Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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New Zealand is a model of economic liberalization. As David Henderson, former head of the OECD’s Economics and Statistics Department recently noted, “… no other OECD country has such a portfolio of liberalizing measures to show,” Indeed, the depth and breadth of reform in New Zealand since 1984 provide a model for all countries, not just OECD members. Nevertheless, many of the world’s central bankers and supervisory authorities, while lauding a number of New Zealand’s achievements in liberalization, have mixed feelings about the new approach to bank supervision that has been adopted by the Reserve Bank of New Zealand. Perhaps, unlike the Reserve Bank, they simply prefer to countenance a relatively high degree of economic regulation. I am inclined, however, to think the doubters are more objective and pragmatic than this. Donald Brash acknowledges that what is good for New Zealand is not necessarily good for other countries. My own view is that, while the Reserve Bank’s approach may or may not be good for New Zealand, it would most likely not be the best approach to adopt in many other countries.

This is not a criticism of New Zealand’s emphasis on public disclosure and market discipline as instruments to achieve a sound banking system. It is widely accepted that public disclosure is, other things being equal, most likely a good thing for any country. The Eurocurrency Standing Committee of the G-10 Central Banks stressed its importance in a report of late 1994, as did the Basle Committee a year later. The real dispute is over the extent to which increased public disclosure can substitute for less supervision of the conventional form. The Reserve Bank’s deemphasis of conventional supervision is not motivated by its direct costs—the wages and overheads of the supervisors. It is motivated by concerns about the potential for large resolution costs of a bank crisis that could result from a lack of market discipline. The central bank’s desire for market discipline is, as an ideal, beyond criticism. The question is whether it is a substitute for certain supervisory activities, as Brash’s paper suggests, or a complement to them.

An analysis of Brash’s interesting paper presents two interrelated questions. First, is the heavy emphasis on bank disclosure in the central bank’s new supervisory approach likely to be good for New Zealand (and, by implication, for countries with a similar degree of structural development)? Second, is this emphasis on bank disclosure good for other countries, in particular developing and transitional countries?

New Zealand’s Experience

Brash states that the central bank’s new approach to supervision arose from a concern in New Zealand that bank supervision might actually be harmful for bank soundness because it could potentially reduce the incentives for banks to oversee themselves. If this proposition is valid, then one would expect that a reduction in conventional supervision, combined with more public disclosure, would increase both the soundness and the long-run profitability of New Zealand’s banks. Since the new supervisory arrangements depend heavily on a prescient market, in principle one could test this proposition, perhaps crudely, by looking at the prices of bank shares relative to the broader stock market index in New Zealand around the time of the changes in the supervisory arrangements. Unfortunately, it is not possible to perform such a test for New Zealand because there is no bank currently listed on the stock exchange that can be considered a “native” New Zealand bank. In any case, it would be interesting to know whether there has been any more rigorous testing to see if there is evidence that the markets expect the new arrangements to be good for banks, independent of other benefits to the nation.

But suppose there were strong evidence that the market thinks the new arrangements are good for bank soundness. It seems that this does not necessarily prove that investors really think the onus is now on them to determine whether their money is safe. The Reserve Bank continues to monitor banks on a quarterly basis, principally using publicly disclosed information to carry out this monitoring. As Brash notes, this information is, in most respects, more comprehensive and more reliable than that previously provided to the Reserve Bank. It could be argued that if the new arrangements better ensure sound banking than the old arrangements did, it is because the new arrangements provide the supervisory authorities with better information than they had in the past. In other words, one suspects that even if information is publicly disclosed, the real concern is its availability to banking supervisors.

Perhaps Brash can dispel this suspicion by elaborating on what the central bank would do if, upon its regular monitoring, it discovered that a bank had been imprudent (or just plain unlucky), and that it would fail. Apparently, the Reserve Bank would do something in its wide-ranging capacity if it thought such a failure would pose systemic risks. But what if there were no systemic risks? How ruthless would the central bank be as a lender of last resort? And would the government of the day really stand by and do nothing? Any implicit commitment to provide deposit insurance is undoubtedly lower in New Zealand than in most, if not all, other countries. But depositors may not be fully convinced that there really is no such commitment until an uncompensated bank failure takes place.

Brash addresses a number of common criticisms of the New Zealand approach:

  • the Reserve Bank “free rides” on the home-country supervision of New Zealand’s largely foreign-owned banking sector;

  • on-site inspections are a vital part of any bank supervisory framework;

  • public disclosure can exacerbate financial distress;

  • the new supervisory arrangements ask too much of the average depositor; and

  • the new arrangements ask too much of the average bank director.

A brief response to Brash’s remarks on each of these criticisms follows. Brash tells us that New Zealand would have gone ahead with the changes in its supervisory system even in the absence of such a high degree of foreign ownership. No doubt he would have adopted this stance, but it is possible some others might not have taken such a position. At least some of the policymakers in New Zealand, who supported the shift to an emphasis on disclosure and market discipline relative to conventional supervisory oversight, no doubt did so because they were confident that the home country regulators of New Zealand’s largely foreign-owned banking sector would continue to supervise banks headquartered in their countries.

Brash is correct when he says that the one-year period between on-site inspections is a long span of time in banking. But supervisory authorities do not sit on their hands in the interim. And the period between public disclosure dates in New Zealand—three months—is also a relatively long time in banking. Experience shows that many banks have become insolvent in less than three months. Moreover, an on-site inspection once a year is far better than none at all. In an IMF seminar in January 1997, Gerald Corrigan, former President of the Federal Reserve Bank of New York, emphasized that “The annual on-site inspection … is the most difficult and most important feature of an effective system of banking supervision.” This view applies to industrial, as well as developing countries. The United Kingdom, for example, has recently increased the effort it puts into on-site inspections, as has the United States during the last ten years.

Brash acknowledges that comprehensive and frequent disclosure could exacerbate a bank’s difficulties. His counterargument that adverse reactions can occur despite little or no public disclosure is a little lacking in evidence; it is a question of degree. His contention that banks can disclose remedial measures being taken to remedy the situation is more appealing, in part because it is consistent with the presumption that the public can intelligently analyze disclosures. But is the public able to analyze remedial measures as well as it can, say, compare two banks’ capital-asset ratios? And are falsehoods or half-truths in this regard easily detected and punished?

Brash’s point that the average depositor can rely on the media’s analysis of the information disclosed by banks is well taken. And it is a credit to New Zealand that various, hopefully widely consumed, media are undertaking this analysis. But the world is becoming increasingly complicated and specialized, and there are limits to all of this. A particular concern is that a supervisory authority is normally in the best position to analyze banks’ market risk management (and that others’ ability to do this is currently so untested as to justify any moral hazard caused by largely leaving it to the supervisors).

There is, of course, already a standardized method for measuring market risk, whether it be interest rate, foreign exchange, or equity risk. And there is potential to develop a good disclosure format for the use of internal models to measure market risk. But, in its January 1996 Amendment to the Capital Accord to Incorporate Market Risks, the Basle Committee was very clear in its belief that supervisors must monitor risk management. In New Zealand, each bank’s directors must attest to whether they have in place, and are properly applying, adequate systems to monitor and control their market risks. As has been noted, such an assessment is very complicated. While more learned than the average depositor, the average bank director presumably could be misled as to whether supervisory systems are properly in place. Presumably, he/she would still be accountable for false and misleading disclosure statements, but this is not enough. Furthermore, false and misleading disclosure statements often occur at precisely those times when there is an increased risk that a bank will run into trouble; that is, that its creditors will incur losses. Can a bank’s own directors easily detect falsehoods in those cases where such falsehoods are being used to temporarily enhance, for personal gain, the publicly perceived worth of a bank?

Developing and Transitional Countries

Brash notes that New Zealand’s new system for ensuring banking soundness may not work for other countries, particularly developing countries. He might have argued, however, that a reasonable number of them could modify the system slightly, while preserving its essence—sound banking and reduced moral hazard—through an overriding emphasis on public disclosure and legal responsibility at the bank director level. But it is doubtful whether this approach would be successful. The problems facing developing countries in implementing such a system are both more serious and more numerous than those facing industrial countries.

There are several institutional characteristics of developing and transitional economies that pose particular problems. First, the degree of state ownership of banks in these countries tends to be much higher than in industrial countries and, partly for this reason, the extent to which the market can be relied on to exercise discipline is more limited. While the goal in many cases should be to divest the state of such ownership, the fact remains that until this goal is achieved, increased public disclosure and reduced conventional supervision will do little to shift the burden of responsibility away from the state. Second, the legal framework in many of these countries needs to be significantly improved before the responsibility can realistically be shifted to directors of either private or state-owned banks. Third, bank lending in developing and transitional economies tends to be more concentrated, directed, and connected than it is in industrial economies. The Reserve Bank of New Zealand retains limits on connected lending, as should any central bank. But this approach does not resolve the problem. The true extent of concentrated and directed lending would most likely be hidden by the need for banks to protect the identity of individual counterparties.

There are also a couple of distinguishing macroeconomic characteristics of developing countries that pose particular problems. First, developing countries tend to be subject to more extreme macroeconomic conditions than industrial countries, and thus their banks are subject to greater market risk. Here the ideal is to promote a more stable macroeconomic environment. But until this is feasible, real questions arise regarding the private market’s ability to monitor a bank’s risk management procedures: market risk is greater while at the same time the general public is probably less capable of assessing any given degree of market risk. Second, more volatile macro-economic conditions in developing and transition economies, typically combined with a higher concentration of banks, are also likely to mean that problems in the banking sector pose systemic risks. The central bank must step in when a bank failure poses systemic risks—as apparently the Reserve Bank of New Zealand would in similar circumstances.

In conclusion, my comments have been stimulated by New Zealand’s bold experiment in increased reliance on market discipline as an instrument to the further goal of ensuring a sound banking system, as well as by the interesting and provocative arguments put forward in Brash’s paper. No one can object to a desire to boost market discipline in any country of the world. But, the jury is still out on whether New Zealand’s new bank supervisory arrangements are, on balance, good for banking system soundness. Even if they are, I think that for developing countries, the introduction of arrangements similar to those now in place in New Zealand would have to come very late in the sequencing of financial reform.

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