Supporting sustainable economic growth
through financial stability policy
Speech delivered to Citi Australia and New Zealand Investment Conference
October
On 16 2019, in Sydney
By Geoff Bascand, Deputy Governor and General Manager of Financial
Stability
Good morning everyone,
a
My thanks to Citi for the invitation for me to come here today and speak with you all - it's
pleasure to be here.
going to
Today I'm start by setting the scene to give you an understanding of where the
Reserve Bank of New Zealand is currently at in achieving both price and financial stability,
also going to
and I'm outline the risks that New Zealand is exposed to in a local and global
environment.
Setting the scene
The Reserve Bank of New Zealand's purpose is to promote the prosperity and wellbeing of
New Zealanders, and contribute to a sustainable and productive economy. For this speech I
want to mostly focus on how we promote sustainability by delivering on our objectives: price
stability, maximum sustainable employment, and financial stability, and the tools we apply to
help keep the economy productive.
Over the past thirty years, we have seen economic volatility decline following the introduction
of inflation targeting, with prices becoming more stable and remaining at relatively lower
levels (Figure 1).
The decline in inflation volatility during the inflation targeting era in New Zealand
Figure 1:
Over this same period we have also seen improvements in economic growth, as well as less
volatility in this growth (Figure 2).
Figure 2: Quarterly real GDP growth before and during the inflation targeting era
Source: Stats NZ, RBNZ calculations.
With monetary policy maintaining price stability and supporting maximum sustainable
employment, other policies we have are aimed at maintaining financial stability. What we
mean by 'financial
stability' is having a financial system that can withstand severe, yet
plausible, shocks and avoid financial crises. These crises can destabilise economic activity
and severely impact business and household income. Indeed, evidence from a wide range of
countries over many decades shows us that when crises do happen, they are immensely
damaging and can have long-lasting effects.1
Usually our price stability and financial stability policies are complementary. However, the
low interest rate world we live in complicates achieving both of our objectives, encouraging a
build-up of leverage in the financial system. The persistent decline in long-term and short-
term interest rates has supported very high levels of private sector leverage.
As shown in Figure 3 below, the credit to GDP ratio in New Zealand remains very close to
that observed just prior to the Global Financial Crisis (GFC).
Figure 3: Declining interest rates and increasing debt levels
Source: Stats NZ, RBNZ calculations.
Household debt as a proportion of disposable income has risen from 60 percent in the early
1990s to 166 percent across all households, and for households with mortgages, the
increase is even larger (Figure 4).
Figure 4: Debt to disposable income ratio in New Zealand
Source: Stats NZ, RBNZ Household Assets and Liabilities Survey, RBNZ estimates.
It's important to remember that
while extremely low interest rates have been commonplace
in the developed world for over a decade now, New Zealand's very low interest rate
environment is a more recent phenomenon. The Official Cash Rate (OCR) only dipped
below 2 percent (year average) in November 2016.
We know that some academic studies suggest that expansionary monetary conditions can
encourage lower lending standards and higher levels of leverage in the financial system.2
And, as we transition into this very low interest rate environment, we will continue to monitor
such vulnerabilities in New Zealand.
We recognise that the risks globally are high, and New Zealand is particularly vulnerable to
external events. Our economy is quite small - less than a fifth of the size of the Australian
economy, and just like Australia, New Zealand is heavily reliant on commodity exports and is
very open to financial capital flows. Commodity price movements in world markets determine
the value of our key exports, as well as the price we pay for our imports, particularly those that
are fuel-related. Monetary policy moves by foreign central banks may generate unfavourable
fluctuations in our exchange rates.
However, as Figure 5 demonstrates, the New Zealand economy has responded much more
than Australia to downswings in the global economy. In contrast to Australia, economic activity
in New Zealand contracted during the Asian crisis in the late 1990s, and the US subprime
mortgage crisis of the late 2000s that snowballed into the GFC. This is despite the fact that
the Australian terms of trade has been through dramatic escalations and downturns, while
New Zealand's terms of trade has experienced relatively less volatility around an upward
trending path (Figure 6).
Figure 5: Economic activity in New Zealand and Australia in the inflation targeting era
Source: Haver Analytics, RBNZ calculations.
Note: The data has been normalised to 100 in 1990 Q1.
In addition to the disruptions in the global economic environment, the New Zealand economy
is occasionally affected by weather-related shocks, such as droughts, that constrain the
agricultural sector. In the past, we have also suffered severe damage to our infrastructure due
to earthquakes.
So when the Bank sets monetary and financial stability policy, it needs to balance concerns
about these different- and sometimes conflicting - domestic and international influences.
Figure 6: The terms of trade in New Zealand and Australia in the inflation targeting era
Note: The data has been normalised to 100 in 1990 Q1.
Mortgage lending in New Zealand is dominated by floating and short one to two-year fixed
rate mortgages (Figure 7). This implies that the changes in the domestic policy rate and
international bank funding market rates pass through to the effective mortgage rates relatively
quickly, and influence the demand for housing and house prices in New Zealand.
Figure 7: Time to re-price on housing loans in New Zealand
Source: RBNZ Bank Balance Sheet Survey, RBNZ Standard Statistical Return, RBNZ calculations.
When interest rates are low, households can accommodate a higher level of debt for given
incomes; though they remain susceptible to adverse macroeconomic shocks.3 For example,
if bank funding costs escalate due to distressed offshore funding markets, lending rates in
New Zealand would rise, and households may find it hard to service debt.
On another front, elevated dairy prices encouraged investment in dairy farms, leading to high
It's worth noting that
debt levels in the agricultural sector. agricultural debt in New Zealand
has increased from $5 billion in 1990 to $63 billion today. Two thirds of this debt is owed by
New Zealand's agricultural export revenue fell due to a weakening of global
dairy farms. If
demand or a domestic drought, the contraction of economic activity in that sector could spill
over to lower income and spending in the household sector, thereby increasing debt defaults.
That's why
maintaining financial stability in this highly vulnerable environment is challenging.
Minor events appear manageable, but we need to be prepared for major shocks, and it is here
that our financial stability policies are centred, including our proposals to increase bank capital
requirements.
Reserve Bank of New Zealand's
The approach to financial stability
Our approach to financial stability is dynamic, and we focus on building financial system
resilience (Figure 8). We recently renewed our approach to financial stability4 to recognise
that the financial system is constantly evolving, as are the risks and challenges. Our baseline
settings are not set-and-forget, we adapt them as risks and the resilience of the financial
system evolve.
The Reserve Bank's
Figure 8: approach to financial stability
Based on our understanding of the financial system, we can enhance resilience by
establishing rigorous baseline requirements and adapting them as necessary. Table 1 lists
the range of prudential and macro-prudential instruments available to us. For example, we
can increase capital buffers for banks, or we can tighten Loan-to-Value Ratios (LVRs) if risks
related to household indebtedness are excessively heightened. We can also adjust liquidity
requirements for banks to ensure they remain solvent.
As a central bank, it's imperative that we have
a full range of tools that we can use if needed
to ensure the financial system remains stable.
The Reserve Bank's
Table 1: prudential toolkit
Purpose Relevant tools Impact on financial system resilience Impact on wider economy
More resilient households and banks
Macroprudential policy Borrower restrictions reduce potential severity of an economic
(LVRs) downturn
Reduce risk that the Reduced losses in a severe economic
financial system amplifies a downturn
Prevention
severe economic downturn Lowers incentives on banks to
Capital and liquidity deleverage in a downturn; supports
Crisis
instruments higher credit supply and economic
Supervision,
(CCyB/SCR) activity
Capital buffers
Prudential policy
oversight
Banks remain solvent through the Maintains market confidence
Liquidity policy
Maintain baseline resilience economic cycle and lowers risk of sudden increases in
and
of the financial system funding costs for households,
Governance and local
businesses and the economy
incorporation
Collateral standards
disclosure
Banks remain functioning parts Maintains availability of credit and
Manage and limit impact of Outsourcing of financial system banking services necessary for
distress or failure economic activity
Open Bank Resolution
Management
Mitigates costs for creditors and
taxpayers
Crisis
Minimum capital Losses absorbed first by shareholders
Depending on the situation, we choose the appropriate regulatory tool to address the
identified risk to financial stability, bearing in mind efficiency costs, the level of effective self
and market discipline, and the regulatory framework as a whole. We adapt tools in response
to unsustainable booms in credit and asset prices in order to reduce the likelihood of crises.
But crisis prevention is by no means assured. As history tells us, crises come from
unexpected sources and are hard to predict. So we need robust standards to maintain
resilience. Minimum capital and liquidity requirements are essential tools for this purpose.
We also need tools to manage the consequences if our financial institutions are unable to
-
survive a period of stress or crisis our crisis management regime that is under review as
part of Phase 2 of the Review of the Reserve Bank Act.
Our holistic approach to macroeconomic and financial stability
As I mentioned earlier, the New Zealand economy is in a good space. Since the beginning of
inflation targeting, macroeconomic volatility in general has declined. Inflation is just below the
mid-point of the target band, and employment remains around its maximum sustainable level.
But we are wary of potential challenges to macroeconomic management.
The OCR is currently set at 100 basis points, a historically low level in New Zealand, in order
to achieve our monetary policy objectives. Lower rates still may be needed to achieve our
inflation and maximum sustainable employment objectives. The Reserve Bank is undertaking
further preparatory work on less conventional monetary policy tools5 that are available, in the
event that the policy rate is pushed down to its effective lower bound. Novel monetary policy
tools, such as large scale asset purchases and targeted term lending that have been
previously used in the United States and the United Kingdom, are tailored to support economic
activity by strengthening credit growth.
However, a highly stimulatory monetary policy stance may lead to over-exuberant levels of
credit growth, and as seen in empirical studies in the international literature, may lead to lower
lending standards. If looser monitoring standards prevail on the supply of credit, the
macroeconomic costs of a severe downturn may be amplified. Macroprudential policy can help
to manage the movements in credit so as to ensure that macroeconomic booms and busts
are not excessively volatile.
Our assessment of financial stability risks is more nuanced than debt levels per se. We look
at the distribution of debt as well as its growth rate, and the sustainability of the asset values
it is attached to. While we are concerned about the levels of debt in parts of the household
and agriculture sectors, there is scope for more borrowing and investment to take place in less
leveraged areas. Our restrictions on high loan-to-value ratio (LVR) lending (one measure of
high risk lending) are one tool we have that can moderate financial stability risks even while
the stock of household debt is rising.
is a key part of building New Zealand's
More capital economic resilience
In December 2018, we proposed to increase bank capital requirements in New Zealand, to
increase the overall resilience of the banking sector to economic shocks. We proposed that
the capital framework should be set so that banks have sufficient capital to withstand a 1-in-
200 year event.
Some have questioned why we are proposing this increase in capital, given the perceived
impacts it could have. So let me explain - first and foremost, from a societal point of view,
setting capital requirements is a long-term game. The benefits of more capital essentially
5
Hawkesby (2019)
result from avoiding future economic and social costs that would arise from a financial crisis
and resulting economic recession (Figure 9).
Figure 9: A conceptual framework relating financial stability to economic output
Expected
Capital requirements that maximise
economic output
expected output (but the level of stability
Trading lower expected
(GDP)
may still be too low)
output for more stability
(though expected
output still higher than
current settings)
Stability and output
combination implied
by current minimum
requirements
Less stable More stable
Financial stability
We targeted a high level of resilience to withstand severe shocks because the costs of
severe crises are very high, while international evidence indicates that the costs of buying
additional insurance are modest. Moreover, we would transition to this higher level of
resilience over time.
For shareholders, the increased equity funding may result in lower returns per dollar
invested, but the flip side for them is a safer investment. Also, it is worth recalling that capital
requirements aren't like other in that they don't create an 'expense' for banks.
regulations,
Indeed, in an accounting sense, interest expenses would reduce for the same level of
funding. And as with most investments, less leveraged businesses earn lower but more
stable returns. We anticipate the same for banks to an extent, and past history does indeed
suggest there is a relationship (Figure 10).
30% 9.00%
8.00%
25%
7.00%
20% 6.00%
5.00%
15%
4.00%
10% 3.00%
2.00%
5%
1.00%
0% 0.00%
Return on Tier 1 Capital Tier 1 Capital to Tangible Assets (RHS)
12 month average 12 month average
Source: RBNZ GDS Survey Data, RBNZ calculations.
Determining appropriate capital requirements is, of course, more than just counting the
benefits. The upsides must be balanced against the downside of higher interest rates. We've
anticipated that there will be a 20 to 40 basis point increase in bank margins in the long term
as a result of these proposals.6 While these are relatively small numbers, they will ultimately
have an impact on investment and spending in the New Zealand economy.
Our approach from the outset has been to set capital requirements at a level where we can
be confident that these costs are outweighed by the benefits of a safer financial system.
To calibrate our proposals for New Zealand, we drew on many pieces of analysis. These
included international literature, stress test results and historical New Zealand data on bank
losses and loan performance.
Currently we are reviewing all inputs and modelling assumptions, and carefully assessing
submissions, before finalising the plans that will be announced in December. As well as the
overall level of capital, we are also re-examining all other aspects of the Review, such as the
quality of capital (capital instruments) and the transition path to the new requirements.
A well-capitalised banking system also means that our banks will be able to
access global funding markets, even in stressed conditions
While higher levels of bank capital cannot stop economic fluctuations, it can help banks with
even the more moderate downturns, not just the 1-in-200 year event we calibrate to.
Research suggests that well-capitalised banks have easier access to funding than their more
7
leveraged peers during turbulent times. For the economy, this means a weakly capitalised
banking system can undermine monetary policy responses to economic downturns as banks
may struggle to pass through lower interest rates with their cheaper funding sources drying
up.
Conversely, a well-capitalised banking system is less likely to face funding issues during
these downturns and we would anticipate a much more orthodox response to monetary
policy in the economy. Bank capital requirements also can have a more direct role in
responding to these economic fluctuations through a counter-cyclical buffer.
Having a well-capitalised banking system in New Zealand, given we are a net importer of
-
capital, also means that our banks and the wider economy - will be able to continue to
access global funding markets even in times of financial stress.
Of course, we are listening to what others are saying about our proposals. We've been
consulting with the public and many of our stakeholders to fully understand the impacts they
believe an increase to capital requirements will have. We've commissioned three
internationally recognised experts to review the proposals, which have been published on
and are being considered, and if we've
our website. All of these views have been captured
got it wrong, we'll make adjustments to reflect that because it's important
that we get this
right.
The international dimension
We set our capital requirements according to the New Zealand specific risk environment, but
we also acknowledge how we 'stack up' internationally, and why we may need a more
capitalised banking system than those in other countries.
We have previously compared our proposed capital levels with Basel Committee estimates
and Poor's (S&P)
and Standard methodology, placing our proposals around the top quartile.8
Since September 2019, S&P's assessment of economic risks in New Zealand has improved.
They viewed that the moderation of house prices since 2017 has reduced the likelihood of a
severe house price correction and with it, the potential losses banks may face in such a
- that's
scenario good news. Our financial stability risks have reduced due to a slowing
housing market, and our LVR policy has contributed to that.
The improved country rating means that the New Zealand banks' capital positions using
S&P's
risk-adjusted capital (RAC) ratio have improved.9 Our Capital Review proposals would
mean that the banks' S&P RAC ratios would increase further still, towards being
among the
best capitalised banks across a range of peer countries (Figure 11).
-
Figure 11: S&P RAC ratio comparison of the four largest New Zealand banks to large
banks in peer countries (October 2019)
20 20
S&P RAC ratio
(%)
18 18
16 16
14 14
12 12
10 10
8
Range
Asset-weighted average
6420 86420
Source: Standard and Poor's, RBNZ
calculations.
8
Bascand (2019b)
Notes: New Zealand (post-CR) shows an estimate of the RAC ratios of the four largest New Zealand banks
assuming the Capital Review proposals are implemented as consulted on, plus a 1% management buffer.
Comparator banks include Erste Group, Raiffeisen Bank International, Bank Austria (Austria), ANZ Banking
Group, Commonwealth Bank, National Australia Bank, Westpac Banking Corporation (Australia), Česká
spořitelna, ČSOB, Komerční (Czechia), Danske Bank, Jyske Bank, Nykredit Realkredit (Denmark), Nordea, OP
Corporate (Finland), Bank of East Asia, Bank of China (HK), Hang Seng Bank, Hongkong and Shanghai Banking
Corporation, ICBC (Asia), Standard Chartered HK (Hong Kong), Allied Irish Banks, Bank of Ireland, Permanent
TSB (Ireland), Hapoalim, Leumi (Israel), Arion, Íslandsbanki, Landsbankinn (Iceland), ABN AMRO, ING,
Rabobank (Netherlands), DNB Bank (Norway), ANZ New Zealand, ASB Bank, BNZ, Westpac New Zealand (New
Zealand), SEB, Handelsbanken, Swedbank (Sweden), DBS, OCBC, UOB (Singapore).
We realise that the slowdown in the New Zealand housing market may be a cyclical rather
than a structural change. In the longer term, we remain vulnerable, especially if household
indebtedness continues to grow. This is why we need policies that aim to ensure enduring
resilience in the financial system. Indeed, in their assessment, S&P note that New Zealand's
economic imbalances remain somewhat elevated because of persistent current account
deficits, high external debt, and an economy that is exposed to fluctuations in commodity
prices.
Relationship with Australia
Our conservatism, relative to Australia, in our bank capital proposals reflects the higher
macroeconomic volatility that we have endured, as I pointed out earlier. However, we have
been, and will continue to work closely with APRA. We continuously update one another on
our prudential regulations, we maintain a strong working relationship, and we also respect
each other's objectives as regulators aiming to
protect our respective financial systems.
Conclusion
With New Zealand's macroeconomic policy framework and strong financial sector
soundness, investors can have long-term confidence in New Zealand as an investor
destination. The prospects of sustainable and productive growth are enhanced through
predictable macroeconomic policy settings and avoidance of financial crises.
New Zealand's economic performance
Economic and other shocks have constrained
historically. Although our macroeconomic stability has improved in recent decades, we
remain vulnerable to external and domestic disturbances. Overall debt levels remain high
while the concentration and persistence of high-leverage within segments of the household
and agricultural sectors questions the quality of banks' lending standards.
The more enduring that low interest rates are, and the more successful they are in promoting
borrowing and investment, the more they are likely to pose challenges to the Reserve Bank's
financial stability objectives.
The Reserve Bank has a number of tools it applies to manage financial stability risks, and its
LVR policies have a role in limiting the risks that could arise from increasing leverage
through inadequate lending standards.
building New Zealand's economic resilience
More capital is a key part of for when severe
shocks do occur. We are in the process of weighing up the costs and benefits of how much
more and the type of capital that is appropriate for the desired level of resilience, and the
timeframe to achieve it. Decisions on the Capital Review are expected to be released in the
first week of December.