Policy report

New Zealand: financial system stability assessment

9 May 2017

Executive Summary

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.

Despite these vulnerabilities, the banking system is resilient to severe shocks. Results of stress tests and sensitivity analysis across all relevant risk factors indicate that the solvency and liquidity of the banking system can withstand adverse and severe shocks. In addition, there is a limited impact of solvency and liquidity contagion from direct exposures to banks and nonbank financial institutions, common holdings of securities, and market contagion. That said, the results from stress tests, although a useful supervisory tool, need to be interpreted with caution and the authorities can strengthen the financial sector oversight and crisis preparedness frameworks to further improve the resilience of the system.

Strengthening the macroprudential framework is important. The financial system is dominated by four major banks with similar business models in which the majority of assets are associated with housing loans. Direct exposures among them are relatively limited, but the potential for spillovers is elevated. Credit has resumed strong growth during the last few years, putting pressure on funding and increasing concerns with the housing sector. So far, the authorities have applied exposure limits to loans with high loan-to-value ratios (LVR) which, while strengthening the profile of banks’ portfolios, have had limited effects given rising housing prices. Adding a debt-to-income cap to the macroprudential toolkit would enhance systemic resilience by limiting the risks from growing household indebtedness. Imposing additional loss-absorbency requirements for domestic systemic banks, and allowing an effective accountability of the RBNZ without jeopardizing the integrity and independence of its macroprudential decision-making process are also recommended.

The approach of the RBNZ to supervision should be strengthened by increasing the weight of regulatory discipline in its three-pillar framework. The RBNZ approach to supervision relies on three pillars: self, market, and regulatory discipline. The authorities have strengthened regulatory discipline since the last FSAP, but the three-pillar framework should be improved by adopting a more intensive approach to supervision. This would increase the ability of supervisors to be proactive to exercise regulatory discipline and obtain reliable information to enforce self- and market-discipline. The RBNZ is encouraged to issue enforceable supervisory standards on key risks, review the enforcement regime to promote preventive action, and initiate on-site programs targeted on areas of high risk. In addition, clarifying the responsibilities of the Treasury and RBNZ on financial sector issues and reinforcing the role and autonomy of the RBNZ as prudential regulator and supervisor would enhance the ability of the RBNZ to respond swiftly to ongoing and emerging risks.

Increasing supervisory resources for all financial sectors is key. This would support the highly qualified RBNZ staff in improving the effectiveness of the supervisory process, enhancing their knowledge of financial institutions’ operations, and deepening risk assessment of supervised entities—and strengthening their ability for early preventive action.

The proposed reforms to the regulatory and oversight framework for Financial Market Infrastructures (FMIs) will get New Zealand broadly on par with international standards. The proposed regime will provide the authorities with the legal basis for the oversight of systemically important FMIs, and with a graduated range of enforcement, crisis management, and regulatory powers. The authorities are encouraged to adopt international principles for FMIs in secondary legislation to provide for a transparent set of requirements to the industry and allow a consistent implementation of international standards among all systemically important FMIs.

The reform of securities market regulation significantly improved the framework, but further enhancements are required. The review of the regulatory framework was instrumental in implementing key reforms, including the establishment of the FMA as conduct regulator. The new regime governs how financial products are offered, promoted, issued and sold, and introduces licensing for providers of certain products, including managers of retail funds. The regulatory perimeter could be reviewed to include wholesale asset managers and custodians, whose activities will become more relevant as the asset management industry matures, bringing potential new risks. There is also a need to enhance conduct regulation in the insurance sector.

The crisis resolution framework needs to be enhanced further. The Open Bank Resolution (OBR) framework, which aims to avoid the use of public funds when resolving systemically important banks, is a step in the right direction. To enhance its credibility and strengthen the financial safety net, the introduction of deposit insurance would be the best option. Absent support for deposit insurance, a second option is to legally establish a de minimis exemption from freezing and haircutting deposits in OBR, set at an appropriate level. The decision-making process in a crisis and the exercise of resolution powers need to be clarified. The RBNZ should be the sole resolution authority, with clear mandates and responsibilities, requiring the approval of the Minister of Finance (MoF) only for resolutions with fiscal or systemic implications.

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 TransTasman 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.

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