## 1. New Zealand’s Four Large Banks: Selected Financial Soundness Indicators

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### Overview of banking-sector position
- Banks remain profitable, with low levels of impaired assets, and aggregate capital well above the regulatory minimum.
- Key vulnerabilities:
  - Heavy exposure to households; household debt rose significantly and assets were hit by a slump in house and equity prices.
  - Reliance on short-term wholesale funding from offshore markets disrupted since the collapse of Lehman Brothers in September 2008.
- System-wide metrics (through mid-2009):
  - Total capital of the four large banks: about 10–12 percent (well above regulatory minimum of 8 percent of risk-weighted assets).
  - Tier 1 capital ranged from 7½ percent to 10 percent in 2009.
  - Four largest banks’ share of total bank assets rose to almost 90 percent in 2008.
  - Loans overdue 90 days+ averaged 0.6 percent of total loans for the four main banks.
  - Credit growth slowed to less than 5 percent year-on-year in mid-2009.
  - Assets-to-capital multiple (leverage): 22 for New Zealand banks.

### Stress-test findings and asset-quality scenarios (housing and corporate)
- Main quantitative finding (aggregate exercise on Four Large Banks average, asset-weighted):
  - An increase in the default rate from less than 1 percent at present to 6–8 percent for all loans would be required to reduce bank capital below 8 percent of risk-weighted assets.
- Housing exposure and stress-test scenarios (December 2008 staff calculations):
  - Reported actual total capital ratio: 11.3
  - Housing loans to total loans, average (actual): 56.5
  - Default on 5 percent of all housing loans:
    - New total capital ratio: 10.2
    - Minimum capital ratio among four large banks: 8.7
  - Default on 10 percent of all housing loans:
    - New total capital ratio: 8.7
    - Minimum capital ratio among four large banks: 6.8
  - Assumed average loss given default: 40 percent.
- Evidence on plausibility of large default rates:
  - HES 2007: less than 4 percent of owner-occupier mortgages in higher risk group (debt service >30 percent of disposable income and loan-to-value >80 percent).
  - Weighted average ex-ante probability of default across risk groups estimated by banks: 1.6 percent.
  - Harrison and Mathew (2008) estimate average probability of default for New Zealand households around 1 percent.
  - To reach overall probability of default of 10 percent would require extremely high default probabilities (60–95 percent) for higher-risk buckets.
- Mitigating factors against large mortgage losses:
  - Mortgage interest rates fell by over 400 basis points from their peak in July 2008.
  - Portion of high loan-to-value mortgages insured by third parties (example: ASB insured ¼ of loans with 80 percent+ LTV).
  - Legal framework: homeowner liable for remaining debt after repossession.
  - Almost three-quarters of mortgage debt in 2007 held by households in two highest income quintiles; median debt-service ratio for those households below 20 percent.
- Corporate lending stress exercise (authors’ “arbitrary exercise” using Basel II disclosures):
  - Authors’ adjusted PD assumptions: assets shift to next highest risk category; category 7–8 PD assumed four times reported by banks.
  - Authors’ adjusted LGD: about 1½ times reported by banks for mortgage debt; unchanged for corporate and other retail.
  - Under this exercise:
    - Average overall default rate for four large banks would rise to about 6–8 percent of total loans.
    - Losses after provisions about 3 percent of loans for mortgages and corporate loans.
    - Total estimated loss: 7,809
    - Less provisions: 1,572
    - Estimated loss after provisions: 6,237
    - Loss as percent of risk-weighted assets: 3.2
    - Implied new total capital ratio (average of four banks): 8.0
    - Implied new Tier 1 capital ratio (average of four banks): 5.1
    - Minimum new Tier 1 capital ratio among the four banks: 4.3
  - The bank most affected would see its Tier 1 ratio fall to just over 4 percent.

### Funding, liquidity, and external-financing risk
- Funding structure and maturity:
  - Nonresidents comprise one-third of banks’ total funding.
  - Almost half of New Zealand’s foreign debt (bank and non-bank) matures in less than one year; more than half of this matures in 90 days or less.
- Funding-cost and market developments since September 2008:
  - Bank access to global financing became more difficult after Lehman; 5-year CDS spreads on four large Australasian banks increased markedly in early 2009, then eased.
  - Reductions in foreign and domestic interest rates have more than offset increased spreads—total cost of funding fell.
  - Two-year NZD swap rate fell to about half the level one year earlier.
  - Short-term wholesale/retail funding costs (90-day bank bill, 6-month deposit rate) fell by similar amounts.
  - Retail deposit growth picked up after retail deposit and wholesale funding guarantees in late 2008.
  - Loan-to-deposit ratio remained high at over 145 percent.
- Balance-of-payments financing vulnerability and illustrative numbers (Table 8 excerpts and scenario notes):
  - Total external debt falling due in current year almost $NZ 120 billion.
  - Official reserves: $NZ 19 billion (Table 8 memorandum item 19.3 under one column).
  - U.S. Federal Reserve swap facility assumed US$15 billion (noted as $NZ 17.1 in Table 8 under illustrative financing).
  - Banks could raise $NZ 25 billion from Australian parents in illustrative scenario.
  - Analysis indicates if two-fifths or more of maturing debt failed to be rolled over in 2009, a financing gap could arise.
  - If only half of maturing debt were rolled over, a sizable financing gap could arise.
  - Balance-of-payments illustrative figures (preserve exact table values where presented):
    - Current account balance 2009 Est.: -10.4 (In percent of GDP) -5.8
    - Capital and financial account balance illustrative: -41.0 and -54.7
    - Overall balance illustrative: -51.4 and -65.0 (In percent of GDP) -28.6 and -36.2
    - Other sources of financing: 51.4 (includes official reserves 9.3; Australian parent banks 25.0; U.S. Federal Reserve swap facility 17.1)
    - Remaining gap in Scenario 2: -13.7 (Remaining gap as percent of GDP: -7.5)
    - Short-term debt (eop) 2009 Est.: 73.0 and 59.3 (table columns)
    - Total external debt (eop) 2009 Est.: 204.0 and 190.3 (table columns)
    - Official reserves 22.3 and 19.3 (memorandum items)
- Mitigants and comparative context:
  - Gross external debt at 170 percent of GDP in June 2009 is smaller than Finland, United Kingdom, Iceland.
  - Gross bank assets about twice GDP in New Zealand (vs factors of 7 UK, 9 Ireland, 11 Iceland).
  - Little exposure to sub-prime assets; asset quality comparatively sound.
  - Gross public debt about 20 percent of GDP in 2008.
  - Banks hedge more than 90 percent of foreign currency debt and more than half of foreign borrowing is in New Zealand dollars.
  - Sharp depreciation (~30 percent vs US$ between May 2008 and end-March 2009) did not materially impact bank or private sector balance sheets.
- Recent policy and regulatory responses:
  - RBNZ prudential liquidity policy (June 2009):
    - Requires minimum core funding of 65 percent of total assets by October 1, 2009, increasing to 75 percent over two years.
    - Core funding defined as Tier 1 capital, wholesale and retail funding with residual maturity >1 year plus 90 percent of short-term retail funding.
  - Australian parent lending constraint: regulations limit direct lending to subsidiaries to maximum of 50 percent of Tier 1 capital (implying maximum lending to all Australian bank subsidiaries ~ $NZ 40 billion), though lending can occur via branches/associated vehicles.

### Policy implications and recommended actions
- Require banks to perform severe/extreme stress tests reflecting large adverse moves in defaults and funding conditions, covering mortgage, corporate, and wholesale funding stress scenarios.
- Mandate capital strengthening if stress-test results indicate capital would fall below regulatory minima (illustrative exercise showed average total capital ratio could fall to 8.0 and Tier 1 to 5.1).
- Implement and monitor prudential liquidity policy (minimum core funding targets of 65 percent rising to 75 percent) to reduce rollover and maturity mismatch risks.
- Maintain contingency planning for balance-of-payments and exchange-rate pressures, including coordinated use of:
  - official reserves,
  - borrowing from Australian parent banks,
  - the Reserve Bank of New Zealand’s swap line with the U.S. Federal Reserve,
  - and the government’s wholesale funding guarantee introduced in November 2008.
- Monitor parent-bank funding capacity and cross-border contagion risks given reliance on Australian parents for potential emergency funding.

*Source: IMF working paper chapter "1. New Zealand’s Four Large Banks: Selected Financial Soundness Indicators" (excerpts).*

### 1. New Zealand’s Four Large Banks: Selected Financial Soundness Indicators...................5

### 1. New Zealand’s Four Large Banks: Selected Financial Soundness Indicators

### Overview of banking-sector position
- Banks remain profitable, with low levels of impaired assets, and aggregate capital well above the regulatory minimum.
- Key vulnerabilities identified:
  - Heavy exposure to households, whose debt has risen significantly and whose assets have been hit by a slump in house and equity prices.
  - Reliance on short-term wholesale funding from offshore markets that have been disrupted since the collapse of Lehman Brothers in September 2008.

### Stress-test findings and asset-quality scenarios
- Main quantitative finding:
  - An increase in the default rate from less than 1 percent at present to 6–8 percent for all loans would be required to reduce bank capital below 8 percent of risk-weighted assets.
- Interpretation:
  - Such a large increase in defaults is judged to be unlikely, but the risks have risen materially over the past year as the outlook for global and local economies has worsened.
- Recommendation stemming from stress-test results:
  - Banks should be required to undertake extreme stress tests and increase their capital if needed.

### Funding, liquidity, and external-financing risk
- Domestic liquidity backstop:
  - Banks would have access to domestic liquidity from the Reserve Bank of New Zealand (RBNZ) in the event of a disruption to capital inflows.
- External-financing pressures and potential mitigation measures:
  - The balance of payments and exchange rate may come under pressure if capital inflows are disrupted.
  - Use of some official reserves, borrowing from Australian parent banks, and tapping some of the Reserve Bank of New Zealand’s swap line with the U.S. Federal Reserve could fill the financing gap if up to two-fifths of external debt in 2009 were not rolled over.
  - The government’s wholesale funding guarantee scheme, introduced in November 2008, should help banks roll over their funding and lessen the possibility of a more severe disruption.

### Policy implications and recommended actions
- Require banks to perform severe/extreme stress tests reflecting large adverse moves in defaults and funding conditions.
- Mandate capital strengthening if stress-test results indicate capital would fall below regulatory minima.
- Maintain contingency planning for balance-of-payments and exchange-rate pressures, including coordinated use of:
  - official reserves,
  - borrowing from Australian parent banks,
  - the RBNZ’s swap line with the U.S. Federal Reserve,
  - and the government’s wholesale funding guarantee introduced in November 2008.

### Paper structure (as provided)
- Section II: Overview of the current financial position of New Zealand banks.
- Section III: Resilience to an increase in residential mortgage defaults; two alternative default scenarios and cross-country evidence assessing plausibility.
- Section IV: Extension of analysis to corporate lending.

*Source: IMF working paper chapter "1. New Zealand’s Four Large Banks: Selected Financial Soundness Indicators" (excerpts).*

### Section V discusses the risks associated with banks’ offshore funding, and in particular, the

### _wp09224 - Section V discusses the risks associated with banks’ offshore funding, and in particular, the

### II. The global turmoil: how has it affected New Zealand banks?
- Direct impact of the global financial crisis on New Zealand banks has been limited thus far.
- Banks had minimal exposure to U.S. subprime-related or other distressed assets; securitization of mortgages in New Zealand was very limited.
- The four largest banks are wholly owned by Australian parents; parents remained profitable and retained high credit ratings.
- Main direct impact: increase in the cost of borrowing relative to the New Zealand dollar swap rate.
- Banking system remained strong through mid-2009:
  - Total capital of the four large banks about 10–12 percent (well above regulatory minimum of 8 percent of risk-weighted assets).
  - Tier 1 capital ranged from 7½ percent to 10 percent in 2009.
  - Four largest banks’ share of total bank assets rose to almost 90 percent in 2008.
- Asset-quality indicators through mid-2009:
  - Loans overdue 90 days+ averaged just 0.6 percent of total loans for the four main banks.
  - Gross impaired assets covered by total provisions.
- Credit growth slowed to less than 5 percent year-on-year in mid-2009.
- Leverage: assets-to-capital multiple of 22 for New Zealand banks (noted as “well below” Finland, Ireland, United Kingdom in text).

### III. Can banks handle an increase in mortgage defaults? (Housing exposure and stress tests)
- Residential mortgages comprised 44 percent of total bank assets and 54 percent of total loans in 2008.
- House prices in early 2009 about 10 percent below the peak (peak in late 2007).
- Household indebtedness and servicing:
  - Total households’ debt about 160 percent of disposable income by end-2007 (stabilized since).
  - Debt service reached 14½ percent of disposable income by June 2008.
- Stress-test scenarios (December 2008 staff calculations; Four Large Banks average weighted by assets):
  - Reported actual total capital ratio: 11.3
  - Housing loans to total loans, average (actual): 56.5
  - Default on 5 percent of all housing loans:
    - New total capital ratio: 10.2
    - Minimum capital ratio among four large banks: 8.7
  - Default on 10 percent of all housing loans:
    - New total capital ratio: 8.7
    - Minimum capital ratio among four large banks: 6.8
  - Assumed average loss given default: 40 percent.
- Evidence suggests assumed default ratios in extreme stress tests are implausibly high for New Zealand:
  - HES 2007: less than 4 percent of owner-occupier mortgages were in higher risk group (debt service >30 percent of disposable income and loan-to-value >80 percent).
  - Weighted average ex-ante probability of default across risk groups estimated by banks: 1.6 percent (Table 7).
  - Harrison and Mathew (2008) estimate average probability of default for New Zealand households around 1 percent.
- Numerical example: to reach overall probability of default of 10 percent would require extremely high default probabilities (60–95 percent) for higher-risk buckets (Table 5).
- Mitigating factors against large mortgage losses:
  - New mortgage interest rates fell by over 400 basis points from their peak in July 2008.
  - Portion of high loan-to-value mortgages insured by third parties (example: ASB insured ¼ of loans with 80 percent+ LTV).
  - Legal framework makes homeowner liable for remaining debt after repossession.
  - Almost three-quarters of mortgage debt in 2007 held by households in two highest income quintiles; median debt-service ratio for those households below 20 percent.
- Prior stress tests (FSSA) combining shocks (20 percent fall in house prices; 4 percentage point increase in unemployment; 4 percent decline in household income) resulted in loss of ¼ of annual bank profits on average; no individual bank’s capital endangered by that scenario.
- Caveat: larger shocks to unemployment or household income could produce more severe losses.

### IV. How vulnerable are banks to higher defaults on corporate lending?
- Corporate and agriculture lending exposure smaller than household lending but grew quickly in the past year.
- Commercial property and agricultural lending rose in 2008; commercial property and dairy prices fell in recent quarters.
- Signs of stress: sharp pickup in past due loans (precursor to liquidations).
- Corporate sector metrics (aggregate ratios for nonfinancial private enterprises, in percent; Table 6 highlights):
  - Leverage (total liabilities to total assets): All industries 52.7; Agriculture 55.2.
  - Current assets to current liabilities: All industries 131.7; Agriculture 160.0.
  - Interest coverage ratio (EBIT/interest payments): All industries 3.7; Agriculture 1/3.7 (table formatting shows 3.7 for all industries, agriculture lower).
  - Return on assets: All industries 6.3; Agriculture 1.1.
- Listed companies show low probability of systemic distress one year ahead; New Zealand has highest distance-to-default ratio among comparators.
- Bank-published Basel II internal model disclosures (Table 7) — staff “arbitrary exercise” raising PDs and mortgage LGD:
  - Authors’ adjusted probability of default assumptions: assets shift to next highest risk category; category 7–8 PD assumed four times reported by banks.
  - Authors’ adjusted LGD: about 1½ times reported by banks for mortgage debt; unchanged for corporate and other retail.
  - Under this exercise:
    - Average overall default rate for four large banks would rise to about 6–8 percent of total loans.
    - Losses after provisions about 3 percent of loans for mortgages and corporate loans.
    - Total estimated loss: 7,809 (units: millions? Table shows numbers without units header — preserve exact figure “Total estimated loss 7,809”).
    - Less provisions: 1,572
    - Estimated loss after provisions: 6,237
    - Loss as percent of risk-weighted assets: 3.2
    - Implied new total capital ratio (average of four banks): 8.0
    - Implied new Tier 1 capital ratio (average of four banks): 5.1
    - Minimum new Tier 1 capital ratio among the four banks: 4.3
  - The bank most affected would see its Tier 1 ratio fall to just over 4 percent.
- Recommendation: banks should be required to undertake more detailed and extreme stress tests and increase capital if needed.

### V. What are the risks related to banks’ wholesale funding?
- Magnitude and maturity structure of foreign borrowing leaves banks vulnerable to disruptions to capital inflows.
  - Nonresidents comprise one-third of banks’ total funding.
  - Almost half of New Zealand’s foreign debt (bank and non-bank) matures in less than one year; more than half of this matures in 90 days or less.
- Since Lehman collapse (September 2008) bank access to global financing became more difficult; 5-year CDS spreads on four large Australasian banks increased markedly in early 2009 (Figure 10), then eased.
- Funding cost dynamics:
  - Reductions in foreign and domestic interest rates have more than offset increased spreads—total cost of funding fell.
  - Two-year NZD swap rate fell to about half the level one year earlier.
  - Short-term wholesale/retail funding costs (90-day bank bill, 6-month deposit rate) fell by similar amounts.
  - Retail deposit growth picked up after retail deposit and wholesale funding guarantees in late 2008.
  - Loan-to-deposit ratio remained high at over 145 percent (Figure 12).
- Balance-of-payments financing vulnerability:
  - Total external debt falling due in current year almost $NZ 120 billion.
  - Financing scenario analysis (Table 8, illustrative scenarios):
    - Official reserves: $NZ 19 billion (use assumption: one-half of reserves available per Table 8 notes).
    - U.S. Federal Reserve swap facility assumed US$15 billion (noted as $NZ 17.1 in Table 8 under illustrative financing).
    - Banks could raise $NZ 25 billion from Australian parents in illustrative scenario.
    - Analysis indicates if two-fifths or more of maturing debt failed to be rolled over in 2009, a financing gap could arise.
    - If only half of maturing debt were rolled over, a sizable financing gap could arise.
  - Historical precedent: during Asian crisis about ¾ of bank debt and 2/3 of nonbank debt was rolled over in Korea/Philippines/Thailand.
  - External short-term debt figures include parent funding to subsidiaries (less rollover risk than arms-length funding).
- Balance-of-payments illustrative numbers (Table 8, select exact figures):
  - Current account balance 2009 Est.: -10.4 (In percent of GDP) -5.8
  - Capital and financial account balance illustrative: -41.0 and -54.7 (two scenarios)
  - Overall balance illustrative: -51.4 and -65.0 (In percent of GDP) -28.6 and -36.2
  - Other sources of financing: 51.4 (includes official reserves 9.3; Australian parent banks 25.0; U.S. Federal Reserve swap facility 17.1)
  - Remaining gap in Scenario 2: -13.7 (Remaining gap as percent of GDP: -7.5)
  - Short-term debt (eop) 2009 Est.: 73.0 and in Table 8 another column 59.3 (preserve table context)
  - Total external debt (eop) 2009 Est.: 204.0 and 190.3 (table columns)
  - Official reserves 22.3 and 19.3 (memorandum items)
- Mitigants and cross-country perspective:
  - Gross external debt at 170 percent of GDP in June 2009 is smaller than Finland, United Kingdom, Iceland.
  - Banking system size: gross bank assets about twice GDP in New Zealand (vs factors of 7 UK, 9 Ireland, 11 Iceland).
  - Asset quality remains comparatively sound; little exposure to sub-prime assets.
  - Public finances relatively strong: gross public debt about 20 percent of GDP in 2008.
  - Exchange rate risk largely hedged: banks hedge more than 90 percent of foreign currency debt and more than half of foreign borrowing is in New Zealand dollars.
  - Sharp depreciation (~30 percent vs US$ between May 2008 and end-March 2009) did not materially impact bank or private sector balance sheets.
- Recent funding patterns and policy response:
  - New Zealand dollar-denominated bank funding from nonresidents remained stable; funding from nonresidents expressed in U.S. dollars declined by 3 percent between December 2007 and July 2009.
  - Exchange rate movements caused overall nonresident funding expressed in NZD to increase from December 2007 through July 2009.
  - RBNZ introduced prudential liquidity policy in June 2009:
    - Requires minimum core funding of 65 percent of total assets by October 1, 2009, increasing to 75 percent over two years.
    - Core funding defined as Tier 1 capital, wholesale and retail funding with residual maturity >1 year plus 90 percent of short-term retail funding.
    - Policy intended to encourage shift to medium-term debt and domestic retail funding.
  - Australian parent lending constraint: regulations limit direct lending to subsidiaries to maximum of 50 percent of Tier 1 capital (implying maximum lending to all Australian bank subsidiaries ~ $NZ 40 billion), though lending can occur via branches/associated vehicles.

### Key policy implications and recommendations
- Require banks to undertake more detailed and extreme stress tests, covering mortgage, corporate, and wholesale funding stress scenarios.
- Ensure banks increase capital buffers if stress tests reveal vulnerabilities (noting the illustrative exercise where average total capital ratio fell to 8.0 and Tier 1 to 5.1).
- Implement and monitor prudential liquidity policy (minimum core funding targets of 65 percent rising to 75 percent) to reduce rollover and maturity mismatch risks.
- Maintain access to official support tools (liquidity via RBNZ; use of US$ swap facility) as contingency for potential shortfalls in offshore funding.
- Monitor parent-bank funding capacity and cross-border contagion risks given reliance on Australian parents for potential emergency funding.

*Italicized source: IMF staff analysis as presented in the supplied PDF content.*

### References

### _wp09224 - References

### Cited works

- Brooks, R., 2008, “Assessing the Impact of a Disruption to Capital Inflows on New Zealand,” in New Zealand: Selected Issues, IMF Country Report No. 08/164 (Washington: International Monetary Fund).

- Harrison, I., and C. Mathew, 2008, “Project TUI: A Structural Approach to the Understanding and Measurement of Residential Mortgage Lending Risk,” Reserve Bank of New Zealand, http://www.fdic.gov/bank/analytical/cfr/2008/jun/Project_TUI-Final.pdf

- International Monetary Fund, 2004, New Zealand: Financial System Stability Assessment, IMF Country Report No. 04/126 (Washington: International Monetary Fund).

- ______, 2008, Global Financial Stability Report: October 2008 (Washington: International Monetary Fund).

- ______, 2009, “Global Economic Policies and Prospects,” Note prepared for the Group of Twenty Meeting of the Ministers and Central Bank Governors, March, http://www.imf.org/external/np/g20/pdf/031909a.pdf

- Reserve Bank of New Zealand, 2008, Financial Stability Report: November 2008 (Wellington: Reserve Bank of New Zealand).

- Rozhkov, D., 2007, “Analysis of Vulnerabilities,” in New Zealand: Selected Issues, IMF Country Report No. 07/151 (Washington: International Monetary Fund).

- ______, 2008, “Australian Banks: Weathering the Global Storm,” in Australia: Selected Issues, IMF Country Report No. 08/311 (Washington: International Monetary Fund).

- Statistics New Zealand, 2009, Balance of Payments and International Investment Position: Year Ended 31 March 2008, January (Wellington: Statistics New Zealand).

* _wp09224 - References_*

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