Financial Stability Report for November 2011

Release date
10/11/2011

Overview

Risks to the New Zealand economy and financial system have increased since the May Financial Stability Report. While progress has been made in recent years in reshaping financial regulation and resolving some aspects of the global financial crisis, other stresses created by weak growth and the overhang of substantial private and public debt have intensified. Most recently, markets have been particularly concerned about the prospect of default by Greece, and further contagion to other highly indebted sovereigns. The outlook for the global economy has also deteriorated with weaker than expected growth, together with elevated financial market volatility in response to the sovereign debt strains in Europe. The exposure of European banks to distressed sovereigns has adversely affected global debt markets, which are an important source of funding for New Zealand’s banks.

Against this backdrop, the New Zealand economy has continued to grow moderately over 2011. Credit growth has remained subdued as households and firms continue to consolidate, thus constraining the overall pick-up in domestic demand. Rural incomes have been boosted by high commodity prices related to robust growth in China and other emerging markets, providing an opportunity for farmers to repay debt. However, rising levels of government debt have limited the overall improvement in New Zealand’s total indebtedness.

The ongoing disruptions to global financial markets and the recent weakening in global economic growth pose financial risks for New Zealand. Some sectors remain highly indebted despite some progress in reducing imbalances over the past few years. A sharp slowdown in global growth would likely reduce export commodity prices, which could expose highly leveraged farms. House prices remain high relative to fundamentals, and household financial difficulties could emerge if economic activity slows and unemployment increases. The scope for fiscal policy to respond to a sharp decline in domestic economic activity is considerably more constrained than at the onset of the global financial crisis. The recent New Zealand sovereign rating downgrades reinforce the imperative for fiscal consolidation.

Recent risk aversion and financial market turbulence have reduced banks’ access to offshore term debt markets, while the cost of term debt is likely to have increased. However, New Zealand’s bank-dominated financial system is arguably better placed today to weather global shocks than at the time of the collapse of Lehman Brothers and subsequent global turbulence over late 2008 and 2009. Banks have increased their capital buffers and lengthened the maturity profile of wholesale funding over the past few years. Increases in core funding (retail deposits and long term wholesale debt) have provided a buffer to help the banks ride out periods of market turbulence, by limiting the amount of debt that has to be rolled over in the near term.

Given the current market tensions, the Reserve Bank has decided to defer, by six months, its planned increase in the core funding ratio (CFR) from 70 percent to 75 percent, which was to have occurred in June 2012. This decision will provide regulatory clarity for banks, and underlines the importance of having a robust CFR while taking account of current market conditions. The Reserve Bank also has the capacity to provide exceptional liquidity support to the banking system should global market conditions deteriorate further – although it is not expected this will be necessary.

The domestic economy has proven relatively resilient to the challenges posed by the Canterbury earthquakes. The high prevalence of property insurance cover, together with government support programmes, has helped to insulate households and firms in the region. However, estimates of insured losses have increased significantly since the last Report as the Earthquake Commission (EQC) and private insurers continue their assessment of damage. The scale of the earthquake claims settlement process facing insurers, combined with ongoing aftershocks, means that there is considerable uncertainty about the timing of claims settlements and the commencement of reconstruction. Insurers remain cautious about writing new insurance in this environment. One large insurer (AMI) is facing financial difficulties associated with meeting the large value of claims, while several small niche insurers have indicated they intend to withdraw coverage for earthquake-related risk. Higher global reinsurance costs are starting to be reflected in increased non-life insurance premiums for New Zealand customers.

The risks to the New Zealand financial system are summarised in figure 1.1 (in the attached PDF). Financial market conditions and the global environment dimensions of the ‘cobweb’ diagram have deteriorated since the May Report reflecting turbulence associated with sovereign debt markets and downward revisions to US and European growth forecasts. There are also risks of a slowdown in China and other emerging economies, where there are signs of domestic overheating related to rapid credit growth and overvalued property prices.

While some domestic activity data have been positive, this must be weighed against the slow progress in insurance claim settlements and subsequent rebuild in the Canterbury region, leaving the assessment of the ‘domestic environment’ unchanged relative to May Global debt market conditions have materially worsened since May, indicated by an outward movement in the ‘funding and liquidity’ dimension of the cobweb. The increases in bank core funding over the past few years, coupled with weak demand for credit on the part of households and firms, have meant that New Zealand banks have not needed to undertake term debt issuance in recent months. As banks return to the term debt market over the coming months, it is likely that funding costs will be materially higher than earlier in the year.

The New Zealand banking system remains well capitalised, with all banks well positioned to meet Basel III requirements for larger and higher quality capital buffers. In addition, the level of non-performing bank loans has started to decline, and net interest margins have edged up. These factors have improved banking system profitability. However, bad debt charges are still elevated and profitability is likely to remain below pre-crisis levels, leaving unchanged the ‘capital and profitability’ dimension of the cobweb.

The Reserve Bank is continuing to strengthen the regulation of the financial system. A consultation paper on the new Basel III capital requirements was released in early November. The Reserve Bank supports the new Basel regime but will adapt some aspects to suit New Zealand conditions. The Reserve Bank has also continued work toward prepositioning for Open Bank Resolution (OBR). OBR is a policy option designed to ensure the uninterrupted provision of essential banking-related services should an individual bank face financial difficulties, while limiting the need for taxpayer support.

Alan Bollard
Governor