Simon Jensen calls for a more internationally orthodox, and less conservative, approach to prudential regulation from the Reserve Bank

By Simon Jensen*

Much has been written about the unexpected resignation of Adrian Orr in the last few weeks. However, there is a risk of distraction from the core issues which are being identified by the Finance and Expenditure Committee's Banking Inquiry.  One of those is, does New Zealand want an orthodox central bank or not? 

A time for orthodox prudential regulation

Much of the focus since Orr's resignation has been on his championing of high bank regulatory capital ratios to deal with a one in two-hundred-year risk. However, while a lightning rod for criticism, it is changing other policies that are more conservative than international norms that will make a difference to competition.

The big banks will be the winners from lower capital ratios unless they pass on the benefit of lower funding costs to consumers and use the extra lending capacity created to help stimulate economic growth. We can only hope there is enough transparency created by the Banking Inquiry to ensure that happens and all borrowers end up better off.

The things that will make a difference to competition will be things like removal on the restriction on the use of the word bank for those that provide regulated banking services, deposit insurance at a low flat rate for new entrants (as the Commerce Commission suggested), and the loosening or removal of restrictions on overseas banks operating through branches in New Zealand.

Far from creating financial stability risk, an approach to prudential regulation aligned with the rest of the world should enhance stability.

Orr's time as governor

It is too easy to lay the blame for the inefficiencies and poor competition in the New Zealand banking market which have been identified by the Commerce Commission and now the Finance and Expenditure Committee (FEC) on the Governor of the Reserve Bank (RBNZ). Orr was, in my experience, the most accessible governor in the last 30 years. Orr, also in my experience, cares about people regardless of whether they are a student he bumps into in the lift or a former senior colleague of his. I suspect he also had the strongest people leadership skills of any recent RBNZ governor. It is also important to understand that when Orr was appointed as governor these were exactly the sorts of skills that were needed at the RBNZ. 

However, everything changed, and Orr ended up as governor during a period of unprecedented complexity. There was no playbook for how to manage during the Covid lockdown. There was, at the same time, fundamental and generational change required to the way in which the RBNZ was being required to prudentially regulate following the 2017 International Monetary Fund's financial sector assessment of New Zealand.

Others are better placed to comment on the RBNZ’s monetary policy during Covid and our subsequent cost of living crisis. However, the RBNZ has not dealt well with changes to the way in which it is being required to prudentially regulate. The ultimate accountability for this, in my view, rests squarely with former Minister of Finance Grant Robertson who did not provide the RBNZ board with the prudential and change management skills required to do this core job.  Instead, it seems he was more focused on the "nice to haves" that were incorporated into his first Financial Policy Remit – things like climate change and financial inclusion.

The RBNZ's history as a prudential regulator

To understand the extent of change required at the RBNZ, it is important to understand its history as a prudential regulator. For much of the last 30 years the RBNZ believed it had a better way of prudentially regulating than other central banks. The RBNZ’s approach was to focus only on two of the three pillars of prudential regulation. These were the self-discipline and market discipline pillars. For long periods the RBNZ avoided using regulatory discipline – in effect anything which could make it accountable for failing to adequately supervise our banks.

Self-discipline involved creating strong accountability regimes for directors. Particularly through attestations required in disclosure statements – but it also spawned in part, the unusual and conservative local incorporation policy to ensure there were local directors to hold accountable.

Market disciple involved ensuring the market – predominantly mum and dad depositors – had the same information as the RBNZ and incentives to monitor their bank's financial performance by ensuring that they would be the ones that lost money if a bank failed. This was at the heart of the RBNZ’s resistance to deposit insurance when virtually every other developed country in the world had it. 

If deposits were insured, the Government through the RBNZ would be responsible for protecting depositors. It also resulted in the controversial open bank resolution scheme which should not still be a RBNZ policy. That policy is designed to ensure that "mums and dads" are responsible for recapitalising a failed bank. We are the only country in the world that has such as explicit policy, most countries now opting for much more sophisticated bail-in arrangements through wholesale investors that were developed in the aftermath of the Global Financial Crisis.

The RBNZ for a long time resisted doing onsite inspections of banks, which is a core element of regulatory discipline. Instead, additional restrictions and obligations were imposed like restrictions on the use of the word bank and obligation to maintain a credit rating. These added costs and created barriers to competition.

The 2017 IMF report on New Zealand

Notwithstanding that New Zealand should have realised the rest of the world was right in its approach to prudential supervision after the Global Financial Crisis, the RBNZ continued with its approach until it became impossible to avoid change. That happened in 2017 when the International Monetary Fund (IMF) did its Financial Sector Assessment of New Zealand. This included a review of the way the RBNZ undertook prudential regulation. The IMF was critical of New Zealand's approach of not having deposit insurance and not undertaking onsite supervision of banks. It also became clear at the same time that New Zealand needed to change both the RBNZ's governance and the legal foundation on which the RBNZ regulated banks. 

This resulted in two new key pieces of legislation, the Reserve Bank of New Zealand Act 2021 and the Deposit Takers Act 2023. Under the Reserve Bank Act, the presidential model of the Governor being accountable to no-one, was replaced by a model whereby the Governor became accountable to a board. Under the Deposit Takers Act, the RBNZ would no longer be able to impose regulation on banks through conditions of registration, but would instead have to use formal standards. These standards would have the same status as regulations and could therefore be disallowed by Parliament. This addressed a concern about an accountability deficit raised in a report for Treasury by a Queens Counsel some years earlier. 

In substance, prudential regulation is no different from any other form of regulation for which politicians should be accountable. Politicians can and should set parameters for that regulation. There is no need for the RBNZ to be operationally independent on prudential regulation, although their specialist skills mean they are well placed to implement the detail of prudential regulation and be the enforcement agency.

How RBNZ should have responded

What should have happened in response to the IMF report and the legislation passed as a consequence is a change management programme at the RBNZ aimed at converting it to an orthodox central bank with policies aligned with international best practice, unless there were market or legal reasons to do otherwise.    

Instead, we have simply layered new requirements, or at least propose to, based on conservative policies designed for a time when the RBNZ did things differently from the rest of the world. 

All of the issues that needed to be addressed long pre-dated Orr and were changes that needed to be driven at board level. However, no attempt was made to appoint board members with the level of technical expertise and change management skill to support this generational change. 

Even with the governance changes it is difficult to understand how or why you would expect the same people leading the board to fundamentally change the way in which they operate and had for over a decade in some cases– effectively transitioning from a "sounding board" to a "governance board". 

Issues with government policy agencies

However, the issues with inefficiency in our financial sector and lack of competition should not be laid solely at the feet of the RBNZ. The issues with the agencies on the other side of the Terrace are just as acute.

It seems clear that successive ministers have not been well advised in areas such as consumer protection in our credit markets, financial conduct regulation, financial markets infrastructure and the government's role in the banking and payments markets. This arises, in my opinion, because of a lack of subject matter expertise amongst those advising ministers, and an embedded culture in our government agencies that sees regulation as the default solution.  Progressively that regulation has become more detailed and more prescriptive.

This happens because we have a public service where the most senior people are not subject matter experts, but typically senior public servants who have moved between multiple government departments during their careers. Very rarely would they have the 10,000 hours of subject matter expertise that Malcolm Gladwell would say is necessary to be an expert.  By contrast in professional services firms the key advisors will often have decades of subject matter expertise and will have teams of people supporting them promoted for their expertise not their tenure. 

Naturally these public servants default to regulation as the area that they are most comfortable with. Furthermore, regulation is often developed in a bubble because public servants are too concerned about being influenced by the private sector if they attempt to collaborate with them in drafting regulations. Feedback from those in financial services firms that deal with regulators globally is that they find the New Zealand officials hardest to deal with because they simply won't talk to them, unlike officials in Australia and the United Kingdom. 

Consequently, we still have very poor consumer credit legislation in spite of issues repeatedly being raised with officials and ministers. The legislation is dense and complex imposing significant compliance costs for anyone who wants to lend money, and many simply avoid lending money to consumers as a result, and doesn't result in benefits to customers.  Consumer legislation should be clear and concise and easily capable of being understood by the people it is intended to protect – the consumers.  The "quid pro quo" for simple principle-based outcomes focused regulation should be easy access to justice by consumers – which is mostly free.  Instead, we choose to tinker with legislation and regulation which is simply not fit for purpose and not focus enough on free and fast access to justice.

On top of that we have a requirement for banks and non-bank deposit takers to have a conduct licence even though the Ministry of Business, Innovation & Employment found in its report there were no conduct issues with them, just some process concerns. Nevertheless, we now have legislation which requires people who never had any conduct issues to start with to be licenced and completely ignores the fringe finance sector who do not require a licence. This is also in spite of the National Party promising to get rid of the regime in the 100 point plan on which it was elected.

Payment Infrastructure

We have just had an infrastructure conference in New Zealand. However, nowhere in that conference was there any discussion on critical infrastructure required for a world class digital economy – being a world class digital payments system.  Australia's Treasury recognised the importance of this five years ago and that even though there were no immediate risks they knew if they didn't do something Australia would be left behind in 10 years. Our government, on the other hand, have done nothing because of a lack of leadership from Treasury who are responsible for banking and therefore payments for government.

FEC final hearings

It will be interesting to hear from the RBNZ and particularly, RBNZ Chairman Neil Quigley, who has been a board member for nearly 15 years and the Chairman for nine years, next week at the Banking Inquiry. The RBNZ’s response to the fact that prudential regulation has been identified by both submitters to the Inquiry and the Commerce Commission as one of the root causes of an inefficient and uncompetitive banking market will tell us the extent of governance, culture and strategy renewal required at the RBNZ.

It is a shame, this same accountability is not being sought by the Inquiry from officials from Treasury and Ministry of Business, Innovation and Employment who have just as much to answer for, but have not appeared before the Inquiry.    

As Andrew Body said to the Finance and Expenditure Committee, this is a once in a lifetime opportunity to get financial regulation settings right for New Zealand. It is to be hoped that the FEC and Minister of Finance Nicola Willis take that opportunity.

*Simon Jensen is a legal consultant with a BCom in accounting and LLB from the University of Auckland.