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Financial Stability Report for May 2007

International conditions have generally been favourable for financial stability.

International conditions have generally been favourable for financial stability. Global growth is expected to soften, but remain relatively robust. Financial markets are performing strongly: asset prices are high, and credit spreads are low. Against this backdrop, New Zealand’s financial system continues to be stable, with liquid financial markets and volatility slightly below historical levels. New Zealand banks’ balance sheets are strong, their reported capital holdings exceed regulatory requirements, asset quality remains good and banks have been highly profitable. The stability of New Zealand’s large banks is further supported by the healthy state of their Australian parents.

However, these developments need to be related to increases in global liquidity and the development of large current account imbalances. Strong growth of savings in Asia and oil exporting countries has contributed to a sustained low level of long-term interest rates globally. It has led to the development of large current account surpluses in the excess savings countries, mirrored by deficits in the United States and other countries such as Australia, the United Kingdom, and New Zealand.

The investment impetus created by strong liquidity has led to an increase in risk appetite, disproportionately pushing up prices on risky assets and reducing credit spreads. Lower credit spreads are consistent with either a reduced assessment of risks, or an increase in risk appetite. However, news that causes risks to be reassessed can still transmit quickly to changes in asset prices. The effects of such reassessment were evident in the case of assets secured on US sub-prime mortgages, and also in the effects on broader asset price volatility from the February sell-off in the Shanghai share market.

The effects of these events extended to a temporary reassessment of the risks inherent in New Zealand dollar investments. These concerns have more recently subsided and we are now once again seeing strong issuance of New Zealand dollar denominated bonds in offshore markets. However, if foreign investors’ perception of the risk attached to New Zealand dollar assets were to rise on a more permanent basis, they would demand a higher premium for buying those assets, and New Zealand borrowers could be confronted with sharply higher interest rates. Meanwhile, New Zealand banks have been highly competitive: interest rate margins have been low, and high loan-to-value lending has become more prevalent. But while competition is to be encouraged, its consequence has been ever increasing levels of household debt and upward pressure on house prices. Margins on some lending have contracted to the point where they might not be expected to cover operating and capital costs on a sustainable basis. This approach, if continued, could perpetuate the housing boom and increase the risk of an eventual sharp downward correction. This would in turn damage the banks’ own balance sheets. More recent margins, however, have returned to more realistic levels.

Our primary concerns lie with the effects of lending on household balance sheets, which are a major driver of financial system health. However, high levels of debt also reside in the corporate and agricultural sectors. Agricultural sector balance sheets are heavily dependent on land prices, that have recently been buoyed by strong dairy returns. Higher aggregate debt levels increase New Zealand’s reliance on foreign savings, and hence increase the vulnerability of New Zealand’s financial system to an adverse shock, and in particular, to a shock that might cause a correction in the housing market and a broader reassessment of the risks around New Zealand dollar assets. Such a development would deteriorate bank asset quality. The banks most at risk would be those with the greatest exposure to high-risk households, such as borrowers with high LVR (Loan-to-Value Ratio) loans and high debt servicing burdens.

This raises the question of whether the existing regulatory framework for capital adequacy is sufficiently sensitive to the riskiness of bank assets. An increased focus on risk sensitivity under Basel II will introduce a better alignment of risk and regulatory capital going forward. For instance, higher LVR loans will require higher regulatory capital holdings. The Reserve Bank is considering whether the current framework should be modified in this direction ahead of the introduction of Basel II. The best contribution to future financial stability would be a moderation and gradual adjustment in the New Zealand housing market. Banks should be mindful of this and take care that their own behaviour does not exacerbate the risks inherent in already-stretched household balance sheets.

Alan Bollard