Financial Stability Report for November 2009
Conditions in the world economy and financial system have improved over the past six months with a general lift in confidence and a return of risk appetite. Substantial fiscal and monetary policy stimulus is providing some support for demand across the major regions, while measures targeted directly at the financial sector have helped to stabilise financial markets. The outlook for the New Zealand economy has been buoyed by the improved global outlook.
In New Zealand and abroad, better market conditions have enabled financial institutions to put their operations on a sounder footing by raising additional term funding and capital. The ability of the banks to issue term debt has been assisted by widespread government guarantees. However, issuance of non-guaranteed debt has also started to emerge as risk aversion continues to abate.
Despite increasing evidence of a global recovery, economic conditions remain fragile and the possibility of setbacks remains. A sharp rise in global equity prices since March has helped to improve sentiment, but may be outpacing the underlying improvement in the world economy. A key issue is whether economic recovery can be sustained once the effects of monetary and fiscal stimulus start to wane around the world. Even if recovery continues, loan losses will continue to mount and are likely to lead to further restructuring of some global institutions.
Impaired assets in the New Zealand and Australian banking systems have been rising over the past year, but remain relatively contained when compared with those of banks in many other countries. The major Australasian banks have had little difficulty raising additional capital. However, further loan losses are likely in New Zealand due to continuing rises in unemployment and weakness in some sectors, such as property, construction and parts of agriculture.
Credit growth in New Zealand has been flat during 2009, with household borrowing increasing only modestly and credit to many parts of the business sector contracting. This partly reflects weak economic activity and asset markets. However, banks’ lending standards, especially for business borrowers, have tightened over the past 18 months. The supply of credit to some sectors, such as property development, has been further curtailed by ongoing difficulties in the non-bank sector. The improvement in financial market conditions over recent months should increase the capacity of the banking sector to extend credit as the economic recovery progresses. However, whether the supply of credit is sufficient to support the recovery will also depend crucially on the banks’ willingness to lend to new borrowers.
While banks have tightened their lending standards for residential borrowers during the financial crisis, there have been signs of an easing in recent months, with some banks prepared to offer housing loans at relatively high loan-to-value ratios. The housing market is currently strengthening, but we believe house price growth will slow after the current recovery phase. We would encourage the banks to avoid any return to riskier mortgage lending practices.
The financial crisis has demonstrated that New Zealand banks, and leveraged firms and households, are vulnerable to stress emanating from global financial markets. The lesson here is that a more cautious approach to credit expansion is warranted during the next economic upswing. Increased caution should be exercised by bank boards and management, with reinforcement from external monitors such as rating agencies and institutional investors. The Reserve Bank also has a regulatory role to play, for example through the recently introduced prudential liquidity policy for banks. The policy, which comes into force in April 2010, will require banks to raise a certain proportion of their funds in the form of deposits or longer-term wholesale borrowing. The policy should, over time, help to reduce the country’s exposure to disruptions in global funding markets, as well as act as a stabilising influence during credit-based asset cycles.
Fundamentally, reducing New Zealand’s financing risks also requires lifting national savings in the medium term, so that the country’s net external liabilities stabilise or decline relative to national income. Some rebalancing appears to have occurred over the past year with the current account deficit beginning to narrow. However, the recent significant rise in the New Zealand dollar, largely on the back of increased global risk appetite and a falling US dollar, could hinder further improvements in the external balance. There is scope for policy changes in other areas (such as the tax system) to assist further rebalancing.
Globally, the extraordinary support measures that have been introduced in response to the financial crisis will need to be gradually unwound. In New Zealand, we have provided additional liquidity support to the banking sector but have announced plans to gradually reduce the scale of that support. The Crown’s retail deposit guarantee scheme has been extended, but the entry criteria have been tightened and the guarantee fee substantially raised. This will hopefully give viable non-bank deposit takers an opportunity to complete restructuring, but some firms are likely to cease operations in coming months.
At the same time, regulatory lessons about the causes of the crisis need to be incorporated into policy. After losses that would have seemed impossible two years ago, governments in many major economies have injected substantial capital into many of the largest global financial institutions. These actions are effectively underpinning sentiment at present, and will continue to do so even if they are unwound, since the market is likely to believe that further support will be forthcoming if required.
It has always been recognised that explicit or implicit government support can create an incentive for banks to be managed in a riskier way. The accentuation of this ‘moral hazard’ risk in the post-crisis environment, together with some apparent regulatory shortcomings, point to a clear need to strengthen the international regulatory framework. The Reserve Bank will be closely watching global policy developments with a view to adopting international policy changes where these are appropriate to New Zealand circumstances.