Tag: New Zealand

NZ Holds Official Cash Rate 1.75 percent

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has continued to improve in recent quarters. However, inflation and wage outcomes remain subdued across the advanced economies and challenges remain with on-going surplus capacity. Bond yields are low, credit spreads have narrowed and equity prices are near record levels.  Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has eased slightly since the August Statement.  A lower New Zealand dollar would help to increase tradables inflation and deliver more balanced growth.

GDP in the June quarter grew in line with expectations, following relative weakness in the previous two quarters.  While exports recovered, construction was weaker than expected.  Growth is projected to maintain its current pace going forward, supported by accommodative monetary policy, population growth, elevated terms of trade, and fiscal stimulus.

House price inflation continues to moderate due to loan-to-value ratio restrictions, affordability constraints, and a tightening in credit conditions. This moderation is expected to continue, although there remains a risk of resurgence in prices given population growth and resource constraints in the construction sector.

Annual CPI inflation eased in the June quarter, but remains within the target range. Headline inflation is likely to decline in coming quarters, reflecting volatility in tradables inflation.  Non-tradables inflation remains moderate but is expected to increase gradually as capacity pressure increases, bringing headline inflation to the midpoint of the target range over the medium term.  Longer-term inflation expectations remain well anchored at around two percent.

Monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly.

Central Bank Inflation Targetting

The Reserve Bank of New Zealand has published a Bulletin article on “An international comparison of inflation-targeting frameworks“. The article compares the inflation-targeting frameworks of 10 advanced economy central banks.

The Reserve Bank of New Zealand (‘RBNZ’) began targeting inflation as a mechanism to ensure price stability in 1988. The RBNZ’s inflation target framework was then formalised with the Reserve Bank of New Zealand Act (1989) and when the first Policy Targets Agreement (‘PTA’) was set in 1990. The Bank of Canada was the second central bank to target inflation, in order to achieve price stability, in 1991. Since then inflation targeting has become internationally regarded as a conventional monetary policy framework. Inflation-targeting frameworks have continued to evolve based on individual country experiences; consequently it is useful to periodically compare the formal and informal inflation-targeting frameworks across advanced economies and understand the key similarities and differences. A previous article by Wood and Reddell (2014) compared the goals for monetary policy across inflation-targeting countries by focusing on primary legislation. This article expands on that analysis by comparing the inflation-targeting frameworks, including informal frameworks, with actual practices.

This article compares the frameworks and practices of 10 advanced economies that employ either full or partial inflation targeting.  This includes six ‘fully fledged’ inflation-targeting central banks: Reserve Bank of New Zealand, the Bank of England (‘BoE’), Norges Bank, the Bank of Canada (‘BoC’), the Reserve Bank of Australia (‘RBA’), and Sveriges Riksbank (‘Riksbank’). These banks explicitly target inflation over a specified time frame in order to achieve price stability, have monetary policy independence, regularly announce monetary policy decisions, and are accountable for policy decisions. Several large central banks also use elements of inflation targeting without either explicitly announcing an inflation target, or they have other objectives alongside low and stable inflation. These are the European Central Bank (‘ECB’), the Swiss National Bank (‘SNB’), the United States Federal Reserve (‘Fed’), and the Bank of Japan (‘BoJ’). Given their importance to international monetary policy, we also assess their frameworks and practices.

The comparison covers five components of an inflation-targeting framework: inflation target definition, communication of monetary policy, secondary considerations5, assessment of the inflation-targeting performance, and framework reviews and revisions. The comparison reveals four key findings.

  1. Despite large differences across inflation-targeting frameworks, the central banks operate and communicate monetary policy similarly.
  2. The central banks pursue forward-looking inflation targets and produce reports that support ex ante and ex post performance
  3. The central banks take account of secondary considerations when setting monetary policy, but not all inflation-targeting frameworks detail how central banks should make these secondary considerations, particularly with regard to financial stability.
  4. Several countries have published reviews of and made revisions to their inflation-targeting frameworks. However, the revisions to the frameworks are not always based on recommendations from published reviews.

The most striking observation from the paper however is the fact that most of the central banks do not expect inflation to return to target any time soon.

This would imply lower interest rates for longer, despite asset price bubbles. This begs the question, is inflation targetting really good and effective policy?

New Factors Play Into Central Bank Forecasting

An external central banking expert has commended the New Zealand Reserve Bank’s forecasting and monetary policy decision -making processes. However, two areas are recommended for further analysis. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.

As part of good practice peer review, the Bank regularly commissions reviews by external experts of its forecasting and monetary policy decision-making processes.  It has modified its processes over the years in light of their findings.

Dr Philip Turner, former Deputy Head of the Monetary and Economic Department and a member of Senior Management of the Bank for International Settlements (BIS), was requested to attend the February 2017 forecasting round, report on his assessment of the process, and make recommendations where relevant.

Dr Turner comments that, in seeking to “avoid unnecessary instability in output, interest rates and the exchange rate”, the Bank’s mandate is realistic about what monetary policy can achieve.

“This mandate would not have been fulfilled in recent years, given the large shocks to international prices, by trying to keep the year-on-year inflation rate in New Zealand at close to 2 percent.  To have achieved this, interest rates would have had to move by more than they have in recent years, and this would have created the unnecessary instability in output and the exchange rate that the RBNZ is enjoined to avoid.”

Dr Turner says it was clear that the Bank’s Monetary Policy Committee, which advises the Governing Committee on the monetary policy decision, has in its sights key questions about what might be called the ‘new normal’ for monetary policy.

These include the lower natural or neutral rate of interest; the increased responsiveness of aggregate demand to any change in interest rates; and how macro-prudential policies will affect monetary policy.

He says that the Bank’s open working-level culture of challenging views or arguments in a constructive and professional way enables the Bank to avoid ‘policy blind spots’.

“The whole forecast round has been engineered to bring to bear a full range of economic analyses and to ensure an open and comprehensive debate.”

Dr Turner recommended further work on two topics.

“Both are on the radar screens of RBNZ economists. The first is what the changing labour market under heavy immigration means for non-tradable inflation.  The second is what the ‘new normal’ for monetary policy after years of very low interest rates means for future monetary policy.  The impact of interest rate increases on the financial industry and on the real economy may be quite different than in the past.”

Dr Turner concludes: “Results over the past few years speak for themselves.  The RBNZ has helped steer its economy through several large external shocks.  Because it has done so without becoming trapped at a zero policy rate and without multiplying the size of its balance sheet by buying domestic assets, it has retained more room to pursue, if needed, a more expansionary monetary policy than is available at present to many central banks of other advanced economies.”

RBNZ Considers The Australian Connection

One really interesting observation from the recent IMF review of New Zealand’s financial system was the structural inter-dependency with financial services in Australia, not least because much of the banking footprint in NZ stems from Australian parent companies. Now the Reserve Bank in New Zealand has published its response. The Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The IMF recommends a number of steps to strengthen institutional arrangements, define responsibilities, and to clarify the objectives necessary to support the operational independence of New Zealand’s financial regulators. These recommendations cover prudential regulation and supervision, crisis management, and macro-prudential policy.

The IMF notes that the Reserve Bank, as a financial regulator, must have a suitable distance between itself and the executive branch of government. Independence is a necessary pre-condition for optimal policy and supervisory outcomes, albeit this needs to be supported by a robust framework that holds the Reserve Bank accountable to both government and the public.

Cooperation with Australian authorities

The IMF recommends strengthening collaboration and cooperation with the Australian authorities in order to recognise the important interdependencies between the two financial systems. The IMF recognise that there are already well-developed working relationships between the New Zealand authorities and their Australian counterparts.

This is reflected in on-going supervisory contact between the Reserve Bank and its counterpart in Australia, as well as through forums such as the Trans-Tasman Banking Council (TTBC) which is a body comprising various New Zealand and Australian agencies.

Reserve Bank response

The Reserve Bank has already begun the process of reviewing all the relevant findings and recommendations. The initial focus is on the extent to which greater alignment with international orthodoxy – as envisaged in most of the recommendations – might further contribute to the Reserve Bank’s statutory objectives tied to the promotion of a sound and efficient financial system.

The Reserve Bank continues to believe that its three-pillar framework, and an emphasis on self- and market discipline, has served New Zealand well. That said, there are a number of recommendations that, if adopted, may support financial system outcomes and the statutory purpose of the Reserve Bank.

In this regard the Reserve Bank will consider how it can more actively cooperate and coordinate with the Australian Prudential Regulation Authority (APRA) in the on-going regulation and supervision of the large Australian-owned banks.

The Reserve Bank will work with the Treasury to consider those recommendations tied to the ‘institutional boundary’ question in order to preserve and enhance a suitable degree of operational autonomy.

More generally, the Reserve Bank will be closely examining those recommendations that taken together may enhance the three-pillar approach to regulation and supervision. Elements of this model could include more independent verification or validation of information provided by regulated institutions, and a greater use of thematic reviews.

Other elements of this enhanced BAU model could include more clearly articulated (and enforceable) policy requirements, a re-emphasis on conservative and simple regulatory settings, and a more systematic and consistent approach to disclosure in the insurance sector. The review of the bank attestation regime currently in progress is likely to provide some insights into the value of the attestation process, how it could be enhanced and possibly how it could be applied to other sectors the Reserve Bank supervises.

The Reserve Bank will provide quarterly reporting, along with other agencies, to the Minister on progress in implementing FSAP findings and recommendations via CoFR.

RBNZ Official Cash Rate unchanged at 1.75 percent

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has increased and become more broad-based.  However, major challenges remain with on-going surplus capacity and extensive political uncertainty.

Headline inflation has increased over the past year in several countries, but moderated recently with the fall in energy prices.  Core inflation and long-term bond yields remain low.  Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has increased by around 3 percent since May, partly in response to higher export prices.  A lower New Zealand dollar would help rebalance the growth outlook towards the tradables sector.

GDP growth in the March quarter was lower than expected, with weaker export volumes and residential construction partially offset by stronger consumption.  Nevertheless, the growth outlook remains positive, supported by accommodative monetary policy, strong population growth, and high terms of trade.  Recent changes announced in Budget 2017 should support the outlook for growth.

House price inflation has moderated further, especially in Auckland.  The slowdown in house price inflation partly reflects loan-to-value ratio restrictions, and tighter lending conditions.  This moderation is projected to continue, although there is a risk of resurgence given the on-going imbalance between supply and demand.

The increase in headline inflation in the March quarter was mainly due to higher tradables inflation, particularly petrol and food prices.  These effects are temporary and may lead to some variability in headline inflation.  Non-tradables and wage inflation remain moderate but are expected to increase gradually.  This will bring future headline inflation to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Monetary policy will remain accommodative for a considerable period.  Numerous uncertainties remain and policy may need to adjust accordingly.

NZ Reserve Bank Consults On DTI Restrictions

The NZ Reserve Bank has released its consultation paper on possible DTI restrictions. The 36+ page report is worth reading as it sets out the risks ensuring from high risk lending, leveraging experience from countries such as Ireland.

Interestingly they build a cost benefit analysis, trading off a reduction in the costs of a housing and financial crisis with a reduction in the near-term level of economic activity as a result of the DTI initiative and the cost to some potential homebuyers of having to delay their house purchase.

Submissions on this Consultation Paper are due by 18 August 2017.

In 2013, the Reserve Bank introduced macroprudential policy measures in the form of loan to-value ratio (LVR) restrictions to mitigate the risks to financial system stability posed by a growing proportion of residential mortgage loans with high LVRs (i.e. low deposit or low equity loans). This increase in borrower leverage had gone hand-in-hand with significant increases in house prices, particularly in Auckland. The Reserve Bank’s concern was the possibility of a sharp fall in house prices, in adverse economic circumstances where some borrowers had trouble servicing loans. Such an event had the potential to undermine bank asset quality given the limited equity held by some borrowers.

The Reserve Bank believes LVR restrictions have been effective in reducing the risk to financial system stability that can arise due to a build-up of highly-leveraged housing loans on bank balance sheets. However, LVRs relate mainly to one dimension of housing loan risk. The other key component of risk relates to the borrower’s capacity to service a loan, one measure of which is the debt-to-income ratio (DTI). All else equal, high DTI ratios increase the probability of loan defaults in the event of a sharp rise in interest rates or a negative shock to borrowers’ incomes. As a rule, borrowers with high DTIs will have less ability to deal with these events than those who borrow at more moderate DTIs. Even if they avoid default, their actions (e.g. selling properties because they are having difficulty servicing their mortgage) can increase the risk and potential severity of a housing related economic crisis.

While the full macroprudential framework will be reviewed in 2018, the Reserve Bank has elected to consult the public prior to the review. This consultation concerns the potential value of a policy instrument that could be used to limit the extent to which banks are able to provide loans to borrowers that are a high multiple of the borrower’s income (a DTI limit). A number of other countries have introduced DTI limits in recent years, often in association with LVR restrictions. In 2013, the Bank and the Minister of Finance agreed that direct, cyclical controls of this sort would not be imposed without the tool being listed in the Memorandum of Understanding on Macroprudential Policy (the MoU). Hence, cyclical DTI limits will only be possible in the future if an amended MoU is agreed.

The purpose of this consultation is for the Reserve Bank, Treasury and the Minister of Finance to gather feedback from the public on the prospect of including DTI limits in the Reserve Bank’s macroprudential toolkit.

Throughout the remainder of the document we have listed a number of questions, but feedback can cover other relevant issues. Information provided will be used by the Reserve Bank and Treasury in discussing the potential amendment of the MoU with the Minister of Finance. We present evidence that a DTI limit would reduce credit growth during the upswing and reduce the risk of a significant rise in mortgage defaults during a subsequent severe economic downturn. A DTI limit could also reduce the severity of the decline in house prices and economic growth in that severe downturn (since fewer households would be forced to sharply constrain their consumption or sell their house, even if they avoided actual default). The strongest evidence that these channels could materially worsen an economic downturn tends to come from countries that have experienced a housing crisis in recent history (including the UK and Ireland). The Reserve Bank believes that the use of DTI limits in appropriate circumstances would contribute to financial system resilience in several ways:

– By reducing household financial distress in adverse economic circumstances, including those involving a sharp fall in house prices;
– by reducing the magnitude of the economic downturn, which would otherwise serve to weaken bank loan portfolios (including in sectors broader than just housing); and
– by helping to constrain the credit-asset price cycle in a manner that most other macroprudential tools would not, thereby assisting in alleviating the build-up in risk accompanying such cycles.

The policy would not eliminate the need for lenders and borrowers to undertake their own due diligence in determining that the scale and terms of a mortgage are suitable for a particular borrower. The focus would be systemic: on reducing the risk of the overall mortgage and housing markets becoming dysfunctional in a severe downturn, rather than attempting to protect individual borrowers. The consultation paper notes that DTIs on loans to New Zealand borrowers have risen sharply over the past 30 or so years, with further increases evident since 2014. This partly
reflects the downward trend in interest rates over the period. However, interest rates may rise in the future. While the Reserve Bank is continuing to work with banks to improve this data, the available data also show that average DTIs in New Zealand are quite high on an international basis, as are New Zealand house prices relative to incomes.

Other policies (such as boosting required capital buffers for banks, or tightening LVR restrictions further) could be used to target the risks created by high-DTI lending. The Bank does not rule out these alternative policies (indeed, we are currently undertaking a broader review of capital requirements in New Zealand) but consider that they would not target our concerns around mortgage lending as directly or effectively. For example, while higher capital buffers would provide banks with more capacity to withstand elevated housing loan defaults, they would do little to mitigate the feedback effects between falling house prices, forced sales and economic stress.

The Reserve Bank has stated that it would not employ a DTI limit today if the tool was already in the MoU (especially given recent evidence of a cooling in the housing market and borrower activity), it believes a DTI instrument could be the best tool to employ if house prices prove resurgent and if the resurgence is accompanied by further substantial volumes of high DTI lending by the banking system. The Reserve Bank considers that the current global environment, with low interest rates expected in many countries over the next few years, tends to exacerbate the risk of asset price cycles arising from ‘search for yield’ behaviour, making the potential value of a DTI tool greater.

The exact nature of any limit applied would depend on the circumstances and further policy development. However, the Reserve Bank’s current thinking is that the policy would take a similar form to LVR restrictions. This would involve the use of a “speed limit”, under which banks would still be permitted to undertake a proportion of loans at DTIs above the chosen threshold. By adopting a speed limit approach, rather than imposing strict limits on DTI ratios, there would be less risk of moral hazard issues arising from a particular ratio being seen as “officially safe”. Exemptions similar to those available within the LVR restriction policy would also be likely to apply.

 

New Zealand’s financial system is sound but continues to face risks

New Zealand’s financial system remains sound and the risks facing the system have reduced in the past six months, Reserve Bank Governor Graeme Wheeler said today when releasing the Bank’s May Financial Stability Report.

“The outlook for the global economy has been improving but global political and policy uncertainty remains elevated and debt burdens are high in a number of countries. A sharp reversal in risk sentiment could lead to higher funding costs for New Zealand banks and an increase in domestic borrowing costs. New Zealand’s banks are vulnerable to these risks because of their increasing reliance on offshore funding for credit growth,” Mr Wheeler said.

“House price growth has slowed in the past eight months, in response to tighter loan-to-value ratio (LVR) restrictions, and a more general tightening in credit and affordability pressures in parts of the country.

While residential building activity has continued to increase, the rate of house building remains insufficient to meet rapid population growth and the existing housing shortage. House prices remain elevated relative to incomes and rents, and any resurgence would be of concern.

“Dairy prices have recovered significantly in the past 12 months, and the majority of dairy farms are likely to have returned to profitability in the 2016/17 season. However, parts of the dairy sector are carrying excessive debt burdens, and remain vulnerable to a fall in income or an increase in costs. Banks should continue to closely monitor and maintain full provisioning against lending to high risk farms,” he said.

Deputy Governor Grant Spencer said “The banking system maintains strong capital and funding buffers, and profitability remains robust. The banking system appears to be operating efficiently when compared with other OECD countries, based on metrics such as cost-to-income ratios, non-performing loans and interest rate spreads.

“Banks have generally tightened credit conditions in light of funding constraints and the increasing risks around housing. Banks are seeking to reduce their reliance on offshore funding and have raised deposit rates.

The Reserve Bank supports a cautious approach to managing foreign debt, in light of lessons learned in the GFC.

“While the LVR restrictions have increased the banks’ resilience to any fall in house prices, a significant share of housing loans are being made at high debt-to-income (DTI) ratios.

Such borrowers tend to be more vulnerable to any increase in interest rates or declines in income. There is evidence that borrowers with high DTI ratios are the most vulnerable to rising mortgage rates. At a mortgage rate of 7 percent, around half of existing borrowers with DTI ratios above 5 are expected to face severe stress. However, this represents just 3 percent of borrowers.

Overall, this analysis suggests that a significant proportion of New Zealand borrowers are vulnerable to a material increase in mortgage rates. A sharp and unexpected rise in mortgage rates could see the most vulnerable households default, sell their houses or reduce consumption to repay debt. Recent borrowers in Auckland and borrowers with high DTI ratios appear most vulnerable, signalling that a continued high share of lending at high DTI ratios is concerning and may present a risk to the housing market and financial stability.

The Reserve Bank will soon release a consultation paper proposing the addition of DTI restrictions to our macro-prudential toolkit.

“The Reserve Bank is making progress on a number of other initiatives.  A review of bank capital requirements is underway and we recently released an issues paper on the intended scope of the review. We recently concluded a review of the outsourcing policy for registered banks, and the Bank and other agencies are assessing the recommendations from the International Monetary Fund’s recent (FSAP) review of New Zealand’s financial system.”

RBNZ Official Cash Rate unchanged at 1.75 percent

The New Zealand Reserve Bank today left the Official Cash Rate (OCR) unchanged at 1.75 percent.

Global economic growth has increased and become more broad-based over recent months. However, major challenges remain with on-going surplus capacity and extensive political uncertainty.

Stronger global demand has helped to raise commodity prices over the past year, which has led to some increase in headline inflation across New Zealand’s trading partners. However, the level of core inflation has generally remained low. Monetary policy is expected to remain stimulatory in the advanced economies, but less so going forward.

The trade-weighted exchange rate has fallen by around 5 percent since February, partly in response to global developments and reduced interest rate differentials. This is encouraging and, if sustained, will help to rebalance the growth outlook towards the tradables sector.

GDP growth in the second half of 2016 was weaker than expected. Nevertheless, the growth outlook remains positive, supported by on-going accommodative monetary policy, strong population growth, and high levels of household spending and construction activity.

House price inflation has moderated further, especially in Auckland. The slowing in house price inflation partly reflects loan-to-value ratio restrictions and tighter lending conditions.
Despite ongoing strength in the fundamental drivers of housing demand,namely population growth and low mortgage interest rates, housing activity has slowed since mid-2016. This likely reflects a range of factors,including changes to LVR policy, and increases in mortgage rates in 2016, and increasing pressure on affordability. This moderation is projected to continue, although there is a risk of resurgence given the continuing imbalance between supply and demand.

Mortgage rates have stabilised since the February Statement,with reduced upward pressure from lower wholesale interest rates (figure 4.5). Mortgage rates remain at low levels relative to history, but recent changes to LVR policy have tightened credit availability for some households. Lending conditions for residential property development have tightened.
The increase in headline inflation in the March quarter was mainly due to higher tradables inflation, particularly petrol and food prices. These effects are temporary and may lead to some variability in headline inflation over the year ahead. Non-tradables and wage inflation remain moderate but are expected to increase gradually. This will bring future headline inflation to the midpoint of the target band over the medium term. Longer-term inflation expectations remain well-anchored at around 2 percent.

Developments since the February Monetary Policy Statement on balance are considered to be neutral for the stance of monetary policy.

Monetary policy will remain accommodative for a considerable period. Numerous uncertainties remain and policy may need to adjust accordingly.

New Zealand Banking’s Deadly Australian Embrace

The IMF published their review of New Zealand, and included a Financial System Stability Assessment.  They highlight the imbalances in the housing market, banks’ concentrated exposures to the dairy sector, and their high reliance on wholesale offshore funding are the key macrofinancial vulnerabilities in New Zealand.

The banking sector has significant exposures to real estate and agriculture, is relatively dependent on foreign funding and is dominated by four Australian subsidiaries. A sharp decline in the real estate market, a reversal of the recent recovery in dairy prices, a deterioration in global economic conditions, and a tightening in financial markets would adversely impact the system. The key risks faced by the insurance sector relate to New Zealand’s vulnerability to natural catastrophes.

There was significant commentary on the relationship between Australian and New Zealand banking.

The home-host relationships between Australia and New Zealand are well above international practice, but stronger collaboration would enhance synergies. The RBNZ could take a more proactive role in collaborative supervision. The scope of the Memorandum of Cooperation on Trans-Tasman Bank Distress Management (MOC) could be extended to include insurance companies and FMIs. Moreover, further work on the trans-Tasman framework for assessing systemic importance and discussing possible coordinated responses would support timely and effective decision-making in an actual crisis.

They highlighted the dominance of Australian banking subsidiaries in New Zealand.

The financial sector in New Zealand is dominated by banks, focuses its activities on lending to the domestic private sector, and is characterized by the importance of four Australian subsidiaries. Banks represent about 75 percent of total financial assets. The sector seems well capitalized and liquid, nonperforming assets are low, and profitability has remained broadly stable. Foreign funding accounts for almost 20 percent of banks’ liabilities.

The system is concentrated on four subsidiaries of the largest
Australian banks, whose share in the banking sector’s total assets was 86 percent at end-2016 and represent a significant share of parents’ assets. The systemic importance of these subsidiaries for the parent banks, which are all systemic for the home supervisor as well, makes New Zealand-Australian interdependence unique among other countries with high foreign bank presence.

Australian subsidiaries (including branch assets of dual-registered banks) account for 86 percent of New Zealand banking sector’s assets, compared to 41 percent for Spanish banks in Mexico and 35 percent for the Swedish bank in Finland.

Nonbank financial institutions (NBFI) have more than halved in size since 2007. Nonbank lending institutions (NBLI) are savings institutions (credit unions and building societies), deposit-taking that fund their activities via deposits or debentures issued to the public and non-deposit taking  finance companies. Most are domestically-owned.

The vulnerabilities of the New Zealand financial system are largely associated with concentrated exposures to the real estate and agriculture sectors, dependence on wholesale funding, and the similar business models of the four Australian subsidiaries. In particular:

  • The banking sector exposure to residential mortgages reached over 50 percent of total claims at end-2015. Low global and domestic interest rates for the last few years are a main driver behind the observed increases in mortgage lending.2 While low interest rates facilitate debt repayments by the existing mortgage borrowers, rising housing prices have elevated the debt-to-income ratios of new house buyers. The rise in real estate prices has been most rapid in Auckland. The property boom has been driven also by increased investor activity.

  • The banking sector has a large concentration of loans to the agricultural sector. Agriculture credit exposure, with the dairy industry accounting for more than two-thirds, stood at 15 percent of total exposures in 2015. Low global milk prices have put significant financial pressure on dairy farms, with half of the sector having experienced a second consecutive season of operating losses. However, prices have recently recovered and, according to the most recent forecasts, the effective payout for the dairy industry will increase above the break-even price in the next season. Nonetheless, the already high dairy-farm debt relative to trend income has increased recently, and remains a source of risk. Credit risk concerns in other sectors are limited, with corporate lending growing at around 5 percent in 2016 (compared to 15.6 percent during January 2007–July 2008), and low debt-to income ratios hovering around 16 percent.
  • The financial system is highly concentrated on a few Australian-owned players, with similar business models and vulnerabilities. As a result, there is a strong correlation in the financial soundness of the subsidiaries among themselves and with their parents.
  • The banking sector depends to some extent on wholesale funding, including foreigncurrency funding sourced from offshore markets, and is exposed to liquidity risk from maturity mismatch. The main liquidity risk has traditionally been a reliance on offshore wholesale funding relative to domestic deposits. Rollover liquidity risk has been mitigated by the introduction of the core funding ratio (CFR) in 2010. However, because over 50 percent of banks’ assets are long term housing financing, the maturity mismatch is still a concern. Banks have also reduced their reliance on non-NZD funding to below 20 percent of total liabilities. While this development mitigates concerns over vulnerability to FX risk and increases the availability of foreign currency swap counterparties, pushing down hedging costs, banks might be vulnerable to risks related to hedging techniques under a stress event. As New Zealand’s banks looking for offshore funding use mostly the primary market, funding liquidity on global markets is relatively more important than market liquidity. Yet, heightened volatility in global financial markets may contribute to a pick-up in wholesale funding spreads.

Inward cross-border spillovers from distressed G-SIBs to New Zealand banks are significant. The analysis suggests that Australian banks have become increasingly exposed to European banks. The transmission of distress is more severe to tail equity returns than to market-implied asset returns during stressed times due to fire sales effects and contagion in funding costs. The reverse is true during calm periods suggesting flight-to-quality rebalancing of investors’ portfolios.

They also comment on housing exposures directly, and the current review of debt to income proposals.

Since housing loans represent more than half of banks’ assets, limits on debt-toincome could usefully become part of the macroprudential toolkit. It is still not possible to assess the full effects of the October 2016 LVR adjustments in the housing market. If the measures do not substantially reduce current risks, as the recent experience with LVR measures seems to suggest, authorities should complement the current measures with Debt-to-Income (DTI) limits. The RBNZ is discussing with the MoF the introduction of DTI limits in the macroprudential toolkit. Caps on DTI (or measures of similar nature such as debt servicing to total income (DSI)) can usefully complement the LVR restrictions and would help addressing remaining risks and targeting more directly risks derived from high household indebtedness. Considering that risks can build up relatively quickly, the expansion of the macroprudential toolkit is an important precautionary measure for the RBNZ to be ready to respond should the need arise. The reliance on multiple tools may also reduce distortions when compared to the use of one conservatively calibrated tool. Firsttime home buyers, for instance, tend to be more affected by LVR restrictions because they do not have the equity gain arising from the increase in house prices, though they tend to be in a relatively better position in terms of servicing debt in relation to investors. In addition, authorities are encouraged to maintain efforts to reduce distortionary tax benefits and facilitate housing supply.

RBNZ Reviews Capital Adequacy Framework

The New Zealand Reserve Bank has announced it is undertaking a comprehensive review of the capital adequacy framework applying to locally incorporated registered banks over 2017/18. The aim of the review is to identify the most appropriate framework for setting capital requirements for New Zealand banks, taking into account how the current framework has operated and international developments in bank capital requirements.

The Capital Review will focus on the three key components of the current framework:

  • The definition of eligible capital instruments
  • The measurement of risk
  • The minimum capital ratios and buffers

The purpose of this Issues Paper is to provide stakeholders with an outline of the areas of the capital adequacy framework that the Reserve Bank intends to cover in the Capital Review, and invite stakeholders to provide initial feedback on the intended scope of the review, and issues that might warrant particular attention. As feedback is received and decisions are made, some of these issues might fall away or be given a lower priority.

Detailed consultation documents on policy proposals and options for each of the three components will be released later in 2017, with a view to concluding the review by the first quarter of 2018.

Basis and framework for capital regulation

The Reserve Bank has powers under the Reserve Bank Act 1989 to impose capital requirements on registered banks. The Reserve Bank exercises these powers to promote the maintenance of a sound and efficient financial system, and to avoid significant damage to the financial system that could result from the failure of a registered bank.

The capital adequacy framework for locally incorporated registered banks is set out mainly in documents BS2A and BS2B of the Reserve Bank’s Banking Supervision Handbook. The framework is based on, but not identical to, an international set of standards produced by the Basel Committee on Banking Supervision.

The framework imposes minimum capital ratios. These are ratios of eligible capital to loans and other exposures. Exposures are adjusted (risk-weighted) so that more capital is required to meet the minimum requirement if the bank has riskier exposures.

The high-level policy options raised in this Issues Paper have the potential to result in reasonably significant changes to the New Zealand capital framework. It is expected, however, that any changes are likely to occur within a Basel-like framework.

The Reserve Bank invites submissions on this Issues Paper by 5pm on 9 June 2017