Politicians and economists often champion
competition in banking. But competition is just a means to an end. The real goal is an efficient financial system providing services at the lowest cost customers are willing to pay.
Yet competition alone is not enough. An efficient regulatory regime is also critical.
The Reserve Bank’s (RBNZ) current prudential regulatory settings – rules aimed at maintaining financial system stability – may be hampering competition and efficiency. This could hurt the very customers the regulations aim to protect.
The FEC’s examination of banking competition provides a chance to review these regulatory rules. It should zero in on three key areas: the RBNZ’s approach to prudential regulation, its governance structure and external monitoring of the RBNZ to ensure its policies truly benefit bank customers and the wider economy.
Prudential regulation should balance the stability and efficiency of the financial system. But the current regulatory framework treats stability as an end in itself.
This approach can lead to excessive safeguards or “gold-plating”. While well-intentioned, such over-protection can raise costs, harming bank customers and potentially hampering economic growth.
To address the problem with the regulatory framework, Parliament should amend the Reserve Bank Act 2021.
The amendment should reinstate “efficiency” as a primary objective of the RBNZ’s financial stability function.
The RBNZ’s 2019 decision to double bank capital requirements illustrates the risks of overregulation.
The RBNZ’s goal was to reduce the likelihood of bank failure to a one-in-200-year event.
But the decision came with a price tag. The RBNZ itself predicted this move would increase the cost of credit and potentially reduce GDP. It is akin to mandating extremely high safety standards that, while increasing security, also significantly raise costs and potentially discourage participation.
The impact on the cost of credit follows a simple logic. New Zealand banks must earn higher profits on domestic loans to cover the costs of maintaining higher capital levels. That means higher interest rates for borrowers, lower rates for depositors, or both.
The RBNZ’s calculations suggested its decision might reduce GDP by up to 0.32% annually. Some commentators estimated impacts as large as 1%. These are significant figures when considering long-term economic growth.
In 2021, S&P Global described the RBNZ’s capital requirements as “some of the toughest bank capital standards worldwide”. It warned this might also force New Zealand banks to cut riskier loans, such as those to smaller businesses.
Five years on, it is time for a fresh look. While the RBNZ conducted a cost-benefit analysis of its decision, several factors suggest a review is warranted.
First, though peer-reviewed, the RBNZ’s cost-benefit analysis relied on questionable modelling assumptions, weakening its case. Second, we now have actual data on the decision’s effects. Third, the lack of similar moves by other central banks raises questions about the wisdom of the RBNZ’s decision.
It is worth at least asking whether we have over-engineered our financial safety net.
Unlike the RBNZ’s role in setting interest rates, its job in maintaining financial system stability needs close political scrutiny.
This is not just because a banking crisis could require costly government intervention, but also because these regulations can significantly impact our economic growth.
The Reserve Bank Act’s Financial Policy Remit (FPR) process provides the crucial layer of democratic accountability. Through the FPR, the Minister of Finance can guide the RBNZ’s financial stability policies.
For example, the minister could ask the RBNZ to align bank capital rules with international standards and aim for resilience against a (more typical) one-in-100-year stress event.
A further concern is the RBNZ board’s lack of directors with recognised prudential regulatory expertise.
This is a significant oversight. It is akin to having a sports team without a coach who understands the game.
There are several ways to address this issue. The Government could appoint new board members with the necessary expertise.
An alternative is to establish a “Financial Policy Committee” to monitor the RBNZ’s financial stability tasks. A more drastic option would be to transfer the RBNZ’s prudential regulatory functions to a separate authority, like Australia’s model.
We also need better external monitoring of the RBNZ’s performance as a prudential regulator.
Previous studies, including the Productivity Commission’s 2014 report and surveys conducted by the New Zealand Initiative in 2017 and 2021, have consistently shown external monitoring of regulatory agencies like the RBNZ is inadequate.
The new Ministry of Regulation, once fully established, could conduct periodic reviews of the RBNZ’s regulatory strategies and performance. These reviews should focus on how prudential regulation affects both banking competition and efficiency.
The FEC’s inquiry offers a chance to recalibrate New Zealand’s banking regulation. By addressing the RBNZ’s prudential settings, governance and accountability, Parliament can create a stable and efficient financial system.
A balanced approach would encourage healthy competition and ensure that regulations support the banking sector’s contribution to New Zealand’s economy.
As the inquiry begins, it is crucial that these aspects of prudential regulation receive the thorough examination they deserve.
