Financial Stability Report for May 2010

Release date
19/05/2010
Main file
Supplementary file

Overview

The global economic recovery has continued to gain momentum over the past six months. Global trade has recovered from the most severe slump since World War II, while financial market pressures have continued to ease with markets now more liquid and prices no longer reflecting the extreme levels of risk aversion evident during the financial crisis. The recovery has been centred in a number of emerging economies and fuelled by a turnaround in the inventory cycle, ongoing fiscal stimulus and the resumption of capital inflows. Robust demand in emerging Asia in particular, together with higher commodity prices, has seen the outlook for the New Zealand and Australian economies strengthen.

However, the global recovery is uneven and fragile. Confidence has been dented in recent weeks by the European sovereign debt crisis centred on Greece. However, joint EU-IMF initiatives to bail out Greece and prevent wider contagion have comforted markets to some extent. Recovery remains weak in the Euro area and the UK, but the US economy has shown greater signs of improvement in recent months. Nevertheless, banks in the US and Europe continue to experience pressure on their balance sheets from the legacy of impaired assets. Ongoing deleveraging by banks has contributed to very subdued credit growth across these countries, with lending conditions tight, especially for businesses. Credit demand also remains weak as households and firms reduce their levels of debt. Global current account imbalances have narrowed over the past two years, but there is a risk that imbalances could widen again as the global recovery proceeds.

Against this backdrop, New Zealand’s banking system has remained relatively healthy and appears well placed to support the domestic economic recovery. This position is strengthened by the resilience of the Australian parents of the major banks. While bank credit growth was subdued through the recession, reflecting weaker demand for credit by households and businesses and tighter lending standards, banks have the capacity to meet an increase in demand for credit and doing so will be important to sustain the economic recovery. However, at the margin some businesses may continue to find credit expensive or difficult to obtain, particularly those involved in higher risk activities.

Forward indicators suggest that non-performing loans for the banking sector may be close to a plateau, with the outlook for bank profits improving as a result. Funding conditions in the banking sector have generally improved over the past six months, with banks able to issue greater quantities of debt at longer terms without a government guarantee. Banks have been able to switch a greater proportion of their funding to more stable sources as encouraged by rating agencies and owners, and as required by the Reserve Bank’s new prudential liquidity policy. New Zealand banks’ efforts to lengthen the maturity profile of wholesale funding have helped to reduce their exposure to future disruptions in global funding markets. However, retail deposits – another valued source of stable funding – have become increasingly expensive for banks.

Reflecting the improvement in funding and liquidity conditions, the Crown’s wholesale guarantee scheme has been discontinued, while the Reserve Bank has removed a range of special liquidity facilities introduced during the financial crisis. The Crown’s retail deposit guarantee scheme has been extended but it is not likely that banks will continue to participate, given the costs of the scheme and because of the strong level of public and market confidence in the banking system.

Parts of the non-bank lending sector continue to face a period of adjustment and the exit of many finance companies has reduced the availability of credit to some activities such as property development. While non-banks and other niche financing vehicles play an important role in funding activities either outside the product profile or risk appetite of banks, it is clear that for parts of the finance company sector deposit-based funding models were unsustainable and that reorganisation of the sector is an inevitable development. In the near term, the expiry of the original term of the Crown’s retail deposit guarantee scheme and the introduction of a more stringent regulatory regime for deposit-taking institutions will provide a catalyst for further consolidation within the non-bank sector. The extension of the retail guarantee scheme until the end of next year gives those institutions that participate extra time to put their business on a more secure footing.

Recent developments in Greece have focused attention on elevated levels of sovereign debt issuance and the medium-term sustainability of fiscal positions both there and in a number of other countries. While large fiscal outlays have helped to stabilise domestic demand and support the banking systems in a number of countries, the large volumes of sovereign debt expected to be issued over the coming years will likely impact the cost of funds for private borrowers. Although the borrowing demands of the New Zealand Government are modest by international standards, fiscal consolidation remains an imperative given New Zealand’s high level of private sector debt.

New Zealand’s large stock of external debt means that it remains exposed to changes in the cost of debt in international markets. A rebalancing of the economy towards higher national savings, and less reliance on external financing, remains highly desirable to stabilise New Zealand’s net external indebtedness at or near current levels, even if it means growth rates will be relatively moderate in coming years. The dramatic narrowing of the current account deficit over the past year and a half has been driven by both the cyclical slowdown in the domestic economy and deleveraging by firms and households. Less clear is the extent to which the improvement in the current account deficit will be sustained as the economic recovery gathers momentum.

Rebalancing will depend on whether households change their behaviour away from debt-fuelled consumption towards higher personal savings over the medium term. To date households have increased savings, and household credit growth has remained modest as domestic activity has increased. Firms are taking a cautious approach to their balance sheets, preferring to repay debt and reduce gearing. However, a return to moderate business credit growth is likely to be necessary over the coming year to support a gradual recovery in business investment activity.

The general improvement in the outlook for the New Zealand financial system is summarised in figure 1.1 (in the attached PDF). The financial stability ‘cobweb’ was introduced in the last Report, and all but one dimension continues to shift inwards towards more historically ‘normal’ levels of risk and away from the elevated levels that prevailed at the peak of the global financial crisis.

The improvement in the ‘global environment’ and the global component of ‘financial market conditions’, is discussed in chapter 2. The improvement in risk appetite and global activity has been tempered by recently intensifying concerns surrounding sovereign risk and fiscal sustainability issues.

The strengthened outlook for the New Zealand economy is encapsulated by the inward shift of the ‘domestic environment’ dimension of the cobweb. While the end of the recession signals a decline in the credit risks associated with New Zealand households and firms, the private sector remains heavily indebted, which presents an ongoing vulnerability for the financial system (chapter 3). Chapter 4 discusses the ability of New Zealand’s bank dominated financial sector to absorb the risks associated with the upper three dimensions of the cobweb. Pressure on bank profits from non-performing loans and abnormal expenses over the past six months have broadly offset improved capital ratios, leaving our ‘capital and profitability’ assessment unchanged from November. Nevertheless, an improved outlook for bank profits, together with ongoing efforts to boost capital ratios, suggests ample room to absorb any future unexpected loan losses. The ‘funding and liquidity’ position of New Zealand banks has been enhanced by a general improvement in access to global wholesale markets over the past six months, and a shift to more stable sources of funding.


Alan Bollard
Governor