03 May 2012

Grant Spencer: Prudential lessons from the global financial crisis

Presentation by Mr Grant Spencer, Deputy Governor of the Reserve Bank of New Zealand, to the Financial Institutions of NZ 2012 Remuneration Forum, where he reviewed the lessons New Zealand had learnt from the crisis.

Mr Spencer talked about three key lessons from the global financial crisis (GFC) that he regards as the most important for prudential policy in New Zealand. Mr Spencer believes they are very relevant for all countries with well-developed banking systems. The three lessons are:

1. The contagion effects of a crisis can be heavily amplified by the contraction of liquidity in funding and asset markets.
2. The credit cycle is a major driver of risk in the financial system – the seeds of crises are often sewn in the credit booms that precede them.
3. Large bank failures can have devastating effects on both financial systems and government finances. Governments must find ways of protecting the financial system from bank failures without having to resort to bail-outs.

Heightened contagion and liquidity risk

In order to ensure greater bank self-reliance going forward, the Reserve Bank introduced a prudential liquidity policy in April 2010. The policy includes minimum liquid asset requirements and, perhaps more importantly, a minimum core funding ratio (CFR).This requires a minimum proportion of total lending to be funded by more stable “core funding” instruments, i.e. retail deposits and long term borrowing (over one year).

The heightened awareness of contagion and liquidity risks has led to a range of other policy responses in addition to the strengthening of capital and liquidity buffers. Such measures include extra safety requirements for large global “systemically important financial institutions” (SIFI’s), and changes to the “wiring” of the financial system in an attempt to reduce contagion risks.

Examples of such measures include the “Volcker rule” in the US, which is aimed at isolating the risks from proprietary trading, and the Vickers recommendations in the UK, which propose to separate retail banking from investment banking. The challenge for such policies is to achieve a sustained reduction in financial system risk rather than simply distorting market behaviour.

Countering the credit cycle

In broad terms, macro-prudential policies are aimed at reducing financial system risk by introducing additional safeguards, such as capital and liquidity buffers or collateral requirements that vary with the macro-credit cycle. Such policies will also tend to have the effect of either: 1) dampening the credit cycle; or 2) dampening international capital flows and hence exchange rate pressures. For those reasons, macro-prudential policies might be expected to play a useful secondary role in helping to stabilise the macro-economy.

Stronger failure resolution mechanisms

In New Zealand, while we already have quite strong failure management powers within the Reserve Bank Act, we know that the failure of any of our large systemic institutions would require close official involvement. Our main response to this third lesson from the GFC has been to enhance our existing failure management framework by including a resolution structure called “Open Bank Resolution” (OBR).

The OBR framework requires banks to structure their systems so that, in the case of a failure where losses exceed a bank’s available capital reserves, the excess losses can quickly be allocated across depositors and other creditors. The Reserve Bank has been developing the  OBR policy over a number of years; the GFC experience provided the final prompt to make it operational. The policy can be seen as a complement rather than a substitute for the various “recovery plan” tools such as living wills and loss-absorbing debt instruments.

Full speech

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