Reserve Bank NZ – Page 7 – Digital Finance Analytics (DFA) Blog

Monetary Policy Faces Challenges in Turbulent Times

Interesting speech from New Zealand, illustrating the difficulty in the current low growth, low rate, low inflation, high exchange rate environment. Expect more rate cuts!

In a speech written for the Otago Chamber of Commerce, Mr Wheeler said the scope and influence of monetary policy, particularly in small, open economies, is heavily constrained by economic and financial developments outside their borders. As a result, expectations of what monetary policy can achieve often run ahead of reality.

“Nearly 10 years on from the Global Financial Crisis, economies face a difficult global economic and financial climate, with below-trend growth despite unprecedented monetary stimulus, declining merchandise trade and rising protectionism, very low inflation and interest rates, and high asset prices presenting financial stability risks. Many of these issues have complex structural elements that are unlikely to fully self-correct as global growth recovers.

“Central banks must make finely balanced judgements when setting monetary policy, based on evidence, research, scenario analysis, and continual review of their policy record and international experience,” he said.

“As is the case elsewhere, there are a range of views about what monetary policy can achieve and how it should be operated. In New Zealand, these include a view that flexible inflation targeting is no longer an appropriate framework for conducting monetary policy.”

Mr Wheeler said that flexible inflation targeting remains the most appropriate framework for conducting monetary policy in New Zealand. Provided sufficient flexibility is allowed to accommodate the frequent and often severe impact of external shocks, the most important contribution monetary policy can make to promoting efficiency and the long-run growth of incomes, output and employment is the pursuit of price stability.

“There is nothing sacrosanct about what particular inflation band or target should be adopted as a measure of price stability. However, changing a target when times become tougher reduces the incentives on central banks to achieve earlier agreed goals. It could damage the central bank’s credibility – particularly if a perception develops that the central bank will continually seek to respecify goals.”

The Bank also encounters a view that it should not lower interest rates, because current strong economic growth makes interest rate cuts unwarranted and undesirable.

However, if financial markets believe that the Bank is content with below-target inflation, they would conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially.

“The TWI exchange rate is already at a high level based on the Bank’s models. A sizeable appreciation would further squeeze incomes in the tradables sector, and drive tradables inflation lower for longer, thereby lowering overall headline inflation.”

Low headline inflation could also bring down inflation expectations in a self-perpetuating spiral.

“If inflation expectations fall too far, it can be very difficult to raise them back up. In such a situation, even further cuts in interest rates would be needed to stimulate economic activity and increase inflationary pressures.”

Mr Wheeler said a third view maintains that the Bank should rapidly lower interest rates to bring inflation quickly back to the mid-point of the inflation band.

However, an aggressive monetary policy that is seen as exacerbating imbalances in the economy would not be regarded as sustainable, and would not deliver the exchange rate relief being sought.

Rapid ongoing decreases in interest rates would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market. It would use up much of the Bank’s capacity to respond to the likely boom/bust situation that would follow, and place the Reserve Bank in a situation similar to many other central banks of having limited room to respond to future economic or financial shocks.

Mr Wheeler drew heavily on and emphasised the messaging contained in the recently released August Monetary Policy Statement.

“The key rationale for cutting the OCR in August was to lower the risk of a further decline in short-term inflation expectations.

“Our present judgement is that the current interest rate track, involving an expected 35 basis points of further interest rate cuts, balances a number of risks weighing on the economy, while generating an increase in CPI inflation back towards the mid-point of the 1 to 3 percent target range.

“We remain committed to the inflation goals in the Policy Targets Agreement. We do not believe that the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings. If the emerging information and risks unfold in a manner that warrants a change in our judgements, we will modify our policy settings and outlook.”

RBNZ Defers LVR Changes

The Reserve Bank NZ is deferring the start of the proposed changes to investor loan-to-value restrictions (LVRs) nationwide from 1 September to 1 October 2016, based on feedback from the banking industry from its recent consultation on the proposals.

Deputy Governor, Grant Spencer, said: “Banks have indicated through their submissions that more time is required to enable them to meet the new restrictions that apply to investor loans nationwide, given the pipeline of loan pre-approvals made prior to our announcement in July.

“We understand that banks have been applying the new LVR restrictions to new loan applications since the LVR changes were announced. On that basis we will defer the formal introduction of the changes to 1 October in order to accommodate the backlog of pre-approvals.”

Mr Spencer noted there had been a number of queries related to exemptions. He clarified that the range of existing exemptions to LVR restrictions will continue to apply under the proposed changes. These exemptions permit the banks to make high LVR loans that would otherwise be limited by the restrictions. Exemptions apply where:

Owner-occupiers or investors are constructing or purchasing a new dwelling (provided the loan commitment occurs prior to, or at an early stage of, construction of the dwelling).

Owner-occupiers or investors require bridging finance to complete the purchase of a residential property on a date prior to the completion of a sale of another property.

Owner-occupiers or investors are re-financing an existing high LVR loan, or shifting an existing high LVR loan from one property to another (provided the total value of the new loan does not increase).

Owner-occupiers or investors are borrowing to fund extensive repairs or remediation that is not routine or deferred maintenance. This includes events such as a fire, natural disaster, weather tightness issues or seismic strengthening).

A loan is made under Housing New Zealand’s Mortgage Insurance Scheme, including the Welcome Home Loans scheme.

Borrowers with owner occupied and investor collateral can use the combined collateral exemption to obtain finance up to 60% of the value of the investment properties and 80% on their owner occupied property.

“It is important to emphasise that these exemptions are permissive but do not create an obligation on the banks to make such loans. The banks will still apply their own lending criteria to individual borrowers and may choose to not provide finance in these circumstances or to provide it only at lower LVRs.

“The consultation process closed on 10 August and we are continuing to analyse submissions. Further adjustments to the proposals, including the exemptions, are still possible and we expect to publish a final policy position later this month,” Mr Spencer said.

Under the proposed new restrictions:

No more than 5 percent of bank lending to residential property investors across New Zealand would be permitted with an LVR of greater than 60 percent (i.e. a deposit of less than 40 percent).

No more than 10 percent of lending to owner-occupiers across New Zealand would be permitted with an LVR of greater than 80 percent (i.e. a deposit of less than 20 percent).

Loans that are exempt from the existing LVR restrictions, including loans to construct new dwellings, would continue to be exempt.

NZ Cash Rate Reduced To 2%

The Reserve Bank today reduced the Official Cash Rate (OCR) by 25 basis points to 2.0 percent.

Global growth is below trend despite being supported by unprecedented levels of monetary stimulus. Significant surplus capacity remains across many economies and, along with low commodity prices, is suppressing global inflation. Some central banks have eased policy further since the June Monetary Policy Statement, and long-term interest rates are at record lows. The prospects for global growth and commodity prices remain uncertain. Political risks are also heightened.

Weak global conditions and low interest rates relative to New Zealand are placing upward pressure on the New Zealand dollar exchange rate. The trade-weighted exchange rate is significantly higher than assumed in the June Statement. The high exchange rate is adding further pressure to the export and import-competing sectors and, together with low global inflation, is causing negative inflation in the tradables sector. This makes it difficult for the Bank to meet its inflation objective. A decline in the exchange rate is needed.

Domestic growth is expected to remain supported by strong inward migration, construction activity, tourism, and accommodative monetary policy. However, low dairy prices are depressing incomes in the dairy sector and reducing farm spending and investment. High net immigration is supporting strong growth in labour supply and limiting wage pressure.

House price inflation remains excessive and has become more broad-based across the regions, adding to concerns about financial stability. The Bank is consulting on stronger macro-prudential measures that should help to mitigate financial system risks arising from the rapid escalation in house prices.

Headline inflation is being held below the target band by continuing negative tradables inflation. Annual CPI inflation is expected to weaken in the September quarter, reflecting lower fuel prices and cuts in ACC levies. Annual inflation is expected to rise from the December quarter, reflecting the policy stimulus to date, the strength of the domestic economy, reduced drag from tradables inflation, and rising non-tradables inflation. Although long-term inflation expectations are well-anchored at 2 percent, the sustained weakness in headline inflation risks further declines in inflation expectations.

Monetary policy will continue to be accommodative. Our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range. We will continue to watch closely the emerging economic data.

NZ Reserve Bank warns of email scam

The NZ Reserve Bank is warning of what appears to be a scam email sent to businesses in the financial sector. The scam email, purportedly from a Reserve Bank staff member, encourages recipients to click on a link to view “New Transaction Guidelines”.

The email was not sent by the Reserve Bank, and clicking on the link could potentially expose the recipient’s computer to a virus. Visit www.scamwatch.govt.nz for more information about how scams work and how you can protect yourself.

RBNZ Cash Rate unchanged at 2.25 percent

Statement by NZ Reserve Bank Governor Graeme Wheeler:

The NZ Reserve Bank today left the Official Cash Rate unchanged at 2.25 percent.

Global financial market volatility has abated and the outlook for global growth appears to have stabilised after being revised down successively over recent quarters. There has been a modest recovery in commodity prices in recent months. However, the global economy remains weak despite very stimulatory monetary policy and significant downside risks remain.

Domestic activity continues to be supported by strong net immigration, construction, tourism and accommodative monetary policy. The dairy sector remains a moderating influence with export prices below break-even levels for most farmers.

The exchange rate is higher than appropriate given New Zealand’s low export commodity prices. Together with weak overseas inflation, this is holding down tradables inflation. A lower New Zealand dollar would raise tradables inflation and assist the tradables sector.

House price inflation in Auckland and other regions is adding to financial stability concerns. Auckland house prices in particular are at very high levels, and additional housing supply is needed.

There continue to be many uncertainties around the outlook. Internationally, these relate to the prospects for global growth and commodity prices, the outlook for global financial markets, and political risks. Domestically, the main uncertainties relate to inflation expectations, the possibility of continued high net immigration, and pressures in the housing market.

Headline inflation is low, mostly due to low fuel and other import prices. Long-term inflation expectations are well-anchored at 2 percent. After falling in recent quarters, short-term inflation expectations appear to have stabilised.

We expect inflation to strengthen reflecting the accommodative stance of monetary policy, increases in fuel and other commodity prices, an expected depreciation in the New Zealand dollar and some increase in capacity pressures.

Monetary policy will continue to be accommodative. Further policy easing may be required to ensure that future average inflation settles near the middle of the target range. We will continue to watch closely the emerging flow of economic data.

RBNZ Does Digital Banking Disruption

An article published today in the NZ Reserve Bank Bulletin explores the potential effects of digital disruption to banks and broader financial system stability. Consumers now expect the same seamless digital services from banks as they receive from other industries. Hence, the banking industry is being ‘digitally disrupted’ as banks and technology firms race to meet this expectation.

This article explores whether the digital disruption of banking is a ‘disruption’ or more of a ‘distraction’ and aims to understand the concept of digital disruption of banking, what is driving it, what are the impacts on banks, and what are the impacts on financial system stability. It finds that the disruption is occurring in all areas of banking but particularly in retail customer interactions.

Banks using new technologies to improve their services is not a new phenomenon. Over the late 1980s to 1990s automated teller machines (ATMs), electronic debit and credit cards, and telephone banking started replacing paper-based payments. Then, through 2000 to 2010, basic banking products became digitally available through the introduction of remote access to bank accounts via mobile banking and internet banking. However, these earlier digital trends were predominantly driven by the supply side (i.e. by banks themselves) to improve the cost efficiency of supplying banking services, and therefore improve profitability.

This current wave of digitisation is different to earlier periods of innovation in the banking industry in that it is primarily driven by consumers rather than banks. Consumers now expect more accessible, convenient and smarter transactions (using internet and mobile devices) when accessing and managing their finances, as they have experienced this convenience in other activities such as shopping and transportation. Advances in new technologies and the changing customer expectations have enabled non-bank firms, such as large technology companies (for example Amazon, Facebook and Google) and start-ups (for example PushPay, Moven and Harmoney), to provide innovative bank-like services and take a share of the banking industry profits. These firms can be referred to as ‘disruptors’.

The emergence of disruptors poses a threat to the traditional banking model and is referred to as the disruption of the banking industry. A survey by Efma and Infosys Finacle (2015) revealed that 45 percent of banks viewed global technology companies as high threat and 41 percent of banks also viewed start-up companies as high threat. Under the current model of retail banking most services are provided by banks. However, after the digital disruption of banking, ‘front-end’ (or ‘customerfacing’) banking services such as the sales and distribution of banking products, account management and payment instructions may also be provided by disruptors. However, disruptors do not appear to be engaging in ‘back-end’ services such as holding deposits and settling payments because these activities tend to be captured by prudential regulation which makes them more expensive to provide due to additional compliance costs.

‘Millennials’ (the generation born 1981–2000) appear to be driving this ‘disruption’ of banking services. A three-year survey of views of 10,000 Millennials in the United States reported that the banking industry was the industry with the highest risk of disruption due to the Millennials’ low loyalty towards banks and expectations that technology companies could service their banking needs better. The survey found that:

71 percent of respondents would rather go to the dentist than hear from their bank,
one in three respondents was open to switching banks,
nearly half of the survey participants were counting on the change to traditional banking models to come from technology start-ups; and
73 percent of respondents indicated they would be more excited about a new financial product offering from Google, Amazon, Apple, PayPal or Square than from their bank.

Banks’ core roles are to act as an intermediary between depositors and borrowers, help manage risks for depositors and lenders, and provide payment services. In fulfilling these roles the banks provide security and convenience to the depositors and access to credit for borrowers. Banks are also key agents in the creation of money (via fractional reserve banking), distribution of notes and coins, and are part of the transmission of monetary policy (via the rates charged for loans and paid on deposits). A central question is if and how this ‘digital disruption’ described in the previous section will affect the bank’s core roles or whether this disruption is limited to the banks’ retail distribution models and interactions with consumers. It appears that digital disruption will impact both the retail distribution and customer interaction models of banks, as well as potentially disrupting the core role of banks.

A survey by McKinsey&Company of the customer segments and products of 350 globally leading financial technology firms (or leading ‘disruptors’) revealed that all banking segments are at risk of disruption. However, the main area of concentration of these disruptors is the retail sector, and the various products and services tied to payments, lending and financing.

A key potential effect of digital disruption on banks in the short to medium term is the loss of profitable activities and services.

In the long term, banks’ role in the financial system may be challenged. Disruptors may become systemically important if they supply a large portion of front-end banking services. For example, if peer-to-peer or equity lending platforms grow rapidly then it is possible that a significant number of credit decisions could be made by lending platforms. Likewise it is possible a significant number of payments may be initiated using mobile wallets.

If banks lose profits generated at the front-end of banking services they may become less resilient in an economic downturn. Stress test results reveal that the profitability of New Zealand banks provides a buffer against losses in downturn scenarios where a large number of creditors default on their loans. Lower profitability results in a smaller buffer against potential losses caused by an economic downturn, and also reduces access to international capital markets as the cost of funds increases in proportion to the riskiness of the bank.

In a more hypothetical long term scenario, banks may be challenged to change the fundamental model of banking in order to meet the demands of Millennials as they progress through life. As described above, digital disruptors are more likely to have a stronger relationship with younger customers (or Millennials) which could pose a considerable threat to the business models of incumbent banks.

In the short to medium term, digital disruption may result in new risks and increased instability in the financial system. For example, peer-to-peer lenders do not take on credit risk in the same manner as a bank, they do undertake decisions on behalf of lenders and so may introduce different operational risks to the borrowing and lending process. Likewise, payments innovations may introduce new operational risks to the payments system.

Further, as banks undertake core banking system redevelopment projects this may increase project risks to the banking system. Large technology projects commonly run over time and over budget and if these projects are not managed appropriately they could result in significant disruptions to customer services and bank profitability.

In the medium to long term, digital disruption of the banking sector may improve the efficiency of the financial system. For example, new payments providers increase the speed and ease of initiating payments for consumers, and the application of new technologies (such as ‘blockchain’) could increase the speed and reduce the cost of making cross-border payments. In addition, P2P platforms reduce the cost of matching borrowers with lenders as there are no physical branches to maintain.

The long term impact of digital disruption on financial system soundness is less clear. Soundness may be reduced if existing banks’ profitability buffers are reduced due to increased competition from digital disruptors. However, digital disruption may also improve financial system soundness if it results in more competitors entering the banking sector and fewer systemically important banking entities. This may reduce the impact of a single entity failure. Further, this may alleviate the ‘too-big-to-fail’ risk where authorities may feel pressured to prevent large banks from failing due to systemic concerns. This would in turn, reduce the probability of banking entities taking on risks that they are not willing to bear (moral hazard).

The introduction of new ‘digital’ competitors is driving banks to respond with digital strategies including the modernisation of their core banking systems. Digital disruption may impact financial stability both positively and negatively, and the Reserve Bank continues to monitor it closely.

NZ Housing and dairy risks to financial stability

New Zealand’s financial system is resilient and continues to function effectively, but risks to the financial stability outlook have increased further in the past six months, Reserve Bank Governor, Graeme Wheeler, said today when releasing the NZ Reserve Bank’s May Financial Stability Report.

“Although New Zealand’s economic growth remains solid, the outlook for the global economy has deteriorated. Despite highly accommodative monetary policies and low oil prices, growth is slowing in a number of trading partner economies.

“Dairy prices remain low with global dairy supply continuing to increase. Many farmers now face a third season of negative cash flow with heavy demand for working capital.

“Imbalances in the housing market are increasing with house price inflation lifting again in Auckland, after cooling in late 2015 and early 2016 following new restrictions in investor loan-to-value ratios and government measures introduced in October.

“House prices have also begun increasing strongly in a number of regions across New Zealand, although house prices outside Auckland are generally much lower relative to incomes.

“The Bank remains concerned that a future sharp slowdown could challenge financial stability given the large exposure of the banking system to the Auckland housing market. Further efforts to reduce the imbalance between housing demand and supply in Auckland remain essential. This includes measures such as decreasing impediments to densification and greenfield development and addressing infrastructure and other constraints to increased housing supply.”

Deputy Governor, Grant Spencer, said: “In the banking system capital and liquidity buffers are strong and profitability is high.

“However, the system faces challenges. Internationally, credit spreads have widened, placing upward pressure on the cost of funds for New Zealand banks.

“The level of problem loans in the dairy sector is expected to increase significantly over the coming year, although we expect that dairy losses will be absorbed mainly through reduced earnings.

“While the moderation in house price inflation has been transitory, the LVR restrictions have substantially reduced the proportion of risky housing loans on bank balance sheets. This is providing an ongoing improvement to financial system resilience.

“The Reserve Bank is closely monitoring developments to assess whether further financial policy measures would be appropriate.

“The Reserve Bank continues to make progress on key regulatory initiatives. Consultation papers on proposed changes to the outsourcing policy for banks and on changes to bank disclosure requirements will soon be released. A consultation paper has also recently been released on crisis management powers for financial market infrastructures.”

NZ Official Cash Rate unchanged at 2.25 percent

The Reserve Bank NZ today left the Official Cash Rate unchanged at 2.25 percent.

The outlook for global growth has deteriorated over recent months due to weaker growth in China and other emerging markets. Prices for some commodities, including oil, have picked up but remain weak.

Monetary conditions are extremely accommodative internationally, with considerable quantitative easing and negative policy rates in some countries. Financial market volatility has eased in recent weeks, but markets continue to watch closely the policy settings of major central banks.

Domestically, the economy is being supported by strong inward migration, construction activity, tourism, and accommodative monetary policy. Dairy export prices have improved slightly, but are below break-even levels for most farmers.

The exchange rate remains higher than appropriate given New Zealand’s low commodity export prices. A lower New Zealand dollar is desirable to boost tradables inflation and assist the tradables sector.

There are some indications that house price inflation in Auckland may be picking up. House prices remain at very high levels and additional housing supply is needed. Housing market pressures are building in some other regions.

There are many uncertainties around the outlook. Internationally, these relate to the prospects for global growth, particularly around China, and the outlook for global financial markets. The main domestic risks relate to weakness in the dairy sector, the decline in inflation expectations, the possibility of continued high net immigration, and pressures in the housing market.

Headline inflation remains low, mostly due to low fuel and other import prices. Annual core inflation remains within the target range. Long-term inflation expectations are well-anchored at 2 percent. However, as we have previously noted, there has been a material decline in shorter-term expectations.

We expect inflation to strengthen as the effects of low oil prices drop out and as capacity pressures gradually build. Monetary policy will continue to be accommodative. Further policy easing may be required to ensure that future average inflation settles near the middle of the target range. We will continue to watch closely the emerging flow of economic data.

Macroprudential stable funding requirement and monetary policy

The Reserve Bank NZ, just released a paper “A macroprudential stable funding requirement and monetary policy in a small open economy” which considers the impact of the Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of long-term wholesale funding and deposits to fund their assets.

Central banks act as lenders of last resort to prevent liquidity pressures from becoming solvency problems. Liquidity provision by central banks, however, can lead to the problem of moral hazard. The availability of public liquidity reduces the incentive for banks to raise relatively expensive ‘stable’ funding such as retail deposits and long-term bonds, and leads banks to underinsure against refinancing risk. In periods when credit has grown rapidly, retail deposits have tended to grow more slowly, and banks have shifted toward less stable funding from short-term wholesale markets. The shift toward short- term wholesale funding increases the exposure of the banking system to refinancing risk, both by increasing rollover requirements and by lengthening intermediation chains through funding from other financial institutions. In response to the systemic liquidity stress experienced during the recent global financial crisis, extensive liquidity support was provided to banks, reinforcing incentives for moral hazard. Hence, stronger liquidity regulation has been proposed to increase banks’ self-insurance against liquidity risk.

The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of stable funding, in the form of long-term wholesale funding and deposits, to fund their assets. We introduce a stable funding requirement (SFR) into a small open economy model featuring a banking sector with richly-specified liabilities; deposits as well as short-term and long-term bonds. The SFR regulates the proportion of loans financed by the ‘stable’ component of the bank’s liabilities. The model is estimated for New Zealand, where a similar policy, the Core Funding Requirement, was adopted in 2010. A distinctive feature of the model is that it allows banks to issue short-term and long-term home currency-denominated debt overseas, in order to make loans in the small open economy.

We evaluate how the presence of the SFR alters monetary policy trade-offs between the volatility in inflation, and volatility in other variables such as output, interest rates and exchange rates. A higher SFR raises the share of long term foreign bonds on the banks’ balance-sheet and hence increases the economy’s exposure to shocks to the interest rate spread on long-term foreign debt. This in turn leads to macroeconomic volatility and hence worsens monetary policy trade-offs. However, since the SFR mainly affects the composition of bank funding rather than the cost, the SFR does not affect the transmission of other macroeconomic disturbances that do not affect the bank funding spread. Since bank funding spread disturbances have a negligible influence on the business cycle, the operation of monetary policy is little changed in the presence of the SFR. The additional macroeconomic volatility generated by the presence of the SFR can be diminished and monetary policy trade-offs can be improved if: (i) the central bank raises the interest rate to react systematically to increases in measures of credit growth in the economy and (ii) the SFR policy is varied over time to respond to credit growth.

Developments in financial market liquidity

The Reserve Bank of New Zealand today published a Bulletin article that looks at liquidity in financial markets.

In recent years, financial market participants have become increasingly worried that the level and resilience of financial market liquidity has declined significantly, raising concerns over the efficiency of markets and increased the risks associated with a liquidity shock.

This article reviews international research on the topic, and generally finds evidence for a decline in the level and resilience of liquidity, although it has been mixed across markets. We also assess liquidity conditions in the New Zealand government bond, funding and short-term money markets using common analytical measures of liquidity as well as drawing on discussions with numerous market participants. We find that liquidity has declined to varying degrees across the different markets, and while risks of a liquidity shock have risen, the decline has been manageable thus far.

Liquidity is a complex concept, with the term encompassing a range of ideas. There are three main types of liquidity in financial markets: market liquidity, which reflects the ability of market participants to execute large transactions at low cost with only a limited effect on the price; funding liquidity, which refers to the ability of an organisation (such as a bank) to raise debt as required at a reasonable cost; and monetary liquidity, which reflects the looseness of monetary conditions, in part owing to the stance of central banks. This article focuses primarily on developments in market liquidity, although funding and monetary liquidity are also discussed where relevant.

Market liquidity is important for the functioning of financial markets, helping to facilitate the efficient distribution of resources through the allocation of capital and risk. A lower level of market liquidity can reduce these efficiencies, potentially inhibiting economic activity. While the level of liquidity in a market is important, the resilience of liquidity in a market is also key, especially in the face of a shock. The IMF note that highly resilient market liquidity is critical to financial stability, because it means market prices are less prone to sudden sharp swings, and more likely to remain aligned with values determined by fundamental factors.

Growing concerns about liquidity from market participants have been stimulated by a number of “shock” events over the past few years. Events such as the October 2014 Treasury market “flash rally” and the April 2015 “Bund tantrum” saw rapid moves in bond prices over short periods of time that did not appear to be explained by fundamentals. These moves are seen by many as evidence of reduced liquidity in some key markets.

While bond market liquidity has been a key focus for several studies, liquidity concerns are not confined to this asset class. Foreign exchange markets have also been affected – including for the New Zealand dollar. For example, the NZD/USD cross rate on 25 August 2015 (NZ time) fell as much as three cents over 10 minutes, before quickly rebounding.

We found that international research into recent liquidity developments generally identified a decline in market liquidity, although this was not evident in all markets. There is also evidence that the resilience of liquidity has declined in some markets, increasing financial stability risks. The primary drivers for the decline in liquidity have been increased regulations on market makers and a changing market structure.

Extraordinarily easy monetary policy on balance has added to liquidity, and is likely masking the full structural decline in liquidity. This means lower financial market liquidity may become even more apparent when major central banks eventually tighten monetary conditions again.

The banks have noted that the ‘new issue premium’ they pay has generally increased over the past year, as global market uncertainty and volatility has increased, although these costs had been manageable thus far. The increase in cost can be illustrated below, which shows the spread above swap for senior unsecured five-year AA corporate bond yields, a similar type of debt to what banks issue. While there is the potential for liquidity problems to worsen over time, banks are actually in a relatively good position at present with their funding, in large part owing to the Core Funding Ratio regulations. This has meant that banks have a larger buffer in their funding, and if they do miss a window of funding owing to market conditions, then they are less exposed, particularly to rollover risk.

We examined liquidity developments in three key areas of New Zealand financial markets: the New Zealand government bond market, bank funding markets, and short-term money markets. Overall, we found that liquidity has declined across these markets, but to varying degrees. In New Zealand government bond markets, we found mixed evidence for declines in market liquidity, with one measure indicating declines, while others pointed to little change. Nevertheless, market makers we spoke to noted they had seen a decline in liquidity in the market, although had been able to ‘absorb’ it this far, allowing investors to trade as normal.

Nevertheless, risks have risen that additional market makers may choose to participate less in the market owing to an increased regulatory burden, exacerbating poor liquidity conditions further and raising costs for investors and the NZ government.

Funding liquidity in New Zealand’s bank funding market has only modestly diminished over the past year, owing primarily to greater market volatility caused by events such as the Greek crisis in 2015. However, these costs have been manageable thus far, and regulations such as the Core Funding Ratio and more conservative bank risk appetites mean that banks are more resilient than prior to the global financial crisis to shocks to funding markets.

Finally, we identified a notable decline in liquidity in New Zealand shortterm FX swap markets, which resulted in higher volatility and key interest rates being out of line with the OCR for longer. In short-term markets the effect of new regulation has caused some market participants to withdraw. In response, the Reserve Bank has chosen to increase its participation in the FX swap market, which appears to have contributed to an improvement in market conditions.