Financial Stability Report May 2016 HE ERVE Reserve Bank of New Zealand Financial Stability Report Subscribe online: http://www.rbnz.govt.nz/email-updates Report and supporting notes published at: http://www.rbnz.govt.nz/financial-stability/financial-stability-report A list of registered banks’ credit ratings is published at: http://www.rbnz.govt.nz/regulation-and-supervision/banks/prudential-requirements/credit-ratings Registered banks’ balance sheet information is published at: http://www.rbnz.govt.nz/statistics/s1 Copyright © 2016 Reserve Bank of New Zealand This report is published pursuant to section 165A of the Reserve Bank of New Zealand Act 1989. ISSN 1176-7863 (print) ISSN 1177-9160 (online) ii RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Financial Stability Report May 2016 Contents 1. Overview 2 2. Systemic risk and policy assessment 4 3. The international environment and financial markets 14 4. Financial risks to the New Zealand economy 24 5. Financial institutions and infrastructure 38 6. Key developments in financial sector regulation 56 Appendices 1. Reserve Bank enforcement 64 2. Presentations November 2015-April 2016 64 A. Initial impact of adjusted LVR restrictions 12 B. Dairy farm land valuation – an examination based on price multiples 35 C. Results of the 2015 common scenario ICAAP stress test 51 D. Recent developments in household deposits 54 Boxes RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 1 Chapter 1 Overview The New Zealand financial system remains resilient and continues to perform its functions effectively. Bank capital and liquidity buffers are strong relative to current regulatory minimums. Despite a modest increase in loan loss provisioning in recent quarters, bank profitability remains close to post-crisis highs. However, risks to the financial stability outlook have increased in the past six months. The outlook for the global economy has deteriorated, causing an increase in financial market volatility earlier this year. Economic growth is slowing in a number of key trading partner economies and inflation is weak. Interest rates remain extraordinarily low as central banks maintain highly accommodative monetary policies, including in the US where the expected pace of policy tightening has slowed. The outlook for the Chinese economy remains particularly challenging given high levels of indebtedness and ongoing capital outflows. In Europe, low growth and inflation persist while legacy problem loans and negative interest rates weigh on bank profitability. Credit spreads have widened, placing upward pressure on the cost of funds for New Zealand banks. Soft global growth and momentum in global commodity production have contributed to weak prices for New Zealand’s commodity exports. Dairy prices remain low with global dairy supply continuing to increase. Many farmers now face a third season of negative cash flow with 2 heavy demand for working capital. Problem loan levels are expected to increase significantly over the coming year, although losses in the banking sector are likely to be absorbed mainly with profits. Imbalances in the housing market continue to increase, contributing to financial stability risk. The Reserve Bank’s restrictions on loan-to-value ratios (LVRs) have reduced the share of risky lending on bank balance sheets. Along with government tax measures introduced in October, the recent investor LVR restrictions led to a cooling in the Auckland housing market in late 2015 and early 2016. However, Auckland prices remain stretched relative to incomes and recent data suggest that price pressures are re-emerging. House prices have also begun increasing strongly in a number of regions across New Zealand, although house price-to-income ratios are generally much lower than in Auckland. The Reserve Bank is closely monitoring developments to assess whether further financial policy measures would be appropriate. Reducing the imbalance between housing demand and supply in the Auckland region remains essential if house price appreciation is to be contained over the longer term. Increasing housing supply is key and further efforts on a range of fronts should be considered to address the supply and demand imbalance. These include measures such as decreasing impediments to RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 densification and greenfield development, and addressing infrastructure and other constraints to increased housing supply. the IMF’s Financial Sector Assessment Programme for New Zealand, which will take place later this year. 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 recently been released on crisis management powers for financial market infrastructures. The Reserve Bank, along with other government agencies, is preparing for Graeme Wheeler RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Governor 3 Chapter 2 Systemic risk and policy assessment Risk assessment Risks to the financial stability outlook have increased… The financial system continues to face three key risks, as identified in the November Report. While the balance of these risks has shifted over the past six months, overall risks to the financial stability outlook have increased. Global financial markets experienced heightened volatility between December and February, as perceived risks to global growth increased. The cost of obtaining wholesale funding for New Zealand banks has increased. Global dairy prices have remained low for longer than expected, with dairy farmers now likely to face cash flow pressure for a third consecutive season. This has contributed to further increases in dairy sector debt. Auckland housing market pressures have moderated but remain a serious risk to financial stability, with prices remaining elevated relative to incomes and rents. …but the financial system remains resilient. Although risks to the outlook have increased, the financial system remains resilient. Capital ratios are at or near recent highs (figure 2.1), and are above current regulatory minimums. Banking system profitability is also high by post-GFC standards, providing an additional buffer to absorb losses in a period of stress. Funding and liquidity buffers also exceed required minimums, which enhances resilience to potential funding market disruptions. Figure 2.1 Regulatory capital ratios – locally incorporated banks (% of riskweighted assets) 16 Capital conservation buffer Minimum Tier 1 Total capital ratio Tier 1 capital ratio CET1 ratio % 14 12 % 16 14 12 10 10 8 8 6 6 4 4 2 2 0 2000 2003 2006 2009 2012 2015 0 Source: Registered banks’ Disclosure Statements. 4 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Financial markets have experienced periods of volatility… Financial market conditions deteriorated following the November Report amid uncertainty about the global outlook. Market volatility increased over the period until February as changes in the economic outlook and risk sentiment prompted large movements in equity prices and sovereign bond yields (figure 2.2). Increased risk aversion also saw credit spreads widen, particularly for high-yield bonds. These movements were amplified by reduced liquidity in key financial markets. Figure 2.2 Global equity markets and volatility Index 130 Equity market volatility (RHS) US equity prices Europe equity prices Japan equity prices Index 50 40 110 30 90 20 70 50 Jan-14 10 Jul-14 Jan-15 Jul-15 Jan-16 0 particular, further build-up in corporate debt from already elevated levels, falling profitability of state-owned enterprises, rising non-performing loans, and the potential for renewed capital outflows pose downside risks to the outlook. Broader economic drivers have also contributed to the deterioration in sentiment. Concerns about growth in other emerging markets and the euro area have increased. Commodity prices have picked up but remain historically low, reflecting weak global demand and continued strong supply. There has also been growing unease about the effectiveness of negative interest rates in Europe and Japan and their impact on financial sector health. Finally, the pace of monetary policy tightening in the US remains highly uncertain. …increasing bank funding costs. The heightened volatility early in the year contributed to higher funding costs for New Zealand banks. This has continued the trend from 2015, with the cost of issuing in both domestic and offshore long-term markets having increased to the highest levels since early 2013. There is a risk that the cost of long-term wholesale funding could increase further if heightened market volatility returns. Source: Bloomberg. Note: S&P 500, Stoxx 600 and Nikkei 225 indices have been rebased to equal 100 in January 2014. Equity market volatility is the VIX index. While market sentiment has recovered more recently, many of the factors that prompted the earlier deterioration remain relevant. Heightened volatility can be partly attributed to concerns regarding Chinese growth and uncertainty about China’s foreign exchange policy. While the Chinese authorities have acted to support near-term growth through easier monetary policy, the risk of a further slowdown remains. In RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 This situation may be exacerbated by the need to fund strong bank credit growth. Following the GFC, strong retail deposit growth and a moderation in credit growth from pre-GFC levels limited the need for banks to access higher cost long-term wholesale funding (figure 2.3). However, over the past 18 months, credit growth has accelerated across the household, agriculture, and business sectors, with aggregate credit growth now outpacing deposit growth. This may induce banks to compete more aggressively for retail deposits, or to increase their reliance on long-term wholesale funding, either of which could place upward pressure on bank 5 funding costs. Higher funding costs would keep lending rates up relative to the OCR and short-term wholesale rates. Figure 2.3 Annual increase in credit and deposit funding (% of GDP) 25 % % Credit 25 Figure 2.4 Fonterra payout and global dairy prices Fonterra payout (RHS) GDT price index (USD) GDT price index (NZD) Index 400 $/kgMS 10 8 300 6 Deposits counted as core funding 20 20 15 15 10 10 200 4 100 0 2000 2 5 5 0 0 Source: Bloomberg, Fonterra, GlobalDairyTrade (GDT). -5 Note: Payout figures in the chart include dividends. The 2015-16 payout refers to Fonterra’s latest forecast. Price indices have been rebased to equal 100 in January 2000. -5 2000 2003 2006 2009 2012 2015 2003 2006 2009 2012 2015 0 Source: Statistics New Zealand, RBNZ Liquidity Survey, RBNZ Standard Statistical Return (SSR). Note: ‘Deposits counted as core funding’ includes haircuts made as part of the liquidity policy, which increase according to the size of the deposit. The dotted line shows growth in deposits measured by the SSR, prior to the introduction of the liquidity policy. Dairy incomes remain under pressure… Global dairy prices remain low, with prices having fallen modestly since November (figure 2.4). Current weakness in dairy prices can be attributed to a range of factors, including concerns regarding Chinese growth, continued growth in European supply, and Russia’s import ban on EU dairy products. While the medium-term outlook for the dairy sector is favourable, with growth in emerging markets expected to be a key driver of increasing demand, the short-term outlook remains uncertain. Prices could remain low if European supply continues to expand in response to the recent removal of production quotas, or if relatively weak Chinese import demand persists for longer than expected. 6 Weak milk prices and a relatively stable New Zealand dollar have led to further downward revisions to the forecast payout for the 201516 season. In response, farmers have continued to reduce on-farm expenditures, particularly with respect to capital investment and supplementary feed. Nevertheless, the average farm would face its largest cash loss in the post-2000 period at Fonterra’s current estimate of a $4.30 payout, including dividends. While dairy incomes are expected to improve, most analysts’ payout forecasts for the 2016-17 season are below DairyNZ’s estimates of the current break-even payout. A third consecutive season of difficult conditions for farmers is looking increasingly likely. …exacerbating risks associated with dairy sector debt. Bank lending to the dairy sector has continued to expand, as farms have borrowed to meet working capital requirements (figure 2.5). Debt RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 positions are increasingly stretched, with the debt-to-trend income ratio approaching its 2009 peak. Demand for bank lending is expected to rise over winter when cash flow is seasonally low. Banks will have to balance the risk of over-extending credit with that of exacerbating the downturn through tightening lending standards. Figure 2.5 Bank loans to the dairy sector (June years) $bn 50 % Debt Debt-to-trend income (RHS) 40 400 300 30 200 Household sector risks remain elevated… Household credit continues to grow strongly, increasing by 7.7 percent in the year to March. As a result, the household debt-to-income ratio has increased to above 160 percent, beyond its pre-GFC peak (figure 2.6). Credit growth is likely to exceed income growth in the near term, resulting in higher debt relative to incomes. Low mortgage interest rates have helped to contain debt servicing costs but the household sector would be vulnerable to an increase in interest rates or an economic downturn. While a large increase in mortgage rates seems unlikely in the current global environment, a relatively small increase could put pressure on some borrowers. 20 100 10 0 2003 2005 2007 2009 2011 2013 2015 0 Source: DairyNZ, RBNZ Annual Agricultural Survey, RBNZ estimates. Note: Trend income is used to adjust for volatility in commodity prices and milk production. The trend payout is assumed to be $6.25 per kgMS in the 2015-16 season. Data for 2016 are forecasts based on private reporting data and DairyNZ production forecasts. Banks have been working with farmers by extending credit while encouraging them to contain costs and sell assets. There have been relatively few forced sales to date which, alongside low interest rates and a positive medium-term outlook, has provided some support for farm prices. Nevertheless, prices have fallen 13 percent over the past year and there is a risk of further price declines if cash flow pressures result in more forced sales. Figure 2.6 Household debt and debt servicing 200 % Household debt-to-disposable income % Household debt servicing ratio (RHS) 25 160 20 120 15 80 10 40 5 0 2000 2003 2006 2009 2012 2015 0 Source: RBNZ Household Assets and Liabilities, RBNZ SSR. Note: Household debt refers to household financial liabilities including debt secured against rental properties. The debt servicing ratio is implied interest and principal repayments on outstanding debt as a share of household disposable income. There are signs of a build-up in risk among new borrowers. For example, a large share of new lending is extended at high debt-to-income ratios. With gross housing lending flows remaining strong at around 35 percent RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 7 of the outstanding stock, this is being reflected relatively quickly in banks’ overall portfolios. …despite a slowing in Auckland house price inflation. In response to the financial stability risks posed by imbalances in the Auckland housing market, the Reserve Bank implemented an Aucklandinvestor LVR speed limit in November 2015. Alongside government policy changes and other factors that may have reduced demand for New Zealand residential property, this has seen annual Auckland house price inflation slow from 27 percent in September to 12 percent in March (figure 2.7, see box A). While this is a positive development, Auckland prices are still very high relative to both incomes and rents, and nearterm indicators suggest pressures may be returning to the market. Figure 2.7 Annual house price inflation (3-month moving average) 40 % 30 Ratio of Auckland-to-rest of NZ house prices (RHS) Auckland Rest of NZ Ratio 2.2 2.0 20 1.8 10 1.6 0 1.4 -10 1.2 -20 2000 2003 Source: CoreLogic NZ, REINZ, RBNZ calculations. 2006 2009 2012 2015 1.0 House price inflation has continued to increase in the rest of New Zealand, particularly in the areas surrounding Auckland. For example, prices in Hamilton and Tauranga are now growing faster than in Auckland. Data from CoreLogic show that some of the strength in these regions reflects a shift in purchases by Auckland-based investors towards nearby regions, which appears to be helping to relieve pressure from the Auckland market. Policy assessment Capital and funding buffers underpin financial system resilience... With risks to the financial system increasing, and bank balance sheets growing rapidly, it is critical that banks maintain sufficient capital and funding buffers. Recent stress tests of the major banks suggest that banks have sufficient capital to withstand a severe economic downturn (box C). However, banks report a significant tightening of lending standards in the stress scenario, which could materially worsen a downturn and exacerbate losses. While key prudential metrics remain above regulatory minimums, the increasing wedge between credit and deposit growth may require banks to make greater use of long-term wholesale funding markets if they are to maintain funding buffers at current levels. As noted in the previous Report, the Reserve Bank will begin a general review of bank liquidity requirements this year. A key purpose of the review is to determine whether greater harmonisation with the Basel approach would be beneficial. A review of capital requirements is also 8 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 planned, partly in response to the recent increase in Australian standards and ongoing reform of the Basel framework. Direct losses on dairy exposures are expected to be manageable… ...but banks will likely face an increase in stressed dairy loans. With the near-term outlook for the dairy sector uncertain, it is important that banks continue to monitor their loan-loss provisions and ensure that they are sufficient. Provisions relating to dairy exposures have increased modestly since November, consistent with the deterioration in the nearterm outlook. However, further increases in banking system provisioning will likely be necessary if NPLs increase as expected. The Reserve Bank expects banks to continue to closely monitor and manage the risks relating to their dairy exposures. As discussed above, banks have adopted a medium-term approach to assessing farm viability and are supporting farmers under short-term cash flow pressures. Nevertheless, with debt levels and servicing costs increasing, particularly for highly indebted farmers with higher break-even payouts, farmers are likely to face tighter borrowing constraints and further pressure to reduce costs. So far, non-performing loans (NPLs) have ticked up only modestly. Watchlist loans, which provide a leading indicator of NPLs, have increased more significantly, but remain well down on levels seen during the GFC. A further increase in NPLs is expected, unless the near-term outlook for the dairy sector improves materially. Late last year, the Reserve Bank conducted stress tests of the five largest dairy lenders to assess the banking system’s resilience to a sustained dairy sector downturn. The tests included two hypothetical stress scenarios, each featuring a sustained low payout and a sharp fall in dairy land prices (table 2.1). While scenario 1 may be broadly comparable to the current near-term market outlook, scenario 2 reflects considerably more adverse conditions. Table 2.1 Stress scenarios and estimated losses Fonterra payout ($ per kgMS) Dairy land prices (annual % change) Cumulative losses (% of initial portfolio value) Scenario 1 Scenario 2 Scenario 1 Scenario 2 Scenario 1 Scenario 2 3.75 4.75 5.25 5.75 6.00 3.00 4.00 4.50 5.00 5.50 -15 -10 0 0 0 -20 -15 -10 0 0 1.3 2.4 3.1 3.2 3.0 2.8 6.0 8.2 8.5 8.5 2015-16 2016-17 2017-18 2018-19 2019-20 Source: RBNZ assumptions. Note: Loss estimates are averages across the five largest dairy lenders. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 9 Both scenarios generated a significant increase in the proportion of loans written off, reflecting sustained pressure on farmers and land price declines. In the severe scenario, average losses were estimated to be 3 percent and 8.5 percent of dairy exposures under scenarios 1 and 2, respectively. While such scenarios would have a significant effect on dairy farms, the associated losses would be manageable for the banking system. Loan losses of this magnitude could be largely absorbed with bank earnings, with relatively little erosion of bank capital.1 …but potential losses contribute to collective financial stability risk. It is important to note that the stress test was designed to provide granular insights into risks associated with dairy lending. Spillovers to dairy support industries and potential stress in other sectors were not part of the exercise. Banking system losses would be much larger if broader macroeconomic weakness resulted in difficult conditions across several sectors. While increasing dairy sector risk may not pose a threat to financial stability in isolation, it comprises part of a significant overall financial stability risk when considered in combination with the current global outlook and elevated domestic household sector risks. The LVR policy is a significant mitigant to financial stability risk. in October 2013 to stem rising financial stability risks arising from the housing market at that time, limiting the share of new lending with LVRs exceeding 80 percent to a maximum of 10 percent. As a result, the stock of high-LVR lending has gradually declined, falling to 13 percent in December 2015 from a peak of 21 percent in 2013 (figure 2.8). Higher equity buffers for borrowers have increased the banking system’s resilience to a housing market downturn. The policy has also promoted financial stability by reducing the likelihood that a large number of borrowers would be forced to sell in a severe downturn. However, a relatively high share of new bank lending is still being undertaken at elevated debt-to-income ratios. Figure 2.8 Stock of high-LVR mortgages (% of total bank mortgage lending) 1 For more background and detailed results, see Dunstan, A (2016) ‘Summary of the dairy portfolio stress testing exercise’, Reserve Bank of New Zealand Bulletin, 79(5), March, http://www.rbnz.govt.nz/-/media/ ReserveBank/Files/Publications/Bulletins/2016/2016mar79-5.pdf 10 % 90≤LVR 80 5 50 40 30 30 20 20 May 2015 Nov 20 % Household Agriculture Business % 20 Tightening standards ↑ 10 10 0 Interest-only lending Nov Figure 5.16 Change in bank lending standards (net percentage) 0 60 40 May 2014 either sector, and expect to continue to work with dairy farmers facing temporary cash flow pressures. In the business sector, strong price competition has seen a further loosening in lending standards, but low margins are expected to generate some tightening over the coming six months. May 2014 Nov May 2015 Nov -10 -20 2010 -10 2011 2012 2013 2014 2015 2016 -20 Source: RBNZ Credit Conditions Survey. Note: Net percentage is the percentage of respondents reporting a tightening of lending standards minus the percentage reporting an easing. Individual bank responses are weighted by market share. The dotted line is the expected change six months ahead. Source: Based on private reporting data from 21 registered banks. Note: Interest-only and TDTI data are currently experimental, and are subject to revision. The Reserve Bank expects to begin regularly publishing data on interest-only mortgage lending around June. Banks report a tightening in lending standards in the household and agriculture sectors since the November Report (figure 5.16), in line with the investor LVR policy and downward revisions to the dairy payout. At this stage, banks are signalling no further near-term tightening in 2 These types of loan are considered more risky because the value of interest-only loans do not diminish over time and borrowers of high-TDTI loans typically have less scope to draw on income to meet potential increases in mortgage payments. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 45 Non-bank lending institutions (NBLIs) NBLI lending continues to grow from a low base. Figure 5.17 Annual change in NBLI lending by sector (March years) Non-bank lending institutions (NBLIs) include non-bank deposit takers, such as credit unions, building societies and deposit-taking finance companies, and non-deposit taking finance companies. The NBLI sector provides a small amount of lending to New Zealand households and businesses, and accounts for around 2 percent of private sector credit. 1 $bn $bn 0 0 -1 Other business Property Agriculture Consumer Housing Total -2 -3 -4 1 2011 2012 2013 2014 2015 2016 -1 -2 -3 -4 Source: RBNZ NBDT reporting, RBNZ SSR. Total lending by the NBLI sector has more than halved since the GFC, with total lending slightly over $11 billion at the end of 2015 compared to $23 billion at the end of 2007. The decline in housing-related lending was particularly pronounced, driven to a large extent by several NBLIs leaving the sector to become banks (figure 5.17). NBLI lending began to increase in 2014 and expanded by $136 million in the year to March 2016, with housing-related lending accounting for around $67 million of that increase (equal to annual growth of 7 percent). This increase is small by comparison to mortgage lending undertaken by banks, suggesting that there has not been material leakage from the LVR policy. 46 Note: Excludes assets of deposit-taking finance companies in receivership or moratorium. In the period shown on the chart, several large NBLIs left the sector and became banks. Insurance Global trends continue to shape local developments. Global trends, such as low interest rates, a relatively benign period of catastrophe events, and a plentiful supply of reinsurance capital continue to shape local developments. Global factors have led to increased competition in some lines of non-life insurance business, notably commercial property. In response, insurers are seeking other ways to improve financial results, including through mergers and acquisitions to achieve greater scale and diversification. Examples of recent merger activity include IAG’s consolidation of its brands AMI Insurance and Lumley General (NZ) Ltd under the IAG insurance licence, while Ace and Chubb, each separately licensed insurers in New Zealand, are now under common ownership. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Competitive pressures are also arising from developments in digital technologies such as new, smaller, players using new pricing models and distribution channels to compete with established insurers. This is prompting competitive responses from the larger insurers. Vero’s partnership with Warehouse Money allowing customers to obtain quotes and buy online is one example of a new distribution arrangement being introduced by an established insurer. Progress has continued on Canterbury earthquake claims. As at 31 March 2016, insurers have paid $29 billion in Canterbury earthquake claims (figure 5.18). This compares to $26 billion at the time of the November Report. While estimates of the total costs are uncertain, due to the complex nature of remaining claims, the Reserve Bank now estimates these to be $34-38 billion. Paid claims to date therefore amount to around 76-85 percent of the ultimate costs. Figure 5.18 Canterbury earthquake paid claims 50 $bn RBNZ estimated range of ultimate costs EQC Paid claims excluding EQC $bn 50 40 40 30 30 20 20 10 10 0 Apr-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 0 Insurance sector data collection is progressing. As noted in the November Report, the Reserve Bank is now receiving insurance sector data, with licensed insurers providing financial, solvency, and liquidity data. While the full range of data is not yet ready for use, available information from the Quarterly Insurer Survey can provide some insight into the composition of the New Zealand insurance sector. Based on premium revenue earned in the December quarter of 2015, general insurance constitutes more than 60 percent of reported large private insurer business in New Zealand (figure 5.19), while life insurance and health insurance represent around 25 and 13 percent respectively. New Zealand’s life insurance share of total insurance business is low by international standards, due in part to New Zealand’s well-developed welfare system and the use of life insurance as a tax efficient savings vehicle in other jurisdictions. The Reserve Bank plans to report on further Figure 5.19 Insurance policy and premium revenue earned by sub-sector (December 2015 quarter) 2500 $m $m 2000 2000 1500 1500 1000 1000 500 0 500 Total Life insurance General insurance Health insurance Source: EQC, RBNZ. Source: RBNZ Quarterly Insurer Survey. Note: Estimated range of ultimate costs does not include the full extent of potential costs of remediating faulty repairs/rebuilds, which are currently not well quantified. Note: Data include the 30 largest licensed private insurers, excluding Lloyd’s of London. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 2500 0 47 data in the November 2016 Report, and to eventually publish aggregate insurance sector statistics. Financial market infrastructure The Reserve Bank is investigating the cause of the problem and will take any necessary remedial action. Figure 5.20 Average daily ESAS transactions 000s 15 Number $bn Total value (RHS) 14 13 Payment and settlement systems have performed effectively. Payment and settlement systems play a key role in the New Zealand financial system. Over the past six months the most important of those systems have continued to perform effectively, processing transactions without significant incident. The Exchange Settlement Account System (ESAS) operated by the Reserve Bank is used to settle inter-bank New Zealand dollar transactions, including higher-value payments related to financial market transactions and the net value of retail payments. Given its importance to the financial system, ESAS must have the capacity to process all transactions submitted for settlement reliably. While the number of transactions processed in ESAS has increased modestly over the past year (figure 5.20), the number of transactions remains well within ESAS’s capacity. ESAS has also delivered the expected high degree of operational reliability in recent months (figure 5.21). On only one occasion was there a disruption to the normal operation of the system. On 4 April, although payments were still being settled, a system problem interrupted the delivery to participants of messages confirming settlement. Consequently banks did not know in a timely fashion when funds had been received. 48 35 30 12 11 25 10 9 Jan-15 Jul-15 Jan-16 20 Source: RBNZ. Figure 5.21 ESAS/NZClear availability and outages Minutes 400 Connectivity and communications related outages System performance related outages % 100.0 Availability (RHS) 300 99.9 200 99.8 100 99.7 0 2012 2013 2014 2015 2016 99.6 Source: RBNZ. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 The pattern of retail payments is changing. Reserve Bank to upgrade ESAS and NZClear. Although the exchange of the net value of retail payments between banks makes up only a small proportion of the total number of transactions settled in ESAS, the Reserve Bank has noted with interest the growing number of retail payment files being exchanged between banks using the Settlement Before Interchange (SBI) arrangements (figure 5.22). This suggests banks are exchanging files of retail transactions more frequently. Banks thus appear to be making progress on addressing the Reserve Bank’s concerns about the length of time taken to settle transactions after a payment instruction is issued by a customer and the value of unsettled transactions at any point in time. The Reserve Bank has also expressed concern about the majority of retail payments being settled late in the banking day. The banks have agreed to address all three matters by the end of this year. The Reserve Bank has begun work on replacing the existing ESAS technology with the aim of ensuring that the system remains reliable and can accommodate future changes in the New Zealand payments landscape. Also, after a strategic review of its securities settlement system, NZClear, the Reserve Bank has decided to retain the NZClear business and to invest in a new platform to provide securities settlement and depository services. The replacement of both systems will represent a major technology project that will require careful management. Figure 5.22 SBI-related transactions in ESAS (average files per day) Number 1000 Number 1000 900 900 800 800 700 700 600 600 500 Jan-14 Jul-14 Jan-15 Source: RBNZ. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Jul-15 Jan-16 500 Co-operative oversight of cross-border financial market infrastructures. Financial market infrastructures that are based in other countries and that operate across national borders play an important role in the New Zealand financial system. Where appropriate, the Reserve Bank participates in international co-operative oversight arrangements for such infrastructures. Co-operative arrangements help promote the safety and efficiency of cross-border FMIs by facilitating efficient and effective communication and consultation between interested authorities. The Reserve Bank has been an active participant in the co-operative oversight arrangements for the CLS system (an international system for the settlement of foreign exchange transactions) since the New Zealand dollar became eligible for settlement in that system in 2004. Recently, New Zealand banks have moved to centrally clear over-thecounter New Zealand dollar interest rate swaps through the SwapClear service operated by LCH.Clearnet Limited (LCH). The Reserve Bank’s preliminary assessment is that LCH is a systemically important financial market infrastructure for New Zealand and the Reserve Bank has 49 therefore taken steps to become involved in the global supervisory arrangements for LCH co-ordinated by the Bank of England. Industry moves to facilitate wider direct participation in the payment system. Major banks consider selling Paymark. In the previous Report, the Reserve Bank encouraged Payments NZ Limited (PNZ) and its existing participants to address outstanding issues to facilitate wider direct participation in the New Zealand retail payment system. This work is consistent with the policy goal of promoting fair and open access to financial market infrastructures. The Reserve Bank welcomes the progress made since November, including the adoption by PNZ of revised access rules. Nevertheless, there remain issues to be resolved and the Reserve Bank will continue to monitor progress. Paymark is the company that processes the majority of point of sale card transactions. Although the Reserve Bank does not currently consider Paymark to be systemically important, the company’s system does play an important role in the retail sector. The Reserve Bank is therefore interested in the system’s performance, risk management and governance arrangements. The Reserve Bank is watching developments as Paymark’s existing shareholders (the four major banks) consider selling their shares. 50 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Box C Results of the 2015 common scenario ICAAP stress test Stress tests play two important roles in the Reserve Bank’s prudential framework. First, stress tests help the Reserve Bank identify and assess risks to the financial system. Second, stress tests are used to identify and manage risks to individual institutions’ capital and liquidity buffers. Individual institutions are expected to use stress tests to assess the viability of current business plans, including as part of their Internal Capital Adequacy Assessment Process (ICAAP). Stress test outcomes are also an important input into supervisory discussions with participating institutions. In late 2015, the four largest banks in New Zealand participated in a common scenario ICAAP test. This test was a hybrid between an internal test (conducted regularly with each institution choosing their own scenarios) and a regulator-led stress test (occurring every 2-3 years with common scenarios and assumptions). Due to the use of a common scenario across banks, the results of the test provided insights for the financial system as a whole. However, the test featured less standardisation of methodology than a full regulator-led exercise. For example, there was no ‘phase 2’ where loss rates were standardised. As with previous regulator-led tests, the stress scenario was a severe macroeconomic downturn. Over a three-year period, real GDP fell by 6 percent, unemployment rose to 13 percent, and dairy incomes remained at low levels. Residential property prices fell by 40 percent (with a more severe fall of 55 percent assumed for Auckland); and both commercial and rural property values fell by 40 percent. Finally, the 90-day interest rate fell by about 3 percentage points due to monetary policy easing, RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 although banks typically assumed a partially offsetting increase in funding spreads above risk-free rates. Banks were asked to simulate the impact of this scenario on loan portfolio performance, and to trace through the implications for their balance sheet and profit and loss statement. Banks reported a steady increase in bad debt expenses throughout the scenario, as would be expected under a severe economic contraction. This reflected a combination of deteriorating credit quality (increasing collective provisions) and rising defaults (increasing specific provisions). The cumulative hit to profits averaged around 4 percent of initial assets (figure C1), which is a similar outcome to phase 2 of the full regulator-led exercise conducted in late 2014.1 About 30 percent of total losses were related to mortgage lending, with half of this due to the Auckland property market. SME and rural lending accounted for most of the remainder of financial system losses. Loss rates for mortgage lending were around 2 percent, significantly lower than the 5 percent loss rate observed for most other sectors.2 The underlying profitability of banks – earnings from core activities, prior to accounting for bad debt expenses – is a first line of defence against rising loan losses. On average, banks assumed a moderate decline in net interest margins during the scenario, reflecting rising defaults reducing interest income and the assumed increase in funding spreads. However, in line with the experience of the GFC, banks expect to be able to maintain net interest margins at around 2 percent by eventually passing on higher funding spreads to customers (rather than reducing 1 See box A from the November 2014 Financial Stability Report, http://www.rbnz.govt.nz/financial-stability/ financial-stability-report/fsr2014-11/stress-tests-of-the-new-zealand-banking-system 2 Relatively low loss rates on mortgages are common in international crises, and the Reserve Bank considers them credible in this scenario. Because homeowners are personally liable for mortgages and lose their own home when in default, they generally keep servicing their mortgages if they can, even if they are in negative equity. 51 Figure C1 Cumulative bad debt expense (% of initial assets) 4 3 % % Other Farm Commercial property Corporate/SME Mortgage Figure C2 Capital ratios relative to respective minimum requirements (% of riskweighted assets) 4 3 % 0 2013 Although projected credit losses were largely absorbed with underlying profitability, capital ratios were expected to decline throughout the scenario. This reflected an increase in the average risk weight from around 50 to 70 percent, due to negative ratings migrations (rising probability of borrower defaults) and falling collateral values (rising losses given default). Although remaining well above the regulatory minimum, the average Common Equity Tier 1 (CET1) capital ratio declined from 10.3 to 8 percent as a result. The total capital ratio came under more pressure, due to smaller initial buffers to the regulatory minimum. As a result, the average bank reported falling into the upper end of the capital conservation buffer in the final year of the test, which would trigger restrictions on dividend payments to shareholders (figure C2). The results of the test suggest that individual institutions would remain 2014 2015 2016 2017 0 2018 Source: RBNZ. Source: RBNZ. mortgage rates by the same amount as the OCR). As a consequence, underlying earnings during the scenario were of a similar magnitude to reported credit losses, so that return on assets averaged around zero. 8 2 0 Note: Other includes consumer lending, lending to financial institutions, and holdings of financial securities. % 4 2 2018 Total 4 1 2017 Tier 1 6 1 2016 CET1 6 2 2015 Conservation buffer Scenario 2 0 52 8 well away from the point of economic failure. However, the results also suggest that the financial system would be far from fully functioning in a way that would support a swift economic recovery. The combined impact of bank responses to the scenario appears to risk a material worsening in the economic downturn, or to push the boundaries of realism: • Deleveraging: Banks assumed that they could reduce credit exposures by around 11 percent (amounting to a decline of around 8 percent of nominal GDP over the scenario). While this could reflect a reduction in customer demand, there is a risk that such a sharp decline could be associated with a range of feedback effects not captured in the tests. For example, the associated increase in stressed sales and tightening in origination standards could further reduce prices and liquidity in property markets. Alternatively, less aggressive deleveraging would tend to lower reported capital ratios. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 • Increased reliance on retail deposits: All banks assumed that they could achieve an increase in the proportion of funding sourced from retail deposits, with the average retail deposit share increasing from 62 to 70 percent. While this can be rationalised as a flight to safety in a crisis, a more limited availability of retail deposits is possible. For example, the scenario could generate concern among depositors about bank safety, or there could be more significant reductions in deposits associated with weak new lending activity. These alternative assumptions would increase the risk of a tightening in credit supply in the event that banks’ ability to raise wholesale funding was impaired. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 • Issuance of Tier 2 capital: All banks assumed that the market environment would allow them to issue new Tier 2 capital instruments, both to replace expiring instruments and to increase the total amount outstanding. In the scenario, this may not be plausible, particularly with most banks operating within their capital conservation buffer. These issues highlight the significant uncertainties involved in assessing the implications of the stress scenario for the financial system as a whole. A careful consideration of recent stress test results will be an input into the upcoming review of bank capital requirements. 53 Box D system from abroad.1 Conversely, money is destroyed when households repay principal from a loan and when money is transferred abroad. Recent developments in household deposits Household deposits within the banking system have grown strongly since the GFC. In dollar terms, household deposit growth has outstripped household credit growth for most of the period since 2009 (figure D1), a key factor allowing banks to reduce their reliance on wholesale funding, particularly from offshore. With more recent data suggesting a reversal in this trend, this box examines the underlying drivers of strong household deposit growth post-crisis and considers whether banks may have to rely more heavily on alternative funding sources in the future. Figure D1 Household credit and deposit growth (% of GDP) 12 % Deposit growth Credit growth 10 % 12 10 These factors have helped drive money creation in New Zealand in recent years. Household credit growth has been strong, partly due to high house price inflation, which generally causes households to borrow more heavily. In addition, net inward migration is at record levels, with over 67,000 more people moving to New Zealand than leaving in the year to March 2016. Statistics New Zealand estimates that over the past year, this net inflow of migrants has brought around $500 million into New Zealand (figure D2). Figure D2 Migrant transfers (annual total) 4 $bn $bn Net transfers Outflow Inflow 3 4 3 8 8 2 2 6 6 1 1 4 4 0 0 2 2 0 2000 2003 2006 2009 2012 2015 0 -1 2002 2006 2010 2014 -1 Source: Statistics New Zealand. Source: Statistics New Zealand, RBNZ Standard Statistical Return. Strong growth in household deposits is likely to occur when there is a rapid increase in the amount of money in an economy and households choose to hold their money in bank deposits. In a modern and open banking system, such as New Zealand’s, money is created when commercial banks extend loans to customers, and credit their deposit accounts in return, and when money is transferred into the banking 54 This estimate, however, may understate the amount of funds that migrants bring to New Zealand. Survey data indicate that around onethird of migrants have assets of more than $100,000, some of which will remain offshore for some period as migrants typically shift their assets 1 Money can also be created in a number of other ways, such as banks purchasing government bonds or banks issuing debt or equity. For further discussion, see McLeay, M, A Radia and R Thomas (2014) ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 to New Zealand gradually. Therefore, we expect the measured value of migrant transfers to increase over time, particularly since the strength in net migration is likely to persist, adding to the New Zealand deposit base. Money created by credit growth and migrant transfers will typically enter the financial system in the form of bank deposits, but whether the money remains as a bank deposit depends on household behaviour. In recent years, households have consumed less of their income, with some of the increased saving remaining in banks as household deposits. When looking at the factors behind this trend, there is reason to believe it may continue for the near-term. The ‘baby boomer’ generation is starting to enter retirement age, and some will be looking to trade down their family home for something smaller. The difference in price between properties bought and sold can result in a large bank deposit being created, especially for Auckland retirees downsizing outside the region. As ‘baby boomers’ are in or approaching retirement, it is likely that a proportion of the deposit generated will remain within the banking system rather than be quickly spent. This may partly explain strong growth in high value deposits recently. With the demographic effects well under way and house prices continuing to grow strongly, this trend suggests household deposit growth is set to continue. Precautionary motives have also caused households to increase their saving rate. While some savers have chosen to save using bank deposits, it appears that a significant number of households have instead chosen to save by paying-down mortgage debts. This form of saving limits net credit growth, but has little impact on household deposits. Additional debt repayment is expected to continue while households remain cautious, for example due to weak commodity prices and low global growth, and interest rates are at low levels. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 In addition, some households may have chosen to save using investment alternatives to bank deposits. Post-GFC, bank deposits appear to have been favoured over non-bank deposits and other investments due to their relative safety and increased household caution. But more recently, the value invested in domestic equities and other investment vehicles has increased, suggesting that households may be viewing them more favourably. Kiwisaver balances, for example, continue to increase as more people join the scheme. However, it is difficult to disentangle flows into these investments from revaluation effects (which can be large in the case of equity markets). Nevertheless, deposit growth could slow if risk appetite increases, or if financial market volatility subsides. In summary, it appears that strong credit growth and net migration has increased the amount of money in the New Zealand economy, and is likely to continue to do so for the near future. This has helped generate strong growth in household deposits, as many households have chosen to use bank deposits to save part of their income or proceeds from house sales. But the flow of money into household deposits could reduce in the future, for example, if households’ appetite for other savings instruments increases or inward migration falls. It is uncertain how banks would respond to a decline in deposit growth. They could, for example, sustain the current growth rate in credit by becoming more reliant on less stable sources of funding, such as international wholesale funding, or they could reduce the supply of credit. The implications for the resilience of the banking system, and the macroeconomy, will depend on the response taken. The Reserve Bank will therefore continue to monitor the growth in household deposits and the potential impact on the banking sector. 55 Chapter 6 Key developments in financial sector regulation Work continues on a broad range of policy initiatives. The Reserve Bank plans to shortly release a second consultation paper on changes to the outsourcing policy for registered banks. This policy aims to ensure that a bank is able to continue to provide basic banking services in the event of the failure of a service provider, or if the bank itself or its overseas parent fails. These policy changes have been designed to better align with the Open Bank Resolution policy. The Reserve Bank will be consulting soon on a ‘dashboard’ approach to disclosure for locally owned banks. This approach is being designed to make quarterly disclosure more efficient for banks, while reinforcing market discipline through timely, standardised disclosure of key metrics. Work is also well advanced on a crisis management regime for systemically important financial market infrastructures. 6.1 Proposed changes to bank outsourcing policy Current policy The Reserve Bank’s outsourcing policy regulates the use of external service providers by locally incorporated ‘large banks’.1 The objective of the policy is to ensure that a bank has the legal and practical ability to control and execute outsourced functions, such that it can continue to provide basic banking services (such as liquidity, payment and transaction services) if one of its service providers fails or becomes dysfunctional, or if the bank itself or an overseas parent of the bank fails. This is important to minimise the impact of such events on the wider economy, and to preserve options for the resolution of bank failures. Reviewing the policy rationale Last year, the Reserve Bank released a consultation paper proposing changes to the current policy. In 2014 the Reserve Bank undertook a stocktake of the operation of the outsourcing policy and found that the policy was not being consistently interpreted and applied by banks. Consequently, revisions to the policy are seeking to: 1) clarify the 1 56 Large banks are defined as those whose New Zealand liabilities, net of amounts due to related parties, exceed $10 billion. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 outcomes sought by the policy; and 2) increase the Reserve Bank’s engagement with banks on the policy and its outcomes. When the policy was developed, the emphasis was on maintaining liquidity in the financial system if one of the largest banks, or a service provider to one of the largest banks, failed. Since that time, the Reserve Bank has introduced the Open Bank Resolution (OBR) policy which is intended to maintain, on an ongoing basis, the basic services of a failed bank.2 Apart from clarifying the outsourcing policy, the proposed changes are intended to improve alignment with OBR and other crisis management policies by putting more emphasis on a bank’s ability to continue operating basic services for an indefinite period in the event of its failure, or the failure of a service provider. ensure continuity of outsourced functions. Incentives may also be weaker for management to put in place arrangements to allow continued availability of outsourced services from a parent company, in the event that the parent fails or is otherwise unable to continue supplying the services. It is not the intention of the proposed policy clarifications and amendments to prevent outsourcing in general, but to manage any wider risks that may arise from outsourcing particular functions. The Reserve Bank acknowledges that appropriately robust outsourcing arrangements can improve a bank’s efficiency and risk management by allowing access to technology and know-how that would not otherwise be available to it. Next steps The first consultation paper reviewed the underlying rationale for regulatory intervention in banks’ outsourcing arrangements, in light of the Reserve Bank’s objective of promoting the maintenance of a sound and efficient financial system; or avoiding significant damage to the financial system that could result from the failure of a registered bank. The paper identified potential threats to this objective arising from banks’ outsourcing arrangements, particularly in the context of the failure of a bank or a parent bank. Bank management will generally have incentives to ensure that outsourcing arrangements are robust, to minimise the risk of their bank failing. However, there may be situations where the incentives facing a bank’s management are not so well-aligned with the public interest. A bank’s management may have less interest in how outsourcing arrangements work after the bank has failed. Complex outsourcing arrangements may make it more difficult for a statutory manager to 2 See http://www.rbnz.govt.nz/-/media/ReserveBank/Files/regulation-and-supervision/banks/ policy/5340579.pdf?la=en RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 In the coming weeks the Reserve Bank intends to release another consultation paper on the review of the outsourcing policy. In light of consultation feedback on the 2015 paper, the Reserve Bank has reconsidered some proposals to mitigate their impact on banks while still addressing the policy concerns. Following the release of the consultation paper, the Reserve Bank expects to hold bilateral meetings with stakeholders, and industry workshops. The Reserve Bank appreciates the constructive contribution that the banking industry is making to the consultation process. A final version of the outsourcing policy is anticipated to be released by the end of the year. 6.2 Dashboard approach to quarterly disclosure In December the Reserve Bank published the conclusions of its Regulatory Stocktake, along with a summary of written submissions.3 3 See http://www.rbnz.govt.nz/regulation-and-supervision/regulatory-stocktake 57 The primary objective of the stocktake was to ensure the efficiency, clarity and consistency of prudential requirements applying to banks and NBDTs. Public disclosure requirements for locally incorporated banks A key focus of the stocktake was the existing disclosure regime for banks, which requires them to publish disclosure statements quarterly. A bank is currently required to publish full and half-year disclosure statements, and also ‘off-quarter disclosure statements’ covering the first three and the first nine months of the financial year respectively. Market discipline is one of the ‘three pillars’ that make up the Reserve Bank’s approach to banking supervision (the others being regulatory discipline and self-discipline). The Reserve Bank continues to view market discipline as a vital component of delivering its financial stability objectives in an efficient way, and good quality disclosure is one of the prerequisites for effective market discipline.4 However, the Reserve Bank considered whether off-quarter disclosure statements added sufficient marginal benefit to market discipline to justify the burden they imposed on banks. After extensive consultation with banks and other stakeholders, the Reserve Bank concluded that, for locally incorporated banks, the balance of arguments remained in favour of retaining some form of quarterly disclosure. While considering how to reduce the burden of off-quarter disclosure, the Reserve Bank has also identified ways in which the disclosure regime could contribute more effectively to market discipline. The Reserve Bank is about to consult on a new ‘dashboard’ approach. 4 A recent Bulletin article discusses the role of market discipline and what is needed for it to be effective, see O’Connor-Close, C and N Austin (2016) ‘The importance of market discipline in the Reserve Bank’s prudential regime’, Reserve Bank of New Zealand Bulletin, 79(2), February, http://rbnz.govt.nz/-/media/ ReserveBank/Files/Publications/Bulletins/2016/2016feb79-2.pdf 58 The dashboard The proposed dashboard is an electronic form of reporting that should not only make quarterly disclosure more efficient for banks, but is also intended to enhance market discipline in two key ways: • Comparability: The dashboard would make it easier for depositors and investors to compare the relative risks of different banks and take decisions accordingly. The dashboard would compare banks side-by-side according to key metrics, in a dedicated location on the Reserve Bank’s website. This would be easier to find and understand than the current summary drawn from banks’ quarterly disclosure statements.5 • Timeliness: The proposed dashboard disclosure would be more timely than the current summary information, which is published with a lag of about four months. The dashboard would involve electronic delivery of data that banks are already producing. Consequently, depositors and investors would be making decisions based on more up-to-date (and therefore relevant) information. The dashboard is intended to suit the needs of the key users of bank disclosure statements, such as retail depositors, financial journalists, ratings agencies and institutional investors. The aim is to present summary information for less sophisticated users, while allowing more sophisticated users to pull out additional detail. By making the data better targeted and more accessible, the dashboard could expand the base of users who exert market discipline on banks. Some of the key design issues for the dashboard are: 5 The current report is available at: http://www.rbnz.govt.nz/statistics/g1 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 • Content: A broad range of information could be included. The Reserve Bank is developing proposals with the aim of best meeting the needs of the users of the information, while also having regard to the costs to banks in producing it. • Mechanics: The Reserve Bank is considering how the dashboard will interrelate with the full and half year disclosure statements that banks will still be preparing. The dashboard will need to be published every quarter rather than only in the off-quarters, as the banks have diverse financial years and only a quarterly approach would allow cross-bank comparison for a given period. • Timing: The Reserve Bank will seek views on how soon after the end of each quarter the dashboard should be published. Alternative option and timing The consultation will also propose an alternative option of continuing with an off-quarter disclosure requirement using the existing mechanism, but scaled back to summary capital and asset quality disclosure. This is not the Reserve Bank’s preferred option as the dashboard is likely to better promote market discipline. The Reserve Bank aims to make final decisions on the dashboard during Q3 2016, although it would not be implemented until 2017. The Reserve Bank is redeveloping its registered bank monthly balance sheet data collection, and currently expects the revised collection to begin officially during the first quarter of 2017. This new reporting will need to be in place before the dashboard can be implemented, as the aim is that a significant number of items in the dashboard will be extracted directly from this new collection, on a quarterly basis. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Public disclosure requirements for branches The Reserve Bank does not intend to include branches of overseas banks within the dashboard approach, instead removing off-quarter disclosure requirements from them altogether. Branch disclosure statements only report on the activities of the overseas bank in New Zealand, and so give investors very little insight into the health of the whole bank. These investors have little ability to influence the behaviour of the whole bank in any case. The marginal contribution that off-quarter disclosure makes to market discipline is therefore much less for branches than it is for locally incorporated banks. The Reserve Bank aims to implement this decision once the new bank balance sheet collection is in place in 2017. 6.3 FMI crisis management proposals Financial market infrastructures (FMIs) are the channels through which financial institutions, governments, businesses and individuals transmit money and financial instruments. They are generally sophisticated systems that centralise certain activities, handling significant transaction amounts both by volume and value. Because of the services they provide, the volume of transactions they can handle, and their interconnections with the rest of the financial system, some FMIs are systemically important; a disruption in the services they provide could undermine the soundness and efficiency of the financial system as a whole. FMIs can be subject to various types of market failures. For example: • Negative externalities: The costs of an FMI failing can be very large given the scale of transactions handled by FMIs and their interconnectedness with the rest of the financial system. Because 59 • • the FMI itself does not bear all of these costs, it may have insufficient incentives to manage the risks of failure. published its conclusions on most of the key elements of this oversight regime, which include the following: Co-ordination issues: Participants in an FMI may have incentives to focus only on their own private costs and benefits, and so may not act in a way that improves the FMI as a whole. For example, in a stress scenario, participants may focus primarily on minimising their own costs, and their actions might not align with the broader public interests and could make the handling of a crisis less efficient. • The Reserve Bank and the Financial Markets Authority (FMA) would have enhanced powers to oversee SIFMIs, via a revised Designation Regime, including powers for investigation and enforcement, setting standards and rules, and crisis management. • FMIs that are classed as systemically important would have to be designated under the new Designation Regime. ‘Club behaviour’ and anti-competitive practices: FMIs often have monopolistic or quasi-monopolistic characteristics, and in some cases this can result in them acting like a club (for instance, limiting access to the system), and can mean that they lack the incentives to invest in underlying infrastructure or innovate in the provision of services. • Payment and settlement systems that are currently designated FMIs would continue to be able to seek legal protection for netting and settlement, by opting in to the revised Designation Regime. The Reserve Bank currently has only limited regulatory powers over FMIs. These powers currently do not extend beyond the gathering of information, except for FMIs that opt in to the voluntary designation regime. That regime provides legal certainty around settlement finality, but does not include all systemically important FMIs. As a consequence, the Reserve Bank has to rely on moral suasion to address any systemic concerns it has. This puts New Zealand out of line with international recommended practice, as set out in the Principles for Financial Market Infrastructures. To address the risks that systemically important FMIs (SIFMIs) pose to financial stability, the Reserve Bank has been working on an enhanced oversight regime for SIFMIs. In December 2015 the Reserve Bank 60 A key part of the proposals is a crisis management regime for SIFMIs. However, the proposals published in December did not go into significant detail on the design of this crisis management regime. In March 2016, the Reserve Bank published the consultation document Crisis Management Powers for Systemically Important Financial Market Infrastructures, which sets out the proposed crisis management regime in detail. This consultation paper notes that the purpose of crisis management powers in this area is to ensure the continuity of essential services (rather than to resolve the affairs of the operator, unless this is necessary to ensure the continuity of those services). It also notes a variety of other matters that distinguish crisis management in this area from the approach for registered banks, licensed insurers and licensed NBDTs (for example, most FMIs have loss allocation mechanisms in their rules). RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 Given this context, the consultation paper proposes a two-tier approach to crisis management for SIFMIs. The first tier of this framework would be a requirement for an operator of a SIFMI to prepare a business continuity plan to achieve rapid recovery and timely resumption of essential services or to facilitate the replacement of the SIFMI’s operator(s); and a recovery and orderly wind-down plan to respond to financial threats to the continued provision of essential services. • This first tier recognises that a SIFMI that has put in place preventative measures and appropriate recovery plans is more likely to address problems without public intervention. This approach also has the merit of building on the existing rules and plans that many SIFMIs will already have in place, and allowing for certain matters, such as loss allocation, to be agreed in advance between participants and operators. It is proposed that the regulators would be able to set out, at a high level, certain matters these plans must address, and that the regulators would have the power to direct operators to amend these plans. FMIs can be structured in diverse ways. Given this, the application of the two-tier framework may be influenced by the nature of the crisis, the legal form of the FMI, and how large a presence the FMI has in New Zealand. The consultation document discusses how the framework would be applied in these different circumstances. Submissions on the consultation document close on 20 May 2016. Once final policy decisions have been made on the design of the crisis management regime, Cabinet agreement will be sought to the entire proposed oversight framework, and work will commence on an exposure draft of a Bill implementing the framework. The second tier of the framework would be a set of statutory powers that could be used by joint regulators when the SIFMI’s business continuity plans, and/or recovery and resolution plans are, for various reasons, not sufficient to address the situation. In summary, these statutory powers are for joint regulators to: • issue directions to the operator(s) of a SIFMI with the consent of joint Ministers; • appoint, replace or remove the directors of an operator with the consent of joint Ministers; and recommend that a SIFMI be placed into a specially designed statutory management regime (the design of this statutory management regime is also laid out in the consultation document). The consultation paper notes that the design of the statutory management regime in particular requires tailoring to the circumstances of FMI crisis management. 6.4 IPSA Review The Reserve Bank will undertake a review of the Insurance (Prudential Supervision) Act (IPSA) during 2016-2017. IPSA provided the first comprehensive framework for the prudential regulation and supervision of entities carrying on insurance business in New Zealand. The Reserve Bank considers that IPSA has had a positive effect on the soundness of the insurance industry in New Zealand and that the legislation has worked well in most areas. However, good regulatory practice requires the timely review of any new legislative regime, to ensure that the regime is working as intended and is fit for purpose. It has been more than five years since IPSA was passed, RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 61 and over this period the Reserve Bank and the industry have gained sufficient experience with IPSA to make it worthwhile to undertake a review. 6.5 The Reserve Bank considers that the legislative purposes of IPSA remain appropriate. The review will therefore be undertaken on the basis of the existing purposes of IPSA, namely to promote the maintenance of a sound and efficient insurance sector and to promote public confidence in the insurance sector. As signalled in the last Report, the IMF will be undertaking a comprehensive review of New Zealand’s financial system, focussing in particular on the quality of the regulatory framework for both prudential supervision (the responsibility of the Reserve Bank) and market conduct (the responsibility of the FMA).7 The Reserve Bank has released a Terms of Reference for the review, along with other relevant information.6 This review, under the auspices of the Financial Sector Assessment Programme (FSAP), will take place over two separate ‘missions’ in late August and early November. In relation to the functions of the Reserve Bank, the 2016 FSAP will involve: The review seeks to ensure that IPSA provides for a cost effective, riskbased supervisory regime that promotes the soundness and efficiency of the insurance sector. The Reserve Bank considers that there are likely to be opportunities to reduce the administrative costs associated with IPSA, for example by reducing the fragmentation of policies across regulatory instruments or through greater use of generally applied, as opposed to individually applied, requirements. The review will also consider whether the requirements for overseas insurers adequately balance the goals of recognising home country regulation, and adequately protecting New Zealand policyholders. Public consultation will be a key element of the review. The Reserve Bank intends to publish an Issues Paper in late 2016 to seek views from interested parties, and will then hold consultation meetings with the industry during 2017 before issuing an Options Paper for public consultation. Any legislative change would not occur before 2018 at the earliest. 6 See http://rbnz.govt.nz/regulation-and-supervision/insurers/review-of-the-insurance-prudentialsupervision-act-2010 62 Update on other regulatory projects Financial Sector Assessment Programme • a detailed (graded) assessment against the relevant international standards that have been developed for the banking and insurance sectors; • a more limited (non-graded) assessment against the international standards for financial market infrastructure; • an evaluation of the macro-prudential policy framework; • an evaluation of the Reserve Bank’s crisis management and resolution framework; and • a stress-testing exercise to assess the resilience of the banking system to a series of large but plausible ‘shocks’. 7 For a further discussion on the scope of the New Zealand FSAP, see Hunt (2016) ‘The 2016 New Zealand Financial Sector Assessment Programme (FSAP)’, Reserve Bank of New Zealand Bulletin, http://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletins/2016/2016apr79-7.pdf RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 The August and November missions will involve meetings with various stakeholders, including regulated entities and industry bodies. Publication of the IMF’s findings and recommendations is expected some time early in 2017. Review of bank capital requirements The Reserve Bank plans to review the capital requirements of New Zealand banks to ensure they are appropriate given the current domestic environment and the emerging international regulatory regimes. The review will take account of recent changes to the Australian bank regulation regime following the Financial System Inquiry and the international standards set out by the Basel Committee for Banking Supervision (BCBS) in the Basel III framework. The BCBS has proposed significant changes to the framework, but final decisions on these have been delayed. This may affect the timetable for the review of the domestic regime, as the Basel III framework is the basis for New Zealand’s current bank capital requirements.  The Reserve Bank is also undertaking a project to compare the capital models of the four largest New Zealand banks. ANZ, ASB, BNZ and Westpac are authorised to use complex internal ratings-based models to estimate how much capital they should hold for regulatory purposes. RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016 The benchmarking project will help the Reserve Bank understand differences between these models by using them to estimate the capital requirements on an identical portfolio of residential mortgage and rural loans. Because the Reserve Bank has imposed various calibrations to achieve a degree of consistency in the model outputs, and because the portfolios are identical, the four banks should generate very similar capital requirements. If there are significant differences, it is likely they will be explained by model form.  Review of bank liquidity requirements New Zealand imposed minimum liquidity requirements on locally incorporated banks in 2010. Since then the BCBS has finalised standards which include conceptually similar (but not identical) ratios. The New Zealand requirements appear to be working well, but in light of international developments it is timely to review the existing liquidity policy, and consider whether there would be benefits in harmonising more closely with the international approach. As part of the review, the Reserve Bank will also consider whether there should be liquidity requirements for New Zealand branches of foreign banks, and will review requirements for the disclosure of liquidity positions. Internal preparatory work for the review is under way, with public consultation expected to take place early in the second half of 2016. 63 Appendices Appendix 1 Appendix 2 Reserve Bank enforcement Presentations November 2015-April 2016 The Reserve Bank has responsibility for enforcing the regulatory obligations of entities in a number of areas, comprising banking, insurance, payments and settlements, non-bank deposit-taking, antimoney laundering, and countering the financing of terrorism. The Reserve Bank monitors entities’ compliance with the obligations it oversees. In responding to identified non-compliance by an entity, the Reserve Bank may consider it appropriate to take enforcement action. The Reserve Bank presented on Financial Stability and related topics to the following sectors and regions: During the past 12 months, the Reserve Bank has undertaken the following public enforcement action: • October 2015 – a formal warning was issued to Kiwibank Limited under section 80 of the Anti-Money Laundering and Countering Financing of Terrorism Act 2009.1 Financial services (9) Auckland, Wellington Sectors (9) Auckland, Wellington Advisers (5) Auckland, Wellington Business groups (5) Auckland, Wellington, Masterton, Christchurch, Timaru Universities Wellington International finance Hong Kong The Reserve Bank also speaks to a range of audiences on Monetary Policy and related topics. They are reported in the Monetary Policy Statement. 1 See http://www.rbnz.govt.nz/news/2015/10/enforcement-action-under-the-aml-cft-act-2009---kiwibanklimited 64 RESERVE BANK OF NEW ZEALAND / FINANCIAL STABILITY REPORT, MAY 2016