over a longer period would be likely to reveal rates of return more in line with the banks ’ international counterparts. there have certainly been periods when new zealand bank profits have been weaker most notably in the early 1990s following the commercial property downturn. another potential explanation relates to the higher cost of capital facing new zealand. riskfree interest rates have been consistently higher in new zealand than in most other countries, and this could account for part of the higher observed rate of return in new zealand. moreover, the degree of support that the major new zealand banks receive from their australian parents allows them to maintain lower capital levels than would otherwise be the case to maintain their credit ratings. nevertheless, the capital ratios of new zealand subsidiary banks are similar to those of the australian parents, and it remains an open question why the australasian banking system as a whole has been relatively profitable. some work we have done comparing the margins that banks charge on some financial products like residential mortgages suggest that the new zealand banks have not earned interest margins that are particularly high relative to other countries. this would support the view that strong profitability was due to low operating costs rather than undue market power being exercised over customers. however, a comparison across the full range of financial products is difficult due to a lack of comprehensive data and other country differences. bis central bankers ’ speeches clearly, operating conditions for the banks have changed profoundly since the financial crisis. it is still too early to be definitive about how this will affect financial performance over the years ahead. in terms of bank shareholders, regulatory changes designed to create safer banks might be expected to lower required rates of return over time. however, a host of other structural changes will also have a bearing on returns. in the past three years, bank balance sheets have shown little growth, with households and businesses choosing to curtail debt and save more. if this trend endures, banks will have less opportunity to generate higher profits through balance sheet expansion. a combination of higher risk aversion, global regulatory changes and sovereign debt issues have led to a rise in the cost of debt funding for banks although where these costs are likely to settle in the longer run is uncertain. the higher funding costs have encouraged some large corporates to raise funds directly in the capital markets in lieu of the banks and it will be interesting to see whether this trend continues. the banks ’ ability to recover higher funding costs from customers will depend partly on the strength of loan demand as well as competitive pressures from other parts of the financial

a new zealand operation. as you know, there has been a very large amount of investment of this kind going back over many years - in banks, insurance companies, and manufacturing - while in recent years the rate of foreign direct investment has, if anything, increased - in telecommunications, food processing, hotels, forestry, commercial property, and transport. in addition, there has been an increasing flow of so - called portfolio investment from overseas - non - controlling investment in new zealand equities, a huge investment in new zealand dollar government securities, and most recently a very large investment in new zealand dollar securities issued by overseas corporations and governments, the eurokiwi and samurai bond issues. these eurokiwi and samurai issues have, through the swap market, provided new zealand banks with attractively priced fixed - term funding, keeping longer - term interest rates lower than they would otherwise have been and making possible the recent rapid growth in the fixed interest rate home mortgage market. new zealanders ’ enthusiasm for borrowing but if this desire to invest in new zealand on the part of foreigners had been the whole story, we might have expected to see interest rates in new zealand at levels equal to or even below interest rates abroad, and asset prices - share prices in particular - at high levels by world standards as the impact of the abundant overseas capital swamped our small economy and readily met new zealanders ’ demand for funds. instead, while new zealand interest rates have been very much lower in recent years than would have been the case had there been no capital inflow, they have tended to be higher than those in major capital markets, whether measured in nominal terms or in inflation - adjusted terms. the prices of shares and commercial property have tended to increase more slowly than those in many overseas countries. this suggests that, while foreign investors have been happy to provide capital, many have done so because new zealand has offered unusually attractive yields. what is striking is the willingness of new zealanders to pay those yields. at least part of the reason must lie in a strong demand for additional funds within new zealand. to some extent this demand has reflected strong investment activity in the corporate sector, as recent reforms have opened up profitable investment opportunities or have obliged companies to invest in cost - reducing facilities to improve their competitiveness. there has also been a strong cyclical recovery in investment spending after the 1991 recession. strong investment spending widens the current account deficit in the short - term, but as long as that investment turns out to be profitable,