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Financial Stability Report for November 2013

New Zealand’s financial system remains sound.

New Zealand’s financial system remains sound. The banks are well capitalised and have strengthened their funding base, while non-performing loans continue to fall. All banks comfortably meet the new Basel III minimum capital requirements introduced at the start of the year. Core funding ratios are also well above the required level.

The main threats to the financial system are the risks associated with growing imbalances in the housing market. The Reserve Bank has introduced measures to moderate these risks to financial stability.

The household sector has high levels of indebtedness relative to both historical and international norms. Although debt levels relative to income have eased from their 2007 peak, they have been increasing since late 2012. Of particular concern has been stronger housing lending, and a reduction in lending standards as reflected in the increased lending to borrowers with high loan-to-value ratios (LVRs). Households and banks are highly exposed to the housing market, with housing representing a majority of household assets and bank lending.

From 2002 to 2007, New Zealand experienced one of the largest increases in house prices among the 34 OECD countries. While house prices fell after the 2008 Global Financial Crisis (GFC), house price inflation has increased over the past 18 months, taking house prices in some regions to well above their 2007 peaks. House prices in the Auckland and Christchurch markets, which together account for just over half of house sales, have risen by 17 percent and 8 percent respectively over the past year. House prices in the rest of the country have been increasing by a more modest 3 percent, but with larger increases in Taranaki, Hawke's Bay, Nelson/Marlborough and Otago. The OECD and IMF both believe that New Zealand’s house prices are significantly overvalued.

Rapidly rising house prices in Auckland and Christchurch reflect both supply and demand pressures. In Auckland, housing construction has been low for some years, partly as a result of land use constraints. In Christchurch the housing stock was significantly damaged by the 2010 and 2011 earthquakes. Housing demand has been stimulated by a range of factors, including the broadening economic recovery; the effects of stronger net inward migration; the decline in mortgage rates; and the increased availability of credit.

If left unchecked, excessive increases in house prices increase the likelihood and potential magnitude of a correction in house prices following an economic downturn. These conditions could cause significant financial distress for some households, while lenders could suffer a decline in asset quality. In a severe downturn, banks and other intermediaries can become much less willing to lend to creditworthy borrowers.

The Reserve Bank has responded to this risk in two ways: by requiring the banks to hold more capital against high-LVR housing loans, and by requiring them to restrict the proportion of new high-LVR housing loans. Higher capital requirements introduced in September 2013 aim to improve financial stability by better reflecting the potential loss associated with high-LVR lending. LVR lending restrictions, introduced in October, will directly limit the amount of high-LVR lending the banks can undertake. Together, these policies are expected to slow housing lending and house price inflation and reduce the potential risks to bank balance sheets.

While it is still too early to draw conclusions on the effect of the policy initiatives, the initial evidence suggests there has been a change in market behaviour. Banks have increased the price of high-LVR mortgages, while significantly reducing high-LVR pre-approvals. If New Zealand is to manage current imbalances in the housing market, it is critical that the underlying housing supply issues in Auckland and Christchurch be addressed. Restraining the growth in housing credit will only assist to moderate excess demand pressures in the short to medium term.

Outside the household sector, parts of the rural sector are also highly indebted. The dairy sector, in particular, is vulnerable to a fall in commodity prices or an increase in debt servicing costs. International dairy prices are at record levels, and are providing a significant boost to incomes in the dairy sector. Growth in farm debt has been modest and farm land prices are still below pre-crisis peaks. Nonetheless, a return to pre-2007 credit growth and spending patterns within the sector would present risks to financial stability.

More broadly, the New Zealand economy faces vulnerabilities associated with its high level of external debt. High external debt is the result of persistent current account deficits, which reflect a shortfall in national savings relative to investment. While private sector saving has improved in recent years, the Reserve Bank expects some worsening in the external balance as residential investment expands over the next 2–3 years. In this context, it is important that the improved savings performance is maintained and that the public sector deficit continues to reduce.

New Zealand’s external debt is mainly intermediated through the banking system. Since 2008, strong growth in retail deposit funding has allowed banks to meet the lift in credit demand without significantly increasing their offshore funding. In the past six months, New Zealand banks have retained good access to wholesale funding markets, with risk spreads returning to levels not seen since before the GFC.

International financial market conditions have continued to improve, but remain fragile, as major economies continue to cope with imbalances revealed by the GFC. The European banking system remains vulnerable to high debt levels and modest economic growth. The United States economy is improving, and the authorities are now presented with the challenge of withdrawing the extraordinary monetary stimulus measures in an orderly manner. The US economy is also pushing up against its legislative public debt ceiling, which has created some policy uncertainty. The developing economies, which experienced relatively good economic growth in recent years, have started to slow. An abrupt slowdown in the Chinese economy could pose risks to New Zealand’s international commodity prices.

Over the past six months the Reserve Bank has continued to enhance the prudential regulatory framework to strengthen the soundness of the New Zealand financial system. The Reserve Bank’s review of the prudential regime for non-bank deposit-takers was completed in September 2013, and several legislative amendments are proposed to ensure the regime is appropriately targeted. A review has been undertaken of the oversight regime for payment and settlement systems, and it is expected that powers will be strengthened in this area. The licensing of insurers to comply with the prudential requirements under the Insurance (Prudential Supervision) Act 2010 was completed on 9 September 2013. This represented a major effort by the industry with 99 insurers granted licences.

Graeme Wheeler

Financial Stability Report conference video for November 2013