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Financial stability risk and policy assessment

Chapter 1 from the May 2024 Financial Stability Report.

Key points

  • New Zealand’s financial system remains strong as it continues to adjust to the higher interest rate environment. The impacts of high interest rates have been contained so far and if anything have been less severe than anticipated. However, above-target inflation and restrictive monetary policy mean that pockets of vulnerability remain.
  • Global inflation is declining from elevated levels and financial markets have priced in lower policy rates over the next year. Central bank communications have been cautious, noting elevated uncertainty around the inflation outlook. Stronger-than-expected inflation could prompt a tightening in global financial conditions.
  • Globally, commercial real estate markets remain under pressure, which is adversely affecting some highly exposed banks overseas. The housing market in China remains weak despite stimulus measures, putting pressure on property development companies. So far, spillovers from these developments to the banking sector have been contained.
  • We are continuing to closely monitor the financial strain on New Zealand’s households and businesses. Most borrowers have repriced onto higher interest rates. Strong nominal income growth has supported the ability to service debt. Households have reduced their discretionary spending and some have reduced principal repayments to make their debt servicing more affordable. Businesses face ongoing pressure from increased costs and reduced economic activity. Non-performing loans across all sectors have gradually picked up from low levels. The extent of further increases will depend on economic activity and the performance of the labour market.
  • Housing market activity remains weak as high interest rates have reduced borrowing capacity and investor demand. House prices have increased slowly over the past year following an earlier decline and remain within our estimated sustainable range. Proposed restrictions on debt-to-income (DTI) ratios will help protect against financial stability risks created by increases in risky mortgage lending, particularly during periods of low interest rates.
  • Our recently-published 2023 Climate Stress Test found that in a severe scenario and without mitigating actions by banks, climate change would reduce bank profitability, affecting banks’ resilience in future economic downturns. In this Report, we further explore the impacts of insurance becoming more expensive or unavailable in some locations. This is a risk to households and businesses in those locations, and banks could also be exposed. We recently published guidance for regulated entities to promote the effective management of climate-related risks.
  • The New Zealand banking system remains well placed to handle a range of severe scenarios. Banks’ capital positions remain strong. Profitability is declining from recent elevated levels. Liquidity remains high and funding conditions are strong. Scale and profitability challenges continue to weigh on the non-bank deposit taker (NBDT) sector.
  • We are continuing to progress work on improving our prudential regulation framework. We recently published the proportionality framework we will apply when developing prudential standards for different deposit-taker types under the Deposit Takers Act 2023. We will publish consultation papers on the new standards later in May and in July. The expected timing of the Depositor Compensation Scheme commencing has been revised to mid-2025.

Global inflation is moderating and monetary policy is expected to become less contractionary this year

Global inflation is declining from elevated levels towards central banks’ targets. Market pricing currently implies that central banks in advanced economies will begin to reduce their policy interest rates later this year. The extent and the timing of monetary policy easing implied by market pricing have been sensitive to data outturns (figure 1.1). In contrast, central bank communications have emphasised that inflation risks remain high and uncertainty around the outlook is elevated. Major central banks remain focused on the slow pace of disinflation in service sectors. Labour market conditions continue to ease gradually, but remain tight in advanced economies including New Zealand. Supply chain pressures have re-emerged in recent months with the disruption to global shipping, amid high geopolitical tensions.

Source: Reuters, Bloomberg, RBNZ calculations. Note: The US series is constructed using swaps indexed to LIBOR interest rates until November 2021, and swaps indexed to the Secured Overnight Financing Rate after that date.

This chart shows wholesale interest rates in several advanced economies. Wholesale interest rates rose in 2021 as financial markets priced in that central banks would tighten monetary policy in response to higher inflation. Rates have moved lower since late 2023 as markets priced in that monetary policy will ease during the next 12 months.

Download the chart (jpg, 689KB)

Expectations for monetary policy easing have led to equity markets rallying in major economies. The IMF’s recent Global Financial Stability Report noted that these rallies have also been supported by buoyant sentiment and optimism about earnings. An abrupt reversal in sentiment arising from weaker-than-expected earnings or inflation remaining elevated could drag stock prices down, which would generate economic and financial risks from a market-driven tightening in financial conditions.

Risks to global financial systems remain

Although the global monetary policy cycle appears to be around its peak, financial stability risks from high interest rates remain elevated due to the lagged impacts of monetary policy on the financial system.

In many countries commercial real estate owners remain under pressure, owing to tight monetary policy settings and structural changes to demand that were accelerated by the COVID-19 pandemic. Demand for office space has declined as remote working has become more prevalent, and demand for retail properties has declined, with consumers switching from in-person to online shopping. Internationally, several banks have experienced large falls in equity prices and credit downgrades in recent months due to their high exposure to commercial real estate. The pressures on these banks have been contained so far, and wider financial stability risks have been limited. In New Zealand, stresses in the commercial property industry are concentrated in the lower-quality office and parts of the retail sector. Risks to New Zealand banks from commercial property exposure are much more limited, with commercial property lending representing less than 10% of overall lending portfolios, and a lack of concentration in individual banks.

The housing market in China remains weak, with prices continuing to decline. Several major property development companies have defaulted on debt obligations as demand remains subdued and inventories are elevated. The weakness of the property market has contributed to a slowdown in economic activity and increased deflationary pressure. The Chinese authorities have announced several stimulus measures to support the property market and the wider economy, including reductions in banks’ required reserve holdings and benchmark lending rates. Local authorities in several Chinese cities have also eased restrictions on house purchases. So far, spillovers from the property market to the banking system have been contained.

In New Zealand, most household and business borrowers have re-priced onto higher interest rates

Most mortgage borrowers have moved off the low fixed rates that were locked in 2 to 3 years ago onto much higher rates. The average rate across the stock of mortgage borrowers is now around 85% of the way to its projected peak. Business lending rates have also repriced higher, albeit more quickly. Borrowers have faced significant increases in interest costs, making it harder to meet their repayment obligations (see Special Topic 1 in Chapter 2).

Read Special Topic 1 - Update on the financial strain faced by households and businesses

Households have reduced their discretionary spending and, in some instances, also reduced principal repayments. The proportion of mortgage borrowers who have not been able to cope with the increased debt servicing costs has picked up from low levels. Loan arrears and non-performing loans are around the levels experienced during the initial period of the COVID-19 pandemic and well below the levels following the Global Financial Crisis (figure 1.2).  Banks expect further increases in loan impairments while interest rates remain high and as economic activity slows. The outlook for non-performing loans depends significantly on the future path of economic activity and labour market conditions. Banks report they are proactively identifying and contacting borrowers who may require assistance and offering them options to restructure their debt to manage pressures. It is encouraging that the increase in borrower stress is not accelerating.

Source: RBNZ Bank Balance Sheet survey, private reporting.

This chart compares the shares of loan across sectors that are are non-performing. Non-performing loans have risen since early 2023 but remain below the levels observed in 2011-12 following the Global Financial Crisis.

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Businesses are facing subdued demand as well as ongoing high operating costs

The business sector is facing soft global growth and subdued demand owing to restrictive monetary policy settings impacting domestic spending. Businesses also face pressure from increased operating costs, such as insurance premiums. Business failures have picked up over the past 2 years from previously very low levels. Banks’ non-performing loans have also increased over recent months. Financial pressures are most severe in sectors sensitive to higher interest rates, either from higher debt servicing costs or from reduced demand, like the construction sector.

As in other countries, high interest rates have added to debt servicing pressure for commercial property owners. While vacancies are generally lower in New Zealand than in many other countries, low quality office and retail properties remain under pressure from structural trends in tenancy demand, such as increased remote working. In the agriculture sector, near-term risks in the dairy sector have eased as milk prices have increased and farmers have cut costs. While this has reduced cash flow pressures, milk prices remain volatile and there are ongoing challenges. In particular, debt-servicing costs are significant for dairy farmers, even though the reduction in debt in the past 5 years has improved their resilience. The sheep and beef industry is under pressure from declining international meat prices reducing profitability.

High inflation and restrictive monetary policy have affected households and businesses through several channels. While the short-term focus remains on the financial stress of higher debt-servicing costs on households and businesses, another impact has been the reduction in demand for credit across sectors. This deleveraging, along with nominal income growth, means that the aggregate debt levels of households and businesses have declined as a share of GDP (figure 1.3). A positive consequence of this deleveraging is that it will help to support the resilience of households and businesses going forward.

Source: RBNZ Bank Balance Sheet Survey, Non-bank Standard Statistical Return, Stats NZ, RBNZ calculations.

This chart shows borrowing from banks and non-bank lending institutions by sector. Reductions in debt levels and strong income growth has meant that debt levels as a share of GDP have fallen in recent years.

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House prices have increased from recent lows but housing market activity remains weak

Housing market activity remains weak overall as high interest rates have reduced borrowing capacity and investor demand. As a result, house sales have been subdued and days to sell remain elevated. Recent house price increases have been underpinned by rental growth, driven by population growth outstripping new supply. Strong net immigration has increased the demand for rental housing, while the supply of new housing is expected to slow once developers complete existing projects. Faced with elevated uncertainty, many house buyers are preferring to purchase existing properties rather than buy new builds off the plans. As a result, many developers are finding it difficult to achieve the levels of pre-sales required by banks to finance new projects.

Recent tax policy changes will also affect the housing market. Restoring the tax deductibility of interest expenses for residential property investments will increase investors’ valuations of existing properties and raise their debt servicing capacity, increasing demand for existing properties. In addition, reducing the duration of the brightline period will increase after-tax capital gains for investors selling properties within 10 years of purchase. This could increase speculative housing activity at the margin. In the near term, some investors struggling with debt-servicing costs and other increases in home ownership costs may decide to sell properties, given they are no longer required to pay tax on capital gains.

Lower house prices and strong nominal income growth have contributed to declines in house price-to-income ratios since 2021, particularly in Auckland, although these ratios remain elevated compared to historical levels (figure 1.4). House prices remain within our estimated sustainable range. Looking ahead, strong population growth, potentially lower mortgage rates and increased investor activity from tax policy changes suggest there is a risk that house prices will rise relative to sustainable levels. We will continue to use our macroprudential toolkit to manage risks to the financial system that could arise from unsustainable house prices.

Source: REINZ, Stats NZ, RBNZ estimates. Note: Figure shows the ratio between the median house price and the median household disposable income.

This chart shows median house prices by region as a ratio to average household disposable income. The ratio peaked in early 2022 and fell back as house prices declined and household incomes rose.

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Introducing restrictions on debt-to-income ratios will help manage housing-related risks to the financial system

We recently consulted on activating restrictions on DTI ratios, as the necessary preparations for their use near completion.  DTI restrictions would complement the restrictions on loan-to-value ratios (LVRs) that are currently implemented. LVR restrictions are mainly aimed at improving the resilience of the financial system by reducing potential losses if borrowers default on their mortgages. On the other hand, the DTI tool aims to improve borrower resilience by reducing the probability of borrowers defaulting. Given these tools have synergies in mitigating losses for the financial system, restricting DTI ratios would allow for more permissive LVR settings while achieving a similar level of overall resilience.

By activating DTI restrictions when the market is relatively subdued, it is likely that they will not be binding initially for most borrowers. Instead, DTI restrictions are intended to protect against increases in risky lending, especially when interest rates decline.

Climate-related risks could reduce financial system resilience if left unmanaged

We continue to monitor and analyse the impact of climate-related risks on the financial system. If these risks are not managed, they would lessen the resilience of the system to other shocks. Our 2023 Climate Stress Test showed that climate-related risks have the potential to reduce bank profitability and increase risk-weighted assets in the coming decades. The stress test is based on a severe but plausible scenario that combines high physical and high transition risks from climate change. Assuming no actions are taken by banks to mitigate the risks in the scenario, such as changing their lending policies, the impact on bank profitability (figure 1.5) comes mainly through an increase in impaired loans to borrowers who are financially vulnerable to the climate-related risks. In this scenario, banks had to reduce dividends by nearly 40% to maintain their capital ratios compared to the base case with minimal climate change. On its own, however, the scenario did not threaten bank solvency or financial stability.

Source: RBNZ calculations.

This chart compares bank profits in the base case scenario (with no climate-related impacts) and the stress scenario (with high risks from climate change) in the Climate Stress Test. Bank profits are lower in the stress scenario than in the base case as loans to borrowers vulnerable to climate-related risks become impaired. 

Download the chart (jpg, 255KB)

Climate change is also influencing insurers’ moves towards a greater use of risk-based pricing for residential dwelling insurance. Driven by improved data and modelling, insurance premiums are becoming more tailored to the specific risks that a property faces (such as seismic or flood risks), as opposed to reflecting broad averages of the risks facing properties over wide areas. In some locations, the exposure to seismic or climate-related risks may exceed insurers’ risk tolerance and their ability to access reinsurance to hedge the exposure. Complete withdrawals of insurance availability in high-risk areas are likely to occur only gradually, although some policyholders are already finding insurance increasingly unaffordable (see Special Topic 2). Banks could also be exposed to insurance retreat as the value of properties in high-risk areas declines if they are no longer insurable or the costs increase significantly.

In addition to stress testing, we are working to support the financial sector to manage climate-related risks. We recently released a guidance document for prudentially regulated entities on managing climate-related risks.  The document aims to help develop a shared understanding of and promote our view of what constitutes good practice relating to managing climate-related risks. It should create a better understanding of the physical and transition risks arising from climate change, ensure business decisions are well informed about climate-related risks and lead to the implementation of appropriate governance, strategy, risk management and metrics and targets. We have also published a bulletin article on using credit risk weights for climate-related purposes. 

A common theme in this work has been the need to enhance stakeholders’ risk management capabilities, including through improvements in the quality and availability of data. Coordinated responses between stakeholders (property owners, central and local governments, insurers and lenders) are essential for effective management of climate-related risks.

New Zealand banking system remains well positioned to handle economic or financial shocks

The New Zealand banking system remains well placed to handle external shocks and a downturn in the economy (see Chapter 4). Bank capital ratios remain well above regulatory requirements and banks are well progressed towards meeting the new requirements being gradually phased in through to 2028.  Indicators of bank profitability have eased from recent elevated levels. Net interest margins have come off recent highs as depositors continue to transition from on-call accounts to term deposits in response to high interest rates. Broader measures of bank profitability are also declining as banks have made provisions for increased loan impairments.

Liquidity in the banking system remains at an historically high level. The high volume of liquid assets has been supported by the Funding for Lending Programme (FLP) and the Large Scale Asset Purchase operations implemented during the pandemic.

Banks’ core funding positions are strong with robust deposit growth amid low credit growth, which reduces their need to obtain funding from wholesale markets. Overseas funding markets are currently highly accommodative, and banks report they are confident about their capacity to raise wholesale funding. 

Funding from the FLP has begun to mature at a gradual pace, and banks are steadily replacing the maturing FLP funding with a combination of wholesale market and term deposit funding. Competition for term deposits is likely to continue as FLP funding matures and as banks prepare for a recovery in credit demand.

From a regulatory perspective, we are continuing to conduct our Liquidity Policy Review. Last December we announced we would retain and modify our existing quantitative liquidity metrics (the mismatch ratios and the core funding ratio) rather than adopt the international Basel liquidity metrics. In addition, we decided to tighten the eligibility criteria for liquid assets under our policy and introduce 2 categories of liquid assets. 

The Commerce Commission recently published the Draft Report of its market study into the personal banking sector in New Zealand. The report identified several factors that were limiting competition in the sector, including the structural advantages of the large banks from operating at a larger scale and lower funding costs, regulatory barriers to new entrants and smaller entities (including the Reserve Bank’s prudential capital requirements) and difficulties for consumers to switch between providers. The Commission made several recommendations aimed at improving competition. Our submission to the Commission on the recommendations in the report is available on our website. In our view, the best way to promote competition is to accelerate progress on open banking. As in other countries, if done comprehensively, it could drive more competition between both existing and new players, enhancing consumer choice and outcomes.

Performance of non-bank deposit takers has been mixed, with some facing challenges from their lack of scale

The NBDT sector consists of building societies, credit unions and deposit-taking finance companies. With total lending at around $2.2 billion, the sector is small relative to the banking sector in total lending but provides services to a relatively large number of customers.

As with banks, there has been a broad-based slowdown in new lending by NBDTs in the last 18 months, particularly by building societies and credit unions. This has been driven by higher interest rates, subdued demand for credit and an uncertain economic outlook. As a whole, the NBDT sector continues to build capital buffers and improve operational efficiency. However, some NBDTs continue to face challenges from the softening economic environment and their lack of scale.

Key policy and supervisory developments

We are continuing to progress work on modernising and strengthening our prudential regulation framework (see Chapter 3). The long-term objective of the Deposit Takers Act 2023 (DTA) is to achieve a resilient and inclusive financial environment that contributes to a sustainable and productive economy. As part of the implementation of the DTA, we recently published the proportionality framework we will apply when developing prudential standards for different groups of licensed deposit takers.  Deposit takers will be allocated into 4 groups based on their total assets and whether they are locally incorporated deposit takers or branches of overseas incorporated deposit takers.

We will soon begin consultation on the standards under the DTA. Standards will replace the existing prudential requirements for banks and NBDTs. Our first consultation in May will cover the 4 core standards: capital, liquidity, disclosure and the Depositor Compensation Scheme (DCS), which will form the basis of relicensing existing deposit takers. In July we will consult on the remaining standards. The DCS is being established to contribute to public confidence in the banking system and support financial stability. With the DCS New Zealanders can have confidence that their deposits are protected. The commencement date for the DCS has been revised from late 2024 to mid-2025.

Cyber risk is a growing source of operational risk for the financial sector, leading to increasing recognition of the importance of cyber resilience. We are implementing requirements for cyber incident reporting, to assist regulated entities to develop improved cyber resilience (see Box A).