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Financial Stability Report for May 2011

New Zealand’s financial system has faced a new challenge with the Christchurch earthquake in February providing a test for the insurance sector.

New Zealand’s financial system has faced a new challenge with the Christchurch earthquake in February providing a test for the insurance sector. Damage from the earthquake is large relative to the size of the economy and insurers face substantial logistical issues dealing with the consequent flow of claims. Economic activity has been disrupted in the near term, with some firms and households facing considerable economic and financial hardship.

The private property-related damage from the earthquake is substantially insured, and much of that has been reinsured with large global reinsurers. This makes the financial consequences of the earthquake more manageable for New Zealand. Other costs will be borne largely by the government, although doing so will place additional pressure on the fiscal position with consolidation in other areas now more imperative than prior to the earthquake. The ‘cobweb’ diagram (figure 1.1 in the attached PDF) summarises our assessment of the stability risks facing the New Zealand financial system. These risks, which were highly elevated during the financial crisis, have continued to reduce over the past year, although they remain above normal in several areas. The earthquake-related challenges have pushed the domestic environment risk assessment up slightly.

The financial system generally appears reasonably placed to support the economy over the period ahead. The resilience of the New Zealand banking system has improved since the financial crisis, with bank profitability lifting recently. The banks have also moved to a more stable funding base, reducing their vulnerability to disruptions in external funding markets. Non-performing loans are elevated, but remain at manageable levels and are supported by relatively high bank capital ratios.

Looking ahead, New Zealand’s financial system continues to operate in a volatile and uncertain world environment. The global economic recovery has broadened over the past six months and strong Asian growth remains supportive of commodity producing economies such as Australia and New Zealand, reducing our assessment of global risks (figure 1.1). However, the durability of the global recovery is still not assured. Any slowdown in growth in Asia, particularly China, would undermine the current strength in the terms of trade and remove an important engine of growth for the New Zealand economy. Furthermore, a combination of stretched sovereign balance sheets and ongoing problems in European banking systems have continued to make wholesale funding markets challenging for local banks. While global financial market conditions have generally improved in recent months, markets remain vulnerable to further adverse developments.

New Zealand’s economic recovery in 2010 was weaker than expected. In part, this was due to the overhang of high levels of indebtedness among parts of the household and business sectors following heavy borrowing over the past decade. Much of this borrowing was financed from debt raised offshore by the banking system and was reflected in a sharp rise in New Zealand’s net external liabilities. The challenging economic conditions and financial market volatility of recent years have made households and firms more cautious. This has resulted in efforts to reduce or constrain debt, leading to weak household and business spending. If sustained, this will assist in improving New Zealand’s external imbalances and moderate the financial system’s exposure to international credit markets. While reducing domestic and external debt imbalances would be a desirable development, an excessively cautious approach to debt could delay the return to a more fully-employed economy. Conversely, there is also a risk that the previous appetite for debt becomes re-established once economic conditions strengthen.

Rising terms of trade and ongoing global recovery continue to support an outlook of stronger activity in New Zealand’s external sector. In addition, earthquake rebuilding efforts are expected to boost domestic demand in due course, adding momentum to the recovery. Some lift in demand for credit is to be expected and it will be important that the banking system meets this demand in order to support the broader economic recovery and to assist the resumption of business activity within the Canterbury region.

The Reserve Bank is continuing to improve the regulation of the financial system. The Bank is currently evaluating the new Basel III global regulatory standards for bank capital adequacy and liquidity announced by the Basel Committee on Banking Supervision (BCBS) in November last year. Although New Zealand is not compelled to adopt the new standards, the Bank is generally supportive of the new standards subject to their suitability for local conditions. The Reserve Bank is also working to enhance its failure management toolkit and is currently consulting with the banks on how to implement Open Bank Resolution (OBR), a resolution option allowing a failing bank to be kept open without a full government bailout. The OBR policy will help to manage any perceived implicit public guarantee of the banks.

The Reserve Bank is also progressing with the implementation of a new licensing regime for insurers given its new responsibility for prudential supervision of the insurance sector. The Bank will continue to consult with the industry as the regulatory regime is developed further. The February earthquake was an extremely damaging event, and one major insurer with a large amount of Christchurch business (AMI) has required a support arrangement from Government to remove uncertainty about its ability to meet earthquake-related claims. The arrangement was also intended to maintain confidence in the broader insurance sector. The Bank will continue to assess the implications of the earthquake for the insurance sector over the months ahead.

Alan Bollard

Financial Stability Report conference video for May 2011