Central Banking in New Zealand Central Banking in New Zealand

Central Banking in New Zealand Central Banking in New Zealand In the 1990s, the Reserve Bank of New Zealand was noteworthy internationally as a central bank that pioneered inflation targeting, disclosure-based banking supervision and, latterly, a wholesaling approach to cash management. More recently, much of what the Reserve Bank has done has come to be seen as orthodox by international standards. This brochure explains how central banking in New Zealand has developed in each of these three areas over the last decade and a half, and the challenges that the Reserve Bank sees ahead. Central Banking in New Zealand The functions of the Reserve Bank The Reserve Bank of New Zealand is similar to other central banks in terms of the duties that it is required to carry out. The Reserve Bank’s three main functions are: • • • operating monetary policy to maintain price stability; promoting the maintenance of a sound and efficient financial system; and meeting the currency needs of the public. Under the Reserve Bank of New Zealand Act 1989, the Reserve Bank is required to independently manage monetary policy to maintain overall price stability. The Act also requires that the operational details of the Bank’s inflation target are set out publicly in a separate agreement between the Governor and the Minister of Finance, which is known as the Policy Targets Agreement (PTA). The current inflation target is annual CPI1 inflation of between 1 and 3 per cent on average over the medium term. This is achieved through managing the overnight interest rate, known as the Official Cash Rate (OCR). The Reserve Bank is responsible for the registration and prudential supervision of banks, to help promote a sound and efficient financial system. Overseas-owned banks are permitted in New Zealand and we operate a light-handed regulatory regime for banks, which relies on a combination of self, market and regulatory discipline. There is no government guarantee for individual banks or any depositor protection in New Zealand. The Reserve Bank issues New Zealand’s currency. We also have some other functions which are typical of central banks generally. Thus we: • • act as banker to the banks, providing inter-bank settlement facilities and related payment services; manage New Zealand’s foreign exchange reserves to enable intervention in the foreign exchange market, if required; • • • provide cash and debt management services to the Government; advise the Government on the operation of the financial system; and provide secretariat services to the New Zealand Overseas Investment Commission.2 1 2 Consumers Price Index. This involves providing staff, offices, systems and, if required, paying for costs not met by application fees. Generally, however, the Commission is self funding. At the time of writing the Commission’s institutional arrangements were under review. Central Banking in New Zealand 1 Governance The Reserve Bank was established in 1934 and is wholly government owned. Its current governance arrangements and institutional purpose are defined in the Reserve Bank of New Zealand Act 1989. A key feature of this legislation is the way it specifies broad objectives for the Reserve Bank’s core functions and then gives the Bank a high degree of autonomy in terms of how the Bank meets these objectives. This is especially pronounced in the monetary policy area. Part of that distinctive operational autonomy is a particular reliance on the Bank’s chief executive – the Governor – to make the Bank’s operational decisions and then to be accountable for them. Thus the Reserve Bank does not use committees, internal or external, to make formal decisions. The Bank has an extensive internal committee system which provides the Governor with detailed advice. However, under the Reserve Bank Act, authority is vested in the Governor, unlike many other central banks where decision-making authority is often vested with committees. This centralised management is designed to strengthen the Bank’s accountability by making the responsibilities of the Bank’s chief executive explicit. In the case of monetary policy this is augmented by a separate written contract – the Policy Targets Agreement – between the Governor and the Minister of Finance, laying out in detail what monetary policy is required to achieve. This is a public document. Accountability is enhanced by the Bank having a Board of Directors which monitors the performance of the Governor and the Bank, and reports to the Minister of Finance. The Board can recommend the Governor’s dismissal and plays a key role in the appointment or reappointment of a Governor. Reserve Bank officials attend a Finance and Expenditure Select Committee hearing. 2 Central Banking in New Zealand Historical context As with many other central banks at the time, prior to the 1989 legislation the Reserve Bank acted as an adviser to the New Zealand Government and was subject to ministerial directions in relation to monetary policy and its other responsibilities. Decision-making was at the discretion of the Minister of Finance. In the case of monetary policy, ministerial directions to the Reserve Bank typically were secret and priorities shifted frequently. Monetary policy was often aimed at a number of sometimes conflicting objectives. In the 1970s, New Zealand had one of the worst inflation records among OECD countries at that time, with annual CPI inflation sometimes above 15 per cent. Economic activity fluctuated widely and showed minimal overall gains, while unemployment climbed significantly. Britain’s entry into the European Economic Community in 1973 meant that the main market for our exports was no longer secure. A structural shift in New Zealand’s terms of trade contributed to a long-term weakening in the performance of the economy and persistent balance of payments difficulties. Among economists and policymakers the legitimate purpose of monetary policy was increasingly controversial. By the early 1980s, these circumstances engendered a sense of economic crisis. In mid-1984 New Zealand began a rapid process of economic deregulation and state sector reform. As part of this, a consensus emerged among policymakers that New Zealand needed to restore price stability. In part, this reflected a growing realisation that attempting to use stimulatory monetary policy to deliver faster sustainable economic growth would not work. The dollar was floated in March 1985 and by ministerial direction monetary policy was switched to an exclusive focus on getting inflation down and then keeping it down. This priority was passed into law with the passage of the Reserve Bank of New Zealand Act 1989, which established the framework within which the Reserve Bank operates today. The 1989 Act also reflected reforms that were occurring more generally in the New Zealand state sector during the late 1980s, as seen in the State Sector Act 1988 and the Public Finance Act 1989. These reforms were based on the belief that public agencies would perform better if they had more discretion as to how they achieved their goals. This was to be balanced by much more explicit directions as to what the goals of public policy should be. This meant giving public sector managers greater authority to manage, but holding them directly accountable for specified outputs – these being measurable products or services that each agency was mandated or contracted to deliver. The need for democratic input was to be met by setting clear goals or required outputs and then holding agencies accountable. Central Banking in New Zealand 3 Reserve Bank of New Zealand Act 1989 The 1989 legislation reflected the approach described previously, and was intended to combine and balance operational independence and democratic accountability. The Reserve Bank Act works as follows. To ensure that the Reserve Bank has operational independence: • responsibility for almost all Reserve Bank decisions and actions lies explicitly with the Governor, as the institution’s chief executive; • • precise rules limit the circumstances in which the government can dismiss the Governor; and a five-year Funding Agreement, between the Bank and the government, gives the Bank greater funding certainty. On the other side, to ensure that the Reserve Bank is responsive to the fundamental policy goals of Parliament and the government, the Act: • declares that the Reserve Bank’s main function is “to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices”;3 • requires that the Bank adheres to the Policy Target Agreement4 between the Minister of Finance and the Governor which sets a precise specification as to how the Bank will achieve “stability in the general level of prices”; and • provides specific rules by which the Minister of Finance may override the Policy Targets Agreement and redirect monetary policy, though this must be done publicly.5 Finally, to ensure that the Reserve Bank is accountable for its actions, the Act: • • Requires the Bank to publish in detail the basis of its monetary policy decisions.6 Requires the Bank’s Board of Directors to monitor the Governor’s and the Bank’s performance on behalf of the Minister of Finance.7 The Board is also required to publish an annual report assessing the Reserve Bank’s performance.8 • Provides for the Governor’s removal from office if the Minister of Finance concludes that the Governor’s performance under the Policy Targets Agreement has been inadequate.9 • Requires that the Bank’s activities are scrutinised regularly by Parliament’s Finance and Expenditure Select Committee.10 • Requires the Bank to publish an annual report.11 3 4 5 6 7 8 9 4 Section 8. Section 9. Section 12. Section 15. Section 53. The Board of Director’s annual report is reproduced in the Reserve Bank’s Annual Report. Section 49. 10 Sections 15 & 163. 11 Section 163. Central Banking in New Zealand The Governor The powers of the Reserve Bank are exercised by its Governor, who is the chief executive officer, the Act saying “It is the duty of the Governor to ensure that the Bank carries out the functions imposed on it by this Act.”12 Especially in the case of monetary policy, the vesting of powers in the Governor reflects the state sector model described previously. Thus, while the Governor is free to make decisions, he or she is clearly identified as the person accountable, should problems occur. That said, the rules for the Governor’s removal from office are designed to provide a buttress against a government attempting to intimidate a Governor. In essence, for a Governor to be dismissed the Minister of Finance must have grounds for believing that the Governor’s performance has been “inadequate” in achieving price stability or that the Bank has not adequately carried out its functions; or the two sides must have failed to negotiate a Policy Targets Agreement. Thus a Governor cannot be dismissed because, in achieving price stability, he or she has irritated the government of the day, or because the timing of his or her decisions has been politically inconvenient. In other areas, such as banking supervision, in day-to-day matters authority is vested in the Governor, though in some extreme circumstances decisions need to be made jointly by the Governor and the government of the day, such as when deregistering or placing a bank under statutory management.13 The rules for appointing a Governor are also designed to provide a brake, should a Minister of Finance ever seek a political or partisan appointment. The Act says that the Governor “shall be appointed by the Minister on the recommendation of the Board”.14 This creates a double veto, in that a Minister of Finance can only appoint somebody recommended by the Board of Directors. Governors are appointed for five-year terms. 12 Section 41. 13 Section 117. 14 Section 40. Central Banking in New Zealand 5 The Board The Reserve Bank’s Board of Directors is integral to the Bank’s operational independence and democratic accountability. The Board has no executive authority over the Bank. Rather, the Board’s primary purpose is to monitor the performance of the Bank and the Governor, and then to report to and advise the Minister of Finance. To this end, the Board typically meets ten times a year to review the Bank’s performance. This includes careful scrutiny of all Official Cash Rate decisions and, especially, any inflation results that are outside the target range. If the Board believes that the Governor’s performance has been inadequate, then it can recommend to the Minister of Finance that the Governor be dismissed. The Board also makes recommendations to the Minister of Finance on the appointment or reappointment of the Governor and advises on the Governor’s remuneration. The Board determines the remuneration of the Deputy Governor on the advice of the Governor. The Board annually prepares a written assessment of the Governor’s and the Bank’s performance, which is made public in the Bank’s Annual Report. Non-executive Board members are appointed by the Government for five-year terms and the Chair of the Board must be a non-executive director. The only executive Board member is the Governor. The Board also has a generic duty to provide the Governor with advice, typically on governance issues. 15 The Funding Agreement The Reserve Bank’s operational independence is further enhanced by the way the Bank is funded. The Act allows for a five-year Funding Agreement with the Minister of Finance.16 The Funding Agreement specifies how much of the Bank’s revenues can be retained by the Reserve Bank to meet its operating costs, with the remainder typically going to the Government. Having five-yearly Funding Agreements is intended to free the Bank from annual funding negotiations with the Government, as is required for government departments. The governance of other central banks When the Reserve Bank’s current governance arrangements were set down in the Reserve Bank of New Zealand Act 1989 they were internationally distinctive. Nowadays they are reasonably mainstream. For a comparison as to how various central banks are organised, look at the table opposite. 15 Section 53. 16 Section 159. 6 Central Banking in New Zealand Central bank independence and objectives Independence RBNZ Independent to pursue an inflation target agreed upon by the Governor and the Minister of Finance. Independent to determine monetary policy, but currently an inflation target has been agreed to with the Treasurer. Legislated objectives “Formulation and implementation of monetary policy aimed at achieving and maintaining stability in the general level of prices.” “To ensure that monetary and banking policy . . . will best contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; (c) the economic prosperity and welfare of the people of Australia.” “Economic growth in line with the economy’s potential to expand; a high level of employment; stable prices; moderate long-term interest rates.” Operational objective Inflation target of 0 to 2% adopted in 1988; 0 to 3% in 1996; 1 to 3% on average over the medium term in 2002. Adopted 1993. Pursues average inflation of 2 to 3% over the business cycle. Reserve Bank of Australia (RBA) US Federal Reserve “Independent within the government.” Its decisions do not have to be ratified by government, but they must work within the government’s overall objectives of economic and financial policy. Has operational control over monetary policy to pursue a goal agreed to by the Bank and the government. Has operational independence to pursue price stability. The Chancellor of the Exchequer informs the Bank every year of what price stability is taken to mean, and of the government’s economic policy. Has autonomy regarding currency and monetary control. The US Federal Reserve has no explicit inflation target but holds the view that price stability is necessary for achieving its legislated goals. Bank of Canada “To promote the economic and financial wellbeing of Canada.” Initial inflation target adopted in 1991. Price stability is currently defined as inflation of 2% +/- 1%. Initial inflation target of 1 to 4% adopted in 1993. Price stability is currently defined as inflation of 2.5% +/- 1% reporting range. Bank of England “To maintain price stability, and subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.” Bank of Japan “Currency and monetary control shall be aimed at, through the pursuit of monetary policy, contributing to the sound development of the national economy.” “To maintain price stability.” Adopted 1998. To maintain price stability. They have no explicit inflation target. Sveriges Riksbank (Sweden) Has operational independence to pursue price stability. Adopted 1993. Maintain price stability – a target of 2% inflation +/- 1%. Adopted 1999. They have an inflation target of less than 2% over the medium term. Central Banking in New Zealand 7 European Completely independent. System of Central Banks “To maintain price stability.” M o n e t a r y p o l i c y a n d t h e P o l i c y Ta r g e t s Agreement The 1989 Act makes the goal of monetary policy explicit and non-negotiable, declaring that monetary policy shall be directed at “achieving and maintaining stability in the general level of prices”.17 This is followed with a requirement that the Governor and the Minister of Finance must negotiate an agreement specifying targets for carrying out monetary policy in accordance with section 8 of the Act.18 This agreement, known as the Policy Targets Agreement (PTA), is signed by both parties and is made public. A new PTA must be signed whenever a Governor is appointed or re-appointed. A new PTA is not required when a new Minister of Finance is appointed, though, with the agreement of the two sides, it can be renegotiated at any time. As at the time of writing, there have been seven PTAs so far since the passage of the 1989 Act. The current PTA is reproduced at the end of this publication.19 The PTA has four clauses. The first confirms that “the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level in prices”. It also summarises the Government’s overall economic objectives. Clause 2 says that the Bank’s inflation target shall be 1 to 3 per cent on average over the medium term, defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand. Clause 3 says that when external events push inflation above or below its medium-term trend, “the Bank will respond consistent with meeting its medium-term target”. This means that in that circumstance the Reserve Bank is required to get inflation back to “1 to 3 per cent on average over the medium term”. The final clause describes how the Reserve Bank shall implement and be accountable for its decisions. This includes providing explanations for any inflation breaches, or projected breaches, in the Bank’s quarterly Monetary Policy Statements. The last section also says that, as it implements monetary policy to achieve price stability, the Bank “shall seek to avoid unnecessary instability in output, interest rates and the exchange rate”. In conjunction with clause 3, this means the Bank should try to ensure that its monetary policy decisions, where possible, avoid disrupting economic activity. A key feature of the PTA is that the Act requires that the PTA be a public document. This is to ensure that financial markets and the public know the inflation target and can plan accordingly. 17 Section 8. 18 Section 9. 19 Appendix 1. 8 Central Banking in New Zealand The override The democratic nature of this framework is strengthened by section 12 of the Act, which allows the government to “override” the Reserve Bank’s price stability objective. Thus the government may, for a 12-month renewable period, “direct the Bank to formulate and implement monetary policy for any economic objective”. However, as with any change to the PTA, this override must be made in writing and made public. This is important, because an attempt to temporarily manipulate the economy by triggering more demand and more inflation would be constrained if the public knew that this was intended. In that situation, market interest rates would automatically rise to offset the likely additional inflation. This would tend to curtail any temporary inflation-induced surge in growth. In addition, globalised financial markets typically pull back from economies seen to be subject to errant policies. A decision to overturn the price stability objective would add a risk premium to interest rates in New Zealand, further restricting economic activity. Central Banking in New Zealand 9 Monetary policy – the record and the issues The Reserve Bank has been successful in delivering price stability as defined under the various PTAs that have applied. Price stability, as so defined, was achieved in 1991. Since then there have been some temporary breaches of the upper limit of the inflation target, but these have been minor and brief, as illustrated in graph 1. New Zealand has also achieved better economic growth in this and the last decade compared to earlier, as shown in graph 2, though there have been many reasons for this. Nonetheless, all has not been plain sailing, as at various stages there has been controversy about the relationship between monetary policy and the real economy. The concern has been that stabilising inflation has caused volatility to migrate into other economic variables, notably interest rates, the exchange rate and output. The actual record in regard to these variables is illustrated in graphs 3, 4 and 5. Of these, the exchange rate has been subject to the most debate, with exporters suggesting that their businesses have been damaged over the years by capricious changes in their New Zealand dollar earnings caused by large swings in the exchange rate. Blame for this has often been attributed to monetary policy, the perceived link being that when interest rates in New Zealand are higher than in other advanced economies, offshore savers buy New Zealand dollars to access those higher earnings, the increased demand for our currency causing the exchange rate to appreciate. This needs to be treated with caution. Often exchange rate movements are caused by events elsewhere, such as the marked US dollar depreciation in late 2003 and early 2004. As well, the evidence suggests that generally the New Zealand exchange rate tracks with the foreign currency prices that New Zealand exporters earn, as shown in graph 6. There are exceptions, as also shown in graph 6, such as in 1987 when a relatively high dollar and low commodity prices penalised exporters, and in 2001 when a low dollar and high prices favoured exporters. Likewise individual commodity prices often vary markedly over time. However, the overall pattern shows that mostly the exchange rate is not imposing arbitrary windfalls and penalties on exporters in general in defiance of the real economy. This needs to be qualified in that sometimes individual currencies do change quickly in value relative to other currencies, but again they generally reflect the changing real-world fortunes of the economies involved. That said, concern about exchange rate cycles has led to amendments to the Bank’s Policy Targets Agreement, reflecting a desire by successive governments for monetary policy to assist in achieving more general economy stability, as well as price stability. To this end, in December 1999 the Policy Targets Agreement was amended in clause 4C to require that “In pursuing its price stability objective, the Bank ... shall seek to avoid unnecessary instability in output, interest rates and the exchange rate”. 10 Central Banking in New Zealand % 20 Graph 1 Inflation % 20 % 6 4 2 (production-based) Graph 2 GDP growth % 6 4 2 0 -2 -4 15 15 10 10 0 5 5 -2 -4 0 Target range 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 Note: excludes interest rates and GST. Target measure from 1989. 0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 Note: 12 quarter moving average Graph 3 Interest rate* volatility Annual change (in basis points) 6 Annual change (in basis points) 6 (based to the average for the years from 1990 to 2003) Index 160 Index 160 Graph 4 Exchange rate comparisons 4 2 0 -2 -4 -6 -8 4 2 0 -2 140 120 100 80 60 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 140 UK 120 J apan US A NZ 100 Australia NZ Australia USA Euro area 90 91 92 93 94 95 96 97 98 99 00 01 02 03 -4 -6 -8 80 60 * 90-day rates Graph 5 Tr a d i n g p a r t n e r G D P g r o w t h % 8 Graph 6 Exchange rate and commodity prices % 8 6 4 2 0 -2 -4 New Zealand USA Australia J apan 70 65 60 55 50 45 Index (TWI) Index (ANZ) 150 6 4 2 0 -2 TWI (LHS) 140 130 120 110 ANZ World commodity prices (RHS) 86 88 90 92 94 96 98 00 02 100 90 Note: annual average percentage change. 90 91 92 93 94 95 96 97 98 99 00 01 02 03 -4 Central Banking in New Zealand 11 This was taken further in September 2002 when the Policy Targets Agreement was amended so that the inflation target was changed from being “12 monthly increases in the Consumers Price Index of between 0 and 3 per cent,” to “future CPI inflation outcomes between 1 and 3 per cent on average over the medium term”.20 The combination of a requirement to avoid unnecessary instability in “output, interest rates and the exchange rate” and an inflation target that applies on average over the medium term was intended to give the Bank more room to attempt to deliver generic stability, as opposed to just price stability. In the Bank’s view, this is achievable only so long as inflation expectations remain low and well anchored, which so far seems to be the case, as illustrated in graph 7. However, this should never be taken for granted. Graph 7 Inflation expectations of businesses % 6 % 6 5 4 3 2 1 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 1 year out 2 years out 5 4 3 2 1 0 The practical implication of this more medium-term focus is that at times it gives monetary policy more leeway to respond to new data either more gradually or more pre-emptively, depending on the circumstances. For example, a more gradual response can help in situations where the effects of interest rate changes are especially uncertain. It can also help when inflation goes temporarily outside the 1 to 3 per cent target range and sharp changes in interest rates, to restore price stability quickly, would be economically disruptive. In this situation we would aim to have inflation comfortably back within the target range during the second half of our typical three-year forecast period. Conversely, more pre-emptive monetary policy can help when we are reasonably confident that the economy has passed a turning point in terms of inflation pressures. Then, even if inflation is still comparatively high or low, an early change to policy settings can help ensure that monetary policy adjustments later in the business cycle are less severe. Hopefully, this can reduce any tendency of monetary policy to cause “unnecessary instability in output, interest rates and the exchange rate”, while still ensuring that price stability is maintained. 20 The raising of the bottom of the target range from 0 to 1 per cent reflected Government concern about the increasing worldwide risk of deflation. 12 Central Banking in New Zealand Either way, the greater flexibility provided by a medium-term focus allows monetary policy to be a little less risk-averse. Governor Alan Bollard has summed this up, saying “In the 1980s and 1990s, the Reserve Bank fought and won the battle against double-digit inflation. In this decade, we are not trying to fight that battle again. The task now is to preserve price stability and the Reserve Bank’s credibility, while also setting monetary conditions so that businesses and people can get on and make their investment and savings decisions, so as to get the best outcome for New Zealand”.21 Dr Bollard has also said publicly that he would be prepared to accept inflation outcomes different from what otherwise would be in the norm, although still within the PTA, were that ever necessary to constrain an extreme and potentially damaging asset price bubble.22 In addition, in early 2004 the Reserve Bank gained an extra tool for implementing monetary policy. The Reserve Bank now has the balance-sheet capacity to intervene in the foreign exchange market to slightly soften the highs and the lows of the exchange rate cycle, while still delivering price stability. When the New Zealand dollar is exceptionally and unjustifiably high, the Reserve Bank can now use New Zealand dollars to buy foreign exchange, putting downward pressure on the exchange rate. And, when the exchange rate is exceptionally and unjustifiably low, we can now sell foreign exchange to buy New Zealand dollars, putting upwards pressure on the exchange rate. By unjustifiable, we mean when the exchange rate has moved well beyond economic fundamentals, which occurs only infrequently. This process is similar to that used for some years by the Reserve Bank of Australia. It is not intended to permanently change the long-run exchange rate or to defend any particular exchange rate, and the exchange rate cycle would not be eliminated. In doing this, there would also be financial risks to the Reserve Bank, requiring careful management. However, we believe, if done right, small but significant benefits to the economy can be realised. 21 RBNZ 2003 Annual Report, p2. 22 Speech, “Asset prices and monetary policy”, 30 January 2004. Central Banking in New Zealand 13 Financial stability The Reserve Bank registers and supervises banks in New Zealand to promote soundness and efficiency in the financial system. New Zealand’s approach to this involves a combination of orthodox supervisory methods and, in addition, techniques such as comprehensive public disclosure by banks of their finances and specific requirements of banks’ directors. We actively use incentives to encourage directors and senior managers of banks to manage their businesses prudently. This is instead of relying on detailed regulatory requirements and intensive inspection systems to detect and constrain risk, which is often the approach taken in other countries. Behind our approach is a belief that prescriptive regulatory requirements and intrusive inspection systems may actually encourage risky or imprudent behaviour by directors and senior managers of banks. Under that approach, an incorrect assumption could be fostered that the Reserve Bank has ultimate responsibility for prudent management of banking risks. This potentially could weaken the role of bank directors and senior managers, and encourage a false presumption that the Reserve Bank stands behind individual banks. A prescriptive and intrusive approach to supervision carries a risk that bank directors and senior managers may assume that compliance with Reserve Bank supervisory requirements is sufficient on its own, and thus give too little attention to the specifics of their banks’ business risks. We want the public and the banks’ directors and senior management to clearly understand that management of banks squarely rests in the banks’ board rooms and not with the Reserve Bank. We also want to make very clear that neither the Reserve Bank nor the government provide any kind of guarantee of individual banks. Encouraging good management There are three main ways that the Reserve Bank seeks to encourage banks to act prudently in their day-to-day business activities. These are as follows. Self discipline: Responsibility for risk management is best placed on the shoulders of banks’ directors and senior managers. This is where risks are best dealt with. To achieve this, four times a year we require registered banks to publicly disclose their financial position and risk profile in considerably more detail than, for example, an ordinary listed company. Within these documents bank directors are required to attest to their bank’s financial position, capital adequacy and risk management systems. If directors make attestations knowing that their bank’s disclosure statement is false or misleading they can face civil or criminal proceedings that could lead to imprisonment. The role of independent directors is particularly important in this regard, which is why we require banks to have a minimum of two independent directors and a non-executive chair. In addition, banks’ disclosure statements must be externally audited annually and are subject to limited audit review at the half year. By making clear that banks must take primary responsibility for risk management themselves, the Reserve Bank underlines the fact that there is no government guarantee of banks, just as there is no deposit insurance. It also keeps to a minimum our regulatory intrusion in the day-to-day practices of banks, and thus avoids any confusion about responsiblity, while reducing banks’ compliance costs and the risk of creating unintended distortions to banking behaviour. 14 Central Banking in New Zealand Central Banking in New Zealand 15 Market discipline: The Reserve Bank encourages robust market disciplines on banks as a further means of strengthening incentives for sound risk management by the banks themselves. We do this by requiring banks to issue disclosure statements each quarter, by maintaining an open and competitive banking system, by avoiding regulatory distortions to market prices such as interest rates, and by maintaining a level playing field in which banks and non-bank financial institutions can compete on broadly equal terms. Banks guard their reputations vigorously, as any reputational loss makes raising funds more difficult and more expensive. The disclosures that banks are required to make ensure that market participants and the public have extensive information about the health of banks operating in New Zealand, including their credit ratings. Regulatory discipline: In addition, banks must meet specific requirements as a condition of their registration as banks. A bank’s international standing, management capability, regulatory or disclosure requirements that it faces in other jurisdictions, and its business strategies and practices are all considered during registration and ongoing supervision. Our specific prudential requirements include minimum capital ratios broadly in line with international norms, limits on a bank’s exposures to connected parties such as a parent bank, local incorporation by systemicallyimportant banks, and some corporate governance rules such as the minimum independent director requirement referred to above. We regularly consult with registered banks and we have wide-ranging powers to intervene to obtain information, give directions, appoint a statutory manager or deregister a bank. Our consent is required for a significant change of ownership of a registered bank. It is important to note that bank registration does not involve licensing the business of banking, as an entity can conduct banking functions, including deposit-taking, without being a registered bank. Bank registration enables an entity to call itself a bank. In terms of credibility with the public, being a registered bank confers a considerable advantage to an organisation providing banking services. In addition, the Reserve Bank has responsibility for overseeing the New Zealand payment system. This covers the various processes by which value is transferred between corporations and individuals to meet their financial obligations and to transact their business, and the means by which these transactions are settled between the banks. We collect and publish information on the payment system, so that all users can judge the quality of the processes that they use. We work closely with the banking industry to promote and maintain a sound and efficient payment system and we “designate” credible payments systems within the financial system which give transactions in those systems greater legal certainty. The Reserve Bank also provides exchange settlement accounts for banks and operates a real-time gross settlement system by which banks can meet their payments system obligations in real time throughout the business day. We believe our overall approach continues to serve New Zealand well, in terms of reducing the chances of banks getting into trouble. However, no system can with certainty prevent all bank crises and for that reason we have recently concluded that we need to do more to ensure that we can manage a banking crisis effectively if and when it actually happens. 16 Central Banking in New Zealand Central Banking in New Zealand 17 Planning for a banking crisis Compared to many other jurisdictions, banks play an unusually predominant role in the New Zealand financial system. A failure of a systemically important23 bank would have much wider repercussions than just causing losses for depositors, such as the economic disruption caused by firms that banked with the failed bank not being able to pay their staff or creditors. The Reserve Bank has a wide range of powers to deal with bank distress and failure. These include having a bank investigated, giving directions to a bank (with the consent of the Minister of Finance), and recommending to the Minister of Finance that a bank be placed in statutory management. The ultimate aim is to be able to resolve a bank failure or distress event quickly and in ways that minimise damage to the financial system, while also minimising or avoiding a taxpayer-funded bail-out of the bank. We require that all systemically important banks maintain the capacity to operate as going concerns on a standalone basis, even if they are part of an international banking group, as almost all of the banks in New Zealand currently are. The aim is to ensure that if we have to put a bank under statutory management it will be a sufficiently well defined entity legally that the statutory manager will be able to run it as a going concern. Thus we stipulate that “the boards of locally-incorporated registered banks have unambiguous legal authority and the practical ability to control all the functions, systems and management capacity necessary to operate on a standalone basis”.24 On the surface, this may seem obvious and straightforward, but in a changing global financial landscape it can be a challenge. Most banks in New Zealand and all the systemically important banks here are overseas owned. Foreign banks have well over 95 per cent of total banking assets in New Zealand. In many ways this delivers considerable benefits to New Zealand, in that we have a banking sector that is well resourced, well-informed of international best practice, and very competitive. As travellers often note, the range and quality of banking services in New Zealand is very good. Foreign banks with significant operations in New Zealand have a strong reputational incentive to ensure that their New Zealand activities are well run. However, this degree of offshore penetration does raise issues. Many banks in New Zealand have parts of their operational work done by facilities offshore. Mostly these are within their parent banks or service providers contracted to parent banks, information technology being the most obvious example. Thus, if a parent bank collapses and its New Zealand bank is also in difficulty, the question of whether a statutory manager could run the New Zealand operation could be a live issue. For example, if the parent bank folded, would the computers keep running so the New Zealand bank could keep transacting? To answer this we have taken several initiatives. We have introduced a requirement that systemicallyimportant banks must be locally incorporated under the Companies Act, as opposed to operating here as branches. This provides two main benefits: additional strength coming from having a local board of directors, and greater certainty about the location of assets and liabilities that it gives to a statutory manager. With a locally incorporated 23 By “systemically important” we mean a bank that potentially could pull down other parts of the financial system if it failed. 24 RBNZ Press Statement, “RBNZ consents to ANZ National Bank purchase”, 24 October 2003. 18 Central Banking in New Zealand bank there is a better chance that in a crisis a statutory manager would have legal authority over the necessary components of an operational bank, given that the New Zealand bank is a standalone legal entity. This would be much less likely if a bank with a branch in New Zealand failed. Our policies in this regard are still evolving and this requirement was a significant consideration in the detail of the Reserve Bank’s consent to the ANZ purchase of the National Bank. As at early 2004, all the systemically important banks in New Zealand were incorporated here, with one exception which continued as a branch for historical reasons.25 We are also keen to ensure that in the event of a bank failure the New Zealand Government has more choices than just a taxpayer-funded bail-out or letting the failed bank be liquidated. One option involves recapitalising a failed bank using depositors’ funds and monies owed to other creditors. The value of this is that the failed bank would be kept operating and depositors would have access to at least some of their funds, with the rest being available once the bank was sound again. The specifics of how this would be done are being worked on currently, the key question being how to ensure that each bank’s computer systems have a prearranged facility for this procedure that can be implemented very quickly in a crisis. Also, other options have not been ruled out. The Reserve Bank has responsibility under the Reserve Bank Act to act as a lender of last resort to the financial system, where it considers it necessary to do so to maintain the soundness and efficiency of the financial system. 25 In the RBNZ 2003 Annual Report, page 16, the Bank stated “A policy path in regard to this (exception) will be decided during 2003/04”. Central Banking in New Zealand 19 Currency The Reserve Bank has a statutory monopoly on the issuance of notes and coins, and has responsibility for ensuring that the country has an adequate supply of notes and coins at all times, and that the currency accords with appropriate standards, in part to minimise the risk of counterfeiting. The Reserve Bank’s approach to providing the nation’s currency has changed in recent years. This was triggered by the introduction in 1999/2000 of polymer bank notes, which cost twice as much as paper bank notes but last four times longer. In assessing the implications of these “long-life” bank notes, we concluded that high volume processing of bank notes by the Reserve Bank as a counting and sorting agency for the banks no longer made sense. Previously, on a daily basis, banks returned their cash surpluses to the Reserve Bank and those banks needing cash purchased bank notes and coins from the Reserve Bank. This was partly justified because of the Reserve Bank’s need to be constantly on the lookout for forgeries and removing damaged and soiled bank notes from circulation. However, with bank notes that are much more durable and harder to forge, this can no longer be justified. Thus, we have encouraged banks and security companies to transfer cash directly to each other, which they are now doing very well. As a result, the Bank has been able to downsize its currency processing operation, selling its facilities outside Wellington. The number of staff involved in the direct processing of currency has reduced from 50 in 1999 to six at present. We now process currency only in Wellington, in effect as a wholesale supplier replacing damaged stock and meeting seasonal demands from our cash reserves. Throughout 1999 we processed about 550 million banknotes, compared with only about 60 million in 2003, despite the amount of currency in circulation steadily rising. Our surveys of the general public and of retailers indicate that polymer bank notes are now well accepted.26 Forgeries are now well below international averages. During the 2002/03 financial year review period, we found 33 forgeries. This is just 0.31 bank notes per million in circulation, compared to 35 notes per million in the United States and 20 notes per million in Europe. 26 RBNZ 2001 Annual Report, p 17. 20 Central Banking in New Zealand Appendix 1: Policy Targets Agreement This agreement between the Minister of Finance and the Governor of the Reserve Bank of New Zealand (the Bank) is made under section 9 of the Reserve Bank of New Zealand Act 1989 (the Act). The Minister and the Governor agree as follows: 1. Price stability a) Under Section 8 of the Act the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level of prices. b) The objective of the Government’s economic policy is to promote sustainable and balanced economic development in order to create full employment, higher real incomes and a more equitable distribution of incomes. Price stability plays an important part in supporting the achievement of wider economic and social objectives. 2. Policy target a) In pursuing the objective of a stable general level of prices, the Bank shall monitor prices as measured by a range of price indices. The price stability target will be defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand. b) For the purpose of this agreement, the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term. 3. Inflation variations around target a) For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary. Such events include, for example, shifts in the aggregate price level as a result of exceptional movements in the prices of commodities traded in world markets, changes in indirect taxes, significant government policy changes that directly affect prices, or a natural disaster affecting a major part of the economy. b) When disturbances of the kind described in clause 3(a) arise, the Bank will respond consistent with meeting its medium-term target. 4. Communication, implementation and accountability a) On occasions when the annual rate of inflation is outside the medium-term target range, or when such occasions are projected, the Bank shall explain in Policy Statements made under section 15 of the Act why such outcomes have occurred, or are projected to occur, and what measures it has taken, or proposes to take, to ensure that inflation outcomes remain consistent with the medium-term target. b) In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate. c) The Bank shall be fully accountable for its judgements and actions in implementing monetary policy. Hon Dr Michael Cullen Minister of Finance Dr Alan E Bollard Governor Designate Reserve Bank of New Zealand Dated at Wellington this 17 th day of September 2002 Central Banking in New Zealand 21 For further information please contact: Paul Jackman, Corporate Affairs Manager Reserve Bank of New Zealand, PO Box 2498, Wellington Telephone: 04 471 3671 , Fax: 04 471 2270, Email: jackmanp@rbnz. govt.nz For further information please contact: Paul Jackman Corporate Affairs Department Reserve Bank of New Zealand PO Box 2498 Wellington Telephone 04 471 3671, fax 04 471 2270 email: rbnz-info@rbnz.govt.nz Visit our website www.rbnz.govt.nz June 2004 Central Banking in New Zealand