8.2  Financial regulation and supervision

Financial instability is caused by asymmetric information and disrupts the efficient functioning of the financial system during periods of distress. Minimising information asymmetry and hence lowering the risk of financial instability is important and requires the production of information through screening and monitoring. Governments can encourage information production by imposing regulations on the financial system. For example, governments typically require financial institutions or firms issuing securities to adhere to standard accounting principles and disclose a wide range of information about their balance sheets. Moreover, governments impose strict penalties for fraud such as hiding information or stealing profits.

Disclosure requirements increase the amount of information available. However, they do not overcome the public good problem of information, leading to socially sub-optimal monitoring and screening of financial intermediaries by the individuals, who provide them with funds. As a result, governments impose further restrictions on the asset holdings of financial intermediaries or capital requirements, for example, to prevent them from taking too much risk.

Demirgüç-Kunt, Laeven and Levine(2003) examine the impact of banking regulations on net interest margins and overhead costs across 72 countries. They find that tighter regulations increase the cost of financial intermediation and do not create countervailing benefits. However, bank regulation must be seen as part of the overall institutional framework, as its effects become insignificant when broader institutional factors such as property rights protection and economic freedom are taken into account.

A second role generally of governments is to provide a safety net. Providing a safety net is important for the banking sector for three main reasons. First, banks are important because they hold and issue a large amount of demand deposits and private loans. Second, banks often provide credit to borrowers who would not otherwise be able to obtain external funding. Third, banks may be subject to contagion, or the risk of spill-over of the effects of shocks from one or more banks to other financial intermediaries or markets, due to interbank exposure.[54]

As Diamond and Dybvig (1983) show banks are vulnerable to bank runs. Bank runs occur when depositors panic and withdraw their deposits immediately, including even those who would prefer to leave their deposits in the bank if they were not concerned about the bank failing. Bank runs cause real economic problems because even “healthy” banks can fail, leading to a recall of loans and the termination of productive investment. In Diamond and Dybvig’s (1983) model, when normal volumes of withdrawals are known and not stochastic, suspension of convertibility of deposits allows banks to prevent bank runs and provide optimal risk sharing. In the more general case (with stochastic withdrawals), deposit insurance can rule out runs without reducing the ability of banks to transform assets. A central bank as a lender of last resort can provide a service similar to deposit insurance under the assumption that banks can not select the risk of their loan portfolios. However, when there is a trade-off between optimal risk and proper incentives for portfolio choice, the lender of last resort may not be as effective as deposit insurance. This is because if the lender of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks to take on risk. Deposit insurance on the other hand is a binding commitment that, in theory, can be structured to retain punishment in the case of bank runs. However, implementing deposit insurance in practice can be difficult (see, for example, Demirgüç-Kunt and Kane 2002) because it may encourage risk taking by financial institutions and by those who hold funds in them.[55]

Safety nets are important in reducing the real effects of financial instability. However, a serious problem arises from moral hazard when depositors expect that they will not suffer losses if a bank fails and are less likely to withdraw their deposits when they suspect that a bank is taking on too much risk. As a result, central banks as lenders of last resort often engage in “constructive ambiguity”; that is, “central banks reserve the right to intervene to preserve stability but give no assurances, explicit or implicit, to individual institutions” (Crockett 1997).

Financial supervision ensures compliance with government regulations. The most supervised institutions are banks. Banking supervision generally consists of regular bank examinations to monitor banks’ compliance with capital requirements and restrictions on asset holdings. Moreover, bank examiners try to assess whether banks maintain proper management controls.

One difficulty of regulation and supervision is that it creates a principal-agent problem; that is, the agent (politician or regulator) may not have the same incentives to minimise the costs to the economy as the principal (the taxpayer). To act in taxpayers’ interests, regulators must impose restrictions. But because of the principal-agent problem they have an incentive to engage in regulatory forbearance.

8.3  Financial regulation and supervision in New Zealand[56]

New Zealand’s financial system is dominated by foreign-owned banks, with the four systemically-important banks Australian-owned. Non-bank financial institutions are not systemically important and allowed to compete with banks in all areas of business.

New Zealand’s regulatory system in the non-bank area is based on a disclosure regime, and disclosure plays an important role in the regulation and supervision of banks as well. Outside of banking, authorities mainly rely on requirements to disclose financial and prudential information and less emphasis is put on merit regulation. Merit regulation involves the authorities applying, monitoring and enforcing prudential standards. Merit regulation includes a gate-keeper role, where the gate-keeper enforces standards to be met in order to obtain and keep a licence to operate in the financial system.[57] The preference for a disclosure based regime for the non-bank parts of the system in New Zealand over merit regulation reflects a view that with a disclosure based regime well-informed markets can develop their own solutions to many of the problems caused by asymmetric information and that more direct merit regulation can undermine those market solutions.

The core, non-bank regulatory regime is provided by the Securities Act 1978 and accompanying Securities Regulations 1983 and the Securities Markets Act 1988. Both acts are administered by the Securities Commission. The Securities Act is a disclosure based regime and applies to all classes of entity raising funds from the public, except for registered banks, and irrespective of the form of the instrument (deposits, debt, equity, syndicate participations, etc). The Securities Markets Act provides for ongoing disclosure by public entities, disclosure by directors and officers and people with substantial security holdings, the regulation of securities exchanges and insider trading. Oversight of much of the non-bank sector and securities markets is undertaken by the Securities Commission, the Registrar of Companies, the Government Actuary and Insurance Savings Unit and the National Enforcement Unit.

To strengthen the regulatory framework in order to encourage investment and enhance the performance of the New Zealand market, a programme of reform has been in progress since 2000. The programme has resulted in the introduction of the Takeovers Code and the passing of the Securities Markets and Institutions Bill. The Securities Trading Law Reform Bill, which implements a new insider trading and market manipulation regime, provides for greater general enforcement and oversight of securities trading law by the Securities Commission and enhanced disclosure. Greater enforcement by the Securities Commission of investment adviser disclosure law will be introduced by the end of the year and a review of the Securities Act 1978 will be commenced later next year.

A specialised regime applies to financial institutions that represent themselves as “banks”.[58] It is administered by the Reserve Bank of New Zealand and is merit based, albeit with a heavy reliance on disclosure. Moreover, it is supplemented by active home country supervision of New Zealand’s largest banks. To maintain the soundness of the financial system the central bank may also act as a lender of last resort and engages in failure management of financial institutions.

New Zealand’s approach to regulation and supervision has been effective in promoting financial stability over the past decade, at a time of significant financial turmoil in other countries (e.g. the Asian financial crisis, the Russian government’s default on its debt and the failure of a major hedge fund). The general soundness of New Zealand’s financial system has been confirmed in the IMF’s recent assessment of financial system stability. However, the IMF report does recommend improvements in some areas of bank and non-bank supervision and securities market regulation, which are currently being considered.