NZ on right reform tack

The reform approach in New Zealand is to adopt market-based principles, suck in a lungful of air and march forward.  By contrast, the Australian reform formula carries a paraphernalia of special inquiries followed by interdepartmental committees that so often end in compromise arrangements overseen by cumbersome government regulation.

This is seen with particular force in banking.  In 1996, NZ abandoned a wide range of regulatory controls on banking.  The NZ Reserve Bank no longer guarantees banks' solvency.  There are no closed-door chats during which the Government's representative, the Governor of the Reserve Bank, jawbones the banks into certain actions and tells them to improve their liquidity or to diversify portfolio holdings.

Instead, aside from ensuring the conformity with the Bank of International Settlements requirements on liquidity, the NZ system depends upon the market to police the activities of the different financial institutions.  The Reserve Bank insists on regular public disclosure of positions so that professionals and even the general public can judge the relative risks of each bank.

These disclosures must be signed by the bank's directors, who face up to three years' jail for false or misleading information.

Market oversight builds on this.  It leads each bank, for its own security, to carefully assess the liquidity and security of the banks with which it does business.  Sound banks will impose pressure on others which may not be able to meet their obligations -- the ultimate sanction being exclusion from the clearing system.

This aside, any bank that is behaving recklessly faces the klaxons of the financial media and creditors.  All this is made possible by publication of information.

Paradoxically, the exit from control of the authorities has meant better disciplines on banks.  There is no longer a body with secret information which offers sometimes unwarranted public sustenance to a risky entity.  Ironically a safety net under banks induces "moral hazard" activity -- it encourages institutions to take excessive risks.

In fact, the information requirements that central banks conventionally impose have rarely been effective in preventing the high-profile failures like those due to the rogue-trader phenomenom.  Lest we forget, the Barings collapse occurred in a branch located in the world's most regulated market.

Other failures, including those in Australia, have demonstrated how a determined bank or quasi-bank management can always hide its impending failure from the regulatory authorities.  The disciplines of the market and prudential action by parties that transact business with banks are powerful means of insuring against failure.

There are also clear cost savings from the NZ approach.  These occur both through a considerable diminution of the public resources used to scrutinise banks and a sizeable reduction in the banks' own resources required to provide special information to the Reserve Bank.

Will the Wallis inquiry adopt the emerging orthodoxy on free banking? Probably not.  Such inquiries, like old generals, tend to fight the previous war.  We will most likely have to await the next review 10 years' hence before we abolish the baggage of regulatory control with the fiction of the all-wise bureaucratic oversight.

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