8  The role of financial regulation and supervision

Policy influences the operation of financial systems through financial regulation and supervision. This section discusses the main sources of financial instability. It reviews the role of financial regulation and supervision and briefly examines the regulatory and supervisory approach in New Zealand.

8.1  Financial instability[49]

The need for regulation and supervision of the financial system arises because financial intermediaries and markets, like firms, are subject to asymmetric information. A key objective for financial regulation and supervision is to increase the effective functioning of the financial system in order to enhance the ability to absorb shocks and maintain financial stability. Financial instability occurs when shocks to the financial system interfere with the payment system and impact on the ability for normal business and trade to occur. It may be caused by the collapse of a systematically important financial intermediary or other shocks. Any disruption in the financial system can potentially have severe real economic effects.[50] During the Asian crisis in the second half of the 1990s, for example, the disruption in the supply of credit was a major factor in the recessions experienced by the affected countries. An economic downturn may be exacerbated by falling prices (Fisher 1933). Given that (most) debt contracts are written in nominal terms, a fall in prices increases real debt burdens and reduces firms’ ability to borrow, adding further to the decline in economic activity. The problem of falling prices is particularly acute for debt contracts of fairly long duration.[51]

There are four main factors that can initiate financial instability: (i) increases in interest rates, (ii) increases in uncertainty, (iii) negative shocks to firms’ balance sheets, and (iv) a deterioration in financial intermediaries’ balance sheets (Mishkin 1997).

Increases in interest rates

In some circumstances increases in interest rates can potentially lead to large declines in lending or even a collapse in the loan market if some form of credit rationing occurs as a result. Credit rationing can occur because changes in interest rates worsen the adverse selection and moral hazard problems of imperfect information (Stiglitz and Weiss 1981). The adverse selection effect of interest rates is a consequence of different borrowers having different probabilities of repaying their loans. The interest rate an individual is willing to pay may act as a screening device. Those who are willing to pay high interest rates may, on average, be worse risks. They are willing to borrow at high interest rates because they perceive their probability of repaying the loan to be low. As a result there exists an interest rate that maximises financial intermediaries’ expected return and beyond which they will be unwilling to supply funds, making the supply of loans curve bend backwards and downward sloping (see Figure 2). A change in interest rates can also affect financial intermediaries’ expected return from loans through the moral hazard effect by changing the behaviour of borrowers. Higher interest rates induce firms to undertake projects with lower probabilities of success but higher payoffs when successful. Increasing the rate of interest raises the relative attractiveness of riskier projects, for which the return to the bank may be lower because of increased default risk.[52] As the interest rate rises, the average riskiness of those who borrow increases and the moral hazard effect reinforces the adverse selection problem. Financial intermediaries and markets therefore have an incentive, in some circumstances, to ration credit.

Increases in uncertainty

The functioning of financial systems may be affected by substantial increases in uncertainty, due to, for example, the failure of a large financial or non-financial institution, a severe recession, political instability or a stock market crash. Increased uncertainty reduces the ability of financial systems to screen borrowers and may result in credit rationing.

Negative shocks to firms’ balance sheets

Information asymmetries and the inability of lenders to monitor borrowers costlessly lead to agency costs, creating a wedge between the costs of internal and external financing for a firm. Firms’ market value (or net worth) is an important determinant of agency costs and hence the cost and availability of finance. Adverse shocks to firms’ balance sheets and net worth due to natural disaster or a stock market crash, for example, affect their ability to borrow and can have severe real economic effects.[53] This is because shocks that lower the market value of firms reduce the value of assets that firms can use as collateral. As a result, financial intermediaries and markets may be less willing to lend to firms because the reduction in collateral increases their potential losses from adverse selection: owners will have a lower equity stake in their firms, which gives them more incentive to engage in risky investment projects. The decline in collateral may lead to loans not being extended upon maturity or being recalled, i.e. to forms of credit rationing.

A deterioration in financial intermediaries’ balance sheets

Adverse shocks to financial intermediaries’ balance sheets may affect their willingness to lend. A deterioration in financial intermediaries’ balance sheets may be caused, for example, by an increase in interest rates, a stock market crash or an unanticipated decline in inflation. Weak bank balance sheets may also be the result of inadequate financial regulation and/or supervision. Adverse shocks to financial intermediaries’ balance sheets can have severe economic real effects if the financial institution affected is systemically important either directly or indirectly. A deterioration in financial intermediaries’ value of equity can affect lending. If banks, for example, are required by regulators or depositors to retain some minimum capital ratio (defined as the value of banks’ equity as a percent of the value of loans outstanding), they will have to either reduce their supply of loanable funds or raise new equity. However, because it takes time to raise equity and also because the cost of new capital has increased due to a lower market value of banks, the typical initial response is a contraction in lending.

Financial regulation and supervision (discussed next) can help increase the effective functioning of the financial system and maintain financial stability. Other factors that are important contributors are a flexible exchange rate regime and a low inflation environment. A sharp depreciation in the exchange rate, for example, may be an early warning to policy makers that their policies may need to be adjusted. Price stability is important because it means that a central bank/government can more credibly take action if required. Sustained low and stable inflation and credible commitment to price stability mean that a central can ease monetary policy or engage in lender of last resort activities (discussed further below) to prevent a financial crisis or promote recovery from it without leading to rapid rises in expected inflation (Mishkin 1997).