Box C: Measuring financial system efficiency

This page contains information on measuring financial system efficiency from the May 2014 Financial Stability Report.

A well functioning financial system is integral to fostering and maintaining economic growth. An efficient financial system is one that enables economic resources to be allocated to their best use across time and space without imposing unnecessary costs (or ‘rents’) on households and businesses. An efficient financial system enables savers and borrowers to share risks in a way that enhances, rather than hinders, economic performance. In contrast, an inefficient financial system can hamper economic prosperity by imposing unnecessary costs on households and businesses, distorting decision-making processes, and misallocating resources throughout the economy over time.

The importance of financial system efficiency to the New Zealand economy is reflected in the Reserve Bank’s mandate to promote the maintenance of a sound and efficient financial system. Although the Financial Stability Report tends to focus primarily on financial system soundness and stability, it also reports on the efficiency of the financial system. In addition, the Reserve Bank also regularly considers the efficiency consequences of prudential policy. For example, when considering the Reserve Bank’s proposed macroprudential framework in the May 2013 Report, the resource allocation consequences and potential for disintermediation were discussed.

Several methods exist to assess efficiency. None is entirely satisfactory due to methodological and data collection issues, and therefore it is desirable to consider information from a range of sources. This box assesses efficiency in the 2009-12 period by comparing banking sector accounting ratios across countries.1

Bank financial ratios in the post-2008 period have been heavily affected by economic disruption, banking stress, and regulatory changes. Cross-country comparisons therefore must be interpreted with caution. Furthermore, cross-country differences in capital structure, business mix, and accounting and tax practices pose further problems for interpretation. It is, however, possible to use accounting relationships to decompose profitability measures into their component parts such as leverage, interest margins and operating expenses. Such an analysis can provide insight into the drivers of profitability, and may suggest where inefficiencies exist. Figure C1 compares the return on equity (ROE) of the New Zealand banking sector with 24 other OECD countries. The data suggest that the New Zealand banking system is highly profitable in an international sense, placing 6th out of the 25 countries in terms of ROE. The common inference is that high profitability may indicate a lack of competition and be representative of an inefficient market. However, this simple interpretation fails to consider the underlying factors which lead to the relatively high profits in the New Zealand banking sector, and as such may be misleading.

Figure C1: Decomposition of return on equity: New Zealand banks’ ranking relative to 24 OECD countries (2009-12 averages)

Figure C1 Decomposition of return on equity: New Zealand banks’ ranking relative to 24 OECD countries (2009-12 averages)

New Zealand’s banking system comprises the majority of the financial system. It is therefore appropriate in the New Zealand context to focus primarily on measuring banking system efficiency.

The breakdown in figure C1 provides some detail as to where these high profits may accrue. At the first level, the data imply the relatively high ROE is not a function of the banks holding relatively low levels of capital (high leverage), but is instead owing to a relatively high return on assets. Finer disaggregation reveals that this is primarily due to lower costs-to-income and loan-loss provisions (for which we use non-performing loans-to- gross loans as a proxy).

The heavy focus on traditional (lower cost) deposit and lending activities, with a lesser focus on insurance and investment banking (higher cost) activity compared to international counterparts can partly explain the New Zealand banking system’s relatively low operating costs-to-income. Nevertheless, compared to other countries with similar banking systems, New Zealand banks’ aggregate cost-to-income ratio is still relatively low which indicates a high degree of technical efficiency.2 Low levels of non-performing loans, which are highly correlated with loan-loss provisions, reflect both a relatively mild crisis in New Zealand and effective credit risk assessment and management processes.

Finally, New Zealand’s aggregate net interest margin, which is slightly above the OECD average, may be relatively high given the less complex nature of the New Zealand banking system. However, analysis of mortgage, deposit, and credit card interest margins suggests that New Zealand banks’ interest spreads are similar to other OECD countries, so the cost of financial intermediation on these product lines does not appear to be particularly high in New Zealand.

The overall conclusion of this comparative analysis is that the New Zealand banking system is relatively efficient in an operational sense, and this would reflect observational evidence that it has been relatively quick to embrace new technology. It has also not been as badly affected as some other countries by the impact of the GFC on non-performing loans. These appear to be the major drivers of the high relative profitability in the New Zealand banking system.

The Reserve Bank will continue to develop the framework for assessing and reporting on the efficiency of the New Zealand financial system.

 

1 New Zealand’s banking system comprises the majority of the financial system. It is therefore appropriate in the New Zealand context to focus primarily on measuring banking system efficiency.

2 Technical efficiency refers to the provision of financial services at the lowest cost, while allocative efficiency refers to the economy’s resources being directed to their best possible use.