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Financial Stability Report for May 2014

The New Zealand financial system remains sound, and well placed to support expansion in the economy.

The New Zealand financial system remains sound, and well placed to support expansion in the economy. The banking system is well capitalised, funding and liquidity buffers are comfortably above required minimums, and non-performing loans continue to decline. Regulatory changes in recent years have helped to improve prudential standards for both banks and non-bank deposit-takers (NBDTs).

However, several risks to the financial system require continued focus. Debt in the household sector remains high relative to income, and house prices are overvalued on several measures. As a result, financial stability could deteriorate if there is a sharp correction in house prices, particularly if accompanied by a reduction in debt repayment capacity. The Reserve Bank introduced a speed limit on high loan-to-value ratio (LVR) lending in October 2013 to help reduce this risk.

Debt is also elevated in the dairy sector, although incomes are currently strong due to high export prices. A reduction in farm incomes, and associated fall in land prices, could place pressure on some highly leveraged borrowers. One risk to farm incomes is a disruption to China’s economic growth, which could result from vulnerabilities in the financial system. A disruption to the Chinese economy could also affect international capital markets, and impair funding conditions for New Zealand banks.

New Zealand’s large net external liability position, predominantly in the form of offshore debt held by the banking system, poses a further risk. Strong domestic deposit growth in recent years has resulted in a decline in the banking system's reliance on offshore funding, and there has also been a lengthening in the maturity of offshore funding following the introduction of the minimum core funding ratio. However, banks remain vulnerable to a deterioration in international debt market conditions. This vulnerability would increase if the rise in private sector saving in recent years was to reverse.

Given the risks facing the financial system, current prudential policy settings remain appropriate. The restriction of high-LVR mortgages appears to be having the desired effect of bringing activity in the housing market back towards a more sustainable level, with both house price inflation and credit growth moderating in recent months. These effects of the LVR policy are expected to be reinforced by the increase in interest rates projected in the March 2014 Monetary Policy Statement. The Reserve Bank expects the speed limit to remain in place until the housing market comes into better balance, with a more sustainable rate of house price inflation.

The Reserve Bank maintains a conservative yet non-intrusive financial oversight regime. Over the coming year, the Reserve Bank will undertake a stocktake of its bank and NBDT regulations, with the aim of improving the efficiency, consistency and clarity of these regulations. A further strategic initiative is the development of a comprehensive stress testing framework for the banking system. Following the completion of the licensing of the insurance sector, the focus of the Reserve Bank has switched to ongoing supervision.

Graeme Wheeler

Financial Stability Report conference video for May 2014