Why NZ Reserve Bank's role is ripe for review

Dr Oliver Hartwich
The Australian
6 June, 2024

It is not every day that a disagreement between a think tank and a central bank makes international headlines. But that is precisely what happened last week.

The New Zealand Initiative had criticised the Reserve Bank of New Zealand’s (RBNZ) approach to bank capital regulation. The RBNZ’s Governor took umbrage at our views and sent a fiery email to the commercial banks. These banks are our members – and institutions the RBNZ regulates.

I was taken aback by the tone of the Governor’s response. Regulators should be open to constructive policy debates without resorting to pressure tactics. I expressed these concerns in a letter to the Minister of Finance and the RBNZ board chair.

When the Minister then mentioned my letter at a press conference a few days later, all this suddenly became a matter of public interest. Even Bloomberg reported on it.

Still, how bizarre was all this: that a difference of opinion on prudential regulation should lead to such a public and internationally reported affair?

This level of media interest is only because the RBNZ is not just our country’s central bank, as the name suggests, but also a prudential regulator. And so, whatever the RBNZ does on one side of its business also affects the other side. This may be surprising for Australian readers because it has not been like that on your side of the Tasman for decades.

However, New Zealand is one of the few advanced economies where the central bank is also the prudential regulator of the financial system and is responsible for supervising banks, insurers, and other financial institutions.

This made me wonder whether the RBNZ has become overloaded by combining these two distinct areas of policy.

New Zealand’s multipurpose model contrasts with the approach adopted by many other countries. As mentioned before, in Australia, prudential regulation was separated from the Reserve Bank of Australia (RBA) in 1998 and vested in a new agency, the Australian Prudential Regulation Authority (APRA). Meanwhile, the RBA now focuses squarely on monetary policy and overall financial stability, while the APRA supervises individual financial entities.

The logic behind this separation is compelling. Monetary policy and prudential regulation sometimes pull in different directions. During an economic upswing, the central bank may want to raise interest rates to curb inflation. Still, the prudential regulator may prefer to keep borrowing costs low to support credit growth and bank profitability.

Conversely the central bank may slash rates during a downturn to stimulate demand, but the regulator may want to tighten lending standards to bolster resilience.

Having monetary policy and prudential regulation under one roof can lead to conflicts and compromises. The bank might make monetary policy decisions based on worries about systemic banking risk rather than focusing purely on controlling inflation. Even if it does not make its decisions in such a way, observers could worry that it has – which is almost as bad. Or, trying to keep prices stable, the bank might not give enough attention to the long-term perspective needed for effective bank supervision conducive to financial market efficiency.

Separating these roles allows each entity to develop the unique skills, culture, and approaches they need. Bank supervisors must understand the nitty-gritty of how each bank operates, including the risks they take and how they are managed. They need to be able to have detailed, bank-specific conversations.

In contrast, the people in charge of monetary policy need to think about the big picture of the economy. They must consider how changes in interest rates ripple out and affect everything from spending to saving to borrowing.

Importantly, separation also protects the independence of monetary policy. Regulating banks inevitably means making politically sensitive decisions about how easy it is to get a loan, how much risk banks can take on, and how competitive the banking industry is. These are important issues, but they differ from the more technical job of adjusting interest rates to keep inflation in check.

In recent years, bank regulators have been asked to take on even more politically charged issues, like climate change risks and promoting financial inclusion. While these are important challenges, they are far removed from what a central bank is best equipped to do. The more the Reserve Bank gets pulled into these politically sensitive areas through its regulatory role, the more it risks political backlash that could undermine its independence in setting monetary policy.

Internationally, the tide has therefore shifted towards separating monetary policy from prudential regulation. More and more countries have embraced this model, from the UK to Singapore to Japan.

Of course, separation is no panacea. As the global financial crisis painfully demonstrated, silos and turf wars between different regulatory agencies can also be detrimental. The delineation of responsibilities for financial stability would need to be crystal clear.

But these challenges can be handled. The Reserve Bank and the new regulator need to have certainty about who does what and how they will work together. Such coordination requires well-designed oversight and clear lines of responsibility.

Separation would also enable each entity to be held accountable in a way that fits their specific role. The Reserve Bank would have the sole primary job of meeting its inflation target and explaining its interest rate decisions.

The new prudential authority, meanwhile, would be responsible for keeping the financial system stable and secure, with clear benchmarks around things like bank capital, liquidity, and governance. It would also seek to ensure that there is competition between entities in the system. It would be mindful of the fact that an excess of red tape can unduly impede such competition.

This clear division of duties would make it simpler for Parliament and the public to assess each regulator’s performance.

For the Reserve Bank, this would be a chance to refocus on its core mission of monetary stability. Freed from the distractions of day-to-day supervision (and dealing with pesky think tanks), it could devote its full institutional heft to the increasingly challenging task of navigating a post-pandemic economy beset by supply shocks, structural change, and geopolitical tensions.

New Zealand used to be at the forefront of regulatory innovation, from the pioneering of inflation targeting in the 1980s to the shift to a fully independent Reserve Bank in the 1990s.

If there is a positive outcome from this, perhaps it would be a debate about the future of this institution.

To read the full article on The Australian website, click here.

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