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Financial Stability Report for November 2006

The Financial Stability Report provides a regular overview of the Reserve Bank’s assessment of relevant financial system risks in New Zealand.

The Financial Stability Report provides a regular overview of the Reserve Bank’s assessment of relevant financial system risks in New Zealand. It also provides a summary of the Bank’s activities aimed at promoting financial system soundness and efficiency. The financial system comprises financial institutions, financial markets, payment and settlement systems, and the broader macroeconomy. The Bank assesses financial stability to exist when all relevant financial risks are adequately identified, priced, and allocated to those best able to manage them.

Since our May Financial Stability Report, the global saving investment imbalances have persisted. Savings continue to accumulate rapidly in some countries; in particular, official foreign reserves in some Asian and oil exporting economies. These savings continue to be intermediated principally through the US and European financial systems, reaching end users who are mostly households, particularly in the US. In turn, these funds are being used to fund consumption and a strong rise in asset prices – especially house prices, until recently.

It is likely that the rapid increase in global liquidity in recent years has put strains on the ability of the global financial system to fully identify, price, and allocate financial risk. In particular, low official interest rates have tempted many investors to take larger risks elsewhere. These circumstances have reduced credit spreads in some of the higher-risk investment vehicles. A sudden rise in actual or expected official interest rates and/or credit risks could thus see a more painful adjustment to the imbalances than is currently expected by most economic forecasters. This adjustment could be reflected in more dramatic exchange rate changes (eg, a lower US dollar) and/or a rise in long term interest rates, with correspondingly lower US domestic spending. One positive sign is that US household spending growth may slow in line with its housing activity. In addition, oil prices have declined. Both factors are assisting in the rebalancing of global savings. However, even much stronger trade balance shifts would take several years to materially alter the global imbalance picture.

At present, New Zealand remains a significant net recipient of global savings; our current account deficit remains at record levels, in large part driven by household borrowing demands. Corporate debt-gearing has also risen recently. Most of the foreign savings are being intermediated through the domestic banking sector into residential mortgages. Bank funding remains very competitively priced, with New Zealand’s credit spreads low.

Given the reliance on foreign capital, any rapid change in global perceptions of New Zealand’s credit-worthiness would dramatically alter the cost of capital. A sudden decline in global investor confidence would also impact negatively on liquidity in key financial markets. The New Zealand foreign exchange market is currently experiencing a high level of ‘cyclical’ liquidity, with foreign currency speculators chasing yields.

Banks operating in New Zealand are competing aggressively at present to retain and grow their market share in mortgage lending. To the extent that this competition leads to credit standards slipping, overall financial system risks will rise. Non-performing loans are very low at present, and banks remain well capitalised. However, there is evidence that some of the Australian parents of locally registered banks are taking increased risks in their lending practices. This evidence includes growth in low-doc lending, acceptance of higher loan-to-value ratios and debt-servicing burdens, and lending at significantly reduced interest margins. There is also increasing anecdotal and other evidence of these practices becoming more widespread among New Zealand registered banks.

Households have an unusually high concentration of their wealth in housing, and their debt-gearing and debt servicing ratios are near record levels. In addition, a material proportion of loans to small-to-medium size enterprises are collateralised by residential property. Households and the business sector are thus very susceptible to any change in economic conditions. Should households come under strain to service their debts, and house prices begin to soften considerably, the quality of banks’ balance sheets would deteriorate. Farm values are also currently at very high levels relative to their underlying earnings, and the farming sector has registered rapid growth in bank debt. An unexpected decline in farm earnings would increasingly impact negatively on bank balance sheets. The Reserve Bank will be watching such developments closely, in particular as it implements the new capital standards under Basel II.

The non-bank deposit-taking financial sector has continued to grow rapidly in terms of assets, despite the slowdown in the economy and signs of isolated stress in some institutions and sectors (eg, the second-hand car market). While some deposit-taking finance companies will continue to come under stress, it is unlikely that these isolated incidents will challenge New Zealand’s overall financial stability.

The Reserve Bank is working closely with Australian regulators and officials to ensure the financial stability of both countries is maintained without unnecessary regulatory cost. Legislation has recently been passed in New Zealand and is progressing in Australia that formalises each regulator having regard to trans-Tasman financial stability when implementing policy. Implementation of the Reserve Bank’s local incorporation policy is now also complete, with the registration of Westpac New Zealand Limited making all large banks compliant. Progress is also being made on implementing the outsourcing policy, Basel II capital requirements for banks, and the oversight of the payments and settlement system in New Zealand. All of these activities promote soundness and efficiency in the financial system.

In summary, the relevant financial system risks in New Zealand appear adequately identified. However, there are some concerns that the global pricing of financial risk is too low. Given New Zealand’s foreign indebtedness, this makes the cost of capital susceptible to sudden changes in foreign investor sentiment. While banks appear well capitalised and sound, the households to which they are lending aggressively are increasingly geared and vulnerable to sudden changes in economic circumstance. Liquidity in the foreign exchange market is also being cyclically bolstered by foreign investor interest. Overall, we continue to view a gradual slowdown in domestic spending and a reduction in the current account deficit as the most likely path to rebalancing in the New Zealand economy. However, risks remain that will need to be monitored by all participants in the financial system.

Alan Bollard