Financial Stability Report for November 2007

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Summary and assessment

In recent months, global financial stability has been severely tested. Defaults and delinquencies by borrowers in the United States' sub-prime mortgage market have been a catalyst for more widespread financial market volatility, a generalised upward re-pricing of credit risk and reduced liquidity. These developments have had their roots in easy credit conditions that have persisted for several years. Low interest rates prompted a ‘search for yield’ that has been noted by many other central banks and international commentators, including this Report. In May, we noted that a reassessment of risks can quickly transmit to changes in asset prices, notably sub-prime assets. From July, we saw this process take place on a broad, international scale with New Zealand’s financial markets significantly affected.

A key reason for the broadening in financial turmoil was a lack of transparency surrounding the repackaging and transferral of risks in United States’ sub-prime mortgage assets across a variety of financial instruments and investors. Doubts regarding the level of exposure across financial markets saw market participants wary of lending to others, and some hoarding of cash as a hedge against uncertain liquidity demands. A clear example of this behaviour was seen in many of the world’s interbank markets – banks became unwilling to lend to each other, creating illiquidity in the market for overnight and interbank short-term funds.

In response, many central banks took steps to ease market liquidity, including the Reserve Bank of New Zealand. In a further step the United States’ Federal Reserve reduced its key monetary policy lever, the target federal funds rate, by 50 basis points on 18 September.

By October, pressures on short-term interest rates in interbank markets had eased while credit markets appeared to be functioning more normally, albeit with credit spreads wider. Nevertheless, recent events will have far-reaching implications in terms of lessons for policy-makers and market participants, in New Zealand and abroad.

To some extent, New Zealand has been insulated from the ructions in global markets. New Zealand has virtually no direct exposure to United States' sub-prime investments. New Zealand’s banking system has very little securitisation, or exposure to affected markets in other countries. However, as a small open economy with a large external debt, and as the recipient of significant ‘carry trade’ investment flows, it was inevitable that the global increase in risk aversion would impact New Zealand. One channel of impact was the exchange rate – as global investors revised their risk assessments we saw large swings in the New Zealand dollar. Liquidity in the New Zealand dollar foreign exchange market was tightly stretched at times during August.

Another channel of impact has been through an increase in New Zealand banks’ funding costs in offshore wholesale debt markets, which are an important source of bank funds. With much of New Zealand’s external debt intermediated through the banks, an increase in banks’ offshore funding costs equates to an increased cost of servicing New Zealand’s external debt. Moreover, liquidity levels in the banks’ offshore funding markets were considerably reduced. Indeed, for a short period of time, the ability of New Zealand banks to fund in offshore commercial paper markets was questionable.

Funding costs for Australian banks also increased in August and September, with the added effect of tighter conditions in the Australian markets for asset-backed commercial paper and residential mortgage backed securities. However, the major Australian banks have relatively low reliance on securitisation markets. Further, credit lines that have been extended by the large Australian banks to issuers of asset-backed commercial paper represent only a small proportion of these banks’ total risk-weighted assets.

The non-bank financial institution sector is undergoing its most significant change for many years. Problems in the sector have been noted in previous Reports, and since the time of the last Report, several more New Zealand finance companies have been put into receivership. Most of these failures have been related to inadequate management of credit risks and balance sheets, but reduced liquidity resulting from lower depositor reinvestment rates has exacerbated problems for failed companies and continues to put pressure on some existing companies. Failures have been largely of domestic origin, and only indirectly linked to developments in international credit markets.

Despite the substantial impact of recent events on nonbank deposit holders, the non-bank failures are unlikely to have broader negative effects on the financial system and the economy. The sector is relatively small, and reduced lending from troubled institutions is likely to be offset by expanded lending from other institutions. In response to stability risks in the non-bank sector, a new supervisory and regulatory regime is planned to enhance minimum prudential requirements and improve the quality of information available to investors.

In our May Report, we highlighted the risks to financial stability coming from the housing boom and the related high level of dissaving in the New Zealand household sector. Debt and debt service ratios were continuing to rise, making households and the financial sector increasingly vulnerable to a housing market correction. We have recently seen signs of an easing in the housing market following domestic interest rate increases through the first half of 2007. Slower growth in housing market activity and strong commodity prices, particularly for dairy products, are expected to contribute towards a shift in the composition of growth from the non-tradable to the tradable sector.

In summary, the international under-pricing of risk had been widely acknowledged by market participants and commentators, and increases in credit spreads have moved pricing towards more realistic levels. The adjustment process has been disruptive and has come at significant cost for many investors and borrowers. But in the wake of the initial shock, markets are increasingly discriminating between assets and institutions on the basis of quality and risk characteristics. The past few months also serve to illustrate New Zealand’s vulnerability to changes in international financial market conditions, accentuated by its large external debt.

Alan Bollard