i. What problem does capital liquidity standards (a more stringent application thereof) address?
This specific question is addressed in relation to the financial crisis of 2007. Various studies conducted have found that perverse incentives, leading many to pursue short term, unsustainable gains in lieu of long term, sustainable profits (Rajan, 2006: 499). One possible solution to quell such interests is regulatory legislation. The problem which capital liquidity requirements address is one that considers the profits gained in the neoclassical era of deregulation to be irresponsible, and against the collective interest of New Zealand’s domestic economy (Skidelsky, 2009: 7-11).
ii. Are regulatory responses to economics issues, in particular financial sector issues appropriate?
Regulatory policy instruments are considered inherently risky in and of themselves (Bernanke, 1997: 4). Neoclassical models of economics warn against state interference in markets, for such interference shall interrupt the equilibrium established (Langely, 2004: 67). In such models, methods of regulation are not only dangerous, but pointless too, for markets shall inevitably return to equilibrium anyway. This paradigm of economics is critically analysed in relation to the issues at hand. This ‘regulatory risk’ is given a thorough risk assessment and is shown to have been applied in other economies without any discernable negative effect.
iii. Would a more stringent capital liquidity law be proportional to the problem at hand?
It is indeed true that a problem of irresponsible lending exists, and a regulatory approach to restrain such lending is plausible as a solution. What next needs to be examined is how far the policy tool of capital liquidity standards can be utilised to restrain irresponsible lending practices. One could implement a standard that allowed too little collateral in relation to lending. This implementation would, in effect not restrain the practices it sought to control, for imprudent lending would still be incentivised, and legally allowed. One could also implement a standard that mandated too much collateral in relation to that lent out. This implementation would preclude prudent lending institutions from functioning properly, potentially having devastating effect on the economy. Balance needs to be emphasised. It is important that regulation be set at the optimal point to achieve the goals for which it was conceived, anything more than this would cause instability (Yeh, 2006: 1-12).
iv. How can one make the capital liquidity laws more stringent? Is the problem one of legislative outputs, or the noneffectiveness of legislative outcomes?
Capital liquidity laws being established as a legitimate and proportional response to a problem of perverse incentives, this particular policy tool must be balanced against others. To endorse a more stringent application of capital liquidity laws it is not enough to say that this tool is indeed legitimate, one must establish that this tool is the best for this particular context. Consequently, a cost benefit analysis is conducted. This cost benefit analysis, as its name suggests weighs the pros and cons of capital liquidity laws against other tools, which may restructure these perverse incentives. Such an analysis covers the competing policy instruments: voluntary programs for lending institutions, marketing campaigns to encourage prudential lending, and education to teach the public just what kind of loans they can/cannot realistically afford.[1] It is from an analysis of these competing solutions that one finds that many of their benefits can be drawn into a policy package to complement the capital liquidity requirements change. It is therefore concluded that a more stringent capital liquidity law accompanied by a voluntary aspect, a marketing campaign, and a public education campaign will achieve the best possible results. It is through this amalgamation of different policy paradigms that the RBNZ will best be able to curtail the perverse incentives, which destabilise our domestic economy.[2]
[1] This list is not a complete list of every policy option available to the Reserve Bank of New Zealand, rather this is a short list of the options, which at prima facie glance seem plausible as alternatives.
[2] It is assumed here that stability is a virtue, rather than a vice of an economy. Certainly, this is contestable. I do not think an economy plagued by such busts as the 2007 financial crisis would be particularly desirable however. One may have to trade off stability for development at some stage, but it would be rather unwise to sacrifice stability to the extent that the events of 2007 would occur again.