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Financial Stability Report for May 2015

The financial system is sound and operating effectively, supporting growth in the economy.

The financial system is sound and operating effectively, supporting growth in the economy. Bank capital, liquidity and funding buffers remain above required minima, while asset quality and underlying profitability are strong. Regulatory changes over recent years have helped to improve prudential standards for banks, non-bank deposit takers (NBDTs) and insurers. There has been continued progress in processing claims related to the Canterbury earthquakes, although significant uncertainties remain.

The financial system continues to face three key areas of risk. Household sector debt is high relative to incomes and house prices are overvalued on several measures, particularly in Auckland where prices have increased rapidly in recent months. The rise in Auckland house prices reflects ongoing supply constraints, increased demand driven by record net immigration, low mortgage interest rates and increased investor participation. House prices have become very elevated in Auckland, and financial stability could be tested if prices were to fall sharply, which could occur if adverse economic conditions led to a reduction in debt repayment capacity. In contrast with Auckland, house price inflation in most other parts of New Zealand has remained relatively subdued.

Following recent consultation, the Reserve Bank is establishing a new asset class for bank loans to residential property investors. These loans will attract a higher risk weighting than for owner-occupier mortgages, requiring more capital to be held against these loans. The Bank is also proposing some changes to its policy on high loan-to-value ratio (LVR) lending to recognise the financial stability risks arising from housing market conditions in Auckland. The changes, which are proposed to be introduced from 1 October 2015, involve a new restriction on loans to property investors in the Auckland region with an LVR of greater than 70 percent (i.e. to set a speed limit on such loans at close to zero). For all residential lending outside the Auckland region, the Bank is proposing to increase the existing speed limit for loans with an LVR of greater than 80 percent from 10 to 15 percent, to recognise relatively subdued housing market conditions outside Auckland. The Bank will issue a consultation paper in late May to outline these proposals in further detail and seek feedback.

The second area of risk for the financial system relates to the dairy sector, which is experiencing a sharp fall in incomes in the current season due to lower international prices. Around 11 percent of farm debt held by farmers with both negative cash flow and elevated LVRs. Financial stress in the dairy sector could rise markedly if low global milk prices persist beyond the current season. The extent of recovery in Chinese milk demand, following a large build-up of inventories in 2013, will be an important influence on global milk prices.

The third source of risk arises from global financial conditions, which remain extremely loose, in part reflecting recent monetary easing in Europe and Japan aimed at supporting economic recovery. Low interest rates are encouraging investment in riskier assets, leading to a reduction in credit spreads, reduced market volatility and rising prices for both financial and real assets. High and rising asset prices could become a point of vulnerability when interest rates begin to return to more normal levels. There is also a risk that the current benign market conditions could unwind in a disorderly fashion, affecting the cost and availability of offshore funding for New Zealand banks.

With the financial system facing significant and increasing risks, it is critical that banks maintain their capital and liquidity buffers, and apply prudent lending standards. Banks should ensure that any new capital instruments continue to maintain loss-bearing capacity, in view of the significant risks the sector faces. The Reserve Bank plans to undertake a review of current bank capital requirements in light of global and domestic changes affecting the banking system in recent years.

The Reserve Bank is continuing to make improvements to its financial oversight regime. Good progress has been made on the stocktake of registered bank and NBDT regulations, with public consultation on specific proposals expected to take place in the second half of 2015. The Reserve Bank also expects to consult with the banks later in the year on a best practice guide for the conduct of stress tests, following a review of the models and processes used by the major banks late last year.

Graeme Wheeler

Financial Stability Report conference video for May 2015