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Financial Stability Report for November 2014

The New Zealand financial system remains sound and continues to operate effectively.

The New Zealand financial system remains sound and continues to operate effectively. The banking system is well capitalised, funding and liquidity buffers are above required minima, and non-performing loans continue to decline. Stress tests of all the major banks' portfolios undertaken over the past six months demonstrate that each bank has the capacity to manage a range of significant negative events.

The financial system faces four key risks: imbalances in the housing market; high levels of indebtedness in the dairy sector; the potential effects of a slowdown in the Chinese economy; and the banking system's reliance on offshore funding. These are the same key risks that the financial system faced at the time of the May Report, although the balance of these risks has shifted in the past six months.

Housing market pressures have eased since the introduction of the loan-to-value ratio (LVR) ‘speed limit’ in October 2013 and subsequent increases in the Official Cash Rate. However, risks in the dairy sector have increased. The forecast dairy payout for the 2014–15 season has been reduced significantly, and could result in rising loan defaults should the lower payout level persist.

Lower global dairy prices are in large part due to reduced demand from China, highlighting New Zealand’s vulnerability to a slowdown in the Chinese economy. Risks arise from both New Zealand’s increased trade linkages, and also from potential spillover effects from a Chinese economic slowdown to global financial markets. Although the banking system’s reliance on offshore funding has reduced in recent years, banks remain susceptible to volatility in international markets.

The LVR speed limit is a temporary policy measure. The Reserve Bank intends to ease or remove the restriction when a sustained moderation in house price inflation is achieved, and when there is little risk of a resurgence in housing market activity. The reduction in house price inflation and housing credit growth are welcome developments, along with indications of increased residential building. However, there is a risk of a resurgence in house price inflation, particularly in light of strong immigration flows. Consequently, it is not appropriate to ease the LVR speed limit at this time. The Reserve Bank will continue to closely monitor the housing market.

The Reserve Bank periodically evaluates its prudential policies to ensure that they effectively support the soundness and efficiency of the financial system. The Reserve Bank is currently undertaking a stocktake of the regulatory framework to ensure it meets its objectives efficiently, clearly and consistently. Several initiatives are in progress to better measure and define bank capital adequacy, including a benchmarking exercise for the large banks’ internal capital models, and the development of a comprehensive stress testing framework. A review of the outsourcing policy for banks is also being conducted, to give confidence that banks are able to maintain full control over their core functions, even in times of market stress.

Graeme Wheeler

Financial Stability Report conference video for November 2014