New Zealand’s financial system continues to face a challenging international environment. Global economic activity is weak and this is affecting emerging market economies, including China. Conditions in the euro area remain fragile and the underlying fiscal and structural issues facing the region are substantial. Global growth could be further undermined by the prospect of a material tightening in US fiscal policy. This external environment poses significant risks for the New Zealand financial system.
Despite this backdrop, financial market sentiment has improved since the last Report. This partly reflects further monetary easing around the globe, which has kept interest rates at unprecedented lows, and various measures to help manage the crisis in the euro area by supporting the financially distressed member countries. The uplift in sentiment has improved the major New Zealand banks’ access to global funding markets over the past few months and has contributed to upward pressure on the New Zealand dollar.
New Zealand’s banks have continued to build their liquidity and capital buffers, giving them greater ability to cope with future periods of financial market volatility or a slowdown in economic growth. The banks are comfortably meeting existing regulatory requirements for core funding and are well placed to meet the increase in the core funding ratio from 70 to 75 percent that comes into effect on 1 January 2013. Profits have recovered to near pre crisis levels although rates of return on equity remain lower due to recent increases in capital ratios.
In recent years, New Zealand’s financial system has reduced its overall reliance on external funding due to the recovery in private savings. This has been reflected in rapid growth in retail deposits and muted credit growth. In contrast, the public sector’s net external liabilities have increased given recent fiscal deficits. In order to reduce New Zealand’s vulnerability to external economic and financial shocks, it is important that the public sector continues to reduce the fiscal deficit and that the private sector continues to strengthen its balance sheets. With economic activity growing modestly, credit growth has begun to pick up and banks are competing for new customers in both the corporate and residential mortgage sectors. Some increase in credit will be necessary to sustain economic growth but excessive credit growth could hinder rebalancing of the economy and accentuate existing vulnerabilities.
Leverage in the agricultural sector remains high, especially among some dairy farmers, leaving the sector vulnerable to a fall in incomes. Households are also relatively indebted due to the substantial rise in borrowing over the past two decades. House prices are rising, particularly in Auckland, in the face of housing supply constraints. Excessive credit growth could worsen housing market imbalances given that house prices appear overvalued on a number of measures.
The Reserve Bank seeks to strengthen the New Zealand financial system in the wake of the lessons learned from the global financial crisis. In September 2012, the Reserve Bank issued a consultation package to put into effect the main elements of the Basel III capital adequacy regime designed to improve the quality and minimum level of capital in the New Zealand banking system.
As part of the Basel III changes, the Reserve Bank is implementing a counter-cyclical capital buffer framework aimed at improving the resilience of the banking system in the aftermath of credit booms. The Reserve Bank is also developing a broader macro-prudential policy toolkit to help achieve this objective. At present, credit growth is still reasonably subdued but the Reserve Bank remains alert to developments that might warrant macro-prudential intervention.
The Reserve Bank is also working through the implementation of a new prudential regime for the insurance sector. All insurers are required to have a full licence by September 2013. The insurance sector continues to process claims related to the Canterbury earthquakes, with nearly $11 billion being paid out so far, out of an expected total claims cost now well in excess of $30 billion.
Other policy developments include engaging with banks on their implementation plans to pre-position for Open Bank Resolution (OBR) and a review of the Reserve Bank’s statutory powers in overseeing the payments and settlement system.
Figure 1.1 (in the above PDF) summarises movements in financial system stress since the last Report in May. Stress on most dimensions of the cobweb remains above normal, although funding and liquidity conditions have improved as the banking system has increased its core funding buffers. Current financial market conditions are also shown to have improved slightly, albeit largely due to extraordinary international policy measures, as discussed in chapter 2.
Graeme Wheeler
Governor