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Financial Stability Report for May 2013

Developments in private sector credit and the residential property market over the past year point to increasing risks to financial stability in New Zealand.

Developments in private sector credit and the residential property market over the past year point to increasing risks to financial stability in New Zealand. House prices are rising rapidly in Auckland and Canterbury, household credit growth has increased and there are signs that the rebuilding in household savings is beginning to stall. Household debt is rising from a level that is high relative to disposable income and house prices already appear overvalued on a number of measures, increasing the risks to both borrowers and the financial system that could arise from adverse economic conditions. Borrowing in the agricultural sector has also increased in the context of already high debt levels that are heavily concentrated within the dairy sector. Recent drought conditions could expose financial vulnerabilities among these indebted farmers.

Low interest rates and a significant improvement in global financial market sentiment over the past six months have supported the recovery in domestic credit growth. Policy actions in advanced economies have reduced the near-term risks of a break-up of the euro area, and a very sharp fiscal contraction in the US. More generally, exceptionally low interest rates and unconventional monetary policy in the major advanced economies have supported a rally in the prices of riskier assets. The improvement in sentiment has reduced funding costs for New Zealand banks, which, together with strong bank competition for mortgage customers, has led to a decline in mortgage interest rates over the past year. These lower rates are contributing to the current strength of the housing market.

Despite the recent improvement in financial market sentiment, there remains a significant risk of renewed turbulence in offshore funding markets. Although New Zealand’s financial system has reduced its overall reliance on these markets in recent years, external debt levels remain high, with most of the debt intermediated through the banking sector. Credit growth is rising and could soon outpace growth in domestic deposits, implying greater reliance on offshore debt to fund further increases in lending. New Zealand’s elevated exchange rate is also continuing to hinder a rebalancing of domestic activity towards the tradables sector, which would assist in reducing external vulnerabilities.

Banks have used a recovery in profitability over the past three years to strengthen their capital levels, which are now well in excess of the new Basel III minimum capital requirements. Despite the higher capital buffers, rising house prices are creating risks for the New Zealand financial system, by increasing both the probability and potential impact on bank balance sheets of a significant house price adjustment. The greater willingness of banks to approve high loan-to-value ratio (LVR) mortgages has further increased the potential adverse impact of a fall in house prices.

As discussed in a new chapter outlining the Reserve Bank’s risk assessment (chapter 2), the recent growth in house prices is problematic from a financial stability perspective. New Zealand has been fortunate to avoid the sort of sharp and costly correction in house prices that has been seen in many other countries in recent years. A sharp fall in house prices would likely be accompanied by increased bad debt on bank balance sheets and a tightening in the supply of credit. Household balance sheets would weaken, households would reduce consumption, and investment in housing would decline. If the correction in house prices was triggered by an external event such as a large financial and economic shock in a major trading partner, reduced export demand would add to the upward pressure on unemployment.

Partly in light of the risks relating to the housing sector, the Reserve Bank has been reviewing whether bank capital requirements for housing loans properly reflect risk in the sector. Following stage one of this review, the Reserve Bank is increasing the amount of regulatory capital required for high-LVR housing loans. This will strengthen the capacity of the banking system to weather a housing downturn, and should also lead the banks to review the riskiness of the loans they are currently writing. The Reserve Bank has also recently concluded a public consultation on a framework and set of instruments for macro-prudential policy (box A). A Memorandum of Understanding is expected to be signed with the Minister of Finance shortly, to agree on the main elements of the framework. The new framework provides the ability to temporarily tighten prudential settings if house prices and household borrowing continue to be of concern

The Reserve Bank is also strengthening regulation of the financial system in a number of other areas, drawing on insights gained from the financial crisis. Banks are making good progress on the pre-positioning of their core systems for Open Bank Resolution, which will provide the Government with a new option to deal with the failure of a bank. The Reserve Bank is also consulting on a proposal to enhance its powers for the oversight of financial market infrastructures, and is continuing to work towards the implementation of a new prudential regime for the insurance sector.

Graeme Wheeler

Financial Stability Report conference video for May 2013