Submission to the UK Parliamentary Commission on Banking Standards
You have asked for some comments on the background to New Zealand’s having “strict liability” attaching to the directors of registered banks, and I’m happy to elaborate on that to the best of my recollection. I must confess that I’m not entirely sure what “strict liability” means in this context, but I’m assuming it refers to the obligations which bank directors assume when they personally sign off bank disclosure statements each quarter.
Historically, prior to the election of the reforming Labour Government in 1984, New Zealand had only four registered banks – one of them owned by the government (the Bank of New Zealand), one owned by Lloyds Bank (the National Bank of New Zealand), and two owned by large Australian banks (the ANZ Bank and Westpac Bank). Supervision of the banks was rudimentary or non-existent, although all of them were subject to a range of controls related more to the implementation of monetary policy than to prudential policy as normally understood.
The Government opened the door to new banks in the mid-eighties and as a result a significant number of foreign banks opened either subsidiaries or branches in New Zealand, and some non-bank financial institutions sought and received banking licences. The Reserve Bank of New Zealand was given the task of registering new banks and supervising their activities. (The four existing banks were “deemed” registered.)
Initially, the Reserve Bank’s supervision was at the “light-handed” end of the spectrum. Following the share-market crash of October 1987, New Zealand saw the collapse of the commercial property market and the failure of a number of highly-geared companies. As a result, several banks and other financial institutions found themselves in severe financial difficulties, including the Bank of New Zealand (still owned by government).
The instinctive reaction of the Reserve Bank’s banking supervisors was to call for much more detailed reporting from the banks than we had been receiving previously. (I became Governor of the Reserve Bank on 1 September 1988.) If we had not been able to avoid the crisis getting information quarterly, then surely we should be getting it monthly or even more frequently. The supervisors also wanted more stringent prudential rules, including a limit on the maximum credit exposure which a bank could have to any single counter-party, expressed as a percentage of the bank’s equity. (Surprisingly to me – I had been appointed Governor after being for two years the CEO of a relatively small retail bank – the Reserve Bank had had no limit on maximum credit exposure previously.)
By contrast, the Reserve Bank’s economists argued that better public disclosure of banks’ activities would be a more effective sanction against imprudent behaviour than more stringent rules laid down by the Reserve Bank.
There followed an internal debate lasting several years, with the banking supervisors arguing for steadily more intensive supervision and the Reserve Bank’s economists arguing for better public disclosure as an alternative to more intensive supervision.
There were several memorable events along the way. One was a chance meeting I had with somebody who had been a very senior official in H.M. Treasury, and who had just become a director of one of the largest UK clearing banks. I had not met this person previously but found myself sitting beside him at a dinner in Washington at the time of the World Bank/IMF annual meetings in September 1992. I asked him how he found being a director of a major bank after a life-time in the Treasury. “Funny you should ask that,” he said. “I’d always thought that banking was all about measuring and pricing risk, and of course I’ve had no involvement in that in the Treasury. So I was greatly relieved to find that all I had to worry about as a director was whether we were complying with the Bank of England’s rules.” (This was, of course, before the establishment of the FSA.)
At around the same time, we in the Reserve Bank were worrying about how to ensure that banks had appropriate risk control systems in place. There was an assumption in the Reserve Bank that we should specify those risk control systems, and monitor that they were being properly operated. But it was clear that no single risk control system would be appropriate for all our banks: some banks were very simple operations, taking money on deposit and making loans on residential mortgages, with virtually no treasury operations; other banks were extremely sophisticated operations, with elaborate treasury operations and complex loan books.
So we decided that instead of the Reserve Bank stipulating what risk control systems each bank should have, we would require bank directors to attest personally to the fact that, in their opinion, their bank had risk control systems appropriate to the nature of their banking operations, and that those systems were being appropriately operated.
In the event, at the conclusion of the internal debate we decided to rely heavily on public disclosure and director attestations rather than on complex rules. So while we did adopt the minimum 8% of risk-weighted capital (as specified in Basel I), mainly because we felt that to have ignored that minimum capital rule would have made New Zealand-based banks international pariahs, we had very few other rules. We did have a rule limiting exposure to related parties but we did not, for example, have any limit on other credit exposures, any limit on open foreign exchange positions, or any requirement for minimum liquidity.
Instead, we required banks to disclosure to the public every quarter detailed financial information in two formats – one was to be highly detailed and was likely to be of interest only to financial analysts (and competitors!); the other was what we referred to as the KIS statement (KIS for Key Information Summary) – a very brief statement of key facts which could be readily understood by the interested layman. The KIS statement had to be available in hard-copy form in every bank branch, whereas the more detailed information had to be provided online and in hard-copy form within four or five days (to minimise needless printing costs).
The disclosure had to include information on such issues as credit risk concentration (how many credit exposures exceed 10% of equity, how many exceed 20% of equity, etc.), liquidity, open foreign exchange positions, etc. We also required banks to disclose a credit rating from a reputable rating agency – if they had a rating – and to disclose the fact that they did not have a rating if they didn’t have one. (Later all banks were required to have a rating.) The statements were designed to cover both end of quarter and intra-quarter information.
The quarterly disclosure statements were to be accompanied by a statement signed by each bank director, personally attesting to the accuracy of the information and the adequacy of the risk control systems.
When we first announced our intention to adopt such a system in the mid-nineties, the banks were not terribly pleased. The CEO of one of the big Australian banks, a bank which had a very big operation in New Zealand, flew to New Zealand to remonstrate with me. He argued that we simply could not adopt a system of the kind we proposed, involving having all bank directors attest to the accuracy and appropriateness of the information being disclosed, and to the adequacy of their bank’s risk control systems, because, he said, “most bank directors know absolutely nothing about banking”. He argued that it was therefore quite unreasonable for us to impose these obligations on bank directors.
I made it very clear to him that, if he didn’t have bank directors who understood banking, he should get some who did – but that in any event I was not going to be responsible for making all the key decisions for the prudent operation of his bank.
In the years since this system was introduced, no registered bank in New Zealand has got into financial difficulties and it would therefore be tempting to believe that the New Zealand approach to banking supervision is a very good one. But unfortunately, although I remain strongly supportive of the New Zealand approach, no such conclusion would be warranted at this stage.
First, that is because the four biggest banks in New Zealand are now wholly-owned by large Australian banks, all of which are supervised by APRA, the Australian regulatory authority, in ways which are more closely similar to the international orthodoxy. And of course many of the smaller banks are subsidiaries or branches of international banks, such as HSBC and Rabobank. Secondly, the largest single part of the asset base of the large Australian-owned banks consists of mortgages over residential property, and while there was a modest fall in the real price of residential property in New Zealand following the onset of the Global Financial Crisis, that fall was quite small by international standards and, at least in Auckland, currently seems to have been largely reversed. Third, at the height of the Global Financial Crisis, in October 2008, even the largest banks were able to access special Reserve Bank liquidity facilities when international capital markets essentially “froze”.
Moreover, since I resigned as Governor in April 2002, the Reserve Bank has moved somewhat closer to the international orthodoxy, while retaining the emphasis on public disclosure and quarterly director attestation. Banks now have an obligation to fund a minimum proportion of their asset base from retail deposits and longer-term wholesale funding, reducing their reliance on short-term capital market funding. The Reserve Bank now reserves the right to approve the appointment of all bank directors, bank CEOs, and “first reports” to the CEO.
Nevertheless, I believe the New Zealand emphasis on public disclosure and director attestation has had a beneficial impact on bank behaviour.
I well recall an event which happened not long after the introduction of this approach in the mid-nineties. The New Zealand subsidiary of Bankers Trust disclosed in their quarterly statement that they had had more on deposit with their parent company in New York than they had shareholders’ funds in New Zealand. The National Bank of New Zealand (wholly owned by Lloyds Bank at that time) protested vigorously to Bankers Trust New Zealand because they (the National Bank) had had very substantial funds on deposit with Bankers Trust New Zealand at that time. Despite Bankers Trust New Zealand being fully guaranteed by its New York parent, the National Bank was angry about the situation and to the best of my recollection Bankers Trust New Zealand never again had such a large exposure to its parent bank. (I can mention Bankers Trust New Zealand by name because of course their quarterly statement was public knowledge.)
Similarly, although the Reserve Bank still has no limit on individual credit exposures, banks keep their individual credit exposures low relative to their equity in New Zealand because they recognise that to disclose high levels of credit concentration is damaging to their reputation.
After almost five years in the New Zealand Parliament, I myself because a director of the ANZ National Bank, by far the largest single bank in New Zealand (formed after the acquisition of the National Bank by the ANZ Bank). When it came time to sign the quarterly disclosure statements, I can confirm that each director took the matter very seriously! Of course, it is not feasible for any bank director to personally check every number in the disclosure statement of a major bank, and we did not attempt to do so. But we had an elaborate process whereby the head of every division in the bank, as well as the Internal Auditor, the CFO and the CEO, were required to attest to the accuracy of the numbers, and the adequacy of the risk control systems, before we individually signed those quarterly statements.
Will this system guarantee that New Zealand will have no bank failures? Of course not, but I have no doubt that the system reduces the risk of bank failure in a useful way by making bank directors very much aware of their responsibilities.
I should add in conclusion that when we were discussing the introduction of this system in the early nineties, one of the previous Governors of the Reserve Bank, Mr Ray White, strongly encouraged me to shed responsibility for bank supervision if possible. He argued that when the banking system was stable, the Reserve Bank would get none of the credit. When a bank failure occurred, as it inevitably would at some stage, the Reserve Bank would shoulder much of the blame. He further argued that almost every bank failure which had occurred in the developed world since 1945 had been a result of either fraud or an abrupt fall in asset prices, typically property prices. He pointed out that bank supervisors are not well placed to detect fraud, especially where there is collusion between bank insiders and their customers (for example, BCCI); and rarely anticipate accurately the problems created by an abrupt fall in asset prices. When asset prices are going up, optimism prevails – bank balance sheets look strong and loss provisions robust. Even “stress-testing” often fails to anticipate just how badly damaged banks would be in the event of a sharp fall in asset prices. It is vitally important therefore that the bank regulator makes it abundantly clear that he cannot be expected to prevent all bank failures, and that bank customers therefore have some responsibility to make their own assessments in dealing with a bank.
Copyright © 2024 Don Brash.