Bank liquidity ratios to create automatic stabiliser

Wednesday 11th November 2009

New Reserve Bank of New Zealand rules will force more prudent lending practice from trading banks over the course of economic cycles and take some of the weight off the Official Cash Rate as the sole tool for setting monetary conditions, the RBNZ has spelt out today.

The identification of stricter liquidity ratio rules as an automatic economic stabilisation tool marks a significant shift in central bank activism to force more prudent behaviour from the banking sector in the wake of the global credit crunch.

The RBNZ's six monthly Financial Stability report, and a subsequent briefing by senior bank officials to Parliament's finance and expenditure select committee today, have revealed the depth of the RBNZ's thinking on ways to avoid the worst impacts of further global financial instability, which it says remains a real danger for a heavily indebted country like New Zealand.

In essence, the new approach will force higher bad debt provisioning in boom times to offset the sudden impact of bad lending on the financial system in recessions, and skew banks to back their lending with longer term funding arrangements.

"There is potential to use liquidity ratios as an economic stabiliser. The idea of dynamic provisioning through the cycle could potentially support the OCR," said deputy RBNZ governor Grant Spencer. "Our main lesson from the crisis was to produce a policy in that area of weakness."

However, the OCR would remain "the only way we have to change (monetary) conditions," RBNZ governor Alan Bollard told the select committee. "The background is that liquidity ratio policies could have beneficial impacts over the cycle. It's new territory and it's something a number of countries are looking at.

"We mustn't over-promise on this," Bollard said, "but we are keen to look at core funding's capacity to contribute to monetary policy."

Bollard says the moves are "not welcomed" by trading banks, but they are feeling similar pressure internationally.

The financial stability report elaborates that such intervention would aim to "reduce the cyclicality of the overall financial system".

"In the New Zealand context, with a large proportion of imported capital, the Reserve Bank believes the fluctuating attitude of international lenders has contributed to excessive exchange rate cyclicality.

"The new liquidity rules restrict the proportion of loans that can be funded through short term wholesale borrowing. This will force future rapid increases in demand to be funded mostly through long term wholesale debt, raising funding costs and likely moderating credit growth.

"In the downturn, this pre-existing long term funding helps maintain investor confidence and reduces the extent to which the bank will need to access (potentially troubled wholesale funding markets, reducing any funding squeeze."

Businesswire.co.nz

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