A Specific Role for Boards in a Regulatory Framework: the New Zealand Banking Case
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A Specific Role for Boards in a Regulatory Framework: The New Zealand Banking Case M. L. McIntyre Sprott School of Business Carleton University 1125 Colonel By Drive Ottawa, Ontario Canada K1H 6S6 [email protected] +1 613 520-2600 ext 2514 David Tripe Centre for Banking Studies Private Bag 11-222 Massey University Palmerston North, New Zealand [email protected] +64 6 350-5799 ext 2337 October 2006 Key Words: Board of Director, Governance, Bank Regulation 1 Abstract The Reserve Bank of New Zealand’s (“RBNZ”) regulatory framework for the New Zealand banking system specifies a role for the boards of locally incorporated banks and also specifies some features of bank board construction.The latter is intended to increase the probability of bank boards fulfilling their regulatory role. In this paper we consider how the RBNZ’s specifications for board construction compare to the standards espoused in the literature. We also examine actual bank board construction in New Zealand to determine the extent to which locally incorporated banks have met or exceeded the RBNZ’s requirements. We find that while some banks have taken a minimalist approach to observing the RBNZ’s requirements, others seem to have formed boards that far exceed them. This finding calls into question critics’ claims that the RBNZ’s rules for bank board construction lead to boards that are excessively costly and potentially dysfunctional. We also find that the RBNZ’s requirements for board construction omit two features commonly associated with effective boards of directors. 2 1. Introduction The Reserve Bank of New Zealand’s (“RBNZ”) regulatory framework for the New Zealand banking system specifies a role for the boards of locally incorporated banks, and also specifies some features of bank board construction.The latter is intended to increase the probability of bank boards fulfilling their regulatory role. In this paper we consider how the RBNZ’s specifications for board construction compare to the standards espoused in the literature. We also examine actual bank board construction in New Zealand to determine the extent to which locally incorporated banks have met or exceeded the RBNZ’s requirements. The approach in this paper is idiographic in that the goal is to observe and describe phenomena and then interpret them using existing theory. The approach is therefore qualitative in nature. This is in contrast to the nomothetic approach in which one seeks to present hypotheses and then test whether or not a suitably large sample of data supports the hypotheses in a statistically significant way. We find that the RBNZ’s requirements for boards address only a small fraction of the dimensions that the literature on effective boards considers important. We also find that the RBNZ standard omits two basic and desirable features of effective boards – independent audit committees, and an independent chair. In our view, the addition of these two requirements would better position the boards of locally owned banks to fulfill the regulatory role envisaged for them. While some banks in our sample meet only the minimum standards set out by the RBNZ, others have formed boards that far exceed them. In our view this calls into question the views expressed by critics that the RBNZ’s requirements are excessive. It also suggests that the RBNZ could raise its standards for locally incorporated bank boards. This paper is organized as follows. In section 2 we present a literature review. In section 3 we present details of how our sample of boards is constructed. Section 4 presents a discussion of our empirical findings. Section 5 concludes. 2. Discussion and Literature Review In New Zealand, the primary bank regulator is the RBNZ. Similar to other bank regulators, it must decide upon a sensible regulatory regime that takes account of matters such as the positive externalities associated with a well functioning banking system (Levine, 1997), the substantial adjustment costs that may follow from a bank or systemic failure (Llewellyn & Mayes, 2003, p 22, Goodhart et al, 1999) and the inherent fragility that arises out of operating within an inter-linked payments system (De Vries, 2005). Unlike many other countries, the New Zealand banking system is characterized by a high degree of foreign ownership. The four major banks (ANZ, ASB, BNZ and Westpac)1, all 1 See Table 1 for full names and ownership details. 3 of which are foreign owned, collectively accounted for 89.1% of banking system assets as at December 31, 2005. Thus, in addition to adopting a regulatory regime that addresses the risks associated with overwhelmingly foreign ownership, the RBNZ must be sensitive to the idea that the costs its regime imposes will have an effect on foreign banks’willingness to operate in New Zealand. The balancing act is an important one because foreign banks can contribute benefits to a host country. Hull (2002), Evans & Quigley (2002), and Mortlock (2003) acknowledge that a high level of foreign-bank ownership has been good for New Zealand because foreign-owned banks have enhanced the efficiency of the New Zealand financial system and its ability to manage in a crisis. The key reason for this is that the foreign-owned banks have access to international capital markets at lower cost than New Zealand’s smaller locally-owned banks (To & Tripe, 2002). Studies by Crystal, Dages & Goldberg (2002), and Dages, Goldberg & Kinney (2000) show that in the Argentinean case, foreign-owned banks provided a stabilising effect on the financial marketplace by providing more effective risk management practises and better access to foreign capital markets than domestic banks. While there are benefits to foreign ownership in the banking sector, a foreign-parent can face a large number competing interests in its many spheres of operation, not least of which are the regulators in its home jurisdiction. The operation in each host country is vulnerable to the risk that the foreign parent or head office might respond to exigencies at home or elsewhere, and that its actions might not be optimal for the operations in the host country. The challenge for the RBNZ has been to ensure that its regulatory approach properly addresses the risks to which the local banking system is exposed, including the risks associated with substantial foreign ownership, while continuing to provide an environment that is attractive for foreign banks to operate in. It has done so within a regulatory regime that is relatively less interventionist than the regimes of other developed economies, in particular, Canada, the United States, and Great Britain. For example, its approach includes neither deposit insurance nor regular bank audits by the supervisory agency. Rather, the RBNZ exercises a self-described “light-handed regulatory regime for banks, which relies on a combination of self, market and regulatory discipline.” (RBNZ, 2004, p. 1). It applies a specific disclosure regime to support its reliance on market discipline, and this disclosure regime calls for the ready availability of two documents: the Key Information Summary and the General Disclosure Statement (c.f. Mortlock, 1996a for a detailed discussion). In addition, the RBNZ’s regulatory policy requires that banks meeting certain criteria must carry on operations in New Zealand through locally incorporated subsidiaries. One of the results of local incorporation is that the locally incorporated entity has a board of directors. The RBNZ has made these boards an integral part of its regulatory framework. It has done this by specifying a particular structure for the boards, requiring them to perform certain tasks, and having them ensure the company adopts and adheres to various operating goals, which are specified in the RBNZ’s Statement of Principles: Bank Registration and Supervision (January 2006). 4 According to RBNZ policy, the boards must include two independent members and a non-executive chair. The RBNZ has also spoken in favour or an audit committee chaired by a non-executive director (Mortlock, 1996b). To facilitate later discussion, we refer to these as the “Board Prescriptions”. In addition to its specific board composition requirements, the RBNZ also stipulates that: “the composition of the board is such that it does not give rise to concerns about the bank's ability to pursue its own interests when these conflict with those of the shareholders.” (RBNZ, 2006, p 12) To facilitate later discussion, we refer to this as the “Overarching Goal”. This requirement of locally incorporated banks raises an important question: How should bank boards be constructed to increase the chances of them achieving this goal? In a paper that addresses a similar question, Murphy and McIntyre (2007) look to the organizational behaviour literature to identify team characteristics that are likely to correlate with board effectiveness. McIntyre, Mitchell & Murphy (2007) test some of the ideas in Murphy and McIntyre (2007) in a study of 151 companies listed on the Toronto Stock Exchange, and their 1,678 directors. They find that diversity with respect to tenure and age on boards is positively correlated with firm performance, large levels of diversity are correlated with diminished firm performance, and that smaller Boards are associated with higher levels of firm performance. In a comprehensive study of board performance, Brown, Brown & Anastasopoulos (2002) find that board performance across a number of wide-ranging measures improves with the number of women on the board. They report2: “By investigating the impact of women’s contributions in six key areas of good governance practice, we show that board processes differ when diverse perspectives are brought to the boardroom table. And these differences in process lead directly to differences in outcome.” (Brown, et al, 2002, p 1) Finally, PriceWaterhouseCoopers’ assessment of the root causes of the National Australia Bank’s A$360 million in trading losses in late 2003 and early 2004 is instructive for boards.