Risks facing financial system have increased

New Zealand’s financial system continues to perform well despite a deterioration in the outlook for global financial stability and increased risks related to the dairy and housing sectors, Reserve Bank Governor, Graeme Wheeler, said today when releasing the Bank’s November Financial Stability Report.

“Global economic growth has softened over the past six months, and uncertainty over the path of economic and financial adjustment in China has helped to depress 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. This environment creates risks for the New Zealand banking system, which remains reliant on the global markets for funding.

“The dairy sector faces a second consecutive season of weak cash flow due to low international dairy commodity prices. Prices have shown some recovery since August, but many indebted farms are coming under increased pressure, which would be exacerbated if low dairy prices are sustained or dairy farm prices fall significantly.

“House price growth in Auckland has increased strongly with house price-to-income ratios in the region now comparable to those seen in some of the world’s most expensive cities. Rising investor activity has been an important driver of price developments, and international evidence suggests that investor loans have a higher tendency to default in the event of a major downturn in the housing market.

“A sharp downturn could challenge financial stability, given the large exposure of the banking system to the Auckland housing market. While it is still too early to judge the effect of recent policy changes, they are expected to help moderate pressure on Auckland house prices, and will improve the resilience of bank balance sheets to a housing downturn.”

Deputy Governor, Grant Spencer, said that “Banks hold strong capital and liquidity buffers and have maintained their profitability with further reductions in cost-to-income ratios. Lending growth to households and businesses has picked up and is being funded mainly through higher domestic deposits.

“The banks are working with dairy farmers experiencing difficulty, and it is important that they continue to take a medium-term view when assessing farm viability. The banks’ losses on dairy exposures are expected to be manageable but banks need to ensure that they set aside realistic provisions for the likely increase in problem loans.

“New rules on Auckland residential investor loans came in to force on 1 November. The bulk of these loans are now required to have a loan-to-value ratio (LVR) of no more than 70 percent. Banks are also now required to put residential property investment loans in a separate asset class and hold more capital against them.

“LVR restrictions have been eased outside of Auckland where housing market activity has been more subdued. However, the Bank is closely monitoring the recent rises in house price inflation in some areas such as Hamilton and Tauranga.

“The Reserve Bank has a number of other regulatory initiatives in train. Public consultation has recently closed on a stocktake of banking regulations and a summary of submissions will be published shortly. We have recently released a consultation paper proposing changes to the outsourcing policy for banks. And we are also well advanced on an improved oversight regime for payment and settlement systems.”