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Financial Stability Report for May 2009

The stability of New Zealand’s financial system is being challenged by continuing strains in financial markets, the sharpest contraction in global economic activity in at least 30 years, and an extended period of weakness in the domestic economy.

The stability of New Zealand’s financial system is being challenged by continuing strains in financial markets, the sharpest contraction in global economic activity in at least 30 years, and an extended period of weakness in the domestic economy. Unlike many other developed countries, however, New Zealand has not experienced significant distress in its banking sector, nor has the availability of credit to households and businesses tightened to the same degree.

As discussed in previous Reports, the international financial system has been in crisis since the middle of 2007. Declining asset prices, initially in the US housing market but also more widely, revealed an unsustainable accumulation of debt in many advanced economies. The process of adjustment has placed severe strain on bank balance sheets, particularly in the US and Europe. The collapse of US investment bank Lehman Brothers in September 2008 led to increased concerns over the solvency of many other financial institutions as credit spreads widened further and equity prices declined sharply. Unprecedented government intervention has been required to forestall systemic banking crises in several countries (including the US and the UK), often with substantial use of public funds.

Economic activity has weakened in all regions, pushing the world economy into recession and causing many international banks to experience continued deterioration in asset quality that is further stretching already weakened balance sheets. Lending criteria have tightened and credit growth has slowed as banks attempt to preserve scarce capital and liquidity. Reduced credit availability is, in turn, exacerbating the economic downturn in several major economies, leading some countries to introduce unconventional measures to support the flow of credit to the real economy. Despite an improvement in world equity markets since March, and some modestly encouraging economic indicators, a global economic recovery appears some way off. Restoring sustainable economic growth is likely to prove a drawn-out process given the overhang of weak balance sheets and impaired credit markets.

The deteriorating global environment has had a major impact on New Zealand, alongside weak domestic demand as households adjust to lower property prices and rising unemployment. Demand for our exports has fallen and international commodity prices have declined, although the depreciation of the New Zealand dollar over the past year has helped to cushion the impact on the tradable sector.

Adjustment to a more sustainable level of household and national indebtedness is a necessary aspect of correcting the imbalances in the New Zealand economy, but will entail significant output costs if the adjustment occurs too abruptly. Recent policy actions by the New Zealand authorities, including substantial monetary and fiscal easing, should help to ensure the adjustment remains orderly. Orderly adjustment is also being supported by the relative health of the domestic banking system. In contrast to experience overseas, it has not been necessary to commit public funds to recapitalise New Zealand’s banks. The four largest banks are also benefiting from the resilience of their Australian parents, all of which have retained high credit ratings and strengthened their capital positions over recent months.

Nevertheless, the current economic and financial environment presents significant challenges for the banking sector in New Zealand. Asset quality has deteriorated markedly, albeit from a very strong level, as unemployment rises and business profitability declines. With the domestic economy expected to remain weak over coming quarters, asset impairments will continue to rise. Banks should ensure that they make adequate provisions and maintain capital levels sufficient to absorb unexpected losses. Exposures to the agricultural and commercial property sectors warrant particular attention.

The banking system has continued to lend to households and businesses over the past year, but credit growth has slowed significantly in recent months. Compared with many other countries, the decline in credit growth in New Zealand has been relatively less abrupt (figure 1.1 in attached PDF). Nevertheless, some businesses are reporting significant difficulty in obtaining credit, and lending criteria have tightened throughout the economy. While current economic conditions warrant caution, it is important that New Zealand’s banks continue to lend to creditworthy households and businesses.

Vulnerabilities are also apparent on the liabilities side of the New Zealand banks’ balance sheets, although policy actions at home and overseas have contributed to a gradual easing of funding and liquidity risks since our November Report. Conditions in offshore credit markets (including the key US commercial paper market) have generally improved in recent months, allowing the New Zealand banks to obtain short-term external funding more easily, and at slightly longer maturities. One bank has now issued offshore term debt under the Crown’s wholesale guarantee scheme and we expect other banks reliant on offshore funding to follow suit. In the interim, funding from the major banks’ Australian parents, along with the Reserve Bank’s expanded liquidity facilities, continue to provide a valuable backstop.

Lengthening the maturity structure of wholesale funding remains an important priority for New Zealand’s banks and will be a primary focus of the Reserve Bank’s new prudential liquidity policy for banks, which is currently being finalised.

The non-bank sector in New Zealand is undergoing protracted adjustment. Liquidity pressures have been eased by the Crown’s deposit guarantee scheme, but many nonbank lenders continue to experience deteriorating asset quality. Following the introduction of the guarantee scheme, the Reserve Bank has brought forward implementation of the new prudential regime for non-bank deposit-takers, and is currently consulting on key parts of this framework including capital adequacy. The new regime will not, on its own, resolve the challenges facing the non-bank sector, but should improve its future resilience. The Reserve Bank is also working with the Government on possible successor arrangements for the deposit guarantee scheme, which is scheduled to expire in October 2010.

Assessing and countering potential threats to financial stability in New Zealand remains an ongoing priority for the Reserve Bank, as the effects of the global crisis continue to be felt. We will also be monitoring domestic credit conditions closely, and stand ready to implement additional policy measures, as necessary, to ensure that normal channels of credit intermediation remain open and act to support New Zealand’s economic adjustment and recovery.

Alan Bollard