrying” about whether they could face a Japan-like low productivity future but to me, Japan still looks pretty attractive by regional standards.


(New Zealand, for example, is at 42.)

In fact, I looked in vain for the promised analysis or description of the “new risks” that might “trigger a repeat contagion”.   Perhaps that was never Bollard’s intent, but the Listener had to attract readers to a fairly tame advertorial for APEC somehow.  The most we get is

We need to remember that the global financial crisis was originally triggered by a building bubble, and that is still on the minds of regulators throughout the region.


Meantime, we are very worried about the likely effects of the growing trade wars. It is too early to judge, but the stakes are high – trade growth has been the big driver behind the immense improvement in living standards through the Asia-Pacific region ……We are now on the alert for signs that these trade frictions could weaken exchange rates, hurt commodity prices, hit stock markets or cause financial volatility, against an unusual background of tightening monetary policy and loose fiscal policy in the US.

But then what more could a serving diplomat, not hired to be a high-profile problem solver (unlike, say, the head of the IMF) really say?

And it all ends advertorial style

As a big trader, New Zealand has always been susceptible to these tensions. But one international platform where they play out is coming closer: in just over two years, New Zealand will commence its year of hosting Apec. The organisation is a voluntary, consensus-driven one, where for 30 years we have promoted regional economic ties and tried out new ideas for trade and investment. As the upcoming chair of Apec, New Zealand will have to contend with continuing antiglobalisation pressures, big-economy tensions, climate-change damage and financial risks in the region. It sounds daunting, but there are many positives: We have learnt some of the lessons of the global financial crisis; banking regulation is tougher; banking chiefs are more cautious; economic demand is still growing; and the Asia-Pacific region is tied ever more closely by its trade flows.

It could have been a paragraph from a speech by one of his political masters.   I guess one wouldn’t know that one of his members (the People’s Republic of China) poses an increasing political and military threat to another (Taiwan) or –  closer to his own territory –  that few major economies have very much effective macroeconomic firepower at all when the next crisis or severe recession hits.  And really nothing at all about financial sector risks.  His final sentence –  “September 2018 should be a month much better than September 2008” –  is almost certainly true (at least outside places like Turkey and Argentina) but not really much consolation to anyone.

In his column in the Dominion-Post this morning, Hamish Rutherford touches a theme of various recent posts here: the limited macro capacity of many countries.  He rightly highlights how low global interest rates are, and the much higher levels of government debt in many countries.

To make matters worse, interest rates are already so low that some economists are speculating that if the Reserve Bank was to respond to a slowdown by slashing interest rates, in a bid to stimulate the economy, it may find that little of the money finds its way to households.

Debt levels among the world’s leading economies are, by and large, far higher than they were a decade ago. In the US, as well as threatening to kick off a global trade war, President Donald Trump’s administration is running the kind of deficit that would be wise in a recession, but at the late stage of a long economic growth cycle appears reckless.

But there was one point I wanted to take issue on.  He argues

Back in 2008, New Zealand benefited from its largest trading partner, Australia, avoiding recession and having almost no debt. This time Australia’s debt is climbing and there are doubts as to whether Canberra will have the discipline to return to a surplus, as the political state becomes more populist.

I don’t think that is true about either the past or the present.  We didn’t get any great benefit out of Australia’s fiscal stimulus in 2008/09, largely because if fiscal stimulus hadn’t been used, the Reserve Bank of Australia would probably have cut their official interest rates further.  Fiscal policy can be potent when interest rates have the effective lower limit, but they hadn’t in Australia (or New Zealand).  More importantly, and for all the New Zealand eagerness to bag Australian politics and policies, here is the OECD’s series of the net financial liabilities of the general government (federal, state, and local) for Australia and New Zealand, expressed as a share of GDP.

debt govt au and nz

Australia’s net public debt has been consistently below that of New Zealand for the entire 25 years for which the OECD has the data for both countries.  The gap is a little smaller now than it was a decade ago, and (on a flow basis) the New Zealand budget is in surplus but Australia’s isn’t.  But if there is a desire to use large scale fiscal stimulus in the next serious downturn, debt levels themselves aren’t likely to be some technical or market constraint in New Zealand, and even less likely in (less indebted) Australia.

And finally in this somewhat discursive post, a chart I saw yesterday from the BIS.

real house prices BIS

A story one sometimes hears is that low interest rates have driven asset prices sky-high setting the scene for the next nasty crisis.  Even if there are elements of possible truth in such a story, the story itself mostly fails to stop to ask about the structural reasons why interest rates might be so low.   All else equal, had interest rates been higher asset prices probably would have been lower – and CPI inflation would have undershot targets even further.  But as this particular chart illustrates, across the advanced economies as a whole real house prices now are much same as they were at the start of 2008.  That isn’t true in New Zealand (or Australia for that matter).  Interestingly, even in the emerging markets –  centre of current market unease –  real house prices are still not 15 per cent higher than they were at the start of 2008, when interest rates generally were so much higher.

But then only rarely is the next major economic downturn or financial crises stemming from quite the same set of financial risks as the last one.

A modestly indebted advanced economy

Sometimes people like to give the impression that New Zealanders are highly indebted.   And so this summary chart, which I stumbled on this afternoon, is some helpful context.

total debt

Among advanced economies, only in Israel and Germany is total debt/GDP lower than in New Zealand.

And also among advanced economies, only Denmark, Israel, and Germany had less of an increase in economywide debt/GDP over the 10 years to the end of 2017 (encompassing the recession and aftermath and subsequent recovery).

A decade ago, a comparable chart would have looked quite different.  I recall getting someone to dig out the data in about 2008 or 2009 which showed that our total debt/GDP ratio had increased in the previous few years about as much as the increase in Japan in the late 1980s (and all the increase was business and household).   And with most other advanced countries having materially increased their debt/GDP ratios over the last decade, New Zealand a decade ago would have been nearer the middle of the pack for the stock of debt than it is now.

Total debt to GDP calculations include household, corporate, and government debt.    As I showed in a post a couple of weeks ago, household debt to GDP hasn’t changed much here.  Government debt to GDP has increased a bit, and corporate debt to GDP also won’t have changed much.

Of course, those who want to remain worried about the New Zealand situation –  if I recall rightly the Governor said he was `scared’ –  will point out the role that big increases in government debt played in many other advanced countries.  Household debt to GDP has not changed very much in some of those other countries either.   But who is government but a collection of households?  We are the ones who have to service government debt.  And in many of these other countries, the total debt/GDP numbers will be understated because public service pension liabilities (contractural obligations) are not typically included in the debt numbers.  In New Zealand, there are almost no such liabilities, and those there are are properly accounted for.

Add in the reduction in the ratio of the net international investment position (net liabilities) to GDP over the last decade, and the picture is one in which debt should be much less of a concern here than in almost all advanced economies, and than in many – perhaps most –  emerging markets economies.  In a better world –  more business investment, on a path to more productivity –  we might perhaps have hoped there would have been more business debt being taken on.


Financial Stability Report and a lack of accountability

When Parliament legislated to require the Reserve Bank to publish six-monthly Financial Stability Reports this is what they said in the two relevant clauses

162AA Purpose of accountability documents

The purpose of the 3 accountability documents required under this Part is as follows:…..

 (c)financial stability report: to—

(i) report on matters relating to the soundness and efficiency of the financial system and other matters associated with the Bank’s statutory prudential purposes; and

(ii) allow assessments to be made of the effectiveness of the Bank’s use of its powers to achieve its statutory prudential purposes. 

165A Financial stability reports

……(2) A financial stability report must—

(a) report on the soundness and efficiency of the financial system and other matters associated with the Bank’s statutory prudential purposes; and

(b) contain the information necessary to allow an assessment to be made of the activities undertaken by the Bank to achieve its statutory prudential purposes under this Act and any other enactment.

Financial Stability Reports over the years seem to do a passable job of reportage –  a collection of sometimes-interesting charts and some text recounting (although only rarely analysing, or putting in context) what has been going on on the financing side of the New Zealand economy.   There are usually some fairly perfunctory updates on policy issues the Bank is considering.

But what is very rarely there is the sort of information that would enable us to really assess the Bank’s use of its powers and the conduct of policy under the various relevant acts.  There is never any critical self-scrutiny; it is as if the Bank thought itself beyond error.

Of course, supply tends to respond to demand.  There is little searching scrutiny of the Reserve Bank at the Finance and Expenditure Committee, and not much more from the media (the level of questioning at the Governor’s press conference this morning seemed weaker than usual).

What do I have in mind about weaknesses in today’s document?

Remarkably, there is no substantive discussion in today’s Financial Stability Report of CBL, the insurance company, regulated by the Reserve Bank, that the Bank petitioned to have put into interim liquidation earlier in the year.   I’m not aware of any reason to think the Reserve Bank acted inappropriately in this matter, but it is a fairly significant institutional failure (on the Bank’s watch), and a fairly significant set of regulatory actions, including the (at least somewhat questionable) use of gagging orders to prevent the company telling its own shareholders and customers about regulatory interventions.  Then again, remarkably no journalist asked a single question on this topic.

Readers will also recall the scathing feedback on the Bank’s prudential regulatory side in the recent New Zealand Initiative report, and survey of regulated entities.  There was, for example, this chart, comparing Reserve Bank and FMA results for the KPIs where the Reserve Bank scores worst in the survey.

partridge 1

This report had come out since the last FSR.  In a newspaper interview a while ago, the Governor had appeared to indicate that he was going to take it seriously, with comments like these

“This place is a diamond, but it needs significant polishing in places,” Orr said in an interview in the Reserve Bank headquarters.

“We need to think much harder about how we behave, how we roll, how we explain, how we do things. That’s a cultural challenge for the bank.”


As well as posting the comments of the report on the Reserve Bank’s internal intranet, Orr had written to bank bosses with the message that: “Hey, this doesn’t print well. We hear you. We need to do something about it.”

Interestingly, he actually talked then of problems in the Bank’s own culture.  But in his main accountability document for the financial regulatory functions, there was no reference to the survey, no comment on cultural issues at the Bank (all while continuing to bash banks), no comment on improving the Bank’s own performance, no nothing.

And, remarkably, the Governor faced no questions on the matter, even though the survey had almost handed them the data with which to grill the Governor.  Perhaps the journalists have forgotten, but the counterpart to the delegation of extensive powers to unelected officials has to be serious scrutiny and accountability.  There appears to be almost none here.

Similarly –  and somewhat remarkably –  the Governor managed to avoid any questions about his “culture war” by noting that he and the FMA would be appearing before a select committee this afternoon, and suggesting deferrring questions.  But I don’t suppose he will be holding a press conference after that appearance, and questions from MPs are likely to be as weak as ever, more interested in associating with the Governor than in holding him to account.

And this failure to ask questions was perhaps more remarkable given that the press release the Governor put out with the FSR  bears the heading “Banking culture in the spotlight”.   Reading that headline one might have expected a substantive treatment, but in the press release there was just the unsubstantiated claim that “an ongoing driver of financial soundness is the conduct and culture of banks”.  To which one can only respond, well yes loans that turn bad tend, in sufficient volume, to be what brings down banks, but misjudgements about big picture credit quality, and the overoptimism that takes hold (of bankers and regulators) in boomtimes, aren’t the sort of stuff the Australian Royal Commission –  which the Governor always tries to associate with –  is about.  Here is what he had to say about that (cutesy picture and all)


Quite how evidence in an inquiry which has not yet reported can really illustrate anything conclusive –  let alone the connection to the soundness of the financial system –  is a bit beyond me.  The Governor seems more keen on his populism, and on associating himself with a highly political Australian inquiry, than on actually identifying specific reasons for concern here.   Perhaps he will explain himself this afternoon?

Reverting to other stuff, there was this extraordinary line in the Governor’s press release

The high dairy-farm indebtedness, and the fact that LVRs were necessary, reflects that banks’ allocative efficiency – eg deciding how much to lend to whom – can be impaired due to the pursuit of short-term, rather than longer-term, profits.

It is an almost incoherent sentence.  For a start, New Zealand bank loan losses have remained consistently low for several decades now –  even the farm losses in the last recession were pretty modest in the scheme of things.  Secondly, you can’t argue –  as a regulator –  that the fact you acted (in this case imposing LVRs) is evidence of a problem.  There might –  as I would argue –  have been no need for LVR controls in the first place –  after all, the Bank’s stress test results have consistently highlighted the resilience of New Zealand banks, and of the system as a whole.  And thirdly, if even there were to be a large stock of troubled lending that would not, of itself, suggest some systematic flaw n the way banks were allocating credit.  None of us –  not banks, not central banks –  operate in a full information world.  Sometimes, events will turn out differently than either lenders or borrowers expected.  That isn’t an indication of any sort of structural failing.   We might reasonably expect rather more substantive analysis before the Governor starts impugning the business decisions of private companies. but……there was nothing else in the report to back up his claims.  (And no cognisance of regulator failure either.)

Somewhat related to this was the pretty unsatisfactory discussion of the housing market, both in the document and the press conference.   The Bank consistently fails to recognise that land use regulation is the key factor explaining the high level of house and urban land prices: against that backdrop, bank lending practices are likely to be of little more than marginal importance.  Thus, they talk like this

housing fsr

But they never once recognise that if the mix of regulatory and population pressures keeps making land artificially scarce, high levels of bank credit are just necessary to accommodate people getting into the increasingly high-priced market.  In that case, credit is at worst a lubricant, a facilitator, but not either the cause or the real problem.  (The Bank might want to argue differently, but if so surely they owe us rather better and deeper analysis.)

There were a couple of interesting snippets in the report.  The smaller one was this comment on the next stage of the review of the Reserve Bank Act

Both the Reserve Bank and the Treasury have provided advice to the Minister of Finance on the scope for Phase 2. The terms of reference for Phase 2 will be published by the Government in June. Phase 2 will be a significant undertaking and could take a number of years to complete.

That suggests the untrammelled rule of the Governor alone –   in the financial stability area –  could continue for some considerable time.  That is unfortunate, especially as there is less effective accountability for the Governor around these functions than around monetary policy (where accountability is weak enough).  Nonetheless, I will look forward to seeing the announcement in June.

The other interesting snippet was Box C, a report on a benchmarking exercise undertaken in respect of a sample portfolio of dairy loans.

The exercise required the banks to measure the risk of the same portfolio of loans to 20 hypothetical dairy farms. These farms represented a range of characteristics and varying degrees of risk. Banks were then provided with financial data and descriptive information for each farm, as well as the details of the hypothetical loans.

The preliminary results of the exercise indicate significant differences in estimates across banks. The highest and lowest average risk weight for the whole hypothetical portfolio differed by 40 percentage points, leading to differences in the hypothetical capital requirement.

Variation in both PD [probability of default] and LGD [loss given default] was was significant. Figure C1 shows the range of average PD estimates across five groups, each containing four loans, ranging from the group of loans with the lowest estimated PDs to the group with the highest estimated PDs. Each line represents the estimates of one bank, before overrides. Absolute variation was largest at the mid- to high-risk end of the spectrum, but proportionate variation was large across all levels of risk. The model overrides applied by banks tended to reduce the variation across banks, but it remained significant.

dairy PD

These are big differences.  The Bank reports that

The provisional results show significant variation in model outcomes, even for the same level of underlying risk. The Reserve Bank is conducting further analysis of banks’ farm lending portfolios to see if patterns in actual risk estimates are consistent with the results of the hypothetical exercise. This work will help inform the Reserve Bank’s review of bank capital requirements.

There are at least two quite different ways of looking at such results.   One could treat them as evidence that “banks can’t be trusted” to get these things right, and that the Reserve Bank should just be setting all the key parameters that feed into calculations of capital requirements.  But one could also see them as a reminder of the uncertainty of the world in which we live, and that equally intelligent people can at times assess the risks of a particular type of loan quite differently.  There is –  or should be –  information in that difference.  That information would be lost if the Reserve Bank  was simply imposing its estimates, the more so as there is no particular reason to suppose that Reserve Bank staff are better able to assess risk than employees of an institution that has its own money on the line.

Without consistent evidence that one bank has been better than the others at assessing risks on particular types of loans, the Bank should be hesitant about what it does with the results of such benchmarking exercises.  As I’ve argued previously for stress tests, perhaps transparency is the best way forward.  Our Reserve Bank  – unlike say the Bank of England –  doesn’t publish stress test results for individual banks.   As the chart above illustrates, it also doesn’t publish information from benchmarking exercises by bank.  Perhaps they should.

Overall, it was another Financial Stability Report that –  for all the cutesy pictures –  fell well short of the level of self-scrutiny and openness that citizens should expect from such a powerful agency (and individual).   And the way the Bank completely passed over the very negative detailed feedback it had received only recently on its own performance, suggests that the cultural failures that dogged the Bank during the Wheeler years might be less likely to be seriously addressed under the new Governor than I’d hoped.

For example, if culture and conduct issues really worry the Governor, perhaps he should start closer to home, and demonstrate consistent excellence, transparency, and accountability as a regulator.  There is plenty of scope to clean up his own house. Physician heal thyself, and all that  (here and here).




Scathing feedback on the Reserve Bank

Late last week the New Zealand Initiative released its report Who Guards the Guards? Regulatory Governance in New Zealand which has a particular focus on the Financial Markets Authoritiy, the Commerce Commission, and (in its financial regulatory/supervisory roles only) the Reserve Bank.  All three are important economic regulators and, if we are going to have such entities, it is important that they are well-governed, and performing excellently (with associated accountability and transparency) the roles Parliament assigned to them.

As part of putting together the report, the New Zealand Initiative undertook a survey

To assess how well our regulators are respected, we surveyed New Zealand’s 200 largest businesses by revenue, together with those members of The New Zealand Initiative not otherwise included as members of the ‘top 200’. In practical terms, this approach allowed adding a sample of New Zealand’s leading professional services firms – accountants, lawyers and investment bankers – into the pool of businesses covered by our survey.   Only one response per organisation was permitted.

And this is what the survey covered

We asked survey respondents both to:
a. rank the regulators they interact with based on their overall respect for them; and
b. rate the performance of the three regulators most important to their respective businesses against a range of KPIs.

The KPIs were based on a combination of the best practice principles identified by the Australian Productivity Commission’s Regulator Audit Framework, and from a similar survey to our own commissioned by the New Zealand Productivity Commission for its 2014 report. The questions were designed to obtain a broad view of regulatory performance, and as such did not enquire into the merits of individual regulatory decisions or the fitness-for-purpose of individual regulators.

Rather, the KPIs cover issues like commerciality, communications, consistency, predictability, accountability, and so on.

For some regulatory agencies –  there were 20+ covered –  there were lots of responses: some regulation is pretty pervasive.  For others with a very sector-specific role, including the Reserve Bank, there were only a relatively small number of responses (8) –  but it seems likely that all the major banks and some other smaller institutions will have responded.

The Initiative is clear that it is a survey of the regulated.  That is not the only, or even the most important, perspective in assessing a regulatory agency.  Regulatory agencies are supposed to work in the public interest, as defined by Parliament, and that means constraining the actions/choices of individuals and firms.  Regulation is intended to prevent people doing stuff they would otherwise choose to do, or compel them to do stuff they would otherwise not choose to do.  In other words, one should worry if a regulator is popular with those it regulates.  Indeed, one of the big risks in any regulatory system is that the regulator and the regulated form too cozy a relationship  –  in which there is some mix of regulators making life easy for the the regulated (eg coming to identify more with the interests and perspectives of the regulators) or regulators in effect working with the bigger and more connected/established of the regulated entities to make new entry and competition less easy than it should be.

The Initiative acknowledges the point to some extent

Of course, we can expect regulators to be unpopular at times with the businesses they regulate. It is, after all, their job to place boundaries on what businesses can and cannot do. But just as we expect communities to respect the police, we should also expect the regulators of commerce to have the respect of the businesses they regulate.

Personally, I’m not sure I’d go that far. I don’t expect “communities to respect the police”, but expect (well, vainly wish) the Police to earn the trust and respect of the community.  But whether or not “respect” is quite the right word, regulated entities should be able to offer some insights that are useful in evaluating regulatory institutions.  And that is perhaps particularly so when, as in this exercise, the survey covers a wide range of regulatory institutions at the same time.   If one institution scores particularly badly relative to others –  particularly others in somewhat similar fields –  it should at least provide the basis for asking some pretty hard questions about the performance of that agency, and of those responsible for it (officials, Boards, Ministers etc).

In this survey, the Reserve Bank’s financial regulatory areas scores astonishingly badly.   I first saw the results months ago when I was asked for comments on the draft report, but even with that memory in mind, rereading the Reserve Bank results (from p 60) over the weekend made pretty shocking reading.

Here is one chart from the report, comparing Reserve Bank and FMA results for the KPIs where the Reserve Bank scores worst.

partridge 1

In summary

In the ratings, the RBNZ’s overall performance across the 23 KPIs was poor. On average, just 28.6% of respondents ‘agreed’ or ‘strongly agreed’ that the RBNZ met the KPIs and 36% ‘disagreed’ or ‘strongly disagreed’. These figures compare very unfavourably with the FMA’s average scores of 60.8% and 10.3%, respectively.  They also compare unfavourably (though less so) with the Commerce Commission’s averages of 39.9% and 25.8%, respectively.

There simply isn’t much positive to say.

One of my consistent themes has been the lack of accountability of the Reserve Bank, across all its functions.  The regulated entities seem to share those concerns.

partridge 2

As part of the survey, interviews were also conducted to fill out the picture the data themselves provided.

Like the survey results, the views of interviewees were also largely [although not exclusively] negative.

The criticisms related both to the RBNZ’s capabilities and processes, and the substance of its regulatory decision-making.
In relation to process and capability, criticisms included the following issues:
a. Lack of consistency in process: One respondent noted that the internal processes of the RBNZ’s prudential supervision department, which is responsible for prudential supervision, can be ‘random’. The respondent referred to long delays between steps in a process involving regulated entities, followed by the imposition of requirements for more-or-less immediate action from them.
b. Lack of relevant financial markets expertise among staff: This was a common
theme. One respondent noted that until the 2000s, there was “regular interchange
of staff between the banks and RBNZ,” meaning RBNZ regulatory staff had firsthand finance industry expertise. But this has changed with the banks moving their head offices to Auckland and the RBNZ based in Wellington. As one respondent said, “They will always struggle to get good people [with financial markets expertise] in Wellington, especially with the banks now in Auckland… this makes interchange impossible.” Another said, “RBNZ [staff are] completely divorced from the reality of how things are done.”  More colourfully, another said, “[RBNZ] is all a little archaic… Entrenched people don’t get challenged.” Another said, “On the insurance side, the level of capability is less than with the banks. There is a potential risk to policyholder protection. RBNZ ends up just focussing on the minutiae.”
c. Lack of commerciality: This concern is allied to both the expertise issue noted above, and the materiality issue noted below. As one respondent said about the RBNZ’s ‘deafness’ to the need for a materiality threshold before a matter becomes a breach of a bank’s conditions of registration, “RBNZ says, ‘If it’s not material just disclose it’. But that’s a regulator way of thinking. They don’t understand the commercial, reputational implications.”
d. Unwillingness to consult or engage: As one respondent said, “I would call them out for not truly consulting.” Another said, “The RBNZ upholds independence to the point that it precludes constructive dialogue.” Several respondents drew a contrast with the FMA, noting that the RBNZ was happy to issue hundreds of pages of “prescriptive, black letter requirements,” but “without much or any guidance” for the banks on their application. One respondent did note, however, that the RBNZ “isn’t resourced to spend time doing this [issuing guidance].”
e. Lack of internal accountability: Several respondents perceived a lack of oversight from the most immediate past Governor, Alan Bollard, in either engaging with the banks over concerns about prudential regulation or trying to resolve them. One respondent noted, “Staff are often running around doing things without serious scrutiny from above.” Another said there is a group “with no accountability within the RBNZ… They favour form over substance and seem to enjoy exercising power.” Another commented it was “unclear how much information flowed up to the RBNZ Board,” but that if the Governor were accountable to the board for prudential regulation, then the board “could be useful in pulling up entrenched behaviour.” Another noted that the RBNZ’s  governance structure meant it did not benefit from outside perspectives: “[t]he value of diverse thinking is to challenge, so you don’t get capture by one person’s view.”

Two main criticisms were made in relation to substance:
a. Materiality thresholds: Several respondents highlighted the lack of a ‘materiality
threshold’ before RBNZ approval is needed either for:
• changes to banks’ internal risk models in the Conditions for Registration of
banks; or
• changes to functions outsourced to related parties.
One respondent noted that without a materiality threshold, the new requirement
for a compendium of outsourced functions – and for approval of any change to
outsourcing arrangements with a related entity – could lead the Australian-owned
banks to cease outsourcing functions to related entities, thereby increasing costs and
harming customers.  Several respondents noted that the lack of a materiality threshold could be attributed to a lack of trust in the banks by the RBNZ staff responsible for prudential regulatory decisions. As one respondent put it, this led the RBNZ to “insist on approving absolutely everything.”

Although this view was not shared by all banks, one respondent noted that even
APRA – long regarded as a more heavyhanded, intrusive regulator than the RBNZ
– was “now more reasonable to deal with than the RBNZ.”

b. Black letter approach: Along with the lack of a materiality threshold in the RBNZ’s
regulatory regime, several respondents commented on the RBNZ’s “black letter”
approach to interpreting its rules: “If RBNZ had two or three public policy experts
who could bring a ‘purposive approach’ to interpretation, that would be hugely positive.”   Another said, “[The RBNZ] has an overly legalistic approach which ignores the purpose of the legislation,” and that “what they’re doing undermines [public] confidence over things that are of no risk.” Several survey recipients noted that this was in stark contrast to APRA’s approach to public disclosure in Australia.

Another respondent put the concern differently, saying the problem was less
about the RBNZ’s ‘black letter’ approach to its rules, and the opaqueness of the rules,
and more about the lack of guidelines from the RBNZ explaining them, an issue the
respondent put down to a lack of resources.

There is more detail there than most readers will be interested in. I include it because the overall effect builds from the relentness of the critical comment.   I’m not even sure I agree with everything in those comments –  but they are clearly perspectives held by regulated entities –  and I suspect that reference to Alan Bollard is really intended to refer to Graeme Wheeler.  But taken as a whole, it is an astonishingly critical set of comments and survey results, that most reflect very poorly on:

  • former Governor, Graeme Wheeler,
  • former Head of Financial Stability (and Deputy Governor and “acting Governor” Grant Spencer),
  • longserving head of prudential supervision, Toby Fiennes
  • the Reserve Bank’s Board, including particularly the past and present chairs, Rod Carr (who had had a commercial and banking background) and Neil Quigley.

And given the enthusiasm of the Bank to emphasis the role of the Governing Committee in recent years, it probably isn’t a great look for the new Head of Financial Stability, and Deputy Governor, Geoff Bascand – he of no banking/markets experience, no commercial perspective, and little regulatory experience – who sat with Wheeler and Spencer on the Governing Committee over the previous four years.

One would hope that the new Governor, the new Minister, and the Treasury and the Board, are taking these results very seriously, and using them to, inter alia inform the shaping of Stage 2 of the review of the Reserve Bank Act.  I’ve not heard any journalist report that they’ve approached the Reserve Bank  –  or the Board or the Minister – for comment on the report and the Bank-specific results.   But such questions need to be asked, and if the Bank simply refuses to respond or engage that in itself would be (sadly)telling.

In the report the New Zealand Initiative authors make much of comparisons with the FMA.  In respect of the survey results, that seems largely fair.  The data are as they are.  But as I’ve noted in commenting a while ago on an op-ed Roger Partridge did foreshadowing this report, I’m not entirely convinced (nor am I fully convinced about the criticisms of the FMA’s predecessor the Securities Commission, which was asked to do a different job).

Partridge cites the Financial Markets Authority as a better model.  In many respects, the FMA is structured like a corporate: the Minister appoints (and can dismiss) part-time Board members, and the Board hires a chief executive.  But it is worth remembering that the FMA has quite limited policymaking powers: most policy is made by the Minister, whose primary advisers on those matters are MBIE.   The FMA is largely an implementation and enforcement agency.  That is a quite different assignment of powers than currently exists for the Reserve Bank’s regulatory functions (especially around banks).  Also unaddressed are the potentially serious conflict of interest issues around the FMA Board, in its decisionmaking role. More than half the Board members appear to be actively involved in financial markets type activities (directly or as advisers), and even if (as I’m sure happens) individuals recuse themselves from individual cases in which they may have direct associations) it is, nonetheless, a governance body made up largely of those with direct interests that won’t necessarily always align well with the public interest.

Reasonable people can reach different views on the performance of the FMA. I gather many people are currently quite pleased with it, although my own limited exposure –  as a superannuation fund trustee dealing with some egregious historical abuses of power and breaches of trust deeds – leaves me underwhelmed.  It is certainly a model that should be looked at in reforming Reserve Bank governance –  it is, after all, the other key financial system regulator –  but I’m less sure that it is a readily workable model for the prudential functions, even with big changes in the overall structure of the Reserve Bank, and some reassignment of powers.  It certainly couldn’t operate well if both monetary policy and the regulatory functions are left in the same institution.  It doesn’t seem to be a model followed in any other country.  And it isn’t necessary to deal with the core problem in the current system: too much power is concentrated in a single person’s hands.  In a standalone regulatory agency, I suspect an executive board –  akin to the APRA model –  is likely to be an (inevitably imperfect) better model.

Whatever the precise model chosen, significant reform is needed at the Reserve Bank.  Some of that is about organisational structure and governance –  I’ve made the case for a standalone new Prudential Regulatory Agency –  but much of it is about organisational culture, and that sort of change is harder to achieve.  I hope Adrian Orr has the mandate, and the desire, to bring about such change.  I hope Grant Robertson insists on it.

Readers will that early last year, Steven Joyce – as Minister of Finance –  had Treasury employ a consultant to review aspects of the governance of the Reserve Bank, particularly around monetary policy.  Extracting details of the review, undertaken by Iain Rennie, from The Treasury proved very difficult.  It took almost a year for the report to be released.  I’ve had various Official Information Act requests in, including for the file notes taken from the (rather limited) group of people outside The Treasury that Iain Rennie engaged with (within New Zealand it turns out that he talked to no one outside the public sector).  That one ended up with the Ombudsman.  A week or so ago I finally got an offer via the Ombudsman’s office –  Treasury would release a document summarising those meetings if I discontinued my request for the full file notes.  Somewhat reluctantly –  balancing the point of principle, against getting something now – I agreed, and last Friday Treasury released that summary to me.  For anyone interested it is here.

Rennie review Summary of discussions with External Stakeholders

There is some interesting material there, including on meetings with the Reserve Bank Board –  where he showed no sign of having grilled the Board on what it accomplishes or adds –  and with some overseas people Rennie talked to.  But what caught my eye was the record of a meeting Rennie (and Treasury) held with the Reserve Bank management (Wheeler, Spencer, McDermott and a couple of others) on 14 March last year.  At the meeting, the Bank seems to have set out to minimise any change and sell Rennie on the virtues of the current informal advisory Governing Committee.

Here are relevant bits of the record (as summarised now by Treasury)

Current Governing Committee (GC)
o The GC reflects public sector reforms, there are checks and balances, which help with accountability.
o It has become important to focus more on the Reserve Bank as an institution, rather than just on the Governor, as the Reserve Bank has taken on more and more responsibilities over time.
o Discussed different overseas models, including strengths and weaknesses of different approaches.
o The approach to decision-making and communications needed to be consistent with the Reserve Bank’s approach (e.g. must be appropriate in the context of forward guidance).

Codification of the Committee Structure
o Codification’s advantage was that it could prevent a future Governor from moving back to a single decision-maker. However, that hasn’t been a problem in Canada, and it would be difficult for a Governor to roll the current committee approach back.

o The cohesion of the GC and the cooperative nature were identified as the most important factors in its success. The GC was relatively informal with collective responsibility, and that worked well.
o Discussed how the current committee operated, and some strengths and weaknesses of the approach.
o Discussed the effectiveness of different options for decision-making and communications design, such as voting and minutes (neither supported).

Some of this is almost laughable, a try-on that surely they should not have expected anyone to take very seriously (and, to Rennie’s credit, he came out with recommendations that went far further than the Bank liked, earning him soe quite critical comment from the Bank).

Take that very first bullet, the claim that the Governing Committee model “reflects public sector reforms”.  I’m not sure how.  It has no basis in statute, the members are all appointed by and accountable to the Governor, and there is no transparency, and no accountability.  The Bank has, for example, consistently refused to release any minutes of the Governing Committee –  on any topic –  if indeed, substantive minutes are even kept.

Or the fourth bullet, the suggestion that “the approach to decision-making and communications needed to be consistent with the Reserve Bank’s approach”, which is a typical bureaucrat’s attempt to reverse the proper order of things.  The Reserve Bank is a powerful public agency, created by Parliament and publically accountable (well, in principle).  The design of the governance and accountability arrangements should reflect the interests and imperatives of the principal (public and Parliament), not those of the agent (the Bank itself).  Officials work within the constraints Parliament establishes.

Or the third to last bullet, about the cohesion of the Governing Committee, collective responsibility etc.  Again, I’m sure they believed it, but on the one hand, we build public institutions to provide resilience in bad times (or bad people) not so much for good times, and on the other there is no collective responsibility –  the Governor alone has legal responsibility, and there is no documentation at all on the Governing Committee processes.  And legislating to entrench a committee in which the Governor appoints all the members, might be a recipe for cohesion, but it is also a high risk of a lack of challenge, debate and serious scrutiny.

And, finally, just to confirm that consistent opposition to anything approaching serious scrutiny, in that final bullet, the Bank reaffirms its opposition to published minutes –  something most of central banks now manage to live with, in some cases with considerable detail.

At one level, these comments no longer matter much.  Graeme Wheeler and Grant Spencer have moved on, and the new government has made decisisions on the future governance of monetary policy.  But they nonetheless highlight the sort of closed culture fostered at the Reserve Bank over the past decade or more, whether on the monetary policy side or on the regulatory side (the latter vividly illustrated in the NZI report).  Comprehensive reform is overdue.  It would make for a better Reserve Bank internally – and/or a better Prudential Regulatory Agency –  and one more consistently open to scrutiny, challenge, and debate, which in turn will reinforce the impetus towards better policy, better analysis, and better communications.


A couple of Reserve Bank items

I had been meaning to write about a speech given last week by Grant Spencer of the Reserve Bank on so-called “macro-prudential policy”.  It was a thoughtful speech, as befits the man, and the last he will give as a public servant before retiring next week.

That it was thoughtful doesn’t mean that I generally agreed with Spencer’s (personal, rather than institutional) views.  There were at least two important omissions.  First, as it has done over the last half-decade (and more) the Bank continues to grossly underplay the importance of land-use restrictions in accounting for increases in the prices of houses (and particularly the land under them).  Until they get that element of the analysis more central, it is difficult to have much confidence in what they say about housing markets, housing risks, or possible Band-aid regulatory interventions of their own devising.    And second, they constantly ignore the limitations of their own knowledge.  I’m not suggesting for a moment that they are worse than other regulators in this regard –  who all, typically, have the same blindspot –  but it might matter rather more from a regulator than exercises, and wants to be able to continue to exercise, large discretionary intervention powers, with pervasive effects over the lives –  and financing options –  of many New Zealanders.   If they won’t openly acknowledge their own inevitable limitations, and discuss openly how they think about and manage the associated risks, how can we have any real confidence that they aren’t just blundering onwards, fired by good intentions and injunctions to “trust us” rather than by robust analysis.  In respect of both these omissions, I hope –  without much hope –  that the new Governor begins to put the Bank on a better footing.

When someone asked me the other day if there was anything new in the speech, one thing I noticed was how far the Bank’s current senior management appears to have come over the last few months around possible changes to the governance of the Bank’s main functions.   Casual readers might not notice the change, because it is presented as anything but.  Specifically, this is what Spencer had to say.

Given the planned introduction of a new decision making committee (MPC) for monetary policy, the Review should consider establishing a financial policy committee (FPC) for decisions relating to both micro and macro prudential policy. The Reserve Bank has supported a two-committee (MPC/FPC) model in place of the current single Governing Committee, for example in the Bank’s 2017 “Briefing for Incoming Minister”.

Of course, it is only a few months since the Bank’s expressed preference was simply to take the existing internal Governing Committee (the Governor and the deputies/assistant he appoints) and recognise it in statute, as the forum through which the Governor would continue to make final decisions.

And what of the claim that the Bank has –  not just does now –  supported a two-committee model, including in its Briefing to the Incoming Minister late last year?  At very best, that is gilding the lily.

As I noted at the time, both in the main text of that Briefing, and in the fuller appendix (both here) they devoted most of their effort to defending the existing Governing Committee model.    The main alternative they addressed was a Monetary Policy Committee  but even then the most they favoured was enacting the current Governing Committee model, perhaps with a few outsiders appointed by the Governor, and with the Governor remaining the final decisionmaker
“Provided the Governing Committee remains relatively small, we believe it should continue to make decisions by consensus, with the Governor having the final decision if no consensus can be achieved.  “
The only mention of a Financial Policy Committee is (from page 9)

The Reserve Bank considers that some evolution in its decision-making approach may be appropriate.  We recommend that the review of the RBNZ Act be limited to your stated change objectives.  We consider a review along these lines could be completed reasonably quickly and we would be happy to prepare a draft terms of reference, in consultation with the Treasury.  A variety of arrangements are possible and these are discussed, alongside the rationale for the Bank’s preferred model, in Appendix 6.

Other legislative changes that may be desirable over time include:

– Creating separate decision-making committees for monetary and financial policy

Note the suggestion to the Minister to keep the forthcoming review of the Act to the minimum of what Labour had promised (which dealt only with monetary policy), with some vague suggestion that at some time in the future –  but not in this review –  separate committees “may” be appropriate.  It could scarcely be called a full-throated endorsement of change.

Of course, the Bank lost various battles.  The first stage of the review is being led by Treasury (dealing with the monetary policy bits) and the second stage will look at (as yet unidentified issues).   And it seems they must have recognised that the ground is shifting, and that it would be hard to defend the current single decisionmaker models for the Bank’s huge regulatory (policy and operational) powers once momentum gathered behind a committee model for monetary policy.  Whatever the reason, it is a welcome move on the part of the current management.  Of course, we have no idea what the new Governor –  taking office in a few days –  thinks about suggestions to curtail his powers.

And just finally on the speech, one element of good governance is obeying, and respecting, the law.    Once again, Spencer’s speech and press release have been put out under the title “Grant Spencer, Governor”.  He simply isn’t.  At best he is “acting Governor”, a specific provision under the Reserve Bank Act.  A “Governor” has to be appointed for a minimum term of five years.   If it were a lawful appointment, there is nothing shameful in being acting Governor –  the one previous example, Rod Carr for five months in 2002, never purported to be the Governor.   As it is, my analysis stills suggests that the appointment was unlawful, and thus Steven Joyce and the Bank’s Board (by making the appointment) and Grant Robertson (in recognising it) both undermined the law and good governance and marred the end of Spencer’s distinguished career.  At very least, those provisions of the Act should be reviewed as part of Stage 2.

Meanwhile, we are still waiting for the now-overdue results of Stage 1, for the report of the Independent Expert Advisory Panel (which, as far as we can tell, has neither sought submissions nor engaged in consultation) and for the new Policy Targets Agreement which wil guide monetary policy from next week.

Still on matters re the Reserve Bank, there is a column in the Dominion-Post this morning by Rob Stock having a go at the Open Bank Resolution (OBR) and associated hair-cut of creditors and depositors option for handling a failed bank.  Like me –  and many other people, including the IMF and The Treasury –  Stock favours deposit insurance.  But he seems to see deposit insurance and OBR as alternatives, whereas I see them natural complements.  Indeed, the only way I can ever see the OBR instrument being allowed to work, if a substantial bank fails, is if deposit insurance is also in place.

Stock introduces his article with a straw man argument that ordinary depositors can’t really monitor banks and so shouldn’t be exposed to any financial loss if a bank fails.  Not even the first point is really true.  There are, for example, published credit ratings, and any changes in those credit ratings –  at least for major institutions –  get quite a lot of coverage.  A huge amount of information is reduced to a single letter, in a well-articulated series of gradations.   Should one have vast confidence in ratings agencies?  Probably not –  although perhaps not much less than in prudential regulators, based on track records.  But if your bank is heading towards, say, a BBB- rating and you have any material amount of money it would probably be a good idea to consider changing banks, or spreading your money around.    No one thought that South Canterbury Finance or Hanover were the same risk as the ANZ, at least until the deposit guarantee scheme made putting money in SCF rock-solid safe, whereupon many depositors rushed for the higher yields.

But there is a broader point that many risks in life aren’t able to be fully monitored, controlled, hedged, avoided or whatever  One might become a highly-specialised employee in a firm or industry that fails, or is taken out by regulatory changes.  Regions and towns rise and fall, and take house prices with them.  Governments might one day free up land use laws, reducing house and land prices to more normal levels.  Wars and natural disasters happen.  Chronic illness can strike a family. Even a marriage can be hugely risky.    For the median depositor there is typically much less at stake in their bank account (and typical losses –  percentage of liabilities – on failed retail banks aren’t that large).

Are there potential hard cases?  For sure, and Stock cites one of them.   If you’ve just sold your mortgage-free house –  for, say $1 million –  and are settling on another house next week and your bank failed in the course of that week, you could be exposed to quite a loss even though you’d had no desire to be a creditor of the bank.   Cases like that are one reason why I favour the Reserve Bank opening up electronic settlement accounts –  central bank e-cash if you like –  to the general public.  There wouldn’t be much demand, but on those rare occasions like the house settlement example, you might happily pay for the peace of mind of an effective government guarantee.  I’m looking forward to the new Reserve Bank Bulletin article on such matters next month.

I don’t think those few extreme examples warrant full insurance for all individual depositors, no matter the size of their balance.  There are many classes of people struck by not-easily-monitorable illiquid risks (see above) I’d have more sympathy with.  But I’m a political pragmatist, and as I argued previously I just cannot envisage an elected government allowing a major bank to fail, allowing all creditors to be haircut, if there is no protection at all.    That is especially so when, almost by construction, the Reserve Bank –  the government’s agent –  will have failed in its duties (and probably kept crucial information from the public, as in the recent insurance failure case) for the situation to have got to that point.    A full bailout will typically be the path of least resistance.

And a full bailout will mean not just bailing out the grandma with a $30000 term deposit, or the person changing homes with $1m temporarily on deposit, but bailing out wholesale creditors –  domestic and foreign –  with tens or hundreds of millions of dollars of exposure.     Do that –  or set up structures that aren’t time-consistent and encourage people to believe in bailouts –  and any market discipline, even by the big end of town, will be very severely eroded.  And, in a crisis, we’ll be transferring taxpayers’ scarce resources to people   including foreign investors – who really should be capable of looking after themselves.  It has happened before and it will happen again.   But deposit insurance –  funded by levies on covered deposits – increases the chances of being able to impose losses on the bigger creditors if things go wrong.

Perhaps OBR would still never be used.  And there are costs to the banks in being pre-positioned for it.  But we shouldn’t easily give in to a view that any money lent to a bank is rock-solid, backed by government guarantees.  It is not as if there aren’t plausible market mechanisms that could deliver much the same result, at some cost to the depositor (eg a bank or money market fund that held only short-dated government or central bank liabilities).   But there is little evidence of any revealed demand for such an asset –  the cost presumably not being worth it to most people, to cover a very small risk.  By contrast, we voluntarily pay for fire or theft insurance –  often to cover what are really quite modest risks.

There may not be any more posts this week (and if there are, they won’t be of any great substance).   I have a couple of other commitments on Thursday and Friday and, as I’m sure many have discovered before me, broken bones seem to sap an astonishing amount of energy for something so small.

Causes of financial crises

Earlier in the week I wrote about a couple of the surveys, of US academic economists, conducted out of the University of Chicago by the IGM economic experts panel.

But another of their 2017 surveys caught my eye.  It was about the financial crisis of 2008/09.

Panellists (US ones, and those of the sister European panel) were asked (with detailed wording of each item at the link)

Please rate the importance (0=none; 5= highest) of each item below (presented to panelists in randomized order) in contributing to the 2008 global financial crisis.

And this was how the results came back (using the version where respondents indicated how confident they were of their views).

2007 IGM weighted-graph

For the most part, the European and American responses were pretty similar (not that surprising given (a) that they were asked about the same events, and (b) that quite a few of the US panel were academics who’d migrated from Europe).  Perhaps the only material differences are on the questions around the role of savings and investment imbalances, and around the role of direct government involvement in the housing finance market.  In neither case do the (weighted) average respondents think these issues were top-tier factors but in Europe extremely large current account deficits (savings/investment imbalances) were much more salient (Ireland, Greece, Spain, as well as various eastern European countries) –  as were the “reinvestment” pressures on eg German banks.  And on other other hand, in the United States, between the role of the agencies (Fannie Mae et al), the FHA, and direct federal pressure on banks to lend to support home ownership, the government has a far larger role in housing finance than in most countries.  And US housing finace was the epicentre of the crisis.

In some ways, it is a funny mix of questions/options.  Even if all these factors contributed in one sense or another to the 2008 crisis, they must have done so in quite different ways.  Take, for example, funding runs, resulting from maturity mismatches (short-term liabilities funding long-term assets).  Clearly they were a phenomenon observed in the crisis –  whether at Bear Stearns or Northern Rock or…. –  but since every banking system in the world, strong or otherwise, operates that way, it isn’t clear that the funding structures (or the runs) were a material cause of the crisis.

And one can criticise the rating agencies all one likes –  and I’m sure most of the criticism is well-warranted – but few people were compelled to use credit ratings to guide their asset allocation choices.  And, for all their faults, the rating agencies were generally only responding to much the same incentives that drove other active participants in the system.

And what might lament that regulators and supervisors didn’t catch the building risks before the crisis broke, but (a) they rarely do, and (b) generally, prudential regulators did not compel or coerce willing borrowers and willing lenders to undertake the transactions that ended badly.

It is interesting to see that the “too big to fail beliefs” item is ranked a fair way down the scale (the specific question is about the beliefs of bankers that their own bank was too big to fail).     That sounds about right.  In boom times, most participants are focused on maximising the upside, with little focus on the possibility of things going very badly.  And for the management and Boards of banks, even if their own bank does prove “too big to fail” it is probably little solace to the people involved –  they will still be ousted (RBS, for example, still trades but Fred Godwin –  knighthood and over-generous pension too –  is long gone).

I’m not quite sure what two or three factors I would rate most important.  But one that would rank fairly highly isn’t even directly on the IGM panel’s list: the creation of the euro and the inclusion of so many peripheral states in it.  That choice –  giving German interest rates to Ireland, Greece, Spain, and associated flows of capital –  greatly accentuated imbalances that might already have been there.   Again, it caused no bad loans directly, but fostered an environment in which they became more likely.

And I still find quite persuasive –  more so than the panels clearly –  the story around the importance in a US context (and the US crisis contributed greatly to crises in the UK, Germany and several other European countries)  of government efforts to promote easier access to housing credit.  As I summarised the story former US official Peter Wallinson told

It is that without repeated, sustained and frighteningly successful US government efforts – under both Clinton and Bush administrations – to promote easier access to housing credit, particularly through the agencies (Freddie Mac and Fannie Mae), there would most likely have been no serious US financial crisis.  Wallinson documents how government mandates compelled the agencies to drive down their lending standards, and how because of the dominant role of the agencies in the market, this contributed to a sustained deterioration in the quality of new housing loans being made across the United States.  As late as 2004, new mandates were imposed, forcing the agencies to meet higher low income lending targets with loans for new purchases, excluding any refinancing or equity withdrawal loans.

Finally, it is interesting to note that household debt (specifically “Elevated levels of US household debt as of 2007”) also doesn’t rank that highly as an explanation.  That has long seemed right to me –  apart from anything else, debt to income ratios at the time were higher in New Zealand and Australia (which had no crisis at all) and in the UK (which had no domestic housing finance crisis) than in the US.   But the Reserve Bank has tended to put (in my view) too much weight on the debt stock.

I noticed this week that credit growth in New Zealand (household or total) has now again dropped a little below the rate of growth of nominal GDP.  I don’t supppose it portends anything very much, but if our debt levels in 2007 didn’t cause a local crisis, the current debt levels don’t seem likely to either.

(with an estimate of Dec quarter 2017 GDP)debt to GDP NZ

It is striking just how little has changed in aggregate.   Debt stocks that, as a per cent of GDP, have barely changed over a decade, are very rarely the stuff of which crises are made.  Big increases in those ratios can sometimes be associated with subsequent crises –  that was what New Zealand had in the 00s, and thus we were worried in 2007 – but very bad banking seems to be what really matters, and in a well-disciplined market economy, “very bad banking” and “more debt” aren’t synonymous.


Governing financial stability policy

On Monday afternoon, The Treasury hosted Professor Prasanna Gai of Auckland University, who gave a guest lecture on the topic “Resilience and reform –  towards a financial stability framework for New Zealand”.     The timing of this event, put on at quite short notice, is presumably not unrelated to the current review of the Reserve Bank Act.

Prasanna Gai is well-qualified to talk about such issues.  He was formerly a professor at ANU, and prior to that worked at both the Bank of Canada and the Bank of England.  These days –  even from the ends of the earth –  he is an adviser to the European Systemic Risk Board.  A few years ago he served as an external academic adviser to the Reserve Bank of New Zealand, and did one of the periodic visitor reviews of our forecasting and monetary policy processes, based on his observation of one Monetary Policy Statement round.

In his presentation the other day, he appeared to set out to be “politely provocative” in pushing for reform, including greater transparency and accountability.   There was a fairly large number of Reserve Bank people at the lecture, and I suspect Prasanna’s calls won’t have gone down that well with them.

He began by noting that even now, 10 years after the last international financial crisis, there is very little academic analysis of the political economy of financial stability policy/regulation.  As he noted, in monetary policy there were key defining papers that laid the groundwork for monetary policy operational independence to become the norm internationally.    There is still really nothing comparable in respect of financial stability –  and certainly nothing robust that would justify delegating a very high degree of autonomy (arounds goals, instruments, and intermediate targets) to unelected officials (especially a single such official).

As he notes, in most countries –  though not the US or the euro-area –  politicians (as representatives of societies) play the lead role in setting/approving the inflation target.   Things aren’t just mechanical from there –  there can be, and are, real debates about how aggressively to respond to deviations from target and the like –  but at least there is some benchmark to measure performance against.    There is nothing comparable for financial stability, and Prasanna Gai argues  –  and I strongly agree with him –  that politicians need to “own” financial stability policy, including taking a view (implicit or explicit) on things like the probability of a crisis that society is willing to tolerate (it is the implicit metric behind much of what systemic financial regulators do).

Gai’s focus in his talk was on what he –  and the literature –  likes to call “macroprudential policy”.     He draws a distinction between the supervision of individual banks and the supervision/regulation of the system as a whole.  I’ve never been convinced that it is a particularly robust distinction, at least in the New Zealand context, where a key defining characteristic of our banking system is four big banks, all with offshore parents from a single overseas countries, all with relatively similar credit exposures (and funding mixes).   Gai –  and others (including the Reserve Bank when it suits them) –  argue that each bank might manage its own risks relatively prudently, but has no incentive to take adequate account of the impact of its choices on other banks.  Again, in a concentrated system like our own, I’m not sure that is really true, at least in a way that has much substantive content.   Anyone lending on dairy farms (for example) will know that the market in such collateral gets extremely illiquid whenever times turn tough (as they did after 2007).  You’d be a fool, in managing your own bank’s risks, not to recognise that other people might be trying to liquidate collateral at the same time as you.   Much the same goes for housing loans –  and even if you didn’t directly take account of other banks’ exposures, if your bank has a quarter of the market, you can’t just assume your actions will have no impact on the value of the overall collateral stock (whereas, say, a 1 per cent player might be able to).   It doesn’t mean that banks don’t get carried away at times, and excessively ease credit standards, but I doubt the big 4 are ever not aware they are big fish in a small pond.  Banks were all very consious of firesale risks in managing dairy exposures in 2009/10.

And if the banks themselves forget it, I don’t think the Reserve Bank ever has.   As regular readers know, I don’t feel a need to defend the Reserve Bank on every count, but……I sat on the Financial System Oversight Committee for the best part of 20 years, and was involved in putting together Financial Stability Reports, and the sort of narrow “my bank only” focus people talk about when they try to carve out macroprudential policy as something different from micro-prudential supervision never resembled the way the Reserve Bank dealt with these issues and risks.   Perhaps it happened to some extent at the level of an individual supervisor, but not at the institution level.  The starting assumption tends to be that the risks –  credit and funding –  are pretty similar in nature for all the big banks.  In fact, we see that illustrated in the way our Reserve Bank treats stress tests –  here is the focus is systemic whereas, for example, the Bank of England provides a high degree of individual institution detail (since banks fail individually, I think the BOE approach is preferable).    What also marks out New Zealand supervision/regulation, is that the statutory mandate is explicitly systemic in focus; there is no explicit depositor protection mandate.

So although Gai’s talk was avowedly focused on macroprudential functions, in the end most of what he had to say applies (at least here) to the full gamut of the Reserve Bank’s financial regulatory functions.  I think that conclusion is reinforced by the scepticism Gai expressed about the ability of central banks/regulators to do much effective to dampen credit/housing cycles, leaning against booms.  He sees the case for regulation as primarily about building the resilience of the financial system.

In passing, I would note that I also think he grossly overstates the cost of financial crises.  He put up a series of charts for various countries showing the path of actual GDP in comparison to what it might have been if the pre-2007 trends had continued, and asserted that the difference was the effect of financial crises (perhaps as much as 70 per cent of one year’s GDP).  I’ve disputed that sort of claim previously here (including here and here) and a few months ago I ran this chart  suggesting that another meaningful way of looking at the issue might involve comparing the path of GDP for a country at the epicentre of the crisis (the US in this case), with the paths for advanced countries that didn’t experience material domestic financial crises,

US vs NZ Can etc

But if the costs of financial crises are far smaller than people like Gai (or Andy Haldane) assert, they probably aren’t trivial either, especially in the short-term (one or two year horizons).  And much the damage isn’t done in the crisis itself, but in the misallocation of credit and real resources in the build-up to the crisis.

So I’m not arguing a case against supervision/regulation –  and have been recently arguing that we should, on second best grounds, introduce a deposit insurance scheme, which would only reinforce the case –  but I am more sceptical than many, perhaps including Gai, about how much value supervisors can really achieve, whether macro or micro focused.    There has been a great deal of  regulatory activity –  sound and fury –  in the few years since the last crisis, but that was precisely the period when banking systems were least likely to run into trouble anyway (managers, shareholders, rating agencies all remembered –  and were often scarred by –  the 2008/09 crisis, and actually demand for credit was generally pretty subdued too).  The test of supervision/regulation isn’t the difference it makes in times like the last 7 or 8 years, but the difference at makes at the height of the next systemic credit boom.  It isn’t obvious –  including from past cycles –  that regulators, and their political masters, will be much different from bankers next time round either.  Some regulators might well want to be different, but typically they will be marginalised, or just never (re)appointed to key positions in the first place.

But given that we have bank regulation/supervision, how should it best be organised and governed?     There is no one model, either in the academic literature or in the institutional design adopted in other advanced countries.  One of the question is how closely tied financial stability policy should be to monetary policy.   At one end there is  –  perhaps the practical majority  – view (including from Lars Svensson) that monetary policy and financial stability are two quite separate things, and should be run separately, possibly even in separate institutions.   At the other extreme, there is an academic view that monetary and financial stability are inextricably connected and policy needs to address both together.  A middle ground is perhaps a view associated with the BIS, seeing a role for monetary policy to lean against credit asset booms, with the advantage –  relative to regulatory measures –  that “interest rates get in all the cracks”.

In New Zealand, the Reserve Bank Act has since 1989 required the Bank to have regard to the soundness and efficiency of the financial system in its conduct of monetary policy (a requirement carried over in the PTA in 2012).  But no one really knows what it means – to the drafters in 1989 it seems to have meant something about avoiding direct controls –  but it sounds good –  motherhood-ish almost.   In practice, it has never meant much: successive Governors have, at times, anguished about housing markets and possible future risks, and on the odd occasion have tempered their OCR calls by those concerns.  But my observation suggested they’d have done so anyway.

So we are in the curious position where financial stability considerations don’t matter to any great extent to monetary policy, and yet we have single decisionmaker deciding policy in both areas with –  partly as a result –  little direct accountability.    The Minister of Finance has little effective involvement in the appointment of the decisionmaker, or in the specification of the goals of financial stability policy.   The Governor decides –  based on whim, rigour, or prejudice, but with little or no legitimacy or democratic mandate. Even the legislation grew like topsy, and the governance provisions never envisaged as active prudential policy as we’ve seen in recent years.

There is a range of different models, and Gai covered some of them in his talk.  In Sweden there is little or no integration between the central bank and the financial regulatory agency.  In the UK, all the functions are (now back) in the Bank of England, but there are statutorily separate committees (albeit with overlapping membersships), most of the members are appointed by the Chancellor, and all members are individually accountable for their views/votes.  In Australia, there are multiple agencies, a Council chaired  by the Reserve Bank, but also a strong role in policysetting for the Federal Treasury, representative of the Treasurer (and the Treasurer/government directly appoint the key players, including the Governor).  There are other countries –  for example, Norway –  where decisionmaking powers on systemic prudential interventions are reserved to the Minister of Finance.

Prasanna Gai wrapped up his talk arguing that there is a strong case for rethinking the governance model around systemic financial stability in New Zealand.     Specifically, he made the case for the Minister of Finance to be more directly involved.  As he had noted earlier in his talk, the sort of regulatory interventions like LVRs are almost inevitably highly political in nature (especially as they can be highly granular –  we saw a couple of years back regulatory distinctions between Auckland and non-Auckland, and we still have distinctions between types of purchasers, even if the collateral is identical), and that the more independent a central bank is around such interventions the more politicised the institution risks becoming.  Gai argued –  and I agree with him –  that we’ve seen this in New Zealand in the last few years.  He argues that wider participation in decisionmaking could help safeguard monetary policy credibility (and perhaps the Bank’s effective operational independence there).

Gai argues for the establishment of a statutory committee to be responsible for systemic financial regulatory matters that are currently the sole preserve of the Governor.  He didn’t spell out clearly what, if any, powers he would reserve to the Minister –  perhaps that is captured in establishing a mandate (backed by statute, not the goodwill/moral pressure of the current MOU).  But he envisages a model in which the members of the committee would be appointed by the Minister of Finance, and would be individually accountable (including to Parliament) –  presumably implying a considerable degree of transparency around minutes/voting records.  He argues –  correctly in my view –  that such a committee would not only provide access to more technical expertise but that it would provide greater “legitimacy” for the choices being made.

Mostly, Gai’s talk was very diplomatic.  But there was a bit of a dig at the current Reserve Bank, noting that there didn’t seem to be much turnover (“churn”) at the senior levels of the Reserve Bank, at least when compared to the experience of places like the RBA or the Bank of England, which –  he argued –  limited the scope for challenging “house views” or established orthodoxies.    Bringing in outsiders –  individually accountable – to a statutory committee could counteract those risks.    Personally I’m less sure that turnover (generally) is the issue –  and as compared to the RBA (most notably) the Reserve Bank of New Zealand has been weak at building internally capability (as a result, 1982 is still the last time a Reserve Bank Governor was appointed from within).  The issues at the Reserve Bank seem to be more about the capability of certain key individuals –  several of whom (Spencer, McDermott, Fiennes and Hodgetts) have been in their roles for a long time –  and the sort of culture fostered from the top in the Wheeler years in particular.     In a high-performing organisation, constantly opening itself to challenge, scrutiny and new ideas (from inside and outside) that stability might be a real strength.  In our Reserve Bank it has become a considerable weakness.  But an external committee, properly constructed, could be part of a process of change, and entrenching new and better behaviours.

Gai’s summary:

  • financial stability policy should be on an equal footing with monetary policy,
  • the focus of such policy should be on resilience of the system, not trying to fine-tune the credit cycle (just too ambitious),
  • politicians need to own the standards of resilience policy is working to maintain/manage, and be engaged more overtly in decisionmaking, and
  • because it will never be possible to establish very specific, short horizon, goals comparable to those in the PTA, the process of policy formulation and governance/accountability mechanisms take on an even greater importance for financial stability than for monetary policy.

I’d largely agree with him.

I hope these are issues that the Minister of Finance is going to take seriously as part of his (currently secretive) review of the Reserve Bank Act.    With central bankers who have a strong incentive to defend their patch and their powers –  including a new Governor with a reputation for fighting his corner, come what may –  if the Minister isn’t engaged it would be all too easy to end up with no material change, and far too much power still concentrated in the hands of one, less than excellent, institution and its single decisionmaker.     This is the opportunity for serious reform – bearing in mind Mervyn King’s injunction that legitimacy (the “battle for hearts and minds”) matters greatly –  and I hope the Minister is exposed to the advice Prasanna Gai offered the other day.  A Financial Stability Committee shouldn’t be dominated by academics, but the Minister could do worse, in establishing such a committee, than to appoint Prasanna as one of the founding members.

For anyone interested in these issues, there is also a presentation here given last year by David Archer – former Assistant Governor of the Reserve Bank, and now a senior official at the BIS. I meant to write about it at the time, but never did.  His title is “A coming crisis of legitimacy?”  and this from his first slide captures his concern

Make the case that many central banks are at risk of a crisis of legitimacy, with respect to new macro financial stability mandates. The issue is an inability to write clear objectives.

He highlights some similar issues to Gai, but is more strongly committed to keeping ministers out of regular decisionmaking, and so his approach is to supplement committees with a clear statutory specification of the issues, considerations etc that should be taken into account in using/adjusting systemic financial regulatory policy.