Financial stability risk and policy assessment

Financial stability risks remain contained as we near the bottom of the economic cycle. In this chapter, we summarise global and domestic economic developments, noting a more severe economic downturn is a risk. Then we step through the impacts on households and businesses. We focus on the sectors banks have significant exposures to, like agriculture. We explain why banks are well placed to deal with potential losses. Finally, we note our policy priorities.

Globally, interest rates are coming down as inflation has subsided

Over the past 6 months, inflation has continued to trend lower globally. Goods inflation has driven this decline. Services inflation remains elevated but it is also expected to continue to decline in line with increased spare economic capacity (see our August Monetary Policy Statement). As a result, persistent above-target inflation has become less of a risk.

Figure 1.1: Market pricing for policy interest rates in New Zealand and the United States
(current vs 6 months ago)

Global economic growth remains below trend. High interest rates are affecting spending by households and businesses. A more severe global economic downturn would be a concern. Some major central banks have started reducing their policy interest rates and market pricing suggests they will reduce them further over the next year (figure 1.1). The pace and extent to which interest rates will fall are uncertain.

Global financial markets have been volatile at times

Global financial markets can affect financial stability in New Zealand. They provide access to foreign capital for large businesses and the banking sector. In addition, New Zealanders own overseas equities and other investments.

Over the past 6 months, uncertainty around the economic and inflation outlook has been elevated. This has contributed to periods of volatility in financial markets, notably in Japanese equity prices (figure 1.2). After the Bank of Japan raised its policy interest rate in August for just the second time since 2007, the yen appreciated sharply and equity prices fell. This reverberated globally but proved short-lived as financial markets stabilised quickly.

Figure 1.2: Global equity prices
(index = 100 on 31 January 2020)

Investors’ willingness to hold risky assets has been sensitive to recent economic developments. Equity prices have appeared overvalued relative to fundamentals in some segments, including for example the technology sector.² Geopolitical risks have also been a concern, given the conflicts in the Middle East and Ukraine (see Box A).

Despite periods of financial market volatility, New Zealand banks have continued to report favourable conditions in funding markets. Low corporate bond spreads indicate that companies have been able to borrow in markets at relatively low risk premiums over government bond yields. Government bond yields have also fallen this year in line with expectations of lower policy interest rates.

Weakness in domestic economic activity has become more pronounced

Subdued global growth and high interest rates have reduced aggregate demand in New Zealand. The economy has shifted from a period of excess demand to one of excess supply. GDP in the June 2024 quarter was 0.5 percent lower than the same quarter a year earlier. This contraction was despite strong net migration until late 2023.

Households have reduced their discretionary spending to manage budget pressures. Consumption per person has fallen by a similar amount over the past year as it did during the Global Financial Crisis (GFC) (figure 1.3).

Businesses have put investment plans on hold. The weaker outlook for demand and high borrowing costs are key reasons for the pause. Government expenditure is expected to decline as a share of the economy. Lending growth has been weak across sectors.

Figure 1.3: Household consumption per person
(quarterly volume, seasonally adjusted)

Despite a significant house price cycle in recent years, financial stress has been contained

Nationally, house prices fell by 14 percent from their peak in November 2021 to April 2023. Since then, house prices have been broadly unchanged. Despite this, few households have more debt than the value of their houses (see Special Topic 2). Residential building consents have fallen and construction activity is declining.

We introduced debt-to-income (DTI) restrictions and eased loan-to-value restrictions in July. These adjustments have had a negligible impact on the housing market, as we expected. We intend for DTI restrictions to act as a guardrail. We set them at a level that will constrain the amount of high-risk lending during periods of low interest rates and rising house prices.

Debt-servicing costs are around their peak and are beginning to fall

High debt-servicing costs continue to squeeze household budgets. The average interest rate across mortgage lending has risen to 6.4 percent, slightly higher than 6 months ago.

Mortgages rolling off fixed rates are starting to reprice onto lower rates. The 1- and 2-year fixed mortgage rates have fallen to around 6 percent. This has occurred as the Monetary Policy Committee has reduced the Official Cash Rate (OCR) in response to the weaker economy. We expect the average mortgage rate to be around its peak now and to decline over the next year (figure 1.4).

Borrowers have preferred shorter-term fixed rates this year. As a result, more people will be able to roll onto lower mortgage rates sooner. We expect around 50 percent of mortgage lending to reprice within 6 months and around 75 percent within a year.

Debt-servicing costs will remain challenging for highly indebted households. Banks have reported to us that many highly indebted households have little incomes or savings buffers available. This makes them vulnerable to unanticipated costs or losses of income.

Figure 1.4: Mortgage rates

Unemployment is affecting more households and contributing to rising non-performing loans

Rising unemployment is starting to create acute financial difficulties for some households. In general, households tend to be able to manage high debt-servicing costs if their incomes are not affected. However, keeping up with mortgage repayments becomes much more difficult or impossible if borrowers lose their jobs.

The unemployment rate increased to 4.6 percent in the September 2024 quarter. Our projection in the August Monetary Policy Statement has the unemployment rate rising to 5.4 percent in the March quarter of 2025 (figure 1.5). With debt-servicing costs generally remaining high for now, rising unemployment is likely to cause more borrowers to default on their mortgage payments over the next 6 months.

Figure 1.5: Unemployment rate

The non-performing share of mortgage lending has continued to pick-up from a low level (figure 1.6). It remains low compared with 2009 following the GFC.

Figure 1.6: Mortgage lending that is past due and non-performing
(seasonally adjusted)

Business conditions are challenging

Businesses are experiencing lower profitability. Weak demand and lingering cost pressures have made the trading environment difficult for firms. This is particularly the case in sectors where demand is more sensitive to interest rates. For example, insolvencies in construction, property development and some retail sectors have increased notably. This challenging environment is likely to continue in the near term.

Reduced profitability is affecting cash balances. Business deposits have declined relative to GDP over the past two years, from a strong position coming out of the pandemic. The decline is most notable for small- and medium-sized firms (figure 1.7). Businesses are also relying more on credit for working capital, for example by utilising their credit facilities with banks.

In August we released a special topic on commercial property in New Zealand.³ We highlighted the challenges for commercial property owners from high interest rates and increased working from home. Tenants preferring smaller but higher-quality offices has contributed to an increase in vacancies in lower-quality office buildings. Growth in online shopping and soft consumer spending have contributed to more vacancies in retail properties. However, stronger lending standards in prior years have helped to contain the impacts on banks.

Figure 1.7: Business deposits by firm size
(share of GDP)

A recovery in export prices is helping farmers meet high costs

Sentiment in the agriculture sector has improved since mid-2023 owing to higher commodity prices (figure 1.8). Fonterra’s payout for the 2023/24 season was $7.83 per kilogram of milk solids, well above its forecast early in the season. Fonterra forecasts a $9.00 payout midpoint for the current 2024/25 season, which is above breakeven for most dairy farmers. Sheep farmers are facing challenging market conditions due to low sheep meat prices.

Figure 1.8: Meat and dairy export prices
(in New Zealand dollars, deflated by input costs)

Farm operating expenses and debt-servicing costs have increased significantly over recent years. Farmers have adapted by cutting back their use of some inputs like feed and fertiliser. Many farmers have also been able to slow the pace at which they are paying down loan principal, having reduced their debts over previous years. As a result, the non-performing share of agriculture lending remains low.

The recent increase in commodity prices and the lower outlook for interest rates should help farmers over the coming year. However, a more severe global economic downturn, particularly in China, remains a risk for farmers.

Recent changes in government policy regarding emissions pricing will delay when the agriculture sector begins paying for its emissions. This additional time may provide the sector with an opportunity to reduce greenhouse gas emissions, for example through research into technological solutions. However, international pressure to price emissions remains significant.

Banks expect more of their lending to become non-performing

Weaker economic conditions and high debt-servicing costs are resulting in more loan defaults. For both business and mortgage lending, the share that is non-performing has increased over the past 18 months.

However, the non-performing share remains low compared to previous recessions. Banks’ exposures to particularly weak sectors like construction and hospitality are relatively small. In addition, stronger lending standards since the GFC have reduced the riskiness of banks’ lending to traditionally cyclical sectors. Borrowers in the commercial property and agriculture sectors are in stronger financial positions than they were going into previous downturns.

Banks expect the non-performing share of their business lending to increase to levels similar to those in 2020. They expect the non-performing share of mortgage lending to increase a little further, peaking around the middle of 2025 (figure 1.9).

Figure 1.9: Banks' projections for non-performing loans by sector
(share of lending value in each sector)

Banks are in a strong financial position to manage losses

Banks have built financial buffers that will help them maintain the supply of credit even if losses grow. They increased their provisions in 2023 when they anticipated an increase in non-performing loans. Strong profitability has also allowed banks to retain earnings and grow their capital positions (figure 1.10). Capital ratios are comfortably above our minimum requirements, even as those requirements increase (see Chapter 4).

Net interest margins remain high compared with the post-GFC period. Banks have benefited from an abundance of cheap deposit funding since the pandemic. Funding from deposits in transaction accounts became relatively cheaper as interest rates increased. This was because these accounts yield little or no interest, while contributing around a quarter of deposits. We have seen a further flow of deposits from these transaction accounts into term deposits. However, this trend has slowed recently as businesses prefer quickly-accessible funds in tough economic conditions.

Soft lending growth means banks have not needed to rely on more expensive forms of funding, like wholesale market funding. Bank contacts are confident that wholesale markets can meet future funding needs when credit growth recovers.

Figure 1.10: Bank capital ratios
(share of risk-weighted assets)

A reliance on overseas funding markets has been a vulnerability for the New Zealand banking sector. Many years of current account deficits led to an accumulation of foreign debt. It peaked as a share of GDP in 2009 and has trended down over the past 15 years (figure 1.11). Recent current account deficits have become sizable again. This could lead to an increase in foreign debt if they persist.

The introduction of core funding requirement since 2010 helps to mitigate this vulnerability. A large share of bank funding is from stable sources, such as long-term debt or deposits. Therefore, banks can step back from wholesale funding markets when conditions are unfavourable.

Figure 1.11: Net foreign liabilities
(share of GDP)

A severe recession remains the key risk to the New Zealand financial system

As part of our stress testing programme this year, we asked 13 banks to simulate the most plausible scenario that would cause them to breach capital requirements (see Special Topic 1). The aim of the exercise was to improve banks’ risk management by examining their vulnerabilities and the actions they could take in response.

The banks’ scenarios typically included a severe recession with extremely high unemployment rates and significant house price declines. The shocks that caused the recession included:

geopolitical shocks and trade disruptions;
seismic or volcanic events; and
an outbreak of foot and mouth disease.

They also often included cyber incidents and climate-related events, such as floods and droughts.

Banks identified a broad range of mitigating actions to restore capital levels to above regulatory requirements. They also drew insights that will help them identify ways to better manage risks. For example, banks are becoming increasingly aware of the risks of declining insurance coverage on properties they lend towards.

Insurance premiums have continued to increase

In our May Financial Stability Report, we examined the reasons building insurance is becoming more expensive or unavailable in some locations. We noted this was a growing risk to households and businesses in those locations, and banks could also be exposed.

Since May, the trend towards greater risk-based pricing appears to have continued. For example, slightly more properties in flood-prone areas have had premiums added to their insurance costs. There has not been any material change in the availability of online quotes for dwelling insurance. Owners of houses in almost every suburb can get online quotes from more than one insurer.⁴ This means dwelling insurance cover is widely available.

Insurance premiums for consumers overall have increased further in the past six months for most types of insurance (figure 1.12). However, the outlook for insurance premiums has improved as cost pressures for insurers ease. Global reinsurers have benefited from fewer events with large claims costs in the past year, after several challenging years. Lower inflation in construction costs due to spare capacity in the sector will also ease pressure on dwelling insurance premiums.

Figure 1.12: Inflation rates for CPI insurance components
(annual, CPI weights in brackets)

The CrowdStrike outage highlights the importance of operational resilience

The outage caused by a failed update to the CrowdStrike security software in July temporarily disrupted banking and payment services in New Zealand. It highlighted the operational risks that come with increased digitalisation and reliance on common service providers. Robust systems and strong oversight are needed to manage these risks. We laid out how we are promoting cyber resilience in Box A of the May Financial Stability Report.

Our work on implementing the Deposit Takers Act is continuing at pace

Implementing the Deposit Takers Act (DTA) is an important step to improve our approach to supporting financial stability in New Zealand (see Chapter 3). The DTA creates a single modern regulatory regime for banks and non-bank deposit takers, which is better aligned to global practice.

Our focus this year has been on developing policies for the prudential standards that deposit takers will need to adhere to from 2028.⁵ At the same time, we are progressing work on the Depositor Compensation Scheme (DCS), which is on track to commence in mid-2025. This will protect eligible depositors for up to $100,000 per institution if their deposit takers fail.

We support efforts to improve competition

Competition is a fundamental contributor to financial system efficiency, which ultimately supports broader economic prosperity and well-being. The Commerce Commission’s market study into personal banking services highlighted that customer inertia is a barrier to competition. Efforts to reduce barriers to switching banks and progress on open banking will assist in strengthening competition both among incumbent banks and from new entrants.

Elements of the DTA are likely to support competition, such as the DCS. The DTA also requires us to take into account competition in our decision making. We are enhancing our assessment of competition impacts to support this. We have also noted specific initiatives of ours that support competition in our submission to the Finance and Expenditure Committee inquiry into banking competition.⁶

Non-bank lenders and private capital funds remain small in New Zealand

As a special feature of this Report, we provide an overview of developments outside the traditional financing channels. Internationally, the share of business finance provided by non-bank lenders and private capital funds has increased since the GFC. Global regulators have raised concerns about the limited regulation of some sectors. For example, complex interlinkages with banks can lead to financial stability risks.⁷ We will continue to monitor global developments.

In New Zealand, non-bank lenders and private capital funds remain small and present little risk to financial stability. Further growth in this industry would be beneficial in promoting efficiency and competition. Access to multiple sources of financing would support business growth and potentially more stable access to credit (see Special Topic 3).

Within the sectors we regulate, non-bank deposit takers are a small but diverse sector. The financial performance of firms within the sector has been mixed over recent years. Firms in the sector have maintained capital above our requirements. However, scale has been an issue for smaller lenders, contributing to low levels of profitability. The number of credit unions has declined as entities have merged.