The New Zealand financial system is sound and operating effectively. Bank lending growth to households and businesses has increased. The banking system maintains capital and funding buffers in excess of minimum requirements and profitability is strong, with a further reduction in costs relative to income. Domestic capital markets have continued to grow, alongside issuance of bonds by both financial and non-financial corporates.
The outlook for global financial stability has deteriorated, with growth in the global economy softening over the past six months and financial market volatility increasing. Slower growth and uncertainty about the path of economic and financial adjustment in China have depressed global commodity prices and added to financial market uncertainty. Interest rates at historic lows are encouraging higher leverage, leading to a build-up in risk in international asset markets. The New Zealand banking system relies on the global markets for funding and in the current environment this represents a source of risk to banking system liquidity.
Against this backdrop, New Zealand’s financial system faces two further risks, which have increased since the May Report. The dairy sector faces a second consecutive season of weak cash flow, due to low international dairy commodity prices. Dairy prices have recovered since August, but some indebted farms are likely to come under increased pressure over the coming year, which could be exacerbated if dairy farm prices fall significantly. Banks are working with customers experiencing difficulty, and it is important that they continue to take a medium-term view when assessing farm viability. While credit losses on dairy exposures are expected to be manageable, banks need to ensure that they set aside realistic provisions for the likely increase in problem loans. The Reserve Bank is currently undertaking stress tests of the largest dairy lenders to assess the resilience of their portfolios to a prolonged period of low milk prices.
The other significant area of risk relates to imbalances in the Auckland property market. House price growth in Auckland has increased strongly and house price-to-income ratios in Auckland look increasingly stretched relative to global and historical norms. Rising investor participation has been an important driver of price developments. A significant market correction could challenge financial stability given the large exposure of the banking system to the Auckland housing market. International evidence suggests that investor loans have a higher tendency to default in the event of a major downturn in the housing market.
New rules requiring most loans to property investors in the Auckland region to have a loan-to-value ratio (LVR) of no more than 70 percent came into force on 1 November, following consultation on the proposed measures. This policy, along with recently enacted tax changes and initiatives to increase housing supply, is expected to help moderate pressure on Auckland house prices. Registered banks are also now required to distinguish loans for residential property investment from other residential loans and hold more capital against them. These policy changes are expected to improve the resilience of bank balance sheets to a housing downturn.
With housing market activity generally more subdued outside Auckland and house prices less stretched, the limit on the maximum share of lending at LVRs above 80 percent for the rest of New Zealand was increased from 10 percent to 15 percent from 1 November. However, the Reserve Bank will continue to monitor developments in regional housing markets closely in light of the recent lift in house sales and house price inflation in some upper North Island areas such as Hamilton and Tauranga.
The Reserve Bank continues to make progress on a number of regulatory initiatives. Public consultation has recently closed on the stocktake of banking regulations and a summary of submissions will be published shortly. The Reserve Bank has recently released a consultation paper proposing changes to the outsourcing policy for banks. The Reserve Bank and other government agencies have also begun preparing for the IMF’s Financial Sector Assessment Programme (FSAP) for New Zealand, a review of the financial system that is expected to take place in late 2016.
Graeme Wheeler
Governor