Prudential regulationi Relationship with the prudential regulator
The Reserve Bank's approach to bank supervision is based on three pillars: self-discipline, market discipline and regulatory discipline.2
The self-discipline pillar involves the Reserve Bank creating incentives for banks to maintain the systems and capacity to identify, measure, monitor and control their risks and maintain prudent operations. This is achieved by:
- requiring high-quality, regular and timely financial public disclosure by banks in the form of disclosure statements;
- requiring directors to sign attestations in their bank's public disclosure statements;
- not creating an impression that the Reserve Bank (rather than the banks themselves) has primary responsibility for the prudent management of banking risks; and
- avoiding explicit or implicit government support for banks.
The market discipline pillar attempts to use market forces to reinforce the incentives for the prudent management of banks. This second pillar is based on the premise that an efficient and well-informed market will reward well-run banks (e.g., through lower funding costs and better access to funding). This is principally achieved by the Reserve Bank maintaining a competitive banking system, and ensuring the market is well informed about a bank's financial performance.
The regulatory discipline pillar involves the Reserve Bank using regulatory and supervisory tools to reinforce incentives for banks to manage their risks prudently. The Reserve Bank has deliberately sought to keep its regulatory interventions to a minimum.
The Reserve Bank monitors all banks on an ongoing basis. Monitoring occurs principally through banks' twice-yearly disclosure statements. The RBNZ Act also provides the Reserve Bank with extensive powers to obtain additional information, to have that information audited if required and to have a bank's affairs investigated.ii Management of banks
When considering an application for registration as a bank, the Reserve Bank will consider the suitability for their positions of the directors and senior managers of the bank. This policy applies, in the case of locally incorporated applicants, to existing or proposed directors, the existing or proposed chief executive officer (CEO) and existing or proposed executives who report directly to the CEO; and, in the case of overseas-incorporated applicants, to existing directors and the existing or proposed chief executive of the New Zealand operations.
If a proposed director or senior manager has already passed a foreign banking regulator's suitability assessment, the Reserve Bank will usually accept that assessment as evidence of suitability.
A locally incorporated bank will be required to maintain adequate separation between the bank and its owners. This will require:
- putting in place policies to monitor and limit exposures to related parties;
- the company having a constitution that does not permit the directors to act in the interests of its holding company;
- the size and composition of the board being such that it does not give rise to concerns about the bank's ability to pursue its own interests when those interests conflict with those of its shareholders; and
- the bank having an audit committee (or other committee whose mandate includes audit matters) comprising non-executive and otherwise independent directors.
The Reserve Bank generally will require a locally incorporated bank to have at least five directors. The majority of the directors must be non-executive, and at least half are required to be independent. At least half of the independent directors must be ordinarily resident in New Zealand. The chairperson must also be independent. The Reserve Bank's criteria for a director to be independent are set out in the Reserve Bank's Corporate Governance (BS14) document.
The Reserve Bank must be supplied with a copy of the curriculum vitae of any potential director, CEO or executive who reports to the CEO of a locally incorporated bank, and the appointment of such a director, CEO or executive can only be made if the Reserve Bank has advised that it has no objection to the appointment.
Directors of banks (and the New Zealand CEO of an overseas bank) are required to sign bank disclosure statements, which include certain attestations by the directors. Attestations include that the directors believe, after due enquiry by them, that:
- the bank has systems in place to monitor and adequately control the banking group's material risks, including credit risk, concentration of credit risk, interest rate risk, currency risk, equity risk, liquidity risk, operational risk and other business risks, and that those systems are being properly applied;
- exposures to connected persons have not been contrary to the interests of the banking group (this applies to locally incorporated banks only); and
- the bank has been complying with its conditions of registration.
In the full-year disclosure statement, a bank must also disclose the following (and address any changes to the composition of the bank's board in the half-year disclosure statement):
- details of each director (including name, occupation, technical or professional qualifications, whether he or she is executive or independent, other directorships and any details of transactions that could materially influence a director in carrying out his or her duties). This information must also be disclosed in respect of the New Zealand CEO of an overseas bank;
- whether there is a board audit committee (locally incorporated banks are required to have an audit committee or other committee that considers audit matters), and certain details of that committee; and
- the board's policy for avoiding or handling conflicts of interest that may arise from directors' personal, professional or business interests.
In addition to the disclosure statements that are published twice-yearly by banks, the Reserve Bank publishes selected financial information for New Zealand banks side by side on what is known as the Dashboard. The Dashboard is updated quarterly with financial information that banks privately report to the Reserve Bank. The Dashboard approach aims to enhance market discipline by aggregating financial information in an accessible format that facilitates side-by-side comparison of banks based on key metrics.
Banks whose New Zealand liabilities, net of amounts due to related parties, exceed NZ$10 billion will also be subject to outsourcing conditions of registration:
- The bank must comply with the Reserve Bank's Outsourcing Policy (BS11). The Outsourcing Policy requires the bank to have the legal and practical ability to control and execute outsourced functions. The policy is intended to minimise the impact of the failure of a large bank, or a service provider to a large bank, on the wider economy, and to preserve the available options if there is a large bank failure.
- The bank must ensure that:
- the business and affairs of the bank are managed by, or are under the direction or supervision of, the board of the bank;
- the employment contract of the CEO or person in an equivalent position with the bank is determined by the board of the bank, and any decisions relating to the employment or termination of employment of that person are made by the board of the bank; and
- all staff employed by the bank have their remuneration determined by the board or the CEO of the bank, and are accountable (directly or indirectly) to the CEO of the bank.
No restrictions have been imposed by the Reserve Bank on bonus payments to management and employees of banks.iii Regulatory capital and liquidity
New Zealand's capital adequacy framework is the product of a recent four-year review (the Capital Review). The Reserve Bank announced its final decisions on the Capital Review in December 2019, and released its finalised bank capital adequacy requirements in Banking Prudential Requirements (BPR) documents in June 2021. Changes began being implemented from 1 October 2021.
In New Zealand, capital is divided into Common Equity Tier 1 capital, Additional Tier 1 capital and Tier 2 capital. The Capital Review decisions include a significant increase in the total amount of capital required to be held by banks. By the end of a seven-year transition period, banks will be required to hold total regulatory capital of at least 16 per cent of their risk-weighted assets (or at least 18 per cent in the case of systemically important banks). Of that regulatory capital, only 2 per cent can be in the form of Tier 2 capital and only 2.5 per cent can be in the form of Additional Tier 1 capital.
The Capital Review decisions also include new rules around capital instruments. As of 1 October 2021, contingent capital instruments (that is, instruments that achieve loss absorption via conversion or write-off) are no longer eligible as Additional Tier 1 or Tier 2 capital. Additional Tier 1 capital instruments must be in the form of redeemable non-cumulative perpetual preference shares. Tier 2 capital instruments consist of long-term subordinated debt.
A bank's capital requirements must be calculated using one of two approaches available under the Reserve Bank's capital adequacy framework. The first is the standardised approach, which uses external credit assessments produced by approved credit rating agencies and is the default approach. The second is the internal ratings-based (IRB) approach, which permits a bank that has been accredited by the Reserve Bank to use its internal models to measure the risks of the bank's business. As a result of the Capital Review decisions, the risk-weighted asset outcomes for banks operating under the standardised approach and those operating under the IRB approach have become more closely aligned. From 1 January 2022, banks accredited to use the IRB approach have become subject to an 85 per cent output floor. The scalar for IRB banks has also increased from 1.06 to 1.2. The Reserve Bank's capital adequacy framework generally aligns with the Basel III global standards, but some departures were made to reflect New Zealand's circumstances. For example, the Reserve Bank did not support the introduction of a leverage ratio for New Zealand banks, relying instead on its liquidity policy (discussed below). A bank must have a capital policy that takes into account any constraints on the bank's access to further capital, for instance if required in relation to an increase in business or an unexpected loss. In addition, a bank must satisfy the Reserve Bank that it has the capacity to implement and manage an internal capital adequacy assessment process that meets the Reserve Bank's Guidelines on a Bank's Internal Capital Adequacy Assessment Process (BPR100).
A branch of a bank incorporated overseas will have to demonstrate to the Reserve Bank that the global bank complies with adequate capital standards that are at least broadly comparable with those in New Zealand, and that it is subject to adequate supervision by the bank's home supervisor.
Banks must also comply with the Reserve Bank's Liquidity Policy (BS13). The Liquidity Policy requires banks to meet a minimum core funding ratio of 75 per cent, ensuring that a greater proportion of bank funding is met through retail deposits and term wholesale funding.
The Reserve Bank considers that its Liquidity Policy is an effective substitute for the leverage ratio proposed by Basel III. The Reserve Bank considers that certain aspects of the Basel III leverage standards are not suitable for adoption in New Zealand. For example, the requirement that government securities comprise the bulk of high-quality liquid assets held by banks is considered unsuitable because New Zealand does not have a sufficient volume of government debt on issue.
In September 2021, the Reserve Bank published its findings from a review of banks' compliance with the Liquidity Policy. While the report identified areas of good practice, it also identified a range of system, controls and risk management weaknesses. A substantive review of the Liquidity Policy commenced in early 2022.iv Recovery and resolution
The Reserve Bank's Open Bank Resolution (OBR) Pre-positioning Requirements Policy (BS17) applies to locally incorporated banks holding retail deposits in excess of NZ$1 billion (although other registered banks may opt in). The OBR is a tool for responding to a bank failure, allowing the bank to be open for full-scale or limited business on the next business day after being placed under statutory management. It is intended to provide an immediate and practical tool for responding to a bank failure and to reduce the moral hazard associated with implicit government support of banks.
The OBR policy places the cost of a failure in the first instance on shareholders, but also provides flexibility to assign losses to creditors without causing unnecessary disruption to the banking system and wider economy. If a statutory manager is appointed to a bank, the bank must close, and all accounts must be frozen to enable the bank's net asset deficiency to be determined. A haircut reflecting the bank's net asset deficiency plus a buffer is applied to all creditors' accounts, and funds equal to the amount of the haircut are frozen. The non-frozen funds are guaranteed by the government, and the bank is able to reopen for core transactions business. On the following day, haircuts are applied to other non-time sensitive liabilities to enable those liabilities also to be partially satisfied. If sufficient funds become available, the frozen funds can be released during the course of the statutory management.
Banks subject to the OBR policy must pre-position for OBR; this means having IT, payments, resource and process functionality in place ahead of a crisis so that, if a statutory manager is appointed, access channels can be closed, funds can be frozen and access channels can be reopened for business by no later than 9am the next business day.