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Financial Stability Report for May 2006

The New Zealand and global financial systems continue to perform soundly.

In promoting financial stability the Bank draws on a variety of information, practices, and ongoing research to make assessments and form policy judgements. In particular, the Bank conducts regular surveillance of financial system risks, with the Financial Stability Report the main mechanism for reporting our assessment.

The New Zealand and global financial systems continue to perform soundly. However, signs of increased volatility have emerged in some markets (eg, commodities and foreign exchange), and some major challenges to financial stability persist.

An ongoing financial system risk remains the potential for disruptive corrections to the current account (or saving-investment) imbalances experienced in many countries – in particular between the United States deficit and surpluses in various Asian and oil exporting countries. These imbalances have sustained unusually low US long-term interest rates, precipitating a global ‘search for yield’. In their quest for higher returns it is possible that global investors may be underestimating their exposure to various market and credit risks. Some of these risks have heightened as global inflation pressures re-emerge, exacerbated in the near term by higher oil and other commodity prices.

More optimistic economic outlooks for Japan and Europe signal more widespread global growth, which will aid somewhat the necessary saving-investment rebalancing. In addition, interest rates have been rising in an anticipated fashion as economic growth has improved, and exchange rates have been adjusting, where able, to better reflect fundamentals.

Many of the challenges to New Zealand financial system stability identified in our November Report remain, and some have increased. For example, New Zealand banks have continued to raise their exposure to the housing market. A very large proportion of foreign capital being utilised in New Zealand is now intermediated through the banking sector via secured residential mortgage lending. A slower housing market will thus pose challenges to bank risk management and we will continue to monitor this closely, especially when implementing the new bank capital requirements regime.

New Zealand households have also been increasingly ready to purchase property for investment purposes. Household indebtedness has increased, so that over time households have raised their financial vulnerability to interest rate changes, unemployment, and swings in rental incomes and property capital values. On balance, the data suggest that the New Zealand household sector has continued to increase its financial concentration and overall debt exposure.

A slower growing economy will thus bring challenges to households and financial institutions – especially those that have recently experienced rapid growth and have limited experience in managing a downturn, as is the case for a number of the non-bank financial institutions. This Report highlights that there is a wide degree of variation in financial exposure amongst households as well as financial institutions. Overall, those who may need to reassess their positions appear to be the lower and middle income households, and institutions exposed to property investment and consumer finance.

Meanwhile, New Zealand’s financial markets have remained sound. The decline in the New Zealand dollar over the March quarter, from its previous exceptional and unjustifiable level, represents a significant risk reduction. The depreciation was managed in the foreign exchange market with good liquidity and efficient pricing, and was principally a cyclical adjustment to better reflect the underlying fundamentals of the economy.

In this Report we reiterate recent steps taken to ensure banks have adequate access to liquidity for settlement purposes. Work on access and governance issues with regard to the payment system also continues, and we will continue to pursue more rapid progress in this area. The Reserve Bank is currently working with banks in other areas of policy development, including outsourcing, the implementation of the Basel II Capital Accord, and pandemic preparedness amongst other things. We are also working with various government agencies on reviewing the prudential regulation and supervision of the non-bank financial sector. All of these developments represent significant efforts in bolstering financial system soundness.

This Report concludes with a special chapter that outlines some of the broad concepts on which we base our surveillance of financial stability assessment. This is work in progress, but it is important to ensure that, should the Bank’s financial regulatory role be expanded, there is a well articulated framework for the conduct of this work.

Alan Bollard