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.

Effectiveness
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.

Transparency: Bank of England vs RBNZ

Open government –  or the lack of it –  has been getting a bit of attention in recent weeks.  The previous National-led government was pretty poor in that area, and if anything there now seems to be a risk that the current government could be worse.  But at least there is some debate around the issues.  Former Cabinet minister, and now Speaker, Trevor Mallard, had one promising suggestion in an article this morning

“Eventually getting some websites going which contain most of that material, for example, Cabinet papers two months after they’ve been to Cabinet automatically up unless there’s a good reason not to, just that sort of stuff would mean you’d have a lot of access to, actually quite boring information, but access to what’s going on.”

Easy to suggest, of course, when you are no longer a minister.  I hope the new Speaker will be as keen on extending the provisions of an (overhauled) Official Information Act to cover Parliament itself.

The Reserve Bank is one of the bodies that likes to claim that it is highly transparent.    There are plenty of counter-examples –  and occasional examples that might suggest that progress is actually being made –  but I stumbled across an interesting contrast this week between our central bank and the Bank of England, the central bank of the United Kingdom.  Recall that the British public sector was notoriously secretive for a very long time, and our Official Information Act was enacted many years before the UK’s comparable legislation.

In its Financial Stability Report this week, the Reserve Bank released a high-level summary of the results of its latest stress tests on the four major banks.  What they released was interesting enough but there wasn’t much of it; 850 words and a couple of charts.  There was, for example, no information on individual banks –  despite a disclosure-focused system –  and no detail on housing mortgage losses –  despite the active regulatory and rhetorical focus on those risks for the last five years.

Earlier in the week, the Bank of England released its Financial Stability Report, and as part of that they released their latest stress test results.  Their release –  on the stress tests alone –  was 64 pages, with a great deal of detail, on the test scenarios themselves, on the overall results, and on the results for individual banks.   It even has an interesting annex on how markets’ view of banks square with the stress test results.

To be sure, the UK banks are typically more complex than the New Zealand banks (some, such as HSBC, are primarily global banks with big international exposures), and there are more of them (seven in this test) so we might not expect 64 pages of results here.  But we really should be entitled to more than the Reserve Bank is giving us.  There is no obvious (good) reason for withholding the material –  including that at an individual bank level.  Disclosure statements are actually already supposed to disclose banks’ risks, and  stress tests are just shocks designed to test the circumstances under which those risks turn bad.  And, in the end, it is banks (individually) that fail, or not, not “banking systems”.

Sure, there is probably some cost to pulling all the material together and presenting it nicely, but those costs will be trivial compared to the costs the banks face in doing the stress tests, or even than the Reserve Bank faces in conducting them and writing them up for senior management and/or the Board.  Accountability provisions and openness do have direct costs –  and, for that reason among others, aren’t typically popular with bureaucrats – but we put them in place for good reason.  With such large and powerful governments we are long past the days when we could safely accept an approach of “trust us, we know what we are doing”, all the more so when it involves agencies – such as the Reserve Bank –  with huge power concentrated in one person’s hands and little direct effective accountability (we can’t vote him out).

I could, of course, lodge an Official Information Act request .  If I did they would probably release some more aggregated material.  But I wouldn’t get very far, as the Bank continues to shelter –  with the protection of the Ombudsman –  behind the egregious (or, more accurately, egregiously abused) section 105(1) of the Reserve Bank Act.  When the Reserve Bank Act is reviewed, doing something about that provision needs to be on the action list.

If the British can manage this high degree of openness around banking sector stress tests –  only a few years after they had to grapple with actual bank failures – surely so can we.

On the Reserve Bank FSR

There are some interesting things in the Reserve Bank’s Financial Stability Report, some questionable ones (including, at the mostly-trival end of the scale, Grant Spencer’s assertion that he is “Governor” when by law he is, at best, “acting Governor”) and some things that are missing altogether.

The Reserve Bank observes that banks have tightened their own (residential mortgage) lending standards

Banks have tightened lending standards, reducing the borrowing capacity of households. Typically, banks are using higher interest rates when assessing the ability of borrowers to service a new mortgage and their existing debt, restricting the use of foreign income in serviceability assessments, placing stricter requirements on interest-only lending, and ensuring that living expenses assumed in a loan assessment are reasonable given the borrower’s income.

If so, you have to wonder why the Reserve Bank is still intervening in such a heavy-handed way in the decisions banks would otherwise make about their mortgage lending.

But they go on to back their claim with an interesting, but on the face of it somewhat dubious, chart

The overall impact of the tightening in banks’ lending standards is illustrated by the Reserve Bank’s recent hypothetical borrower exercise,  which asked banks to calculate the maximum amount that they would lend to a range of hypothetical borrowers. This repeated an exercise that was conducted in 2014. The 2017 results suggest that maximum borrowing amounts have declined by around 5-10 percent since 2014 (figure 2.3).

max lending amounts

But it is hardly surprising that, with the same nominal income, banks would lend a little less now than they would have been willing to do so in 2014.  After all, there has been three years’ of inflation since then.   Even if the borrowers had declared the same monthly living expenses to their bank, banks use their own estimates/provisions for living expenses in deciding how much to lend.  Supervisors, indeed, encourage them to do so, and to be sure to leave adequate buffers.   An income of $120000 would comfortably support more debt in 2014 than the same income does in 2017  (the reduction in the maximum amount lent to owner-occupiers was 3.5 per cent in the chart).  It would probably be better to do all these comparisons using inflation-adjusted inputs.

In this FSR, the Reserve Bank reports the results of their latest set of bank stress tests.    This year’s macro stress test didn’t seem particularly demanding in some ways.

stress test.png

Previous scenarios have featured falls in house prices of more like 50 per cent (in Auckland) and 40 per cent nationwide, which seemed like suitably tough tests.  Previous test also featured an increase in the unemployment rate to 13 per cent (which was so implausible that I pointed out then that no floating exchange rate advanced country had ever experienced such a large sustained increase in its unemployment rate).

But there are several unrealistic things about this scenario

  • it is highly improbable that even a severe recession in another country would lower New Zealand house prices by 35 per cent.  A massive over-supply of houses here might do so, or even the end of a massive credit-driven speculative boom, but neither an Australian nor Chinese recession is going to have that sort of effect.  In the 2008/09 recession –  as severe a global event as we’d seen for many decades – we saw about a 10 per cent fall in nominal house prices in New Zealand.
  • it is also highly unlikely that house and farm prices would fall by much the same amount in this sort of scenario.  Why?  Because in this scenario it is all but certain that the exchange rate would fall a long way (helped by the fact that the Reserve Bank has more scope to cut interest rates than their peers in other countries), in which case the dairy payout (and any fall in farm prices) will also be buffered relative to the fall in prices of domestic-focused assets.
  • But perhaps most implausible of all was the requirement that “banks’ lending grows on average by 6 per cent over the course of the scenario”.   Governments of the day might, at the time, be keen for banks to keep taking on more credit exposures, but those private businesses –  amid a pretty severe shakeout –  are unlikely to be willing to do so.  And there wouldn’t be many potential borrowers. If the asset base was stable –  or even shrank a bit, as it would tend to do naturally with sharply lower asset prices –  a fixed stock of capital goes quite a bit further.

As it is, once again the stress tests suggests that on the lending practices banks have operated under over recent years –  and they can change –  our big banks are impressively resilient.   Here is the key chart.

buffer macro

The chart is presented to make the deterioration in banks’ capital positions look large (by being presented as a margin over the minimum regulatory capital, rather than an absolute capital ratio –  creditors lose money when banks run out of capital, not when they get to the regulatory minimum).   But even then, look at the results.   The blue line is the result if the banks do nothing in response.  Which bank would do that in the middle of a period of multi-year stress?  But even then, at worst, the banks in aggregate end up with a buffer of capital of 2 percentage points above their required minimum.  With mitigants –  the red line –  they never even dip into the capital conservation buffer (the margin over the minimum; if banks dip into that zone there are limits of their ability ot pay dividends).

It is good that the Reserve Bank does these stress tests.  It would be better if they provided more information on the results (eg in this scenario they tell us that half the credit losses come from farm lending and residential mortgage lending, but don’t provide the breakdown –  from previous tests’ results, I suspect the residential contribution is relatively small  –  and don’t give any hint where the other half of the losses is coming from (given that housing and farm lending get most of the coverage in FSRs).

It must surely be hard to justify onerous and distortionary controls on access to credit for one large sector of borrowers when year after year the results come back showing that the banks look pretty robust to pretty severe shocks.  And when the Bank also tells us that the prudential regime isn’t designed to avoid all failures.  In combination, could one mount an argument that banks aren’t being allowed to take enough risk?

Operating in a market economy, banks in New Zealand –  and those in Australia and Canada –  appear to have done a remarkably good job of managing their own risks and credit allocation choices.  It is, after all, more than a 100 years since a major privately-owned bank has failed in any of those three countries.  Things can go wrong –  and often have in heavily distorted financial systems (eg that of the United States) – and bank regulators are paid to be vigilant, but it might be nice –  just occasionally –  to hear senior Reserve Bankers pay credit to the competent (never perfect) management of the risks our banks take with their shareholders’ money.

I mentioned things that were missing entirely from the FSR.  

The Reserve Bank Act requires FSRs to be published

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.

That second item is no less important than the first.  And when the Reserve Bank has, during the period under review, imposed significant regulatory sanctions on a major bank you might have supposed that in the next FSR there would be a substantial treatment of the issue (there is, after all, more space than in a press release).  It is, after all, an accountability document, designed to allow the public (and MPs) to evaluate the Reserve Bank’s handling of its responsibilities.

But in the case of the recent Westpac breach (operating unapproved capital models), which resulted in big temporary increases in Westpac’s minimum capital ratios and –  it appears –  a requirement that Westpac issue more capital over and above those minima you would be quite wrong.  I read the entire document yesterday and didn’t spot a single reference.  A proper search of the text revealed a single footnote, which simply noted that Westpac’s minimum capital ratios had been increased, with a link to last week’s Reserve Bank press release.

This really should be regarded –  by the Board, by MPs, by citizens and other stakeholders –  as unacceptable: an organisation, that despite its constant claims, seems to regard itself as above any sort of serious public accountability, despite the clear requirements imposed by Parliament.    You will recall that last week I noted that there was a range of unanswered questions about this whole episode (here and here).  The FSR answered none of them.  For example:

  • who discovered the error, and how?
  • how did it happen (both at the Westpac end, and at the Reserve Bank end)?,
  • what confidence can we have that there are not similar problems at other banks?,
  • what changes has the Reserve Bank made to its own procedures to reduce the risk of a repeat?
  • why was there no reference in the Reserve Bank statement to the failures of Westpac directors (even though director attestation is supposed to be central to the regulatory regime)?
  • did the Reserve Bank compel Westpac to raise new capital?
  • how much difference did the use of unauthorised models make to Westpac’s capital ratios?

Jenny Ruth of NBR (who covered the story in a column last week, noting that the Bank’s failure then to provide more information was “appalling”) asked some questions about the issue at press conference yesterday.     The answers weren’t particularly clear or helpful.

She asked why no directors were prosecuted (these were, after all, strict liability offences, and director attestations are a key part of the regime).  Grant Spencer basically refused to answer, just claiming that the steps they had taken were a “strong regulatory response”.

She asked about the other internal-ratings banks and whether there were such problems with them.  The first answer seemed to suggest that the Bank was confident, having checked, that there were not.  But as Spencer and Bascand went on, even that seemed to become less clear.  By the end it seemed to be a case of “we aren’t aware of any other problems and we are encouraged that some are having a look to check”.  It didn’t exactly seem like an aggressive pro-active response by the Reserve Bank, to a potential problem it has known about for more than a year (since the Westpac issues first came to light).  It turns out that ASB has had other problems around its capital calculations (apparently without penalty).

We learned one thing.  Asked who first uncovered the issue –  Ruth suggested she had heard that Westpac had uncovered the problem itself –  the Bank representatives responded that they had had their own suspicisions and had raised the matter with Westpac, who had then confirmed that there was a problem.   That was good to know, but it was only one small part of the questions that should be answered.

It is, perhaps, getting a bit repetitive to say so, but if the new government is at all serious about more open government –  and serious media outlets have raised questions about that in recent days –  then the Reserve Bank would be a good place to start.   The culture needs changing, and culture change is only likely to come from the (words and actions at the) top.    How the government can expect to find a Governor who would lead the Bank into a new era of openness and transparency when they are relying on the Board –  always emollient, always keen to have the Governor’s back, never revealing anything, never even documenting their meetings in accordance with the law,  – is a bit beyond me.  Sadly,a more probable conclusion is that the government doesn’t really care much, and that the repeated promises  by Labour, the Greens, and New Zealand First around the Reserve Bank were more about being seen to make legislative changes, rather than actually bringing about substantive change in the way this extraordinarily powerful, not very accountable, agency operates.  If so –  and I hope it isn’t –  that would be a shame.

 

Very slowly lifting LVR controls

It is a strange form of democracy in which an unlawfully appointed (and certainly unelected) bureaucrat, who faces little or no effective accountability, can descend from the mountain-top and decree new limits for how much different types of (potential) house buyers can borrow from banks.  But that is what Grant Spencer of the Reserve Bank did this morning with the release of the latest –  his one and only –  Financial Stability Report.  Our politicians seem to see nothing strange about this –  rabbiting on about “respecting Reserve Bank independence” in an area where there is no obvious reason for Reserve Bank independence at all.  If we have to live under the burden of regulation –  especially of the sort that directly affects ordinary citizens –  those controls should be imposed, or lifted, by politicians.  We can toss them out.  In this particular case, it is not as if there is even a clear statutory framework: the Reserve Bank is required to exercise its powers to promote “the soundness and efficiency of the financial system”, but neither they –  nor anyone else –  can really tell us what that means, or hence what limits, if any, it places on a Governor’s (or “acting Governor’s”) freedom of action. Arbitrary whims aren’t a good basis for government.

Don’t get me wrong.  I’m pleased to see the Reserve Bank making another start on easing the LVR controls (there was a partial easing a couple of years ago, but that didn’t last long).     The controls should never have been put on in the first place.   They started as a knee-jerk reaction from the previous Governor, without any good supporting analysis, and –  as so often happens with controls –  one control, originally sold as temporary, soon led to others, ever more onerous, with ill-founded exceptions.   As I summed up LVR restrictions a few months ago

They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

That discrimination?

We have direct controls on lending secured on housing, but none on lending secured on farms or property development –  even though the FSR notes that the dairy debt position still looks stretched, and recognises that internationally many of the losses in financial crises are on commercial property (especially development) loans.

We have much more onerous direct controls on potential owner-occupiers than on investors, even when the nature of the underlying collateral is identical.  Even if the investor borrower might, objectively, be a much better credit  (think of someone with a really secure job like a teacher or police officer buying a first investment property, and contrast then with a person (with the same income) with a job in a highly cyclical sector (thus at considerable risk of unemployment in the next recession) buying an owner-occupied dwelling).

And we have direct controls on housing lending by banks, but not by other lending institutions.

And, again as I noted earlier

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries –  appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks.   We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan books –  and those in other similar countries –  came through just fine.

The Reserve Bank has never seriously engaged with this sort of perspective, and never told us why we should be confident that they are better-placed to make credit allocation judgements than experienced bankers whose own shareholders’ money in on the line.

Some months ago the former Prime Minister called on the Bank to lay out clear and explicit markers that would see the LVR limits wound back and eventually removed.   Unfortunately we got nothing of the sort today (indeed, the idea that the restrictions will eventually go altogether –  and we can back to having banks making credit allocation decisions, at an individual and portfolio level –  got barely a mention in the FSR itself or in the subsequent press conference).    No doubt, the bureaucrats like having toys to play with.  They stress how hard it is  for them to lay down clear markers, but appear to put no weight at all on how hard it might be for citizens who have to make their own decisions against a backdrop of such regulatory uncertainty.  Sadly, there are few effective incentives to ensure that bureaucrats and politicians internalise those costs at all.   Politicians have to face re-election (and scrutiny in the House each day), but the Reserve Bank bosses face no such pressure.

Now, to be fair, this mess was primarily of Graeme Wheeler’s making, and Spencer and Bascand are left to tidy up the mess.  Since the LVRs were never grounded in good analysis in the first place, it is hard to set out analytically robust markers for lifting them.  But if analysis couldn’t offer much, perhaps there should have been a premium on predictability: the Bank could have laid out an expected numerical path under which over the next two years the LVR limits would be removed completely, with modest easing scheduled for each quarter.  Sure, they couldn’t have made binding commitments –  apart from anything else, some as-yet-unknown person will be calling the shots as Governor after March –  but indicative plans help provide certainty to banks, their competitors, to borrowers, and to other participants in the housing market.  And they create some hurdles that the Reserve Bank would need to get over before deviating from the announced path.    As it is, we have no idea –  no clues at all –  as to what pace the controls might be lifted at.

As a reminder, if the Reserve Bank is really concerned about the soundness of the financial system –  let alone the “efficiency” of the system, a key part of the mandate –  capital requirements (risk weights and required capital ratios) clearly dominate direct (and discriminatory) intervention in the credit allocation process.     That sort of insight was behind getting rid of direct controls back in the 1980s.

The Bank did attempt to lay out the criteria it would be using  in assessing whether and when to relax LVR limits further.  There were three.

  • Evidence that house price and credit growth have fallen to around the rate of household income growth.
  • A low risk of housing market resurgence once LVR restrictions are eased.
  • Confidence that an easing in policy will not undermine the resilience of the financial system.

The second and third aren’t specific at all, and provide little basis for citizens to hold the Bank to account.   But the second is also problematic, because the Bank has always claimed that its goal isn’t to eliminate, or even to materially dampen, house price cycles (the “acting Governor” this morning reiterated that there will always be housing cycles).  That second criterion only makes sense if there is evidence that house price cycles/increases are mostly caused by changes in bank lending standards, and the Bank has never produced any evidence for that in a New Zealand context.

The first criterion looks slightly more useful –  at least we can see the data for that.  But I’m not sure it is very robust.  First, why “household income”, when many of the houses are now bought by the small business sector –  nominal GDP growth might be as useful.  But, more importantly, the Bank’s criterion seems to cement in the current ratios of price and debt to income as some sort of equilibrium.   And they have absolutely no evidence at all for such a claim.  As they surely know, if land use is heavily-regulated then fresh shocks to demand –  from any source, including unexpected population growth –  will tend to raise debt and price to income ratios, with no particular reason to think that such movements raise financial stability concerns.  Lending standards are really what matter, not macroeconomic indicators.  And, of course, in floating exchange rate countries with a market-led allocation of housing credit, I’m not aware of a single case where housing loan losses have been central to systemic financial crises.

There was the customary self-congratulation this morning about the contribution the LVR controls have made.  The Bank keeps telling us LVR restrictions have “substantially improved” the resilience of the financial system.  It is another claim for which they advance no serious evidence.  They correctly note that the volume of high LVR loans is lower than otherwise (although a little footnote on page 6 suggests even that effect might have been quite modest), but they never ever explicitly recognise that if banks have fewer high-LVR loans they will be required to hold less capital than otherwise.  Or that since the incentive was now to lend lots of, say, 79.99 per cent LVRs –  not economically different from a loan of 80.01 per cent –  and yet capital requirements are typically materially lower on lower LVR loans, it is quite possible that the effective resilience of the banks has actually worsened a little.  As it is, their stress tests have told throughout that the banks are robust.

Two final points:

The first is that in some respects today’s moves further increase the regulatory wedge imposed between access to credit for investors, and that for owner-occupiers.  In essence, no one (or almost no one) can borrow from a bank to buy a residential rental property using a mortgage of more than 65 per cent of the value of the property.  (There is provision for up to 5 per cent of such loans to be above 65 per cent, but given the larger buffers banks operate to ensure that they don’t breach conditions of registration, it is effectively a near-zero limit).  That isn’t a decision of a professional credit-manager.  It is regulatory fiat, from people with little or no experience in credit allocation.  By contrast, 15 per cent of owner-occupied housing loans can now be to borrowers with LVRs in excess of 80 per cent.  If banks judge it prudent –  and it might well be, depending on the borrower and the overall portfolio –  some owner-occupiers will be able to borrow perhaps well above 90 per cent.    The Reserve Bank has not produced a shred of evidence –  in the past or today –  for such a huge gap, on identical collateral.   Recall my example earlier: lending an 82 per cent LVR loan to the police officer buying an investment property is likely to be materially safer than lending to, say, a person on the same salary buying a first home, but working in a highly-cyclical sector (eg construction or tourism).  Banks can make those sorts of distinctions – they get to know and evaluate their customers –  but the Reserve Bank can’t. Instead, we get crude controls slapped on and maintained for years.  It looks and feels a lot more like politicised credit preferences – owner-occupiers favoured over investors.  When politicians do it it might be odious and undesirable but….they are politicians, and they have to face the voters.  When bureaucrats do it, it is highly inappropriate.

As I noted in my housing post yesterday, in some ways it is a bit odd for the Reserve Bank to be starting to declare victory now.  For the last few years there has been little or no prospect of any material oversupply of physical dwellings (or urban land).  There was little effective liberalisation and huge population pressures, and much of the new building has been on a pretty small scale, done by the private sector.   But now net immigration looks as if it may have turned a corner, easing some of the demand pressures.  A series of tax and regulatory changes will also dampen demand, at least temporarily, a little.     And the government is talking up “build, build, build”, in a government-led process designed to generate a huge number of new houses in the next decade  You might be sceptical, as I am.  But it is explicit government policy.  And government-led investment projects face considerably weaker market disciplines –  and often operate on a considerably larger scale –  than private sector ones.    Government interventions in the housing finance market were a big part of what went wrong in the United States. Physical oversupply was a big issue in Spain, Ireland and (parts of) the United States.   How confident can the Reserve Bank be that if Kiwibuild really gets going at the scale envisaged that the risks can be effectively managed?   It is, after all, almost certain there will be at least one recession  –  wich won’t be foreseen – in the 10-year horizon of Kiwibuild.     I’m not using this as an argument for keeping LVR restrictions on –  they aren’t fit for purpose, and in any case the Bank bowed to political pressure to exclude loans for building new houses (the riskiest sort of housing loans) from the LVR controls altogether.  But I think they are wrong if they believe, as they stated this morning, that risks are now easing.  And capital standards are a better, less intrusive, way to manage any risks.

The sooner the LVR controls are behind us the better,  Sadly, unless the right Governor is chosen, that day doesn’t seem likely to be soon.

I’ll have some comments tomorrow on some other aspects of the FSR.