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Financial Stability Report for November 2008

The New Zealand financial system has been forced to weather extreme disorder within international financial markets over the past few months.

The New Zealand financial system has been forced to weather extreme disorder within international financial markets over the past few months. Following a period of relative calm after the rescue of Bear Stearns in March, financial markets became increasingly dysfunctional in September with the failure of Lehman Brothers and ongoing concerns around the viability of several other major US institutions. Risk aversion rose markedly, markets became illiquid and equity prices declined sharply around the globe. A further worsening in investor sentiment gradually forced the merger or restructuring of a range of other sizable financial institutions in the US, UK and Europe.

In response to the market turmoil, central banks and governments around the world have announced a wide range of measures to support their financial systems. These have included the recapitalisation of ailing institutions through various means and the extension of guarantees on financial institutions’ retail deposits and other debt instruments. There are some early signs that these measures, which have been of unprecedented scale, are having some beneficial effect on markets. However, confidence remains fragile as markets increasingly confront the prospect of a marked slowing in global economic growth.

New Zealand’s banks have not experienced the significant financial losses associated with housing lending that have been at the heart of the global financial meltdown. However, global market conditions continue to affect the cost and accessibility of offshore funding on which the New Zealand banking system relies, highlighting a vulnerability noted in previous Reports. Over the past two months, even well-rated financial institutions, such as the Australasian banks, have found it very difficult to borrow in global wholesale markets given the extreme levels of risk aversion among foreign investors. As a result, the availability of credit for New Zealand households and businesses has been tightening.

New Zealand has also adopted a range of policy measures to help reduce the financial and macroeconomic risks that these extraordinary developments create. In October, the Minister of Finance announced the introduction of an opt-in retail deposit guarantee scheme, following the announcement of a comprehensive guarantee in Australia. The scheme gives assurance to New Zealanders that their deposits are safe. The scheme covers all retail deposits of participating New Zealand-registered banks and nonbank deposit-taking entities for a period of two years. In early November, the Minister announced the introduction of a temporary opt-in wholesale guarantee facility, which will cover the wholesale debt of investment-grade New Zealand financial institutions. This facility is aimed mainly at facilitating their re-entry to offshore wholesale debt markets.

These measures are a temporary response to exceptional circumstances. Inevitably, such guarantees create distortions and can disadvantage some borrowers and lenders since they cannot cover all financial contracts and institutions. Both the retail and wholesale guarantee schemes are being structured in a way that attempts to reduce these distortions as much as possible by using risk-based pricing and other features. Regulatory oversight will also need to be very alert to the moral hazard that can arise in the presence of guarantees.

For its part, the Reserve Bank has enhanced its liquidity facilities over the past year and in May expanded the range of securities acceptable in domestic market operations to include AAA-rated residential mortgage backed securities (RMBS). The banks have been working to construct RMBS and in some cases now hold RMBS that are eligible collateral for Reserve Bank operations. The Reserve Bank has indicated that it will be prepared to lend on a temporary and penal basis against RMBS yet to achieve formal ratings. These facilities provide scope for the Reserve Bank to maintain liquidity in the banking system when banks are unable to access their normal funding channels, which remains a risk even in the presence of guarantees.

Recent international events, including the bailout of institutions on a wide scale, are expected to prompt a widespread review of financial regulation and its appropriate balance with market discipline. These events have also demonstrated the risks faced by financial systems that have a high level of dependency on external financial markets, including those in New Zealand and Australia. Notwithstanding the measures taken to reduce the financial system’s exposure to adverse conditions overseas, individual financial institutions have a fundamental responsibility to manage their own balance sheet risks appropriately. The Reserve Bank is currently consulting with the registered banks on proposed new standards for the management of their funding and liquidity. It is expected that this policy, when finalised, will reinforce incentives on the banks to diversify away from short term wholesale funding and thus reduce their vulnerability to market disruptions over the longer haul.

New Zealand’s economy has contracted over 2008 following a sustained period of growth. Domestic spending has been affected by the sharp increase in oil and food prices until recently along with a tightening in global credit conditions. In addition, the sharp run-up in house prices and household debt, which had fuelled the expansion and stretched resources, could not be sustained indefinitely. Looking forward, a consolidation of domestic spending and an expected recovery in national savings should help to improve the country’s external balance assisted by the recent depreciation in the New Zealand dollar. Exports will, however, be restricted by the weakening in global activity.

With the domestic economy softening, structural weaknesses in some non-bank financial institutions have been revealed over the past year. These have been exacerbated by slowing property markets, resulting in a large number of failures of non-bank deposit takers and a flow of funds away from investments exposed to this sector. With guarantees now in place, the non-banks have the opportunity – which will be reinforced by the new Reserve Bank prudential regime – to consolidate their balance sheets while improving systems and risk management practices.

Collectively, the banks, which represent the bulk of the deposit-taking sector, appear well placed to weather a weaker economy. New Zealand’s banks, and the Australian parents of the large Australian-owned banks, have sufficient capital to withstand an increase in loan losses associated with an economic downturn. Moreover, the banks are not directly exposed to many of the negative factors affecting their global peers. The banks appear to have tightened lending standards over the past year. The credit tightening has become more severe recently due to dislocations in the international funding markets, but the recently announced wholesale guarantee scheme should assist in alleviating these pressures.

Prospects for the New Zealand financial system and the broader economy will remain linked to developments in global markets. In essence, the global financial sector is undergoing a prolonged adjustment to the aftermath of a multi-year period of excessive optimism in asset markets, fuelled by lax lending standards in the US and some other regions. Assuming adequate recapitalisation and restructuring of the major distressed global financial institutions, we will eventually reach the point where financial institutions are again able to support global economic growth. In the interim, the adjustment process is proving extremely disruptive and it will likely be some time before financial market conditions normalise.

Alan Bollard