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Financial Stability Report for May 2005

The maintenance of financial system stability is founded on robust financial institutions and markets.

The maintenance of financial system stability is founded on robust financial institutions and markets. Robust institutions are those that maintain a strong underpinning for the safety they represent in their deposit and other obligations. Robust financial markets are characterised by buyers and sellers being able readily to transact when they need to. Both can be tested by, and need to be resilient to, adverse circumstances. This regular Financial Stability Report reviews the current state of the financial system, taking account of potential sources of stress.

The last six months have seen a continuation of economic conditions generally supportive of financial stability. Despite some emerging pockets of strain in the export sector, household and business incomes have been generally robust, making for few debt-servicing difficulties. Asset prices, including those for most classes of real estate and equities, have been buoyant.

Looking forward, conditions are likely to be a little less benign. Internationally, global imbalances, and the possibility of disruptive adjustment, loom as large as they did six months ago. A sharper decline in the US dollar could put additional pressure on New Zealand exporters, as could a reversal of global commodity prices.

Domestically, income growth is also projected to slow and interest costs have been increasing. These developments could see more highly leveraged borrowers face some debt-servicing strains. There have also been signs of lending on less traditional terms, such as ‘low-doc’ loans and 100 per cent loan-to-value mortgages. As the economy slows, we will be watching for whether these riskier forms of lending become more prevalent, and assessing the implications. We assess that the main financial institutions are currently well placed to weather less favourable conditions. The four major banks remain institutions with strong balance sheets, good earnings, high credit ratings, and strong owners. On the whole, the other banks in the system also achieved stronger performance in 2004 than in 2003.

In terms of the potential transmission of international disturbances, the New Zealand banking system raises a substantial amount of funding from offshore wholesale financial markets. It is vital that banks are able to maintain access to these offshore funding sources even during periods of disruption in global financial markets. That depends on banks maintaining high credit ratings and, in turn, strong loan portfolios and adequate levels of capital.

Finance companies have been growing rapidly during the last few years, and may represent a sectoral risk going forward. With bank deposit interest rates now higher than a year ago, finance companies face greater competition for funds. Also, in a slowing economy with a slowing property market, the risk of loan losses is heightened. There have been some welcome developments in the supply of information to the public on these institutions, which should help investors assess their investment risk.

On the policy front, a number of issues are currently under attention. These include a general review initiated by the Government of the regulation of financial products and providers in the non-bank sector, including whether a greater degree of prudential regulation is needed. Two, more specific, issues being addressed by the Bank are the effects of pockets of illiquidity in the government bond market, and failure-to-settle arrangements for retail payment systems.

A number of banking supervision issues are also being progressed by the Bank, including outsourcing by registered banks, and the implementation of the Basel II capital adequacy framework. Another priority is achieving appropriate regulatory harmonisation with the Australian Prudential Regulation Authority (APRA). This will be assisted by the work of the Trans-Tasman Council on Banking Supervision, on which the Bank is an active member. These initiatives should help to ensure the maximum effectiveness of ‘home-host’ supervision of the banks in New Zealand, and continued financial soundness and stability.

Alan Bollard