26 August 2008 Banking specialist forecasts more supervision for lenders

Action needed while sector is performing well

A former Reserve Bank chief economist says the recent financial crisis highlights the need for authorities to improve their ability to limit the build-up of risks in periods of strong economic growth, and to restore confidence when the downturn comes.

“The lesson from the UK is particularly instructive,” says Professor David Mayes, who has been working in Lincoln University’s Commerce Division as this year’s EU Centres Network Lecturer.

“They thought they had one of the best systems in the world, yet when it was tested it turned out to be flawed and there is now a rush to improve it fundamentally.”

He says the main lesson from the international credit crunch is to work on financial market supervision issues before a crisis occurs.

“New Zealand is lucky that its systems have not been tested.  Arrangements can look excellent on paper and perform well in simulations but the stress of the real thing when people face losing their savings, their jobs and their homes brings challenges we fail to imagine.  We need to look very carefully at the mistakes others have made.  We all feel smart enough in advance, which is why threats to stability emerge.”

“These are issues that need to addressed while things are going well,” he said following a three week placement focused on research into European integration and cross-border banking arrangements. “It is too late in the rush to put things right once the shock hits.”

“We are appreciating now, with the worst of the credit crisis behind us, that central banks must look at the financial side of the banking sector just as much as the monetary side. In New Zealand, the Reserve Bank clearly has responsibility for both.”

Professor Mayes, who is also Advisor to the Board of the central bank of Finland, says the New Zealand banking system is essentially well thought out and there are good incentives for banks to act prudentially.  But New Zealand has a relatively narrow definition of banks, which means many financial institutions have not been well supervised.

“Reports of reckless behaviour in some finance companies have caused people to try to withdraw their savings from many of the others, bringing them down too.  All financial institutions round the world are inherently vulnerable.  They help economic development and wealth creation by borrowing from one group of people for relatively short periods of time and lending to others for much longer periods. “Banks play it very safe by holding substantially more assets than liabilities but no one can pay out everybody in a hurry.  Asset prices would collapse.”

Further measures such as limits on borrowing against property would provide additional protection against imprudent risk-taking in a rising market – something the Reserve Bank has been addressing.  However, confidence needs to be maintained when the economy turns down.  It is significant that New Zealand is the only OECD nation to have ruled out any requirement for bank deposit insurance.

It was instructive to see how others had responded to instability, he said. “The United States Federal Reserve has been very innovative, but this creates something of a moral hazard.  The Federal Reserve has tried to make it clear that if the same thing were to happen again, the institutions would have to face the consequences without federal support. It is very difficult to make that message believable.”

Professor Mayes says New Zealand is much more exposed than many to what other banking systems are doing, and so additional cushions were needed to protect against instability offshore. These have been addressed through measures such as tight fiscal management and promoting individual savings.  But levels of household debt were worryingly high for some people.

“Perhaps the biggest lesson we can learn is a rather insulting one – it is to improve our levels of financial literacy.  New Zealand schools have done a lot to improve education around financial decision-making but our literacy levels are still not high, as has been seen in New Zealand’s poor record on personal savings and risk management.

“Unfortunately the reason New Zealand does not require bank deposit insurance is the exact opposite.  The idea is that individual depositors must make their own judgements about bank soundness. Elsewhere in the OECD people have concluded that this is a vain hope.”

Professor Mayes says the total losses from sub-prime lending appeared to be in the region of US$400 billion.  With three-quarters of those losses now recapitalised, the worst of the credit crunch appeared to be over. 

In New Zealand, the long term economic impact of finance company failures would take time to emerge.  Clearly there will be losses for some of those who lent them money and there may also be problems for borrowers in small and medium-sized businesses – a major part of the New Zealand economy – but rising deposits at the retail banks and better lending conditions may solve this, he said.

About Professor David G. Mayes
David Mayes was previously Chief Manager and Chief Economist at the Reserve Bank of New Zealand, following posts in the National Institute of Economic and Social Research in London, the National Economic Development Office and the University of Exeter. He is a former Director of the NZ Institute of Economic Research. His work in the main has been focused on a range of aspects of economic integration particularly in Europe. His current focus is on issues of monetary and financial integration particularly with respect to banking. He is a former member of the European System of Central Banks’ MPC, and is an Editor of the Economic Journal. He has published some 30 books, the most recent of which are ‘Deposit Insurance’ and 'The Future of Financial Markets,' and a large number of journal articles. He becomes Director of the Auckland University’s Europe Institute later in the year.

About the Commerce Division
The Commerce Division is the largest of the four divisions at Lincoln University, accounting for around 40 per cent of total student numbers.  The Commerce Division provides teaching, research and professional services in the areas of Accounting, Business Management & Law, Economics, Finance, Marketing and Property. It has an extremely active Postgraduate Programme with around 130 postgraduate students currently enrolled, including 40 PhDs.

It also has an established Executive Development Programme (EDP) aimed at managers and professionals who are unable to study full-time or on-campus.  The EDP includes a specialised Master of Property Studies and a Master of Professional Studies.

Dr Ross Cullen, Deputy Director, Lincoln University, Canterbury, New Zealand.
Ian Collins, Communications Group, Lincoln University, Canterbury, New Zealand.