## _wp1307

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---

### Introduction and overview
- The soundness of the New Zealand banking sector was crucial to the resilience of the economy during the global financial crisis.
- The banking sector is dominated by four large subsidiaries of Australian banks; their combined assets are close to 90 percent of total banking sector assets and about 160 percent of GDP.
- Bank profits are strong and nonperforming loans are less than 2 percent of total loans.
- The four large New Zealand banks have capital well above regulatory requirements with high quality capital, but headline capital ratios are below the global average for large banks in a sample of advanced and emerging market economies.
- New Zealand’s conservative implementation of Basel II implies headline ratios underestimate capital strength.
- Stress tests indicate the four large banks can largely withstand sizeable stand-alone shocks to residential mortgages (calibrated on the Irish crisis) or corporate lending, but sizable combined shocks would exert much greater pressure on capital.

### Key features of the New Zealand banking sector
- Market concentration and size:
  - Four large banks’ assets: close to 90 percent of total banking sector assets.
  - Four banks account for about 95 percent of the residential mortgage market.
  - Combined assets of the four large banks are about 160 percent of GDP.
- Profitability and asset quality:
  - Return on assets (annualised): 1.1; other values shown: 0.9, 0.7, 1.0, 0.9, 0.9, 1.1, 0.9, 0.4, 0.9, 0.7, 0.5.
  - Return on equity (examples shown): 12.2, 10.3, 8.1, 14.7, 16.1, 15.5, 16.8, 15.2, 7.0, 11.9, 10.1, 7.3.
  - Nonperforming loans to total loans (past due 90 days plus/total loans): 0.2, 0.3, 0.3, 0.4, 0.4, 0.4, 0.4, 0.6, 0.7, 0.3, 0.5, 0.5.
- Capital adequacy and capital composition (selected indicators, in percent unless noted):
  - Tier one capital ratio (Basel II): 10.8, 10.0, 9.7, 10.4, 9.0, 8.9, 11.7, 11.2, 10.9, 10.8, 10.5, 9.9.
  - Total capital ratio (Basel II): 12.5, 12.7, 13.1, 12.7, 11.8, 11.8, 12.6, 12.8, 13.2, 12.5, 13.0, 12.7.
  - TCE/Total Assets: 5.7, 5.7, 6.0, 2.5, 2.0, 2.1, 3.5, 3.6, 3.5, 5.0, 5.7, 6.3.
  - TCE/Tangible Assets: 5.9, 5.9, 6.1, 2.5, 2.0, 2.1, 3.5, 3.6, 3.5, 5.3, 5.8, 6.4.
  - Net impaired assets to equity: 8.6, 11.6, 13.7, 5.8, 9.9, 13.2, 4.2, 6.7, 7.5, 10.2, 12.7, 10.9.
  - Specific provision to gross impaired assets: 32.9, 28.6, 30.2, 39.4, 34.4, 31.3, 30.7, 22.8, 18.4, 31.8, 28.2, 40.6.
  - Total provision to gross impaired assets: 77.2, 67.0, 69.8, 99.8, 76.8, 66.7, 86.5, 70.2, 80.1, 73.8, 75.4, 102.2.
  - Cash to total assets: 2.3, 2.0, 1.9, 2.0, 2.7, 2.9, 1.6, 2.0, 1.8, 2.3, 2.0, 0.9.
  - Cash and due from banks to total assets: 3.7, 5.8, 4.9, 3.7, 4.8, 4.7, 1.9, 2.0, 1.8, 2.8, 3.2, 1.0.
  - Notes: 2012 data are as of end June; income statement data are annualised.
- Asset composition and household metrics:
  - Residential mortgages and other lending are material shares of bank assets.
  - Household net wealth (mainly housing) exceeds 500 percent of disposable income.
  - Household debt remains high at over 140 percent of disposable income.
  - Residential house prices are estimated to remain elevated about 10-20 percent.
- Funding and external debt:
  - Short-term external debt (mostly held by banks) remains sizable at about 50 percent of GDP.
  - Banks have lengthened wholesale funding maturities since 2008 and increased share of retail deposits, but loan-to-deposit ratios are high.

### Risks, vulnerabilities, and systemic considerations
- Concentration and systemic risk:
  - Four systemically important banks’ large size and similar business models create potential for significant systemic repercussions if one becomes distressed.
  - Markets and rating agencies perceive the large banks as too big to fail; they could pose a sizable potential fiscal liability.
- Asset-side vulnerabilities:
  - Large exposure to highly indebted households and to the agriculture sector.
  - Household debt over 140 percent of disposable income; household net wealth above 500 percent of disposable income.
  - Residential house prices appear overvalued; estimates indicate they remain elevated about 10-20 percent.
  - A large fall in commodity prices could substantially impair agricultural loan quality; capital requirements for these loans have been strengthened since mid-2011.
- Funding-side vulnerabilities:
  - Reliance on short-term offshore funding increased exposure to global market disruptions; after Lehman, New Zealand banks used RBNZ liquidity support and a government wholesale funding guarantee.
  - Total short-term external debt about 50 percent of GDP.
  - Loan-to-deposit ratios are high.

### Basel II implementation and capital ratios
- Implementation choices:
  - The Reserve Bank of New Zealand required banks to adopt a more conservative approach than the Basel II minimum in several cases.
  - A 20 percent LGD floor was adopted for residential mortgages, above the Basel II floor of 10 percent.
- Consequences:
  - New Zealand banks’ LGD rates are higher than those of many other countries’ banks, meaning New Zealand’s regulatory risk weights and headline capital ratios underestimate underlying capital strength.

### Mortgage exposure, Pillar 3 disclosures, and LGD/PD effects
- Mortgage concentration:
  - Residential mortgages account for about 45 percent of the four large banks’ total lending.
- Weighted average effects (Table 3 weighted averages):
  - Using current LGD (21.6% 1/): Tier 1 = 10.1, Total = 12.6
  - Assuming LGD 10%: Tier 1 = 11.7, Total = 14.6
  - Assuming LGD 15%: Tier 1 = 11.0, Total = 13.7
  - Assuming average for Canadian 4 large banks' LGD (13.9% 1/): Tier 1 = 11.1, Total = 13.9
  - 1/ Weighted averages (Table 3 sources: Banks' disclosure statements; and IMF staff estimates).
- PD and composition:
  - The weighted average PD on residential mortgages for the four large New Zealand banks is over three times that of Canada’s three large banks, or about 1.2 times that of Australian four large banks.
  - Over 60 percent of the four large Canadian banks’ residential mortgages belong to the lowest risk bucket in 2011, compared with just about 10 percent in New Zealand and around 40 percent in Australia.
- Average risk weights:
  - New Zealand banks’ average risk weight is almost 3 times the average of the Canadian banks or around 1½ times that of the Australian or UK banks.
- Impact of applying other countries’ risk weights to New Zealand banks (Table 4 weighted averages):
  - Using current risk weight (28.7% 1/): Tier 1 = 10.1, Total = 12.6
  - Assuming Australian 4 large banks' risk weight (16.8% 1/): Tier 1 = 11.3, Total = 14.1
  - Assuming British 4 large banks' risk weight (18.5% 1/): Tier 1 = 11.1, Total = 13.9
  - Assuming Canadian 4 large banks' risk weight (10.3% 1/): Tier 1 = 12.1, Total = 15.1
  - Assuming Canadian 4 large banks' risk weight (7.4% 1/ 2/): Tier 1 = 12.4, Total = 15.5
  - 1/ Weighted averages. 2/ As of October 2011. (Sources: Banks' disclosure statements; and IMF staff estimates.)

### Quantitative stress scenarios for residential mortgages (September 2011 baseline; NZ$ millions unless noted)
- Ireland calibration used: unemployment rose to 14.8 percent in 2012 from 4.7 percent in 2007 and housing prices declined 50 percent from the 2007 peak.
- Baseline (Actual Sept 2011):
  - Residential mortgages exposure = 158,235
  - Total exposure = 359,638
  - PD (%) Residential mortgages = 2.7
  - LGD (%) Residential mortgages = 21.6
  - Risk weight (%) Residential mortgages = 28.7
  - Risk weighted assets: Residential mortgages = 46,580; Total = 183,693
  - Capital: Tier 1 = 18,507; Total = 23,111
  - Provisions = 2,501; Estimated loss = 1,073
  - Tier 1 (%) = 10.1; Total (%) = 12.6
- Scenario 1 (shares of 3 highest risk categories at Irish-bank levels):
  - Residential mortgages PD (%) = 10.6; LGD (%) = 22.0; Risk weight (%) = 37.2
  - Risk weighted assets: Residential mortgages = 58,880; Total = 195,993
  - Capital: Tier 1 = 17,548; Total = 21,192
  - Provisions = 2,501; Estimated loss = 4,420
  - Total loss to capital ... = 1,919
  - Tier 1 (%) = 9.0; Total (%) = 10.8
- Scenario 2 (Scenario 1 plus increases of LGD and RW by 1½ times):
  - Residential mortgages PD (%) = 10.6; LGD (%) = 33.1; Risk weight (%) = 55.8
  - Risk weighted assets: Residential mortgages = 88,319; Total = 225,432
  - Capital: Tier 1 = 16,197; Total = 18,983
  - Provisions = 2,501; Estimated loss = 6,629
  - Total loss to capital ... = 4,128
  - Tier 1 (%) = 7.2; Total (%) = 8.4
- Interpretation:
  - Under Scenario 1 PD rises from 2.7 percent to 10.6 percent and estimated losses exceed provisions, reducing Tier 1 capital ratio by about 1 percentage point.
  - Under Scenario 2 Tier 1 capital ratio is estimated to decline to about 7 percent; all four banks’ Tier 1 ratios remain above the regulatory minimum of 4 percent.
  - Downward internal ratings migration accounts for more than half of the reductions in Tier 1 capital ratio under both scenarios.

### Resilience factors and caveats for mortgage stress
- Mitigants:
  - RBNZ’s higher LGD assumptions in Basel II implementation.
  - Banks’ conservative origination practices and limited exposure to high-risk borrowers.
  - According to the 2010 Household Economic Survey, about 1 percent of owner-occupied mortgages had loan-to-value ratios above 80 percent and debt-service ratios above 50 percent.
  - Full recourse nature of mortgage lending reduces strategic defaults.
- Caveats:
  - Differences in definitions of eligible capital and measurement rules can result in larger Tier 1 capital deductions under Australian rules than elsewhere.
  - A fuller analysis of variances in regulatory and disclosure standards would facilitate international comparisons of headline capital ratios.

### Corporate lending stress scenarios (As of September 30, 2011; NZ$ millions unless noted)
- Credit exposures (Sept 30, 2011):
  - Corporates: 98,964
  - Residential mortgages: 158,235
  - Other retail/Small business: 23,329
  - Sovereign: 22,736
  - Bank: 26,535
  - Other: 29,839
  - Total: 359,638
- Simulation design and assumptions:
  - Corporate lending is treated as much riskier than mortgage: risk categories are shifted up by one category.
  - Scenario 1: Corporates' PD/LGD/RW shift to next higher risk category.
  - Scenario 2: Scenario 1 plus increase LGD and risk weights by 1½ times.
- Key parameter changes (Corporates):
  - Actual PD (%) 3/4.4 -> Scenario 1 PD (%) 14.5 -> Scenario 2 PD (%) 14.5
  - Actual LGD (%) 3/38.2 -> Scenario 1 LGD (%) 36.2 -> Scenario 2 LGD (%) 54.2
  - Actual Risk weight (%) 2/66.7 -> Scenario 1 Risk weight (%) 102.7 -> Scenario 2 Risk weight (%) 154.0
- Risk-weighted assets — Corporates:
  - Actual: 68,192
  - Scenario 1: 101,596
  - Scenario 2: 152,394
- Risk weighted assets — Total:
  - Actual: 183,693
  - Scenario 1: 217,097
  - Scenario 2: 267,895
- Capital and losses:
  - Capital — Tier 1: Actual: 18,507; Scenario 1: 16,583; Scenario 2: 14,675
  - Capital — Total: Actual: 23,111; Scenario 1: 19,740; Scenario 2: 16,805
  - Provisions: 2,501 (Actual and both scenarios)
  - Estimated loss: Actual: 1,738; Scenario 1: 5,872; Scenario 2: 8,807
  - Total loss to capital: Scenario 1: 3,371; Scenario 2: 6,306
- Capital adequacy ratios (In percent):
  - Tier 1 (%): Actual 1/ : 10.1; Scenario 1: 7.6; Scenario 2: 5.5
  - Total (%): Actual 1/ : 12.6; Scenario 1: 9.1; Scenario 2: 6.3
  - Regulatory minimum Tier 1 ratio: 4 percent (Scenario 2 remains above this minimum at about 5½ percent)
- Drivers of capital reduction:
  - Primary driver is downward internal ratings migration increasing measured risk-weighted assets and capital requirements.
  - Under Scenario 1 estimated PD rises to 14.5 percent from 4.4 percent.
  - Under Scenario 2 increases in LGD and RW by 1½ times further depress capital ratios.

### Combined shocks, broader stress-testing context, and policy implications
- Combined shocks:
  - Combined shocks to both mortgages and corporate lending put more pressure on banks’ capital than stand-alone shocks.
  - Example tail-risk: a hard landing in China (and thus Australia) reducing demand for New Zealand exports, worsening terms of trade, triggering a sudden decline in house prices, weakening consumer demand and growth, and negatively affecting banks’ balance sheets.
- RBNZ and APRA 2012 joint stress-test example:
  - Scenario included: a 40 percent drop in the world price of New Zealand’s commodity exports, a six-month freeze in wholesale debt markets, a cumulative output loss of four percent, unemployment rising to 11.4 percent, and a fall in house, farm and commercial property prices of about 30 percent.
  - That scenario resulted in Tier 1 capital ratios falling from over 10 percent to around 6 percent over three years — broadly similar to the combined shocks (Scenario 1) in Table 10.
- Illustrative combined-shock outcomes (In percent):
  - Tier 1: Actual 10.1 -> Scenario 1 6.3 -> Scenario 2 3.3
  - Total capital: Actual 12.6 -> Scenario 1 6.7 -> Scenario 2 3.3
- Policy implications and recommendations:
  - New Zealand’s four systemically important banks can withstand sizable stand-alone shocks to either mortgage or corporate lending, but combined shocks materially erode capital.
  - Continued strong bank supervision is important to maintain financial stability.
  - Options to strengthen prudential norms could include:
    - Higher minimum capital requirements for systemically important domestic banks to provide higher loss absorbency, taking into account evolving international standards and other measures to be implemented in New Zealand.
    - Raising the core funding ratio to more than the planned 75 percent to reduce short term external debt further.
    - Implementing the planned counter-cyclical capital buffer framework and other macroprudential instruments to improve resilience to extremes in the credit cycle.
  - Rationale:
    - Systemically important banks are perceived as too big to fail and pose a potential fiscal risk.
    - Higher capital buffers would reduce fiscal risk, limit the risk that asset-quality deterioration raises banks’ cost of capital, and reduce offshore funding difficulties.
  - Suggested enhancements to future stress tests:
    - Consider longer time horizons to capture sustained high unemployment effects (other FSAP stress tests used horizons up to five years).
    - Consider scenarios that include a jump in global longer-term interest rates, reflecting a rise in global rates and an increase in New Zealand banks’ risk premium, given dependence on offshore funding.

*Source: IMF staff analysis as presented in the supplied content unit.*

### 1. International Comparison of Key Soundness Financial Indicators .................................. 5

### 1. International Comparison of Key Soundness Financial Indicators

### Introduction and overview
- The soundness of the New Zealand banking sector was crucial to the resilience of the economy during the global financial crisis.
- The banking sector is dominated by four large subsidiaries of Australian banks; their combined assets are close to 90 percent of total banking sector assets and about 160 percent of GDP.
- Bank profits are strong and nonperforming loans are less than 2 percent of total loans.
- The paper finds that the four large New Zealand banks have capital well above regulatory requirements with high quality capital, but headline capital ratios are below the global average for large banks in a sample of advanced and emerging market economies. New Zealand’s conservative implementation of Basel II implies headline ratios underestimate capital strength.
- Stress tests indicate the four large banks can largely withstand sizable stand-alone shocks to residential mortgages (calibrated on the Irish crisis) or corporate lending, but sizable combined shocks would exert much greater pressure on capital.

### Key features of the New Zealand banking sector
- Market concentration and size:
  - Four large banks’ assets: close to 90 percent of total banking sector assets.
  - Four banks account for about 95 percent of the residential mortgage market.
  - Combined assets of the four large banks are about 160 percent of GDP (center of distribution across sample countries).
- Profitability and asset quality:
  - Return on assets (annualised): 1.1; other period values shown: 0.9, 0.7, 1.0, 0.9, 0.9, 1.1, 0.9, 0.4, 0.9, 0.7, 0.5.
  - Return on equity (examples shown): 12.2, 10.3, 8.1, 14.7, 16.1, 15.5, 16.8, 15.2, 7.0, 11.9, 10.1, 7.3.
  - Nonperforming loans to total loans: less than 2 percent (noted generally); table entries include past due 90 days plus/total loans values: 0.2, 0.3, 0.3, 0.4, 0.4, 0.4, 0.4, 0.6, 0.7, 0.3, 0.5, 0.5.
- Capital adequacy and capital composition (Table 1, New Zealand’s four largest banks — selected indicators, in percent unless noted):
  - Tier one capital ratio (Basel II): 10.8, 10.0, 9.7, 10.4, 9.0, 8.9, 11.7, 11.2, 10.9, 10.8, 10.5, 9.9.
  - Total capital ratio (Basel II): 12.5, 12.7, 13.1, 12.7, 11.8, 11.8, 12.6, 12.8, 13.2, 12.5, 13.0, 12.7.
  - TCE/Total Assets: 5.7, 5.7, 6.0, 2.5, 2.0, 2.1, 3.5, 3.6, 3.5, 5.0, 5.7, 6.3.
  - TCE/Tangible Assets: 5.9, 5.9, 6.1, 2.5, 2.0, 2.1, 3.5, 3.6, 3.5, 5.3, 5.8, 6.4.
  - Net impaired assets to equity: 8.6, 11.6, 13.7, 5.8, 9.9, 13.2, 4.2, 6.7, 7.5, 10.2, 12.7, 10.9.
  - Specific provision to gross impaired assets: 32.9, 28.6, 30.2, 39.4, 34.4, 31.3, 30.7, 22.8, 18.4, 31.8, 28.2, 40.6.
  - Total provision to gross impaired assets: 77.2, 67.0, 69.8, 99.8, 76.8, 66.7, 86.5, 70.2, 80.1, 73.8, 75.4, 102.2.
  - Cash to total assets: 2.3, 2.0, 1.9, 2.0, 2.7, 2.9, 1.6, 2.0, 1.8, 2.3, 2.0, 0.9.
  - Cash and due from banks to total assets: 3.7, 5.8, 4.9, 3.7, 4.8, 4.7, 1.9, 2.0, 1.8, 2.8, 3.2, 1.0.
  - Notes: 2012 data are as of end June; income statement data are annualised.
- Asset composition and household metrics:
  - Bank asset composition shows material shares in residential mortgages and other lending (Figure 7).
  - Household net wealth (mainly housing) exceeds 500 percent of disposable income.
  - Household debt remains high at over 140 percent of disposable income.
  - Residential house prices are estimated to remain elevated about 10-20 percent.
- Funding and external debt:
  - Short-term external debt (mostly held by banks) remains sizable at about 50 percent of GDP.
  - Banks have lengthened wholesale funding maturities since 2008 and increased share of retail deposits, but loan-to-deposit ratios are high.

### Risks, vulnerabilities, and systemic considerations
- Concentration and systemic risk:
  - The large size and similar business models of the four systemically important banks create potential for significant systemic repercussions if one becomes distressed.
  - Markets and rating agencies perceive the large banks as too big to fail; they could pose a sizable potential fiscal liability.
- Asset-side vulnerabilities:
  - Large exposure to highly indebted households and to the agriculture sector.
  - Household debt over 140 percent of disposable income; household net wealth above 500 percent of disposable income.
  - Residential house prices appear overvalued; estimates indicate they remain elevated about 10-20 percent.
  - A large fall in commodity prices could substantially impair agricultural loan quality; capital requirements for these loans have been strengthened since mid-2011.
- Funding-side vulnerabilities:
  - Reliance on short-term offshore funding increased exposure to global market disruptions; after Lehman, New Zealand banks used RBNZ liquidity support and a government wholesale funding guarantee.
  - Total short-term external debt about 50 percent of GDP.
  - Loan-to-deposit ratios are high (Figure 12 comparisons with Australian banks).

### Basel II implementation and capital ratios
- Implementation choices:
  - The Reserve Bank of New Zealand required banks to adopt a more conservative approach than the Basel II minimum in several cases.
  - Most importantly, a 20 percent LGD floor was adopted for residential mortgages, well above the Basel II floor of 10 percent.
- Consequences:
  - New Zealand banks’ LGD rates are higher than those of many other countries’ banks, meaning New Zealand’s regulatory risk weights and headline capital ratios underestimate underlying capital strength.

### Stress-testing and policy implications
- Stress-test findings:
  - Four large banks are largely able to withstand sizeable stand-alone shocks to residential mortgages (calibrated on the Irish crisis experience) or corporate lending.
  - Combined sizable shocks to both mortgages and corporate lending produce much more pressure on banks’ capital.
- Policy recommendations and options:
  - Ongoing assessment of banking sector vulnerability is necessary to minimize systemic risk from systemically important banks.
  - Options to strengthen prudential norms include higher minimum capital requirements for systemically important domestic banks to provide higher loss absorbency, taking into account evolving international standards.
  - Higher capital buffers at systemically important domestic banks in New Zealand would be beneficial, particularly during market uncertainty and given high bank concentration and large offshore wholesale funding needs.

*Source: _wp1307 - 1. International Comparison of Key Soundness Financial Indicators (IMF staff summary of provided content).*

### 12.      The headline capital ratios for the four large New Zealand banks are lower than for

### _wp1307 - 12.      The headline capital ratios for the four large New Zealand banks are lower than for

### Capital ratios and international comparability
- Headline capital ratios for the four large New Zealand banks are lower than for other advanced and emerging countries’ banks (Figures 13 and 14).
- Differences in regulatory rules affecting required capital calculation imply cross-country capital ratios should be interpreted with caution.
- New Zealand’s requirements for calculating risk weighted assets likely imply that risk-weighted assets in New Zealand banks are higher than for comparable banks in other countries, resulting in lower headline capital ratios for the same amount of capital.
- Due to the RBNZ’s conservative capital eligibility and deduction rules New Zealand banks tend to hold higher quality capital; this is reflected in higher rankings in tangible common equity ratios compared with their rankings in Tier 1 and total capital ratios (Figures 15 and 16).

### Mortgage exposure, Pillar 3 disclosures, and LGD/PD effects
- The paper focuses on residential mortgages because New Zealand banks have high exposure to residential mortgages (about 45 percent of the four large banks’ total lending).
- All banks in the four-country comparison adopted the advanced internal ratings based approach under Basel II.
- The RBNZ required higher loss given default (LGD) rates for residential mortgages than many other countries, producing higher Pillar 1 risk weighted assets for the same amount of mortgages (Figure 18).
- Weighted average effects (Table 3):
  - Using current LGD (21.6% 1/): Tier 1 = 10.1, Total = 12.6
  - Assuming LGD 10%: Tier 1 = 11.7, Total = 14.6
  - Assuming LGD 15%: Tier 1 = 11.0, Total = 13.7
  - Assuming average for Canadian 4 large banks' LGD (13.9% 1/): Tier 1 = 11.1, Total = 13.9
  - 1/ Weighted averages (Table 3 sources: Banks' disclosure statements; and IMF staff estimates).
- Probability of default (PD) and composition:
  - The weighted average PD on residential mortgages for the four large New Zealand banks is over three times that of Canada’s three large banks, or about 1.2 times that of Australian four large banks (Figure 19).
  - Over 60 percent of the four large Canadian banks’ residential mortgages belong to the lowest risk bucket in 2011, compared with just about 10 percent in New Zealand and around 40 percent in Australia (Figure 20).
- Average risk weights (Figure 21):
  - New Zealand banks’ average risk weight is almost 3 times the average of the Canadian banks or around 1½ times that of the Australian or UK banks.
- Impact of applying other countries’ risk weights to New Zealand banks (Table 4):
  - Using current risk weight (28.7% 1/): Tier 1 = 10.1, Total = 12.6
  - Assuming Australian 4 large banks' risk weight (16.8% 1/): Tier 1 = 11.3, Total = 14.1
  - Assuming British 4 large banks' risk weight (18.5% 1/): Tier 1 = 11.1, Total = 13.9
  - Assuming Canadian 4 large banks' risk weight (10.3% 1/): Tier 1 = 12.1, Total = 15.1
  - Assuming Canadian 4 large banks' risk weight (7.4% 1/ 2/): Tier 1 = 12.4, Total = 15.5
  - 1/ Weighted averages. 2/ As of October 2011. (Sources: Banks' disclosure statements; and IMF staff estimates.)

### Quantitative stress scenarios for residential mortgages
- Scenario setup:
  - Uses September 2011 bank disclosure data and applies Irish banks’ residential mortgage developments during the global financial crisis to New Zealand banks’ balance sheets.
  - Ireland calibration: unemployment rose to 14.8 percent in 2012 from 4.7 percent in 2007 and housing prices declined 50 percent from the 2007 peak (Figure 22).
  - Scenario assumption: shares of the three riskiest residential mortgage categories at the four large New Zealand banks rise to Irish banks’ 2010 levels (Table 6).
- Scenario outcomes (Table 7, all figures in millions of New Zealand dollars unless otherwise indicated; weighted averages where noted):
  - Actual (Sept 2011) baseline:
    - Residential mortgages exposure = 158,235
    - Total exposure = 359,638
    - PD (%) Residential mortgages = 2.7
    - LGD (%) Residential mortgages = 21.6
    - Risk weight (%) Residential mortgages = 28.7
    - Risk weighted assets: Residential mortgages = 46,580; Total = 183,693
    - Capital: Tier 1 = 18,507; Total = 23,111
    - Provisions = 2,501; Estimated loss = 1,073
    - Tier 1 (%) = 10.1; Total (%) = 12.6
  - Scenario 1 (shares of 3 highest risk categories at Irish-bank levels):
    - Residential mortgages PD (%) = 10.6; LGD (%) = 22.0; Risk weight (%) = 37.2
    - Risk weighted assets: Residential mortgages = 58,880; Total = 195,993
    - Capital: Tier 1 = 17,548; Total = 21,192
    - Provisions = 2,501; Estimated loss = 4,420
    - Total loss to capital ... = 1,919
    - Tier 1 (%) = 9.0; Total (%) = 10.8
  - Scenario 2 (Scenario 1 plus increases of LGD and RW by 1½ times):
    - Residential mortgages PD (%) = 10.6; LGD (%) = 33.1; Risk weight (%) = 55.8
    - Risk weighted assets: Residential mortgages = 88,319; Total = 225,432
    - Capital: Tier 1 = 16,197; Total = 18,983
    - Provisions = 2,501; Estimated loss = 6,629
    - Total loss to capital ... = 4,128
    - Tier 1 (%) = 7.2; Total (%) = 8.4
- Interpretation:
  - Under Scenario 1 the four large New Zealand banks’ PD increases from 2¾ percent to 10½ percent and estimated losses exceed provisions, reducing Tier 1 capital ratio by about 1 percentage point.
  - Under Scenario 2 the banks’ Tier 1 capital ratio is estimated to decline to about 7 percent; all four banks’ Tier 1 ratios remain above the regulatory minimum of 4 percent.
  - Downward internal ratings migration accounts for more than half of the reductions in Tier 1 capital ratio under both scenarios (Figure 23).

### Resilience factors and caveats
- Factors mitigating mortgage-related risks:
  - RBNZ’s higher LGD assumptions in Basel II implementation.
  - Banks’ conservative origination practices and limited exposure to high-risk borrowers.
  - According to the 2010 Household Economic Survey, about 1 percent of owner-occupied mortgages had loan-to-value ratios above 80 percent and debt-service ratios above 50 percent.
  - Full recourse nature of mortgage lending reduces strategic defaults.
- Caveats and comparability issues:
  - Differences in definitions of eligible capital and measurement rules (equity investments, dividends, expected loss and eligible provisions) can result in larger Tier 1 capital deductions under Australian rules than elsewhere.
  - A fuller analysis of all variances in regulatory and disclosure standards would facilitate international comparisons of headline capital ratios.

### Corporate lending exposure and risks
- The four large New Zealand banks’ exposure to businesses, including the agriculture sector, is 27 percent of total lending (Table 8 reference).
- Risks:
  - Debt levels in the agriculture sector and rural property prices remain elevated (Figures 24, 25, 26).
  - A large fall in dairy and meat prices could substantially reduce the quality of agricultural loans, given high levels of debt relative to agricultural output (Figure 26).
  - Nonperforming business loans picked up sharply since 2009, with some recent improvement (Figure 27).

*Italic: Source — IMF staff analysis as presented in the supplied content unit.*

### 25.      To assess the risks to banks of corporate lending, this section simulates a shock to the

### To assess the risks to banks of corporate lending, this section simulates a shock to the four banks’ corporate lending, using data published on their risk exposure.

### Simulation design and assumptions
- Corporate lending is classified as much riskier than mortgage in the banks' disclosures; for corporate lending, risk categories are shifted up by one category to a higher risk.
- The probability of default (PD) and loss-given-default (LGD) for category I loans are assumed to become those for category II loans, and so forth.
- Scenario 1: Corporates' PD, LGD, RW: shift to the next higher risk category.
- Scenario 2: Scenario 1 plus increase LGD and risk weights (RW) by 1½ times.

### Credit exposures (As of September 30, 2011; in millions of New Zealand dollars)
- Corporates: 98,964
- Residential mortgages: 158,235
- Other retail/Small business: 23,329
- Sovereign: 22,736
- Bank: 26,535
- Other: 29,839
- Total: 359,638

### Key parameter changes (Corporates)
- Actual PD (%) 3/4.4 -> Scenario 1 PD (%) 14.5 -> Scenario 2 PD (%) 14.5
- Actual LGD (%) 3/38.2 -> Scenario 1 LGD (%) 36.2 -> Scenario 2 LGD (%) 54.2
- Actual Risk weight (%) 2/66.7 -> Scenario 1 Risk weight (%) 102.7 -> Scenario 2 Risk weight (%) 154.0

### Risk-weighted assets and capital impact (In millions of New Zealand dollars)
- Risk weighted assets — Corporates:
  - Actual: 68,192
  - Scenario 1: 101,596
  - Scenario 2: 152,394
- Risk weighted assets — Total:
  - Actual: 183,693
  - Scenario 1: 217,097
  - Scenario 2: 267,895
- Capital — Tier 1:
  - Actual: 18,507
  - Scenario 1: 16,583
  - Scenario 2: 14,675
- Capital — Total:
  - Actual: 23,111
  - Scenario 1: 19,740
  - Scenario 2: 16,805
- Provisions: 2,501 (Actual and both scenarios)
- Estimated loss:
  - Actual: 1,738
  - Scenario 1: 5,872
  - Scenario 2: 8,807
- Total loss to capital:
  - Scenario 1: 3,371
  - Scenario 2: 6,306

### Capital adequacy ratios (In percent)
- Tier 1 (%):
  - Actual 1/ : 10.1
  - Scenario 1: 7.6
  - Scenario 2: 5.5
- Total (%):
  - Actual 1/ : 12.6
  - Scenario 1: 9.1
  - Scenario 2: 6.3
- Regulatory minimum Tier 1 ratio: 4 percent (Scenario 2 remains above this minimum at about 5½ percent)

### Drivers of capital reduction
- Primary driver: downward internal ratings migration, which increases measured risk-weighted assets and capital requirements.
- Under Scenario 1 the four banks’ estimated PD rises to 14½ percent from 4½ percent.
- Under Scenario 2, increases in LGD and RW by 1½ times further depress capital ratios.

### Combined shocks and broader stress-testing context
- Combined shocks to both mortgages and corporate lending put more pressure on banks’ capital than stand-alone shocks.
- Example tail-risk: a hard landing in China (and thus Australia) reducing demand for New Zealand exports, worsening terms of trade, triggering a sudden decline in house prices, weakening consumer demand and growth, and negatively affecting banks’ balance sheets.
- RBNZ and APRA 2012 joint stress tests included: a 40 percent drop in the world price of New Zealand’s commodity exports, a six-month freeze in wholesale debt markets, a cumulative output loss of four percent, unemployment rising to 11.4 percent, and a fall in house, farm and commercial property prices of about 30 percent. That scenario resulted in Tier 1 capital ratios falling from over 10 percent to around 6 percent over three years — broadly similar to the combined shocks (Scenario 1) in Table 10.
- Table 10 illustrative combined-shock outcomes (In percent):
  - Tier 1: Actual 10.1 -> Scenario 1 6.3 -> Scenario 2 3.3
  - Total capital: Actual 12.6 -> Scenario 1 6.7 -> Scenario 2 3.3

### Policy implications and recommendations
- New Zealand’s four systemically important banks can withstand sizable stand-alone shocks to either mortgage or corporate lending, but combined shocks materially erode capital.
- Continued strong bank supervision is important to maintain financial stability.
- Options to strengthen prudential norms if needed could include:
  - Higher minimum capital requirements for systemically important domestic banks to provide higher loss absorbency, taking into account evolving international standards and other measures to be implemented in New Zealand.
  - Raising the core funding ratio to more than the planned 75 percent to reduce short term external debt further.
  - Implementing the planned counter-cyclical capital buffer framework and other macroprudential instruments to improve resilience to extremes in the credit cycle.
- Rationale:
  - Systemically important banks are perceived as too big to fail and pose a potential fiscal risk.
  - Higher capital buffers would reduce fiscal risk, limit the risk that asset-quality deterioration raises banks’ cost of capital, and reduce offshore funding difficulties.
- Suggested enhancements to future stress tests:
  - Consider longer time horizons to capture sustained high unemployment effects (other FSAP stress tests used horizons up to five years).
  - Consider scenarios that include a jump in global longer-term interest rates, reflecting a rise in global rates and an increase in New Zealand banks’ risk premium, given dependence on offshore funding.

*Source: IMF staff estimates and banks' disclosure statements (As of September 30, 2011).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1307.pdf_