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Financial Stability Report for May 2008

New Zealand’s financial system has so far withstood a severe test of global financial markets, initially triggered by losses in the US sub-prime mortgage market.

New Zealand’s financial system has so far withstood a severe test of global financial markets, initially triggered by losses in the US sub-prime mortgage market. These losses have cascaded through a wide range of credit markets, a process facilitated by some complex financial engineering over recent years. Many financial institutions, including some of the world’s largest banks, have incurred substantial losses. Amid lingering uncertainty over the scale and distribution of these losses, international money markets have remained under pressure and some financial institutions have encountered significant liquidity pressures. Bank funding costs have increased in the US, Europe, and Australasia.

The New Zealand financial system has had very little direct exposure to structured products linked to the US mortgage market and New Zealand’s banks have not developed the complex financial instruments at the heart of the current financial problems in the US. The same is also largely true of the Australian parent banks. However, the banks in both New Zealand and Australia source a significant amount of their funding from global financial markets with much of it at relatively short maturity. The banks are currently facing a higher cost of funds and reduced liquidity in some markets, particularly for term funding. As a consequence, there has been an increase in the cost of borrowing for both households and businesses and the banks appear to be tightening the availability of credit. These conditions have led to increased uncertainty among financial institutions, households and businesses.

In current circumstances, a more cautious approach to lending on the part of the banks appears prudent. However, there is a risk that if credit conditions are tightened excessively, the slow-down in the economy will be exacerbated, putting additional financial pressure on households and businesses. New Zealand’s banks appear well positioned to absorb the range of credit losses that can reasonably be expected over the course of the economic cycle, with all banks holding a sufficient capital buffer. The banks are less favourably positioned to withstand a scenario under which funding becomes more difficult to access in global markets. Although such funding has been readily available in the past, recent events show it may not always be as accessible as previously thought. The banking system is very reliant on non-resident funding given the country’s high net external indebtedness and ongoing large current account deficits.

In early May, the Reserve Bank announced some further changes to its liquidity management arrangements designed to help ensure adequate liquidity for New Zealand financial institutions in the event that global market disruptions were to intensify. These measures included expanding the range of acceptable securities for domestic market operations to include New Zealand dollar, New Zealand registered AAA rated Residential Mortgage Backed Securities (RMBS). These measures aside, the banks need to ensure that they adopt strategies that will help to reduce their overall exposure to disruptions in global funding markets. The Reserve Bank is currently reviewing its prudential liquidity policy for banks and is closely monitoring financial system liquidity. Part of the prudential liquidity review is likely to be focussed on ensuring that the banks diversify their funding sources and lengthen the maturity structure of their debt.

The IMF has recently described unfolding events in global markets as the largest financial shock since the Great Depression. The adjustment process, which involves widespread deleveraging, could prove protracted. Further volatility in world equity markets, exchange rates and debt markets is likely. The outlook for global economic activity has deteriorated with a sharp deceleration now clearly evident in the US economy. In response to financial stresses and the downside risks to growth, the US Federal Reserve has substantially lowered its policy interest rate over the past few months and, like many other central banks, has taken actions to ease money market liquidity.

Partly reflecting the weaker global outlook, the New Zealand economy is entering a period of slower growth, which is particularly evident in the housing sector. The slow-down is expected to assist in unwinding some significant economic imbalances that have built up over recent years, and have left the economy more exposed to adverse financial or economic shocks. These imbalances have been reflected in household dissaving and increases in both domestic and external indebtedness. While most projections are for a relatively moderate slowdown, there is a risk that the adjustment is sharper, causing financial strains in the household and business sectors as well as the broader financial system.

These macro-financial risks would be greater in the event that the global economic slow-down, currently centred in the US, Eurozone and UK, were to become more broadly based. Encouragingly, economic growth in the Asian region (excluding Japan), which has an important bearing on New Zealand’s economic prospects, has continued to display considerable momentum. Activity in Australia has also been strong, but has recently shown signs of softening. The extent to which the economies of Asia-Pacific will be affected by developments in the rest of the world remains unclear.

Although the banks have enjoyed a very benign period of low credit losses in recent years, there is increasing evidence that losses are starting to increase. In implementing the new Basel II regime, the Reserve Bank has been mindful that the relatively benign credit conditions will not continue indefinitely and an objective has been to ensure that banks’ minimum capital requirements are appropriately calibrated against the risks they face through the cycle in their various lending markets. This will remain a key focus of prudential policy.

Parts of New Zealand’s non-bank financial sector continue to face considerable upheaval, with further finance companies placed in receivership or reporting difficulties since our last Report in November. Some companies continue to face liquidity pressures due to lower reinvestment rates. Current financial market pressures have also reduced the capacity of some institutions to obtain funding from other sources, including the banking system. However, we remain of the view that these disruptions are unlikely to have widespread effects on the financial system and that their effects on the economy are likely to be relatively contained.

Alan Bollard