Global financial stability risks and domestic debt vulnerabilities remain. Prolonged low long-term interest rates could generate excess leverage and overheated asset prices.
The New Zealand economy relies on international demand for our exports, and the financial system borrows money from international financial markets. This means that developments in the international economy and financial system can have important effects on New Zealand’s financial stability.
The global economy has slowed, largely due to uncertainty about trade policy. The global economy remains vulnerable to a more significant downturn, especially since there is relatively little room to further ease monetary or fiscal policies in many countries to support growth.
Long-term interest rates have declined in a number of countries, including New Zealand, and are expected to remain low for a prolonged period. Low rates are necessary, and have helped to cushion the New Zealand economy and borrowers from the effects of weaker global growth.
Over the longer term, prolonged low interest rates could lead to some borrowers taking on too much debt and for asset prices to become overheated. This could increase the vulnerability of the economy and borrowers to future economic downturns.
Some households have high debt and could face stress if their incomes fell or if interest rates increased. Banks could experience significant losses if a large number of borrowers became stressed in an economic downturn, particularly if house prices also fell significantly. This risk has remained stable recently but at an elevated level.
Restrictions on low deposit (or high loan-to-value ratio) loans have improved the resilience of banks and households by reducing the volume of loans with a higher risk of defaulting in a downturn. Current policy settings remain appropriate and we will be watching how risk evolves over the coming months.
Capital is the equity funding that is provided by bank shareholders. Strong capital positions are important, as it provides a buffer for banks to absorb unexpected losses without threatening their ongoing viability.
Currently banks hold sufficient capital to withstand a range of economic risks. However, their viability may be threatened if very severe events were to occur. Bank failures can cause very large economic and social costs, and to improve resilience we have proposed increasing capital requirements for banks. Under the proposed changes, we believe banks would be able to withstand the kind of event that occurs about once every 200 years.
Resilience of financial institutions is underpinned by a sound understanding and management of the risks that they face. Recent reviews of the culture and conduct of banks and life insurers have found weaknesses in processes for managing conduct risks. Further risk management weaknesses have been revealed by a number of banks recently disclosing errors in their calculation of key regulatory requirements.
We expect institutions to improve their own assurance processes and controls, and we will work with them to ensure this happens. We will also be increasing the intensity of our supervision, with greater scrutiny of institutions’ compliance.
The Reserve Bank sets minimum solvency requirements for insurers which requires them to maintain sufficient capital and reinsurance coverage to ensure they can meet their future obligations to policyholders with a high degree of certainty. Solvency ratios have declined for many general and life insurers, leaving a low buffer over minimum requirements.
Recent sharp falls in long-term interest rates are putting further pressure on some life insurers. Changes in long-term interest rates can affect the value of insurers’ assets and liabilities, and low interest rates can also affect profitability by reducing investment returns. Affected insurers are preparing plans to improve their solvency and we have increased our supervisory engagement with these firms.