Our one-eyed Reserve Bank

Roger Partridge
31 August, 2018

In Greek mythology, the Cyclops were a race of giants, each with great power yet with only a single eye. According to legend, the Cyclops traded their second eye for the gift of prophecy.

As we know from Homer’s Odyssey, the Cyclops’ bargain was both a strength and a weakness: powers of foresight are of no use if you cannot see the present out of your one, good eye.

There may be some lessons from the Cyclops for New Zealand’s Reserve Bank.

When having one eye is a strength
Next week, submissions close on the Reserve Bank of New Zealand (Monetary Policy) Amendment Bill. The bill is the culmination of phase 1 of Minister of Finance Grant Robertson’s review of the Reserve Bank. It follows the report of the Minister’s Independent Advisory Panel and implements Labour’s election pledge to reform the Bank.

The bill amends the Bank’s objectives in implementing monetary policy.  Instead of a one-eyed focus on inflation, the bill will require the Bank to track two targets: price stability and maximum sustainable employment.

Some may argue that this new dual mandate is revolutionary. To economists it is controversial. This is not because it will result in a profound change to the way the Bank operates. As any good economist knows, there is no long-term trade-off between inflation and employment. The best way a central bank can promote full-employment is by maintaining stable prices. And as the Reserve Bank only employs good economists, it would be a surprise if the Governor and his team became any less monocular if the bill becomes law.

However, the bill does more than simply introduce a dual mandate. It also introduces a fundamental change to how monetary policy decisions are made by the Bank. Instead of sole power for rate-setting decisions residing with the Governor, that power will rest with a new monetary policy committee.

Of the two changes, this governance change could have been more significant, opening the way for political intervention in monetary policy decision-making. But with the bill proposing that Reserve Bank staff make up a majority of the committee’s membership, the risks of political skulduggery in rate-setting are low. And they are lower still because the bill adopts the same dual-veto for the appointment of committee members as applies to the appointment of the Bank’s governor. Any appointments must be approved both by the Minister and the Reserve Bank’s board.

As a result, we can take comfort that monetary policy decision-making will remain as one-eyed as it ever has.

When monocular vision is a weakness
While the Bank’s governance arrangements have proved a strength in monetary policy decision-making, they have been its Achilles heel when it comes to its other principal function: prudential regulation of the finance sector.

Like a Cyclops, the Bank’s governor has immense power. Indeed, the regulatory powers vested in the governor are unparalleled in New Zealand. We saw these powers in action earlier this year with the Bank’s lightning strike on CBL.

With great power comes great responsibility. Yet in our research report published earlier this year, Who Guards the Guards? Regulatory Governance in New Zealand, we found serious deficiencies in the Bank’s performance and behaviours. The shortcomings did not suggest it had left New Zealand’s financial system vulnerable to risks. Rather, the problems centred on the standards of behaviour of the Reserve Bank in exercising its regulatory powers and with the quality of analysis informing its policymaking.

On almost every performance metric measured in our report, the gap between the performance of the Bank, and the performance of its sister regulator, the Financial Markets Authority, was cavernous.

The issues related to lack of consistency of process, lack of relevant financial markets expertise among staff, lack of commerciality, unwillingness to consult or engage, a lack of internal accountability, and an excessively “black-lettered” approach to the enforcement of its rules.

If respect is a hallmark of a well-performing regulator, our research revealed that the Bank has neither the respect nor the confidence of many of the businesses it is tasked with regulating.

These shortcomings are troubling. Poor decision-making by regulators can cause both uncertainty and risk-aversion, stifling innovation and economic efficiency. This risks harm not just to the regulated entities themselves, but to their shareholders, and to consumers.

In the case of CBL itself, confidentiality orders still prevent us from knowing all of the background to the Reserve Bank’s sudden strike. But it is more than a little troubling that the Bank’s application to liquidate CBL’s insurance subsidiary has been repeatedly deferred. Six months on it has still not been heard.  The delays suggest there may be more to the CBL story than meets the eye. Time will tell. But the results of our study provide little basis for confidence in the Bank’s regulatory decision-making.

Fortunately, the Reserve Bank’s performance as prudential regulator forms the subject of Phase 2 of the Minister of Finance’s review of the Bank. Announced on 7 June, the terms of reference for the Minister’s Independent Expert Panel include the Bank’s regulatory decision-making, governance and accountability.

High on the list of outcomes should be a second eye to overlook the Bank’s regulatory decision-making. The Cyclops model may be suited to monetary policy, but regulators need oversight.

“Who guards the guards?” has been a troubling question since the time of the ancient Greeks. It is time for some 21st century answers.

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