Banking Soundness and Monetary Policy

16 Banking Soundness and the Role of the Market

Charles Enoch, and J. Green
Published Date:
September 1997
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Banking soundness and the role of the market is a subject of particular relevance to New Zealand, given its adoption of a banking supervision approach that places considerable emphasis on the role of the market in promoting a sound financial system. Initially formalized in 1987, New Zealand’s approach to banking supervision was relatively orthodox between 1987 and the end of 1995. It involved minimum capital requirements (based on the Basle Accord); limits on the amount that banks could lend to individual customers and related parties; a limit on banks’ open foreign exchange positions; off-site monitoring of banks, using information provided privately to the central bank, the Reserve Bank of New Zealand; annual consultations with the senior management of banks; and a range of powers to enable the Reserve Bank to respond to bank distress or failure.

However, that system of banking supervision differed in some important respects from the approaches adopted in many other countries. In particular, New Zealand’s supervisory framework did not involve the licensing or supervision of deposit taking or the business of banking. Only those entities wishing to use the word “bank” in their name were subject to supervision. The country also did not have deposit insurance and did not seek to protect individual depositors. Instead, it sought to protect the financial system as a whole. Finally, New Zealand did not have on-site examination of banks. (These distinguishing features continue to apply under the new supervisory framework.)

In late 1991, the Reserve Bank commenced a major review of its banking supervision arrangements. The review was motivated by a number of concerns. Probably the main reason was a concern that conventional approaches to banking supervision make insufficient use of market discipline as a means of promoting a sound and efficient financial system. There appeared to be considerable scope to use market disciplines to promote systemic stability, in particular to hold the directors and management more accountable for the sound management of their bank. The Reserve Bank also wanted to improve the market’s ability to make well-informed decisions as to which banks they would do business with. It was felt that a well-focused and comprehensive disclosure regime would go a long way toward achieving these objectives.

Another factor that led to the review of banking supervision arrangements was a concern at the compliance costs and regulatory distortions associated with conventional approaches to banking supervision. This concern reflected the view that banking supervisors tend to have strong incentives to promote a stable financial system, without always having appropriate regard for the costs and distortions such supervision can cause.

There was also concern about the taxpayer risk involved in the traditional approach to banking supervision. Although this risk is present regardless of the form banking supervision takes, it is likely to be greater where the banking supervisor, and only the banking supervisor, has regular access to financial information on a bank. It is also likely to be greater the more intensive is the supervision process. The Reserve Bank wanted to explore ways of reducing the risk of the government being called upon to rescue a bank in distress.

Finally, conventional banking supervision can go only so far in promoting a sound banking system. There are inherent limitations in the extent to which prudential regulation and supervision, even supervision that includes on-site examinations, can minimize the incidence of bank distress and failure. This is evidenced by the fact that countries with intensive supervisory regimes have not been immune from serious episodes of financial distress. Indeed, banking supervision can even increase the risk of bank failure or distress by reducing the incentives for bank directors and managers to make their own considered judgments about what constitutes prudent behavior.

New Approach to Banking Supervision

In the light of these concerns, and following a lengthy period of review, New Zealand’s authorities decided to place greater reliance on market disciplines through public disclosure by banks, increasing the accountability of bank directors and management, and reducing the extent of prudential regulation. The new banking supervision arrangements, which came into force on January 1, 1996, reflect these aims.

The new approach differs from the former regime in two main areas. First, a new disclosure regime applicable to all banks has been introduced. The disclosure regime is designed to substantially strengthen the market discipline on banks and sharpen the incentives for the directors and management of banks to manage their banks’ affairs in a sound and responsible manner. The second major change involved a reduction in the extent of prudential regulation of banks: the removal of the limit on the amount that banks may lend to individual customers; the removal of the limit on banks’ open foreign exchange exposures; the removal of the Reserve Bank’s guidelines on internal controls and the associated audit requirements; and the removal of the need for banks to privately report their financial position and risk exposures to the Reserve Bank. In other words, it was felt that the new disclosure regime obviated the need for many of the former prudential controls on banks.

Undoubtedly the feature of the new approach that has attracted most attention is the disclosure regime. Under it, all banks must publish a disclosure statement each quarter. The statements are in two forms: a brief Key Information Summary, aimed at the ordinary depositor; and a more comprehensive General Disclosure Statement, aimed at the professional analyst. The Key Information Summary contains a short summary that covers the bank’s credit rating (or a statement that the bank has no credit rating); the bank’s capital ratios, measured using the Basle framework; and information on peak exposure concentration, peak exposures to related parties, asset quality, shareholder guarantees (if any), and profitability.

The Key Information Summary must be displayed prominently in, and be available on demand from, every bank branch. The General Disclosure Statement contains more wide-ranging and more detailed information on a bank and its banking group:

  • corporate information and some information on parent banks (where applicable);

  • comprehensive financial statements (including a five-year summary of key financial data);

  • credit rating information (including any changes in the rating in the two years preceding the bank’s most recent disclosure statement);

  • detailed information on capital adequacy, asset quality, and various risk exposures (including exposure concentration and related-party exposures);

  • information on fund management and securitization activities, risk management systems, and a summary of the prudential regulations imposed on the bank by the Reserve Bank; and

  • information on the bank’s exposure to market risk, both peak and end of period (and in respect of the full banking book).

The disclosure statements issued by banks are subject to a full external audit at the end of each year and a limited scope audit review at the half-year. Disclosure statements issued at the other quarters are not required to be audited.

One of the most important features of the disclosure framework is the role it accords bank directors. Each director is required to sign his or her bank’s disclosure statements (or authorize someone to sign on his or her behalf) and to make certain attestations in the disclosure statements, including:

  • whether the bank is complying with the prudential requirements imposed on it by the Reserve Bank;

  • whether the bank has systems in place to adequately monitor and control its banking risks and whether those systems are being properly applied;

  • whether the bank’s exposure to related parties is contrary to the interests of the bank; and

  • whether the disclosure statement contains all the required disclosures and is not false or misleading.

Directors face severe criminal and civil penalties (including up to three years in jail and personal liability for creditors’ losses) if a disclosure statement is held to be false or misleading.

The new disclosure arrangements are expected to bring a number of important benefits to the New Zealand financial system. First, they are likely to play an important role in strengthening market discipline on banks. Under the new arrangements, the market has considerably greater information on a bank’s financial performance and risk positions than was previously the case. And the information is available more frequently and in a more timely manner. The market therefore has greater scope to react to developments affecting a bank’s financial condition—rewarding those banks that are well managed and penalizing those that are not. The strongest banks are likely to benefit from lower funding costs; weaker banks are likely to be under pressure to strengthen their position. Over the longer term, less restricted markets are expected to make a major contribution to the soundness of New Zealand’s financial system.

Another benefit of the disclosure regime is a growing emphasis on the prudent management of banks. In particular, the disclosure framework clarifies the role of bank directors in ensuring that their bank has the necessary systems in place to identify and manage the bank’s various business risks and that those systems are being properly applied at all times. As a result, directors appear to be taking greater care to ensure that they adequately discharge their obligations.

Over time, the increased accountability of bank directors is likely to lead to an improvement in the quality of bank boards. Shareholders now face stronger incentives to ensure that the directors of their banks have the appropriate skills, experience, integrity, and judgment to fulfill the duties expected of them.

Another important benefit to flow from the disclosure regime is a reduction in the risk that the government will have to rescue a bank. As a result of the disclosure arrangements, there will be a stronger public perception that the management and directors of a bank have sole responsibility for the management of their bank’s affairs. Moreover, the public now has access to much the same information as does the Reserve Bank, thereby eliminating the monopoly of information that supervisors once enjoyed. Both of these factors should enable future governments to resist the inevitable pressures to rescue a bank in distress or to insulate creditors from losses—at least to some extent.

Although the new supervisory framework places great emphasis on the role that market forces can play in promoting systemic stability, it is important to note that the Reserve Bank of New Zealand has not abandoned its responsibilities for the financial system. It recognizes that, for the time being, systemic stability is best served by a combination of market disciplines and banking supervision. As such, a number of the Reserve Bank’s core functions have been retained.

  • It continues to have responsibility for registering new banks.

  • Banks continue to be subject to minimum capital requirements (in line with the Basle Accord) and to a limit on lending to related parties. Although disclosure alone would probably ensure that banks would maintain capital at least equivalent to the 8 percent minimum, the minimum capital requirements work to reinforce the credibility of the new supervisory framework, at no additional cost to banks.

  • The Reserve Bank continues to monitor banks on a quarterly basis. However, monitoring is now conducted principally using banks’ public disclosure statements, in contrast to the former system of monitoring on the basis of information provided privately to the Reserve Bank. In most respects, banks’ disclosure statements contain information that is more comprehensive and more reliable than the information previously provided to the Reserve Bank.

  • The Reserve Bank also continues to consult with the senior management of banks. Formal prudential consultations are held annually and generally focus on the strategic direction of the banks, major changes in their operations and other high-level issues. In addition, the governor of the Reserve Bank meets with the chief executives of the larger banks on a regular basis to discuss a broad range of issues, including those relating to the banking industry and to the wider economy.

  • And, importantly, the Reserve Bank retains a wide-ranging capacity to respond to financial distress or bank failure where a bank’s financial condition poses a serious threat to the stability of the banking system.

As with the former supervisory arrangements, the objective underlying the above responsibilities is the promotion of a sound and efficient financial system. Depositor protection does not feature in the Reserve Bank’s objectives.

Reactions to the New Supervisory Approach

All in all, the new approach has been relatively well accepted, although it has taken time for that acceptance to be achieved. It is fair to say that, during the review process, reservations about the new approach were expressed from a number of quarters, both at home and abroad. One of the observations was that New Zealand is “free riding” on the efforts of the home supervisors in a situation where most of our banks are subsidiaries or branches of foreign banks. We firmly reject this notion: the new supervisory framework is at least as effective at promoting prudent banking practices as are the more traditional approaches to banking supervision. Moreover, the Reserve Bank is satisfied that the new framework enables it to fulfill its duties as a host supervisor within the terms of the Basle Concordat. In that regard, under the new approach to banking supervision, the Reserve Bank remains well informed of the activities and financial condition of all banks operating in New Zealand and well placed to respond to incipient financial distress where appropriate. Indeed, the disclosure regime provides the central bank (and the public) with information that is more comprehensive than ever before. But it is certainly true that any host supervisor will inevitably rely, to some extent, on the supervision of the home supervisor. After all, this is an intrinsic part of the Basle Concordat. The most a host supervisor can realistically achieve is to promote prudent banking practices in the local operations of the banks within its jurisdiction.

In this context, some commentators have suggested that the Reserve Bank of New Zealand is not well placed to anticipate emerging financial distress in the absence of conducting on-site examinations of banks or otherwise obtaining private information from banks. Although on-site examinations do increase the information available to banking supervisors, it is not clear that the information obtained from such examinations enables the supervisors to reliably anticipate incipient financial distress. In modern banking, risk positions can and do change rapidly. A week in politics might be a long time, but in banking it is a very long time indeed! And this is increasingly the case. The information obtained from on-site examinations, or from any other source for that matter, can provide a snapshot of a bank’s risk position only at a particular point in time, and even then with respect to a subset of the bank’s business. For these reasons, such information is of limited usefulness in assessing the dynamics of a bank’s risk positions or in anticipating financial distress.

Of course, publicly disclosed information also has these limitations. But at least public disclosure brings with it incentives for the sound management of banking risks. It is not at all certain that the private disclosure of information to a banking supervisor—whether on-site or off-site—creates these types of incentives.

A further concern with on-site examinations or the off-site collection of detailed private information on banks, at least in the New Zealand context, is the risk that these approaches can blur the lines of responsibility for the management of banks. If the banking supervisor has responsibility for regular on-site examinations, it presumably follows that the supervisor also has responsibility for encouraging or requiring a bank to modify its risk positions or make other adjustments to its balance sheet where the supervisor has concerns in relation to the bank’s risk profile. This has the potential to erode the incentives for the bank’s directors and managers to take ultimate responsibility for the management of banking risks, effectively passing some of this responsibility to the banking supervisor. It also has the potential to create public perceptions that the responsibility for managing banking risks is effectively shared by a bank’s directors and banking supervisors. This makes it very difficult for a government to eschew responsibility for rescuing a bank in difficulty.

Any system of banking supervision—even one that relies principally on public disclosure—will inevitably create public expectations that the supervisory authority takes some responsibility for the management of banking risks. And any system of banking supervision creates a risk for the taxpayer in the event that a bank gets into difficulty. In order to minimize these risks, it is preferable to keep the spotlight on the directors and managers of a bank, rather than risk a further blurring of their accountability. Not having on-site examinations, and not having a regular flow of private information from banks, assists in this regard and reinforces market disciplines on banks.

Another frequent observation is that New Zealand would not have adopted its new supervisory framework had a substantial part of its banking system been domestically owned. It is my firmly held conviction, however, that we would have adopted this approach even if all or most of New Zealand’s banks had been locally owned. As noted above, the new regime is more likely to promote prudent banking behavior than the more traditional approaches, and with a lower likelihood of moral hazard and regulatory distortion. In this context, it should be noted that in late 1991, when the review of banking supervision commenced, a significant part of the New Zealand banking system was still domestically owned. Indeed, many of the changes implemented in New Zealand would be of equal relevance to those jurisdictions in which the core of the banking system is domestically owned.

Another criticism of the New Zealand approach is that comprehensive and frequent disclosure can, in some circumstances, exacerbate financial distress rather than promote systemic stability. This is true to some extent. For example, where a bank is required to disclose a loss or a severe deterioration in asset quality, this could lead to a sharp adverse reaction by the market, possibly causing the bank in question to come under liquidity pressure. Of course, this possibility exists with even the barest disclosure requirements—such as with the release of an annual report or six-month interim disclosures. And the risks of adverse market reaction are present even in the absence of disclosure requirements—for example, as a result of market speculation as to a bank’s financial condition. Indeed, in some circumstances the disclosure of comprehensive information might actually reduce the risk of the market reacting adversely to misinformation or to an absence of information. In any case, where a bank knows in advance that it will be making adverse disclosures, it would generally have the opportunity to take steps to reduce the risk of an adverse market reaction. These steps would include the disclosure of the remedial measures being taken to address the bank’s difficulties. In addition, the risk of a severe market reaction to an adverse disclosure creates the very incentives for banks to ensure that they manage their affairs in such a way that there will be no adverse developments to disclose. In the longer term, therefore, the risk of adverse market reaction could be expected to promote a sounder financial system.

One of the criticisms often made of public disclosure by banks is that the vast majority of depositors will not read banks’ disclosure statements. On this assumption, some observers suggest that disclosure is of limited effectiveness. We at the Reserve Bank do not agree. It is certainly true that most depositors are unlikely to read the disclosure statements, but the disclosure regime in New Zealand is not predicated on the assumption of wide readership by the ordinary depositor. The source of market discipline does not lie in wide public readership. Rather, the efficacy of disclosure rests on the assumption that the statements will be read by the agents of depositors, such as the financial news media, financial analysts, and investment advisers, and by wholesale creditors and fellow bankers. It is the risk of adverse reactions by these types of users that creates the incentives for bank directors and managers to conduct their banks’ affairs in such a way as to avoid the need to make adverse disclosures.

Although the disclosure regime does not rely on the mass readership of disclosure statements by depositors, the Reserve Bank is encouraging depositors to take a greater interest in their banks’ public statements. Over much of last year, it has actively publicized the new disclosure arrangements and prepared a “user’s guide” to assist depositors (and their agents) in understanding the disclosures being made by banks. The user’s guide is now available in every bank branch in the country. While it is unlikely to be a “bestseller,” it is encouraging to note that there has, in fact, been a surprising degree of interest in it from the public. Perhaps, over time, an increasing proportion of depositors will take a keener interest in their banks’ financial condition.

A final observation made about the new framework is that New Zealand’s approach places an excessive emphasis on the role of bank directors—that it asks too much of them. To illustrate this point, during the review process, the chief executive of a major international bank with operations in New Zealand visited the Reserve Bank. He had come to protest strongly the requirement that bank directors sign the disclosure statements every quarter and attest to the appropriateness of their risk management systems. He argued that “bank directors understand absolutely nothing about banking.” This comment is quite unfair about many bank directors, but there is an uncomfortable element of truth in some cases. The blame for this situation almost certainly lies with a supervision regime that assumed too much responsibility for the viability of banks. A regime based primarily on market disclosure and director attestations, combined with some key regulations, will improve that situation.

Early Effects of the Disclosure Regime

Although it is far too early to judge the success of the new supervisory approach, there have been some encouraging signs that the disclosure requirements are meeting a number of their objectives.

First, the financial news media in New Zealand have taken a close interest in the new bank disclosure regime. The quarterly disclosure statements have received detailed scrutiny from the news media, resulting in greater and more focused public exposure of banks’ financial results and risk positions. This type of media attention should sharpen the incentives for banks’ directors and managers to manage their banks’ affairs prudently.

A good example of the news media’s interest in banks’ disclosure statements is the story of one bank’s disclosure of its noncompliance with a Reserve Bank prudential requirement. The media’s response to this disclosure was surprisingly intense; most likely the managers and directors of the bank in question were not expecting it. This type of media attention, and the adverse publicity to which it inevitably gives rise, should encourage banks to comply with Reserve Bank requirements in the future. The threat of adverse publicity is likely to be a more effective discipline on banks than are many of the standard supervisory sanctions for breaches of regulatory requirements.

Second, the new regime seems to be strengthening the extent to which banks scrutinize each other’s financial performance and risk positions; banks are making considerable use of the disclosure statements to monitor each other. The additional and more frequent information now available could be expected to assist banks in managing their interbank exposures and in assessing the extent and nature of the business they conduct with each other. Thus, the banking industry itself is one of the most potent sources of market disciplines on individual banks.

Third, anecdotal feedback suggests that the obligations now placed on bank directors are causing some of them to look more closely at their banks’ risk positions. In turn, this seems to be focusing greater attention on the systems in place for identifying and managing risks. Moreover, some banks are taking steps to increase the accountability of various levels of management within their banks. Some have engaged external consultants to review aspects of their risk management systems, and part of the motivation for conducting these reviews seems to lie in the disclosure requirements—particularly the director attestation as to the adequacy of a bank’s risk management systems.

These are all pleasing developments, and they auger well for the success of the new arrangements. But the Reserve Bank is under no illusion that the new arrangements guarantee financial system stability; no system of banking supervision can do that. At the most, the disclosure regime will significantly reduce the likelihood of financial system instability in the future—at lower regulatory, compliance, and taxpayer costs than other supervisory options might be expected to achieve.

Market Disciplines and Banking Supervision

How representative is New Zealand’s experience of using market forces to encourage prudent behavior in the banking sector? Could market disciplines be better incorporated into the supervisory frameworks in other countries with similar success? The remainder of this paper deals with these questions.

At the outset, it should be emphasized that the Reserve Bank is not promoting the New Zealand supervisory model as the ideal model for other countries. It makes no such claims. The New Zealand model meets our country’s particular needs, but it might not necessarily be suitable for other countries. Each country needs to make its own judgment as to the type of supervisory framework best suited to its unique circumstances.

Nonetheless, market disciplines can play a substantial role in most financial systems. In particular, policymakers in many countries should consider the merits of comprehensive and well-focused disclosure requirements for banks. Similarly, there is much to gain from strengthening the responsibilities of bank directors, so that the ultimate responsibility for the management of banking risks resides squarely in the boardroom, rather than balanced between the bank director and the banking supervisor.

The effectiveness of market disciplines will depend on the structure of the regulatory arrangements in place and the nature of the infrastructure within which the banking system operates. In particular, the following factors contribute to the effectiveness of disclosure as a mechanism for promoting systemic stability.

  • Market disciplines are more likely to be effective when governments do not insulate depositors from losses—whether explicitly in the form of deposit insurance or implicitly through depositor protection. Understandably, depositors and other creditors are less likely to take an interest in a bank’s financial condition when they know, or have good cause to surmise, that they will be insulated from losses should the bank get into difficulty. In such circumstances, banks that perform poorly are less likely to face adverse market reaction than when creditors operate under the expectation that they are likely to lose money in the event of a bank failure. In part, this is why New Zealand has eschewed deposit insurance or depositor protection and has sought to make it clear to depositors, among others, that they should not expect the government to insulate them from losses in the event of a bank failure.

  • It is also fair to say that market disciplines are more likely to be effective when the supervisory requirements applied to banks are kept to a minimum. First, the greater the supervisory requirements, the more likely it is that the market will perceive that the government is underwriting individual banks. And second, the greater the supervisory requirements, the less likely it is that bank directors and managers will view themselves as having ultimate responsibility for the management of their banks.

  • The effectiveness of market disciplines will also depend on the structure of the financial system. In particular, market disciplines are likely to be more effective when a bank is domestically owned—that is, when no other bank stands behind it. When a bank is owned by another bank, the market naturally looks to the financial condition of the parent bank when assessing how to react to disclosures made by the local bank. Market disciplines might therefore be somewhat more subdued in a financial system characterized by high levels of foreign ownership than in one dominated by locally owned banks. Having said this, even in a financial system that is largely foreign owned, such as New Zealand’s, there is very considerable scope to use market disciplines to promote improved risk management by the subsidiaries and branches of foreign banks. Indeed, it is possible that New Zealand’s disclosure regime might well be adding to the incentives for overseas parent banks to supervise their New Zealand operations more vigilantly and to give greater attention to their own financial condition.

  • The extent of government ownership of the banking system is also likely to influence the effectiveness of market disciplines. The market is simply less likely to impose meaningful disciplines on a bank that is state owned than one that is privately owned—assuming that the market has faith in the financial soundness and political stability of the government in question. However, even when a bank is state owned, a robust disclosure regime might well strengthen the accountability of the directors and managers of the bank, leading to improved risk management within the bank.

  • New Zealand’s experience shows that market disciplines are more likely to be effective where banks are required to make comprehensive disclosures on a frequent and timely basis. The disclosure requirements should focus on the key aspects of a bank’s financial performance and risk profile and should be made with sufficient frequency and timeliness as to provide the market with a meaningful basis for assessing a bank’s financial condition and comparing one bank with another. Disclosure is likely to be more meaningful and effective if it is supported by robust accounting standards that have the force of law. Certainly, in the case of New Zealand, our disclosure regime has been assisted greatly by the introduction of legally binding and more rigorously drafted accounting standards. Moreover, disclosure requirements should ideally be coupled with an appropriate legal framework governing bank directors—a framework designed to encourage directors to manage the affairs of their bank in a sound manner and to hold them accountable for any breaches of those duties.

  • Finally, the effectiveness of market disciplines through public disclosure is influenced by the infrastructure within which banking operates. “Infrastructure” refers to the nature and adequacy of corporate law; the adequacy of accounting standards and auditing requirements; the sophistication and integrity of the accounting profession; and the adequacy of the financial news media and financial professionals. All else being equal, the more well developed the infrastructure, the more likely it is that market disciplines will be effective. This suggests that, in the case of some developing countries, where perhaps the infrastructure is not well developed, the scope for using disclosure to promote market disciplines is somewhat more limited. But even so, there is merit in developing relatively simple disclosure requirements, drawing on international accounting and auditing standards as appropriate, as a means of promoting some rudimentary market disciplines.

There is one case in which it would not be helpful to introduce new disclosure requirements—when the banking system is fragile. Doing so could well exacerbate the weakness. That is why New Zealand introduced the disclosure regime when the financial system was in a strong position and when disclosure would help to maintain confidence in the banking system, not detract from it.


Market disciplines can play a powerful role in promoting systemic stability, in conjunction with some degree of banking supervision, and policymakers should give further thought to how market disciplines could be used to better reinforce the efforts of banking supervisors in the quest for systemic stability. However, in giving thought to this matter, it may well be necessary for policy makers to reassess some fundamental aspects of the conventional approaches to banking supervision and their relationship to the promotion of market disciplines. These include such issues as depositor protection, deposit insurance, the extent of prudential regulation of banks, and the intensity with which banking supervision is conducted. These are all substantial issues, and there will be continuing international debate as to where the appropriate balance lies. I very much hope that the approach we have adopted in New Zealand will assist in promoting international debate on supervisory options.

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