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Financial Stability Report for May 2012

New Zealand’s financial system remains vulnerable to global financial instability despite an improvement in financial market sentiment since the start of 2012.

New Zealand’s financial system remains vulnerable to global financial instability despite an improvement in financial market sentiment since the start of 2012. Policy measures by the European Central Bank (ECB), including the provision of substantial long-term funding to the banking system, have helped to mitigate the effects of softening European growth, deteriorating sovereign debt positions and weakening bank balance sheets. In addition, a successful debt exchange by Greece forestalled the prospect of a disorderly default, and signs of a slightly stronger recovery in the US have also helped to buoy sentiment.

However, the European situation remains fragile. While the ECB liquidity injections have taken pressure off vulnerable sovereigns and banks, little has been done to address fiscal imbalances and competitiveness issues. This will be necessary to restore confidence on a sustained basis. Markets are currently focused on imbalances in Spain and remain vulnerable to a further loss in confidence. An escalation of concerns could again risk freezing global debt markets, which are important to New Zealand’s banks. Further instability would also undermine the fragile global recovery and could have significant economic and financial implications. Growth in most advanced economies remains anaemic, and there have been recent signs of slowing in Australia and China, two of New Zealand’s major trading partners. Reflecting the challenging global environment, the market price of risk remains elevated on some measures.

Assisted by high commodity prices, the New Zealand economy has continued to grow modestly. However, commodity prices have eased in recent months, which will dampen prospects for the primary sector and may place some farmers under stress. Private sector indebtedness remains high but has been declining relative to income.

The pattern of increased caution since the global financial crisis has continued with households saving more and businesses being cautious with their investment plans. Offsetting the recovery in private savings, public debt has been increasing at a rapid rate. However, fiscal policy is now being tightened, with the aim of keeping public debt at manageable levels. Despite the growing public debt, higher private sector saving and lower investment have contributed to a modest reduction in New Zealand’s net external indebtedness.

The combination of increased household saving, weak credit growth, and a freeing up of international debt markets has improved funding conditions for New Zealand banks. With term funding available but still expensive, the banks have relied more on the strong inflow of retail deposits to meet their core funding requirements. Given improved conditions since late 2011, the Reserve Bank now confirms its intention to increase the minimum core funding ratio from 70 percent to 75 percent as of 1 January 2013.

As shown in the bottom left ‘spoke’ of figure 1.1, the banks have also improved their capital and profitability positions. Banks are well positioned to meet the new Basel III capital standards. Asset quality has also improved, with problem loan levels declining since the start of 2011, albeit gradually. This improvement in asset quality has helped to underpin an increase in profitability.

The Reserve Bank is continuing to strengthen regulation of the financial system, drawing on lessons learned from the financial crisis. For the banking system, the Reserve Bank has released consultation papers on its proposed implementation of the Basel III capital adequacy regime. The Reserve Bank will soon respond to submissions on the Basel III proposals and release draft standards. Other key regulatory developments for the banking system include the introduction of a legislative framework for covered bonds and the pre-positioning of banks’ systems for Open Bank Resolution. In the insurance sector, the provisional licensing regime for insurance companies came into force on 7 March, with 105 insurers licensed to conduct insurance activity from this date.

Alan Bollard

Financial Stability Report conference video for May 2012