RBNZ FSR 20240501

Purpose of the Financial Stability Report

The Financial Stability Report outlines our assessment of the state of, and risks to, financial stability. The Report is one of our key publications, and aims to raise public awareness of developments in the financial system. It is published pursuant to section 170 of the Reserve Bank of New Zealand Act 2021, which states that the Report must:

• report on matters relating to the stability of New Zealand’s financial system, and other matters associated with the Reserve Bank’s prudential objective; and

• contain the information that is necessary or desirable to allow an assessment to be made of the effectiveness of the Bank’s use of its powers to protect and promote the stability of New Zealand’s financial system, and achieve the prudential objective.

Our prudential objective is to protect and promote the stability of New Zealand’s financial system. Financial stability means having a resilient financial system that can withstand severe but plausible shocks and provide the financial services that we all rely on. This ensures everyone in Aotearoa can safely save their money, make everyday transactions, access credit to consume and invest, and insure against risks.

The Report outlines our assessment of the state, resilience, and vulnerability of the financial system and its component parts. We assess how global and domestic developments are affecting the financial health of New Zealand’s households and businesses, and the financial performance and resilience of our financial institutions. We also highlight longer-term risks and issues that may affect financial stability.

This analysis feeds into setting our strategy and priorities for pursuing our financial stability objectives. These priorities, and progress towards achieving them, are also outlined in the Report, including actions to strengthen the regulatory framework, the use of our macro-prudential policy tools to mitigate the build-up of systemic risk, work to enhance the risk management of regulated entities, and our enforcement activities.

REPORT AND SUPPORTING NOTES PUBLISHED AT:

www.rbnz.govt.nz/financial-stability/financial-stability-report

Subscribe online: www.rbnz.govt.nz/email-updates

A summary of New Zealand’s financial system is published at: www.rbnz.govt.nz/financial-stability/overview-of-the-new-zealand-financial-system

This Report uses data available up to 29 April 2024.

Copyright © 2024 Reserve Bank of New Zealand

ISSN 1176-7863 (print)

ISSN 1177-9160 (online)

rbnz.gov t .nz

Chapter 01

Financial stability risk and policy assessment

Mt Cook. Photo: Esther Bonaparte

Chapter 1 . Financial stability risk and policy assessment

Key points

• New Zealand’s financial system remains strong as it continues to adjust to the higher interest rate environment. The impacts of high interest rates have been contained so far and if anything have been less severe than anticipated. However, above-target inflation and restrictive monetary policy mean that pockets of vulnerability remain.

• Global inflation is declining from elevated levels and financial markets have priced in lower policy rates over the next year. Central bank communications have been cautious, noting elevated uncertainty around the inflation outlook. Stronger-than-expected inflation could prompt a tightening in global financial conditions.

• Globally, commercial real estate markets remain under pressure, which is adversely affecting some highly exposed banks overseas. The housing market in China remains weak despite stimulus measures, putting pressure on property development companies. So far, spillovers from these developments to the banking sector have been contained.

• We are continuing to closely monitor the financial strain on New Zealand’s households and businesses. Most borrowers have repriced onto higher interest rates. Strong nominal income growth has supported the ability to service debt. Households have reduced their discretionary spending and some have reduced principal repayments to make their debt servicing more affordable. Businesses face ongoing pressure from increased costs and reduced economic activity. Non-performing loans across all sectors have gradually picked up from low levels. The extent of further increases will depend on economic activity and the performance of the labour market.

• Housing market activity remains weak as high interest rates have reduced borrowing capacity and investor demand. House prices have increased slowly over the past year following an earlier decline and remain within our estimated sustainable range. Proposed restrictions on debt-to-income (DTI) ratios will help protect against financial stability risks created by increases in risky mortgage lending, particularly during periods of low interest rates.

• Our recently-published 2023 Climate Stress Test found that in a severe scenario and without mitigating actions by banks, climate change would reduce bank profitability, affecting banks’ resilience in future economic downturns. In this Report, we further explore the impacts of insurance becoming more expensive or unavailable in some locations. This is a risk to households and businesses in those locations, and banks could also be exposed. We recently published guidance for regulated entities to promote the effective management of climate-related risks.

• The New Zealand banking system remains well placed to handle a range of severe scenarios. Banks’ capital positions remain strong. Profitability is declining from recent elevated levels. Liquidity remains high and funding conditions are strong. Scale and profitability challenges continue to weigh on the non-bank deposit taker (NBDT) sector.

• We are continuing to progress work on improving our prudential regulation framework. We recently published the proportionality framework we will apply when developing prudential standards for different deposit-taker types under the Deposit Takers Act 2023. We will publish consultation papers on the new standards later in May and in July. The expected timing of the Depositor Compensation Scheme commencing has been revised to mid-2025.

(2-year swap rates)

Global inflation is moderating and monetary policy is expected to become less contractionary this year

Global inflation is declining from elevated levels towards central banks’ targets. Market pricing currently implies that central banks in advanced economies will begin to reduce their policy interest rates later this year. The extent and the timing of monetary policy easing implied by market pricing have been sensitive to data outturns (figure 1.1). In contrast, central bank communications have emphasised that inflation risks remain high and uncertainty around the outlook is elevated. Major central banks remain focused on the slow pace of disinflation in service sectors. Labour market conditions continue to ease gradually, but remain tight in advanced economies including New Zealand. Supply chain pressures have re-emerged in recent months with the disruption to global shipping, amid high geopolitical tensions.

Expectations for monetary policy easing have led to equity markets rallying in major economies. The IMF’s recent Global Financial Stability Report noted that these rallies have also been supported by buoyant sentiment and optimism about earnings. An abrupt reversal in sentiment arising from weakerthan-expected earnings or inflation remaining elevated could drag stock prices down, which would generate economic and financial risks from a market-driven tightening in financial conditions.

Risks to global financial systems remain

Although the global monetary policy cycle appears to be around its peak, financial stability risks from high interest rates remain elevated due to the lagged impacts of monetary policy on the financial system.

In many countries commercial real estate owners remain under pressure, owing to tight monetary policy settings and structural changes to demand that were accelerated by the COVID-19 pandemic. Demand for office space has declined as remote working has become more prevalent, and demand for retail properties has declined, with consumers switching from in-person to online shopping. Internationally, several banks have experienced large falls in equity prices and credit downgrades in recent months due to their high exposure to commercial real estate. The pressures on these banks have been contained so far, and wider financial stability risks have been limited. In New Zealand, stresses in the commercial property industry are concentrated in the lower-quality office and parts of the retail sector. Risks to New Zealand banks from commercial property exposure are much more limited, with commercial property lending representing less than 10 percent of overall lending portfolios, and a lack of concentration in individual banks.

The housing market in China remains weak, with prices continuing to decline. Several major property development companies have defaulted on debt obligations as demand remains subdued and inventories are elevated. The weakness of the property market has contributed to a slowdown in economic activity and increased deflationary pressure. The Chinese authorities have announced several stimulus measures to support the property market and the wider economy, including reductions in banks’ required reserve holdings and benchmark lending rates. Local authorities in several Chinese cities have also eased restrictions on house purchases. So far, spillovers from the property market to the banking system have been contained.

Source: Reuters, Bloomberg, RBNZ calculations.

Note: The US series is constructed using swaps indexed to LIBOR interest rates until November 2021, and swaps indexed to the Secured Overnight Financing Rate after that date.

Figure 1.1

Wholesale interest rates

In New Zealand, most household and business borrowers have re-priced onto higher interest rates

Most mortgage borrowers have moved off the low fixed rates that were locked in two to three years ago onto much higher rates. The average rate across the stock of mortgage borrowers is now around 85 percent of the way to its projected peak. Business lending rates have also repriced higher, albeit more quickly. Borrowers have faced significant increases in interest costs, making it harder to meet their repayment obligations (see Special Topic 1 in Chapter 2).

Households have reduced their discretionary spending and, in some instances, also reduced principal repayments The proportion of mortgage borrowers who have not been able to cope with the increased debt servicing costs has picked up from low levels. Loan arrears and non-performing loans are around the levels experienced during the initial period of the COVID-19 pandemic and well below the levels following the Global Financial Crisis (figure 1.2).1 Banks expect further increases in loan impairments while interest rates remain high and as economic activity slows. The outlook for non-performing loans depends significantly on the future path of economic activity and labour market conditions. Banks report they are proactively identifying and contacting borrowers who may require assistance and offering them options to restructure their debt to manage pressures. It is encouraging that the increase in borrower stress is not accelerating.

Businesses are facing subdued demand as well as ongoing high operating costs

The business sector is facing soft global growth and subdued demand owing to restrictive monetary policy settings impacting domestic spending. Businesses also face pressure from increased operating costs, such as insurance premiums. Business

Figure 1.2

Non-performing loans by sector (share of lending by value, seasonally adjusted)

Source: RBNZ Bank Balance Sheet survey, private reporting.

failures have picked up over the past two years from previously very low levels. Banks’ non-performing loans have also increased over recent months. Financial pressures are most severe in sectors sensitive to higher interest rates, either from higher debt servicing costs or from reduced demand, like the construction sector.

As in other countries, high interest rates have added to debt servicing pressure for commercial property owners. While vacancies are generally lower in New Zealand than in many other countries, low quality office and retail properties remain under pressure from structural trends in tenancy demand, such as increased remote working. In the agriculture sector, near-term risks in the dairy sector have eased as milk prices have increased and farmers have cut costs. While this has reduced cash flow pressures, milk prices remain volatile and there are ongoing challenges. In particular, debt-servicing costs are significant for dairy farmers, even though the reduction in debt in the past five years has improved their resilience. The sheep and beef industry is under pressure from declining international meat prices reducing profitability.

1 Current economic conditions and forecasts of future conditions in the February Monetary Policy Statement are much more benign than the scenario tested in the most recent Bank Solvency Stress Test. In the stress test, bank capital remained well above the regulatory minimum despite a highly adverse stagflation scenario. See https://www.rbnz.govt.nz/-/media/project/sites/rbnz/files/publications/ bulletins/2022/2022-bank-solvency-stress-test-bulletin.pdf

High inflation and restrictive monetary policy have affected households and businesses through several channels. While the shortterm focus remains on the financial stress of higher debt-servicing costs on households and businesses, another impact has been the reduction in demand for credit across sectors. This deleveraging, along with nominal income growth, means that the aggregate debt levels of households and businesses have declined as a share of GDP (figure 1.3). A positive consequence of this deleveraging is that it will help to support the resilience of households and businesses going forward.

House prices have increased from recent lows but housing market activity remains weak

Housing market activity remains weak overall as high interest rates have reduced borrowing capacity and investor demand. As a result, house sales have been subdued and days to sell remain elevated. Recent house price increases have been underpinned by rental growth, driven by population growth outstripping new supply. Strong net immigration has increased the demand for rental housing, while the supply of new housing is expected to slow once developers complete existing projects. Faced with elevated uncertainty, many house buyers are preferring to purchase existing properties rather than buy new builds off the plans. As a result, many developers are finding it difficult to achieve the levels of pre-sales required by banks to finance new projects.

Recent tax policy changes will also affect the housing market. Restoring the tax deductibility of interest expenses for residential property investments will increase investors’ valuations of existing properties and raise their debt servicing capacity, increasing demand for existing properties. In addition, reducing the duration of the brightline period will increase after-tax capital gains for investors selling properties within 10 years of purchase. This could increase speculative housing activity at the margin. In the near term, some investors struggling with debt-servicing costs and other increases in home ownership costs may decide to sell properties, given they are no longer required to pay tax on capital gains.

Borrowing from financial institutions by sector (Bank and non-bank lending as a percent of GDP)

Lower house prices and strong nominal income growth have contributed to declines in house price-to-income ratios since 2021, particularly in Auckland, although these ratios remain elevated compared to historical levels (figure 1.4). House prices remain within our estimated sustainable range. Looking ahead, strong population growth, potentially lower mortgage rates and increased investor activity from tax policy changes suggest there is a risk that house prices will rise relative to sustainable levels. We will continue to use our macroprudential toolkit to manage risks to the financial system that could arise from unsustainable house prices.

Figure 1.4

House price-to-income ratios by region

Source: REINZ, Stats NZ, RBNZ estimates. Note: Figure shows

Figure 1.3

Source: RBNZ Bank Balance Sheet Survey, Non-bank Standard Statistical Return, Stats NZ, RBNZ calculations.

Introducing restrictions on debt-to-income ratios will help manage housing-related risks to the financial system

We recently consulted on activating restrictions on DTI ratios, as the necessary preparations for their use near completion.2 DTI restrictions would complement the restrictions on loan-to-value ratios (LVRs) that are currently implemented. LVR restrictions are mainly aimed at improving the resilience of the financial system by reducing potential losses if borrowers default on their mortgages. On the other hand, the DTI tool aims to improve borrower resilience by reducing the probability of borrowers defaulting. Given these tools have synergies in mitigating losses for the financial system, restricting DTI ratios would allow for more permissive LVR settings while achieving a similar level of overall resilience.

By activating DTI restrictions when the market is relatively subdued, it is likely that they will not be binding initially for most borrowers. Instead, DTI restrictions are intended to protect against increases in risky lending, especially when interest rates decline.

Climate-related risks could reduce financial system resilience if left unmanaged

We continue to monitor and analyse the impact of climate-related risks on the financial system. If these risks are not managed, they would lessen the resilience of the system to other shocks.3 Our 2023 Climate Stress Test showed that climate-related risks have the potential to reduce bank profitability and increase risk-weighted assets in the coming decades. The stress test is based on a severe but plausible scenario that combines high physical and high transition risks from climate change.4 Assuming no actions are taken by banks to mitigate the risks in the scenario, such as changing their lending policies, the impact on bank profitability

(figure 1.5) comes mainly through an increase in impaired loans to borrowers who are financially vulnerable to the climate-related risks. In this scenario, banks had to reduce dividends by nearly 40 percent to maintain their capital ratios compared to the base case with minimal climate change. On its own, however, the scenario did not threaten bank solvency or financial stability.

Climate change is also influencing insurers’ moves towards a greater use of risk-based pricing for residential dwelling insurance. Driven by improved data and modelling, insurance premiums are becoming more tailored to the specific risks that a property faces (such as seismic or flood risks), as opposed to reflecting broad averages of the risks facing properties over wide areas. In some locations, the exposure to seismic or climate-related risks may exceed insurers’ risk tolerance and their ability to access reinsurance to hedge the exposure. Complete withdrawals of insurance availability in high-risk areas are likely to occur only gradually, although some policyholders are already finding insurance increasingly unaffordable (see Special Topic 2). Banks could also be exposed to insurance retreat as the value of properties in high-risk areas declines if they are no longer insurable or the costs increase significantly.

2 See: https://www.rbnz.govt.nz/hub/news/2024/consultation-on-dti-and-lvr-settings

3 See: https://www.rbnz.govt.nz/financial-stability/stress-testing-regulated-entities/climate-stress-test

4 We refer to the scenario as ‘Too Little Too Late’ because in the scenario limited and delayed global policy action to reduce emissions is insufficient to prevent significant climate change. The scenario features a range of climate-related risks, including floods, insurance retreat, drought, stringent emissions pricing (including for agriculture) and broad macroeconomic effects.

Figure 1.5

Bank profits in Climate Stress Test (after tax, five-year total)

Source: RBNZ calculations.

In addition to stress testing, we are working to support the financial sector to manage climate-related risks. We recently released a guidance document for prudentially regulated entities on managing climaterelated risks.5 The document aims to help develop a shared understanding of and promote our view of what constitutes good practice relating to managing climate-related risks. It should create a better understanding of the physical and transition risks arising from climate change, ensure business decisions are well informed about climaterelated risks and lead to the implementation of appropriate governance, strategy, risk management and metrics and targets. We have also published a bulletin article on using credit risk weights for climate-related purposes.6

A common theme in this work has been the need to enhance stakeholders’ risk management capabilities, including through improvements in the quality and availability of data. Coordinated responses between stakeholders (property owners, central and local governments, insurers and lenders) are essential for effective management of climate-related risks.

New Zealand banking system remains well positioned to handle economic or financial shocks

The New Zealand banking system remains well placed to handle external shocks and a downturn in the economy (see Chapter 4). Bank capital ratios remain well above regulatory requirements and banks are well progressed towards meeting the new requirements being gradually phased in through to 2028.7 Indicators of bank profitability have eased from recent elevated levels.

Net interest margins have come off recent highs as depositors continue to transition from on-call accounts to term deposits in response to high interest rates. Broader measures of bank profitability are also declining as banks have made provisions for increased loan impairments.

Liquidity in the banking system remains at an historically high level. The high volume of liquid assets has been supported by the Funding for Lending Programme (FLP) and the Large Scale Asset Purchase operations implemented during the pandemic.

Banks’ core funding positions are strong with robust deposit growth amid low credit growth, which reduces their need to obtain funding from wholesale markets. Overseas funding markets are currently highly accommodative, and banks report they are confident about their capacity to raise wholesale funding.8

Funding from the FLP has begun to mature at a gradual pace, and banks are steadily replacing the maturing FLP funding with a combination of wholesale market and term deposit funding. Competition for term deposits is likely to continue as FLP funding matures and as banks prepare for a recovery in credit demand.

From a regulatory perspective, we are continuing to conduct our Liquidity Policy Review. Last December we announced we would retain and modify our existing quantitative liquidity metrics (the mismatch ratios and the core funding ratio) rather than adopt the international Basel liquidity metrics. In addition, we decided to tighten the eligibility criteria for liquid assets under our policy and introduce two categories of liquid assets.9

5 https://www.rbnz.govt.nz/hub/news/2024/03/guidance-issued-on-managing-climate-related-risks

6 https://www.rbnz.govt.nz/hub/news/2024/03/the-use-of-credit-risk-weights-for-climate-related-purposes

7 For our assessment of the first two years of Capital Review implementation, see https://www.rbnz.govt.nz/hub/news/2024/03/rbnzpublishes-assessment-of-capital-review-implementation

8 Bank funding from overseas wholesale markets contributes to funding New Zealand’s current account deficit. The current account deficit has been elevated in recent years relative to its historical level, however international credit rating agencies have assessed the financial and economic risks arising from the current account deficit as relatively low, given that its funding it does not rely to any significant extent on short-term international liabilities. See Special Topic 2, https://www.rbnz.govt.nz/hub/publications/monetary-policy-statement/2023/ monetary-policy-statement-august-2023

9 https://www.rbnz.govt.nz/have-your-say/2022/review-of-liquidity-policy

The Commerce Commission recently published the Draft Report of its market study into the personal banking sector in New Zealand.10 The report identified several factors that were limiting competition in the sector, including the structural advantages of the large banks from operating at a larger scale and lower funding costs, regulatory barriers to new entrants and smaller entities (including the Reserve Bank’s prudential capital requirements) and difficulties for consumers to switch between providers. The Commission made several recommendations aimed at improving competition. Our submission to the Commission on the recommendations in the report is available on our website.11 In our view, the best way to promote competition is to accelerate progress on open banking. As in other countries, if done comprehensively, it could drive more competition between both existing and new players, enhancing consumer choice and outcomes.

Performance of non-bank deposit takers has been mixed, with some facing challenges from their lack of scale

The NBDT sector consists of building societies, credit unions and deposit-taking finance companies. With total lending at around $2.2 billion, the sector is small relative to the banking sector in total lending but provides services to a relatively large number of customers.

As with banks, there has been a broad-based slowdown in new lending by NBDTs in the last 18 months, particularly by building societies and credit unions. This has been driven by higher interest rates, subdued demand for credit and an uncertain economic outlook. As a whole, the NBDT sector continues to build capital buffers and improve operational efficiency. However, some NBDTs continue to face challenges from the softening economic environment and their lack of scale.

Key policy and supervisory developments

We are continuing to progress work on modernising and strengthening our prudential regulation framework (see Chapter 3). The long-term objective of the Deposit Takers Act 2023 (DTA) is to achieve a resilient and inclusive financial environment that contributes to a sustainable and productive economy. As part of the implementation of the DTA, we recently published the proportionality framework we will apply when developing prudential standards for different groups of licensed deposit takers.12 Deposit takers will be allocated into four groups based on their total assets and whether they are locally incorporated deposit takers or branches of overseas incorporated deposit takers.

We will soon begin consultation on the standards under the DTA. Standards will replace the existing prudential requirements for banks and NBDTs. Our first consultation in May will cover the four core standards: capital, liquidity, disclosure and the Depositor Compensation Scheme (DCS), which will form the basis of relicensing existing deposit takers. In July we will consult on the remaining standards.

The DCS is being established to contribute to public confidence in the banking system and support financial stability. With the DCS New Zealanders can have confidence that their deposits are protected. The commencement date for the DCS has been revised from late 2024 to mid-2025.

Cyber risk is a growing source of operational risk for the financial sector, leading to increasing recognition of the importance of cyber resilience. We are implementing requirements for cyber incident reporting, to assist regulated entities to develop improved cyber resilience (see Box A).13

10 https://comcom.govt.nz/about-us/our-role/competition-studies/market-study-into-personal-banking-services

11 https://www.rbnz.govt.nz/hub/news/2024/04/rbnz-releases-submission-on-draft-commerce-commission-market-study

12 https://www.rbnz.govt.nz/hub/news/2024/03/a-proportionality-framework-allows-for-diversity-while-promoting-financial-stability

13 For an international assessment of the financial stability implications of cyber risk, see Chapter 3 in the IMF’s Global Financial Stability Report (April 2024).

Chapter 02

Special topics

Ngaio, Wellington. Photo: Charles Lilly

Chapter 2 . Special topics

This chapter covers topical issues relevant for financial stability in New Zealand.

In this Report, we cover the following:

1. Update on the financial strain faced by households and businesses

2. Insurance availability and risk-based pricing

Selected special topics and boxes from the past 12 months Topic Date/publication

An international perspective on the financial stability implications of higher interest rates

Developments in the agricultural sector

Trends in bank deposits through the period of monetary policy tightening

Financial stability implications of recent North Island weather events

Trends in bank profitability

Interest rate risk management in the New Zealand banking system

The relationship between financial inclusion and financial stability

November 2023 Report (Chapter 2.1)

November 2023 Report (Chapter 2.3)

November 2023 Report (Box C)

May 2023 Report (Chapter 2.2)

May 2023 Report (Chapter 2.3)

May 2023 Report (Box A)

May 2023 Report (Box B)

1 Update on the financial strain faced by households and businesses

The relatively quick transition to high interest rates after more than a decade of low interest rates has been a major development affecting global financial systems over the past two years. The impact of higher interest costs on indebted households and businesses has been a key focus for us given its implications for financial stability in New Zealand. An increase in defaults as borrowers fall behind on their debt repayments would result in losses to banks and, on a large enough scale, could lead to financial instability.

Distribution of mortgage rates across the stock of mortgage lending

To date, the impacts of higher interest rates on the financial system have been more benign than generally expected. This is despite higher interest rates contributing to reduced economic activity, subdued credit growth across sectors, and house prices falling by around 15 percent between late 2021 and early 2023. This special topic provides an update on the financial strain facing households and businesses, and how this is expected to develop over the coming year.

Mortgage repricing

is now well advanced and households continue to adapt

Most borrowers have moved off the low fixed mortgage rates that were locked in two to three years ago onto much higher rates. Only around 10 percent of mortgage lending remains on fixed rates below 4 percent (figure 2.1). As a result, the average rate across the stock of lending is about 85 percent of the way to its projected peak. This rate has increased to 6.0 percent from a low of 2.8 percent in 2021. It will likely continue to increase to around 6.5 percent at around the end of this year based on the forward path of interest rates implied by market pricing.

Mortgage borrowers have had to adapt to the higher interest costs. Retail spending volumes have declined since early 2022 despite strong net immigration. This suggests that households have limited their discretionary spending. In addition, some borrowers have reduced principal repayments, which is an option available to borrowers who have paid off principal faster than required (figure 2.2).

Source: Stats NZ, RBNZ Income Statement survey, RBNZ estimates.

Figure 2.1

Source: Privately reported data from the four largest banks: ANZ, ASB, BNZ, and Westpac.

Figure 2.2

Composition of scheduled mortgage repayments (share of disposable income for mortgage borrowers)

Mortgage arrears continue to rise from recent lows

A small proportion of mortgage borrowers has not been able to manage higher interest costs. Difficulty in keeping up with payments has likely been made worse by cost-of-living pressures and other unforeseen events like job losses. As a result, an increasing share of mortgage lending has been categorised as non-performing (defined as those 90 or more days in arrears or impaired). This share has increased from 0.2 percent in 2022, a very low level, to around 0.5 percent currently (figure 2.3). We also monitor the share of lending that is 30 days or more past due as a leading indicator of future non-performing loans. The share has also gradually increased to slightly above the 2020 peak. A similar trend can also be seen in the share of mortgage lending categorised as in hardship, where borrowers have suffered unforeseen circumstances that have needed them to change their debt repayments to be able to keep up with their obligations.

Data from the four largest banks show that the non-performing share is somewhat higher for lending already on higher mortgage rates, highlighting the link between debt servicing costs and borrower cash flow pressures (figure 2.4).

Households that borrowed heavily relative to their incomes are particularly strained by rising interest costs. Centrix data show that rates of financial hardship are highest amongst those between the ages of 30 and 50, who also tend to have larger loans. The share of new lending at high debt-to-income (DTI) ratios, i.e. above 6, was particularly elevated around 2021. This was when interest rates were particularly low and banks were using mortgage rates of around 6 percent in their affordability assessments for new lending. We recently consulted on the calibration of DTI restrictions, which aim to limit this vulnerability in the future.

Non-performing and past due mortgage lending (share of lending by value, seasonally adjusted)

Source: RBNZ Bank Balance Sheet survey, private reporting, registered banks’ Disclosure Statements.

Note: Historical 30+ days past due data covers the four largest banks.

Mortgage arrears by fixed mortgage rate (excludes floating-rate mortgages, February 2024)

Source: RBNZ estimates.

Note: Based on data from the four largest banks: ANZ, ASB, BNZ, and Westpac. Floating mortgages are excluded to separate the impact of mortgage rates on arrears from other factors that cause the share of non-performing loans on floating rates to be higher. Mortgages in arrears may be rolled onto or kept on floating rates to allow banks flexibility to manage the loan and find longer-term solutions.

Figure 2.3

Figure 2.4

Banks are well positioned to manage further increases in mortgage arrears

More borrowers are expected to fall behind on their mortgage payments. Banks have provided us with projections of the nonperforming share of their mortgage lending (figure 2.5). They expect this proportion to increase to 0.7 percent by around the end of this year, around half what it was during the Global Financial Crisis.

Arrears are expected to rise as some borrowers continue to roll onto even higher mortgage rates, albeit with the bulk of the transition already complete. The impact of higher debt servicing costs is also often only fully realised after some time, as a strained borrower exhausts savings and other buffers. However, banks have reported to us that on average borrowers still have capacity to handle high debt servicing costs, either through reducing principal repayments or drawing on savings buffers. As an example, an option for borrowers in financial stress is to pay only the interest costs and stop principal repayments. Over the past year, the share of interest-only mortgages has remained flat at historically low levels. Despite this, a small portion of borrowers will have few options available and are at risk of default.

Robust labour market conditions and strong nominal wage growth have supported borrowers over recent years. In general, if a mortgage holder still has a job, they can find ways to manage their repayments. However, with most economic forecasters expecting the unemployment rate to increase over the next year, a softer labour market is likely to lead to an increase in arrears.

With mortgages making up around 60 percent of bank lending, increased mortgage losses are likely to affect bank profitability. However, very few households are in a position of negative equity and banks would likely face relatively small losses in the event of an increase in borrowers defaulting. In addition, banks are in a strong financial position to continue to support their customers and maintain credit availability, owing to a combination of higher

Projections for non-performing loans by sector (share of lending by value)

Source: RBNZ estimates.

Note: Non-performing loan ratio data prior to 2016 are for the banking sector as a whole, and after that date, for the five largest banks (ANZ, ASB, BNZ, Kiwibank and Westpac). The projections are weighted averages (based on lending amounts) of the five largest banks’ projections for their own lending, as surveyed in February 2024 and August 2023.

collective provisions and capital ratios, even if a significant deterioration in economic conditions eventuates (see Chapter 4).

Business failures are also rising from low levels

The business sector is facing subdued demand compared to the past few years, owing to the impact of high interest rates on domestic spending and below-trend global growth. High operating costs are accentuating lower demand, even as capacity pressure in the economy has eased somewhat. Growth in labour costs remains high, putting pressure on margins. Insurance costs and local authority rates have also increased considerably for businesses (Special Topic 2 covers the drivers of higher building insurance premiums, which affect both households and businesses).

These developments have had varied impacts across sectors. Retail trade, manufacturing and construction face weak demand owing to the impact of higher interest rates, particularly on the housing market. Service-based sectors like restaurants and hospitality appear somewhat more resilient, benefiting from the rebound in net migration and international tourist arrivals following the removal of pandemic-related restrictions.

Figure 2.5

The number of business failures has picked up over the past two years from very low levels (figure 2.6), particularly in the construction sector. The share of bank lending to businesses that is non-performing has increased over the past six months to around its 2020 level, and banks expect this share to remain broadly around current levels in the year ahead (figure 2.5). This projection is lower than what was expected six months ago, driven by a lower expected default rate among agricultural and general business lending. Cautious lending standards over recent years are helping to contain the increase in default rates.

The revision also partly reflects the improved outlook for global inflation and lower expected path of interest rates, the fact that repricing of business lending rates occurs relatively quickly following interest rate changes, and the recent recovery in dairy prices and farm profitability.

Reflecting recent challenges as well as higher interest rates, business lending has stopped growing. Banks’ responses to our Credit Conditions survey highlight that many businesses are delaying capital expenditure, which is reducing demand for credit, particularly from smaller businesses. Relative to GDP, business debt has declined noticeably since early 2020, suggesting lower leverage overall and greater financial resilience (see figure 1.3 in Chapter 1).

Near-term risks to the agriculture sector have eased with the recovery in dairy prices

Dairy prices are often volatile, and this has been the case again in the past year. In August 2023, the midpoint of Fonterra’s milk price forecast for the 2023/24 season was $6.75 per kilogram of milk solids (kgMS). Since then, international dairy prices have recovered and Fonterra’s milk price forecast has been revised higher to a midpoint of $7.80 per kgMS. Demand for dairy products has recovered in the major trading partners, while supply conditions have tightened in Europe and the United States. In addition to the rebound in milk prices, potential dry conditions related to El Niño have generally not occurred so far. Most dairy farms are likely to be profitable in the current season and the near-term risks to the sector have abated somewhat.

While revenue continues to fluctuate, the sector has other ongoing challenges to manage. Operating costs remain high following strong cost inflation over the past few years. The average cost of producing a kgMS for the 2023/24 season is estimated to be around $7, including operating and interest costs. This is lower than the average cost in the previous season as farms have significantly cut a range of operating expenses to manage cash flows. Some of these cuts are likely to be temporary, for example those to repairs, maintenance and fertilizer.

Source: New Zealand Companies Register.

Figure 2.6

Company failures (seasonally adjusted, 3-month average)

Debt servicing costs have increased considerably. Anonymised farm-level data from Figured (which operates a financial management platform for farmers) show the range of interest costs that farms incur (figure 2.7). While varying across farms, a majority of farms currently pay between $1.0 and $2.5 per kgMS. Around 7 percent of farms pay more than $3 per kgMS, and this proportion has been increasing. The reduction in debt held by the sector over the past five years has helped to contain these increasing costs. Farmers have also reduced principal repayments considerably to mitigate the rising cash flow pressure in the short term, which will slow any further debt reduction.

Climate-related risk and regulatory changes continue to affect the dairy sector. Investment has been cut as farmers manage their shortterm cash positions. This means progress towards more efficient production methods to help reduce emissions may be slower than otherwise expected. Our November 2023 Report delved further into climaterelated risks for the agriculture sector using the results of a sensitivity analysis that we undertook with banks. The analysis showed there would be material impacts on farm lending from drought conditions and various levels of emissions pricing.

Despite these challenges, the share of banks’ dairy lending that is non-performing or potentially stressed remains low (figure 2.8). The higher expected milk payout compared to six months ago is supportive. Also, several profitable seasons have put farmers in a stronger position to manage the current challenges. A prolonged period of low payouts would see a material rise in loan losses for banks.

Around 40 percent of bank’s agriculture lending is outside the dairy sector, which is around 3 percent of their total lending. These other parts of the agriculture sector are struggling overall, with potentially stressed lending picking up over the past six months. For example, falls in international prices are impacting the profitability of sheep and beef

Distribution of interest costs for dairy farms (dollars per kgMS)

Source: Figured.

Source: Private reporting, RBNZ Bank balance sheet survey.

Note: Non-performing loans includes loans classified as 90+ days past due or impaired. Potentially stressed loans includes loans that banks have assigned internal credit rating grades equivalent to B (S&P/Fitch) or B2 (Moody’s) or lower, but which are not non-performing.

farmers and the goat dairy industry. Meat prices have been temporarily dampened by additional supply from a drought-related surge in slaughter numbers in Australia. Like dairy, the meat sector faces higher debt servicing costs and climate change-related risks in the longer term, and many farms still require substantial investment to transition to a lower emission environment. These challenges could exacerbate the current financial strains. The horticulture sector is having a better season this year owing to generally good growing conditions, with parts of the sector still recovering from the devastating impacts of Cyclone Gabrielle last year.

Figure 2.7

Figure 2.8

Non-performing and potentially stressed loans in the agriculture sector

Commercial property risk remains a focus internationally and in New Zealand

Commercial property lending is a key source of risk to financial institutions in many developed economies, with some small and medium-sized banks in the United States particularly exposed. In New Zealand, commercial property makes up around 8 percent of bank lending. Structural trends such as increased remote working and online shopping, which were accelerated by the pandemic, have caused a rise in vacancies for office and retail properties. These trends vary across countries, with the United States seeing relatively more remote working. In addition, high interest rates mean debt servicing costs have increased and property valuations have declined.

These trends are evident in New Zealand as well, but are generally less acute than those overseas. Remote working has increased by less than it has in other developed economies. Office vacancies have risen primarily for lower-quality spaces, while demand for higherquality offices remains solid as firms prioritise locational advantage and collaborative spaces (figure 2.9). New Zealand cities tend to have lower office vacancy rates compared to Australian cities, except in the case of secondary office spaces in Auckland (figure 2.10). In general, the domestic market has been supported by strong migration-led population growth over the past decade and a relatively limited supply of new properties. Healthy market fundamentals have supported solid rent growth in recent years, which is helping owners to manage increased debt servicing costs and is underpinning capital values.

The ongoing slowing in the New Zealand economy is the key near-term risk to the commercial property sector. In addition, the proposed removal of depreciation from allowable tax deductions could add to existing cash flow pressures. Banks are generally willing to support stressed customers by providing interest-only lending and other options to mitigate cash flow pressures, while some borrowers are also able to draw on other income sources. Interest coverage covenants for existing borrowers have generally been eased where business models are assessed to be financially viable.

Commercial property vacancy rates (Auckland and Wellington CBDs)

Source: JLL.

Office vacancy rates in major centres in Australia and New Zealand (December 2023)

Source: JLL.

The capacity of banks to support their customers is partly a result of prudent lending standards over the past decade, which have reduced the vulnerability of banks’ loan portfolios to a downturn.

Some property owners may also look to reduce their debt through property sales, particularly if cash flow stress is severe. There have been fewer property sales in the market since 2021, pointing to a less liquid market that could make this deleveraging harder. A global commercial property slowdown could further exacerbate this as it could weaken foreign investors’ appetite for property in New Zealand. This would further reduce the pool of potential buyers.

Figure 2.9

Figure 2.10

Insurance availability and risk-based pricing

Key points

• Insurance availability makes an important contribution to New Zealanders’ financial and economic wellbeing, by spreading the cost of risk events across time and across policyholders. Property insurance also contributes to financial stability by protecting the assets used to secure much of the banking system’s lending.

• Premiums for residential dwelling insurance have outstripped general inflation over the past decade, reflecting elevated construction cost inflation and higher reinsurance costs as reinsurers adjust their views of New Zealand risks. Climate change has increased the underlying risks of flood, storm and other weather events in many areas of the country, a trend that may accelerate in the future with additional warming.

• There is a clear trend of insurers moving towards greater use of risk-based pricing for residential dwelling insurance, meaning that the value of insurance premiums is becoming more tailored to the specific risks a property faces (e.g. seismic or flood) as opposed to reflecting broad averages of the risks facing properties over wide areas.

• Greater adoption of risk-based pricing depends on insurers’ ability to accurately identify granular risks (e.g. through highquality property-level data) and how material a risk is for insurers.

• To date, risk-based pricing has been most prominent for seismic risk, affecting regions such as Wellington. Granular pricing for flood risk is at varying stages of being rolled out by insurers.

• A withdrawal of insurance availability for high-risk properties is likely to occur only gradually. However, some owners may find insurance increasingly unaffordable. Insurers may begin to make coverage of some risks optional as risk-based pricing becomes more commonplace. Rising premiums may also lead to customers choosing to underinsure (with higher excesses and/or lower sums insured), leaving owners of high-risk properties vulnerable in a total loss event.

• Looking ahead, it is important for stakeholders (insurers, central and local governments, buyers and lenders) to take actions now to improve their understanding of natural hazards so that future affordability challenges can be managed proactively. Banks need to be conscious of the ongoing insurability of the properties against which they lend. This will require more scrutiny in their lending decisions than currently. Banks also need to pay closer attention to insurance coverage given the risks of underinsurance for high-risk properties over time.

Insurance makes an important contribution to New Zealanders’ financial and economic wellbeing

By spreading the costs of risk events over a large number of policyholders, across borders and across time, insurance reduces the impacts of a given risk event on affected households and businesses. This means that policyholders can confidently take on and manage risks, supporting investment and economic growth. Similarly, through global reinsurance markets countries like New Zealand can reduce the impacts of very costly events through overseas reinsurers taking on part of the risk. The availability of insurance also supports financial stability by protecting against risks to the value of property that is used to secure much of the New Zealand banking system’s lending, such as home and commercial property lending.

This Special Topic focuses on recent developments in the residential dwelling insurance market, particularly the trend towards a greater use of risk-based pricing of insurance contracts and the impacts this may have on future insurance affordability and availability. While our focus is on residential dwelling insurance, the trends and implications we describe here are equally applicable to the multi-unit (apartment) and commercial building insurance markets.

Residential insurance costs have risen significantly in recent decades

The residential insurance market is important for financial stability, given that residential dwellings and land account for around 25 and 36 percent of New Zealand households’ net worth respectively. Similar to past decades, households continue to have a very high uptake of residential insurance by international standards, at around 96 percent currently based on surveys conducted by the Insurance Council of New Zealand. High uptake in part reflects the fact that insurance is a requirement for obtaining a home loan.

Premiums for residential dwelling insurance have increased significantly over the past decade, well above the general level of consumer price inflation (figure 2.11).

Figure 2.11

Annual inflation rate for dwelling insurance and all consumer prices

Source: Stats NZ

Dwelling insurance and construction cost indices

Source: Stats NZ, CoreLogic.

Note: The Cordell Construction Cost

Contributing factors include:

• Construction costs have outpaced general inflation, increasing the cost of replacing insured dwellings on a like-for-like basis. Insurers use construction industry price benchmarks to recommend adjustments to policyholders’ sums insured in the event of a total loss of a property. Rising construction costs also increase insurers’ claims costs for events where a house is only partly damaged, which impacts premiums. These two factors have accounted for significant increases in average premiums in recent years (figure 2.12).

Figure 2.12

• Global reinsurers have raised their premiums for New Zealand insurers after revising their assessment of New Zealand’s risk profile, particularly in relation to seismic risk. New Zealand is a relatively large consumer of global reinsurance, underlining the need for reinsurers to assess New Zealand’s risk profile accurately. Following the Canterbury and Kaikōura earthquakes, the industry updated its assessment of the potential damage that liquefaction can cause to the land underlying buildings, and gained new information on regional seismology and how buildings perform through complex earthquake sequences.

Climate change is also contributing to higher underlying physical risks, including floods, storms and other damaging weather events. Insurance premiums will increase if insured losses from these events also grow. Claims from the 2023 Auckland Anniversary weekend floods and Cyclone Gabrielle have totalled $3.7 billion so far, contributing to New Zealand insurers bearing higher reinsurance premiums over the past year.

Approaches to insurance pricing and product design

The basic business model of an insurance company is to:

• assess a risk and its potential losses;

• determine the premium needed to compensate for losses covered by the policy and allow the company to make a profit over time, taking into account any reinsurance arrangements; and

• collect and invest premiums and pay out assessed claims as necessary.

Two contrasting approaches to assessing risk and determining premiums are communitybased and risk-based rating.

• Under a community-based approach, an insurer assesses a risk based on broad averages across policyholders and does not apply much or any differentiation in premiums charged, even if an individual policyholder is materially more or less exposed to an insured risk than others. Insurers typically apply a community-based rating where they have limited data or abilities to predict which customers within the population would be more likely than others to suffer losses from a given risk.

• Under a risk-based approach, an insurer will vary premiums charged based on a more individualised assessment of apolicyholders’ risk profiles and likelihood of making a claim. For example, risk-based pricing is commonly applied to car insurance. Insurers can use their extensive data on historical claims to statistically assess a policyholder’s risk based on their age, gender, type of car and driving history, and how the car is stored etc. While a risk-based approach may lead to the exclusion of high-risk customers, it can be beneficial for society’s overall risk management because it provides a price signal to encourage the proactive mitigation and reduction of risks.

When designing insurance products, insurers also choose what risks will be bundled together in the same policy. New Zealand’s residential insurance market is currently characterised by the widespread offering of comprehensive ‘all perils’ policies by insurers. Generally, New Zealand house insurance policies cover all major risk events, such as fires, storms and floods, earthquakes and volcanic activity. New Zealand insurers’ all perils policies can be contrasted with those of other markets:

• In Australia, coverage of flood risks in residential policies was historically uncommon. The inclusion of flood cover gradually increased from around 3 percent of policies in 2006 to around 93 percent of policies by 2020, following government and industry efforts to improve coverage after large flood events in Eastern Australia in 2010 and 2011. Owners of high-risk properties continue to opt out of flood cover given the very high premiums they would need to pay to obtain it. In the absence of flood cover, owners are reliant on their own savings and potential government assistance, which may not fully compensate for their losses.

• Only around 13 percent of Californian households opt to add earthquake cover to their standard residential policies. Insurers withdrew earthquake coverage from their standard policies in the 1990s. Informed by the experience of the Northridge earthquake, projections of the potential losses from a major earthquake highlighted that insurers might not have been able to meet their potential claims.

Adopting risk-based pricing

The preconditions for adopting a risk-based approach are that an insurer can accurately identify granular risks and that adoption of a risk-based approach would have a material financial impact for the insurer, given that it is operationally more complex. Risk-based pricing requires an insurer to develop their information systems so that they can integrate a range of information sources. In general, insurance companies will have a tendency towards risk-based pricing over time as their data, systems and understanding of different risks improve.

Competition between insurance companies drives a greater use of risk-based pricing, as companies that are able to differentiate risks and premiums accurately will be able to grow their market share by offering more attractive pricing to lower-risk policyholders, leaving insurers that continue to use communitybased pricing holding onto a higher-risk pool of customers. In that situation, the communitybased pricing approach would necessitate a continued rise in premiums to compensate for the increased risks the companies carry.

Reinsurance costs also play a part in insurers’ decisions to adopt risk-based pricing. For risks that are relatively small and statistically predictable and where claims tend to be uncorrelated, such as house fires, insurers will generally be able to pay claims out of the premiums they collect over time. However, for very large but infrequent risk events such as a major flood or earthquake, insurers will face many claims from policyholders all at once. Insurers take out reinsurance contracts with large, global reinsurers to ensure that they would still be able to cover all claims following catastrophic events. Insurers with the granular risk data that underlie a riskbased pricing model are best placed to obtain more favourable reinsurance terms and costs than competitors using more community-based approaches. This is because they can demonstrate to reinsurers that they better understand the underlying risks being insured, and because they will be less exposed to high-risk properties.

Risk-based pricing is becoming more prevalent

Improved data, modelling and systems over the past decade have prompted an acceleration of risk-based pricing for seismic risk. This has been felt strongly in some regions, such as Wellington (figure 2.13).

The Earthquake Commission’s EQCover, which covers the first $300,000 (plus GST) of losses to residential properties from earthquakes and some other natural disasters (including flood cover for the land only), is based on a uniform levy throughout the country i.e. community-based rating. Losses for sums insured above the EQCover cap are covered by a policyholder’s insurance company, and consequently insurers can apply risk-based pricing to that portion. A tripling in the EQCover cap between 2019 and 2022 helped to dampen the divergence in premiums between regions, as with a uniform levy EQCover effectively acts as a cross-subsidy from low-risk to high-risk areas and helps to ensure that premiums are more affordable than otherwise for higher-risk homeowners. However, because the EQCover cap only partially covers most properties, the trend towards more risk-based pricing for seismic risk is likely to continue.

Figure 2.13

Average annual expenditure on dwelling insurance, by region (CPI-adjusted, 2023 dollars)

Source: Stats NZ, RBNZ calculations.

Note:

Expenditure Survey.

Historically, New Zealand insurers have taken a partially community-based approach to flood risks for most residential properties, being limited by insufficient modelling and data to inform a more risk-based approach to pricing. While seismic risks can be modelled and differentiated at regional or local levels, flood risks depend on the characteristics of an individual property and can vary considerably between houses on the same street. For example, flood risk can depend on the topography of a section and the nearby land, and the floor height above the ground.

Currently, insurers are taking varied approaches to adopting risk-based pricing of flood risks. Several vendors offer datasets and models covering flood risks for New Zealand, which insurers use in their underwriting decisions. However, each has limitations in terms of its accuracy – for example, national models based on elevation maps can provide insights into the general flood risks for a section but may not have granular detail on the specific location and height of the house relative to the flood risk. Hydraulic processes play an important role in determining flood risks but are difficult to model accurately without detailed datasets.14 Larger and better-resourced local governments are generally better placed to provide detailed hydrological information not contained in national datasets. In practice, insurers are currently using a combination of data sources to improve their understanding of flood risks.

Residential insurance remains generally available, even in higher risk areas

While a long-term trend towards risk-based pricing poses challenges for insurance availability and affordability for higher risk properties, the evidence to date suggests that insurance continues to be generally available. Full insurance retreat is uncommon so far, even for properties exposed to high seismic and flood risks.

Since 2022 the Treasury has contracted Finity, an actuarial and insurance consulting firm, to provide regular reports on the pricing and online availability of residential insurance. The report includes an analysis of 57 specific suburbs around New Zealand exposed to the risk of flood, with both highand low-risk properties in each suburb selected in the sample.15 Availability is assessed based on whether an insurer offers online quotes to the majority of properties in the suburb, as this will reflect insurers’ risk management strategies. Insurance may still be available through other methods outside automated online systems. The four underwriters surveyed are AA Insurance, IAG, Vero and Tower, which collectively comprise about 88 percent of the private residential insurance market. It is possible that properties for which quotes are not automatically generated online can still obtain insurance on a case-by-case basis with a given insurer.

14 For example, our 2022 flood risk assessment of banks’ residential mortgage portfolios used data on flood zones from Auckland Council. See https://www.rbnz.govt.nz/hub/publications/bulletin/2023/rbb-2023-86-02

15 See https://www.treasury.govt.nz/publications/oia-response/quarterly-reports-provided-finity-consulting-oia-20240086

Source: Finity Consulting, Treasury.

Note: “Flood pricing” indicates where a quote is assessed as including a flood premium of more than $250. High flood risk refers to properties with an annual return interval of a flood event of less than 100 years. Stratification of properties by seismic risk is determined in terms of their expected peak ground acceleration in the National Seismic Hazard Model.

The latest set of results from this reporting indicate that a majority of insurers continue to offer insurance online for properties with both high seismic and flood risks (figure 2.14):

• For suburbs with high seismic risks, on average three quarters of the insurers surveyed make insurance widely available online. However, insurer participation varies geographically, with some insurers having withdrawn online quoting in recent years from some parts of the Wellington, Marlborough and Canterbury regions, for example.

• Around 6 percent of properties (around 120,000) are assessed being at high flood risk, defined in the analysis as properties where a riverine or surface water flood event is expected to occur more frequently than once every 100 years. For these properties, an average of around 20 percent of the insurers’ quotes were assessed as including additional flood risk premiums averaging $250 or more annually (‘flood pricing’), relative to properties in the same suburb assessed as not being subject to flood risk. This

result varies by suburb, with no insurers applying flood pricing in some suburbs, and many insurers applying flood pricing in others.

• 0.6 percent of residential properties are subject to both high flood and seismic risks. On average, more than half of the insurers offered policies with no additional flood risk premium in these areas. However, in a small proportion of sampled suburbs availability was lower, meaning that there were fewer participating insurers to choose from. Even without flood risk premiums, owners of these properties may find insurance unaffordable if a high earthquake risk premium is also charged.

Implications of more risk-based

pricing

and insurance retreat

Insurers’ adoption of greater risk-based pricing is a rational response to a changing operating environment. For many decades, the prevalent approach for New Zealand residential insurers was community-based rating for both earthquake and flood risks.

Figure 2.14

So far, a lack of granular, property-level data on hazards has been the main constraint to a more widespread and comprehensive adoption of risk-based pricing. Pricing for seismic risks at regional and local levels has become more prevalent over the past decade. Higher premiums for properties with elevated flood risks are being introduced by some insurers as data and modelling improve. As some insurers have moved to risk-based pricing, the pressure has increased on others to do likewise to avoid their insuring a disproportionately large number of higherrisk properties for which community-based premiums are insufficient.

Risk-based pricing acts as a price signal to encourage proactively mitigating and reducing exposure to risks, which can be beneficial for society’s overall risk management. Risk-based pricing also supports the financial stability of insurers and is one way that they can manage their exposure to climate-related risks in the future.

It is difficult to pinpoint if and when insurers will completely withdraw the availability of insurance for certain properties and/or areas or risks, although it could occur relatively quickly given that contracts are typically annual. The withdrawal of insurance will depend on the severity and frequency of flood events in a location, improvements over time in the understanding of flood and seismic risks, the competitive dynamics between insurers, and how risks evolve (e.g. due to climate change and mitigation actions). Withdrawal would tend to first occur in communities where these physical risks are already well known. Owners of properties where natural hazard risks have already manifest through claims (and particularly repeated claims), such as those properties badly affected by the 2023 Auckland Anniversary weekend floods and Cyclone Gabrielle, are unlikely to be able to obtain comparable cover in the future, unless there has been a substantial mitigation of the now known risks. Even if the complete withdrawal of insurance availability in certain areas is some time away, owners of high-risk properties may find insurance increasingly unaffordable.

Similar to overseas markets, a potential outcome of the trend towards more risk-based pricing is that insurers begin to unbundle different risks, particularly if one type of peril is a dominant driver of the unaffordability of premiums for an all perils policy. For example, unbundling could take the form of removal of flood cover for a flood-prone property in an area with low seismic risk. This may help to maintain insurance accessibility for other risks such as fire and EQC cover (which typically requires a policyholder to have private insurance), but it comes at the expense of leaving property owners uninsured for flood risks. Moreover, with optional cover for some risks such as flood, property owners who need that cover the most may not be able to afford it, as the risk pool for flood risk could shrink as owners not exposed to flood risk choose to opt out of cover. Homeowners may also respond to decreasing insurance affordability by reducing their coverage through higher excesses and reducing their sums insured, although this would leave them more exposed to a total loss event.

Insurance retreat presents a long-term challenge for the financial system. It is important for all stakeholders (insurers, central and local governments, buyers and lenders) to take action now to improve their understanding of natural hazards, so that future insurance affordability challenges can be better managed. Central and local governments have an important role in collecting and sharing natural hazard data, setting policies for land use and coordinating adaptation plans. Improvements in data will help support insurers’ risk modelling, and thereby enhance the price signals sent by premiums for different natural hazards.

Banks need to be conscious of the ongoing insurability of the properties against which they lend, which will require greater scrutiny in their lending decisions than currently. Banks also need to pay close attention to insurance coverage given the increasing risks of underinsurance of high-risk properties over time. Banks need to work with insurers to obtain better and more regular information on mortgaged properties’ insurance status. This was a finding from our Climate Stress Test.16

16 See: https://www.rbnz.govt.nz/financial-stability/stress-testing-regulated-entities/climate-stress-test

Chapter 03 Regulatory developments

Queen Street, Auckland. Photo: Charles Lilly

Chapter 3 . Regulatory developments

We continue to make significant advances towards implementing legislative reform to ensure we have fit-for-purpose regulatory frameworks for deposit takers, insurers and financial market infrastructures. Our work on the implementation of the Deposit Takers Act 2023, a significant enhancement to our regulatory architecture, is continuing at pace and will ultimately strengthen New Zealand’s financial system.

We continue to modernise as a prudential regulator and embed a more intensive supervisory approach, while engaging with industry to support the development and implementation of our new regulatory requirements. As we strengthen the regulatory framework, we remain focused on carrying out our key responsibilities of regulatory stewardship, supervision and enforcement activity.

This chapter provides an update on recent policy and supervisory developments in the deposit-taking and insurance sectors, as well as describing the final steps in the implementation of the Financial Markets Infrastructures Act. It also contains a discussion of technology and operational risks, and our approach to promoting cyber resilience (see Box A).

Policy developments

Forthcoming consultation on prudential standards under the Deposit Takers Act

Later this year, we intend to start consultation on the standards that will bring about the expected benefits of the DTA (figure 3.1). Standards set out the key prudential requirements for deposit takers to ‘protect and promote the stability of the financial system’.

The standards will replace the existing banking handbook, most conditions of registration, Orders in Council that currently

create disclosure standards for banks and the equivalent instruments that set the current non-bank deposit taker (NBDT) regime. This brings the existing prudential requirements into line with the DTA legislative framework.

Our first consultation is planned for May 2024 and will cover four standards: capital, liquidity, disclosure and the depositor compensation scheme (DCS).

In July 2024 we will consult on the remaining standards: outsourcing, lending, related party exposures, governance, risk management, operational risk, open-bank resolution, general restrictions and branches.

All standards will apply to both new and existing deposit takers when they come into force (which is planned for July 2028) and firms will be expected to comply with them from that point. However, prior to this date, we will make decisions about licensing existing deposit takers based on the four standards to be consulted on in May 2024.

Figure 3.1: Outcomes of the Deposit Takers Act 2023

Overall, the DTA will benefit New Zealanders by providing a single regulatory framework for deposit takers, which will help support a resilient deposit-taking sector for New Zealanders.

For depositors, there is certainty that their deposits are protected, increasing confidence in the financial system.

For deposit takers, there will be a streamlining of prudential standards into a consistent and proportionate framework.

Implementation of the Depositor Compensation Scheme

The DCS will protect customers for up to $100,000 if their deposit taker fails. The DCS will be funded through levies (fees) on deposit takers and is expected to commence in mid-2025.17

We are currently consulting on policy proposals for the regulations under the DTA, which are necessary to fully operationalise the DCS. These regulations are technical in nature and will be used to set the DCS levies. The regulations will also help to determine:

• which deposits will (and will not) be protected, and

• how depositors would be compensated.

For the financial system more broadly, it will bring New Zealand’s prudential regulatory approach into line with international best practice.

We are engaging with industry on a regular basis, as an integral part of our policymaking process. A series of workshops was conducted in March 2024, which enabled NBDTs and banks to raise questions and concerns regarding the proposed DCS regulations. Alongside formal consultations, we are maintaining open dialogue with industry and providing information on the upcoming changes under the new regime.

Proposals for how deposit takers will identify which deposits are protected have been included in the standards consultation and will be decided on after feedback has been considered. In order for the DCS to promote trust and confidence in the financial system, depositors must be able to identify easily if their deposits are protected. We are also developing a trademark to support the identification of protected deposits once the DCS goes live and before the standards come into force.

17 The DCS was originally scheduled to be operational by late 2024. However, following the passage of the DTA near the end of the previous Parliament, the time needed to consult on policy details and implement secondary legislation, and the feedback from industry on the timeframes needed to put the DCS into operation, the Minister of Finance now intends to commence the DCS by mid-2025.

Finalisation of our proportionality framework

We published our proportionality framework for developing prudential standards in March 2024. The framework is the first step in developing standards as it sets out how we will take a proportionate approach in developing the DTA standards. Taking a proportionate approach - that is, balancing the risks and costs of regulation in relation to different deposit taker types - is important, as it means the public can benefit from not only a safe, sound and stable deposittaking sector, but also one that can be diverse, innovative and inclusive. Under the framework, deposit takers will be allocated into four groups:

• Group one: locally incorporated deposit takers with total assets of $100 billion or more.

• Group two: locally incorporated deposit takers with total assets of less than $100 billion but more than $2 billion.

• Group three: locally incorporated deposit takers with total assets of less than $2 billion.

• Overseas deposit takers: branches of overseas incorporated deposit takers that are not locally incorporated.18

We will design standards for each group, taking into account the proportionality principle as well as the purposes and other principles contained in the DTA. The framework provides for variations from the groupings, where appropriate, to account for the idiosyncratic risks of particular deposit takers and classes of deposit takers. As noted above, we will begin consulting on the standards in May 2024.

Table 3.1

Update on selected regulatory policy initiatives

Capital review implementation

Climate-related risk

Crisis management framework development

Cyber data collection

We are continuing to implement the 2019 Capital Review decisions, with the next milestone in the transitional phase being the increase in minimum capital requirements from 8 percent to 9 percent in July 2024. We have also published the first biennial assessment of banks’ progress towards the new higher capital requirements from 2021 to 2023.

In March 2024 we published a Bulletin article on the use of credit risk weights for climate-related purposes. After consultation, we also published guidance on managing climate-related risks for all prudentially regulated entities. In April 2024 we released the results of our 2023 Climate Stress Test, in which the five largest banks participated.

We are undertaking multi-year policy work to implement the updated crisis management and resolution framework under the DTA (see Chapter 3 of the November 2023 Report). As part of the development of DTA standards, we will look to modernise some aspects of our Open Bank Resolution (OBR) policy (BS17) and integrate the DCS with the OBR tool.

We published our response to submissions and decisions on our cyber data collection proposals in March 2024. Material incident reporting requirements began in April 2024 and the two periodic surveys will start from October 2024.

18 A branch is a part of an overseas bank that operates in New Zealand, rather than a retail location where a bank makes services available. In this context, a branch is a part of a legal entity incorporated overseas, and can be contrasted with a bank that is incorporated in New Zealand.

Implementation of the Financial Market Infrastructures Act 2021

The Financial Market Infrastructures Act 2021 (FMI Act) is now fully operational. The implementation work involved several rounds of public consultation and was done jointly with the Financial Markets Authority (FMA).

In March 2024 the five systemically important Financial Market Infrastructures (FMIs) (previously designated as such under the old regime in the Banking (Prudential Supervision) Act 1989) were re-designated under the FMI Act. Designated FMIs are required to comply with the FMI standards, which have been adapted from the Principles for Financial Market Infrastructures (a set of international standards).

Work is now underway to identify other FMIs that may be systemically important and, if they are assessed as such, to recommend their designation to the Minister of Finance.

Liquidity policy review

Macroprudential policy

In December 2023 we announced key decisions in response to our second consultation paper. These decisions were to retain and modify our existing quantitative metrics (rather than adopt Basel’s international metrics), tighten the eligibility criteria for liquid assets and apply liquidity requirements across deposit takers in a proportionate manner.

As part of the DTA standards consultation in May 2024 we will publish the third consultation paper for the review. This paper will consult on proposed modifications to our existing quantitative metrics, a simplified quantitative liquidity requirement for small deposit takers, revised qualitative liquidity requirements and any potential liquidity requirements for branches of overseas banks.

Our consultation on activating the debt-to-income (DTI) restrictions and easing loan-to-value ratios (LVRs) on residential mortgage lending closed in March 2024. We are currently reviewing submissions. We will announce our decision on DTI and LVR settings around the middle of the year. The earliest activation of the DTIs would be from July 2024.

Review of policy for branches of overseas banks

Review of the Insurance (Prudential Supervision) Act 2010

Review of the Interim Solvency Standard 2023

We published key decisions from the review in early November 2023, as part of a Regulatory Impact Statement. We also published a third consultation paper proposing a longer implementation timeline, and that the policy decisions be brought into effect through a standard or conditions of licence issued under the DTA.

There will be public consultation on the proposed Branch Standard under the DTA in July 2024. However, we consider that the announcement of the key decisions will allow industry sufficient confidence to work towards complying with these new requirements.

The Insurance (Prudential Supervision) Act 2010 review is considering the primary legislation that underpins our prudential supervision of the insurance sector. We published an omnibus consultation in September 2023 setting out a package of proposed changes to the legislation. We are currently reviewing the feedback received and considering which proposals to develop for consideration by the Government.

We consulted on an amendment to the Interim Solvency Standard 2023 in the second half of last year. The proposed amendment will be subject to external technical review in mid-2024, and then be published for consultation.

Consultation related to stage 2 of the solvency review will follow in 2025. It will look in detail at the methods and parameters used in the Standard.

Supervision and enforcement

We continue to operationalise our refreshed risk-assessment framework for banks, NBDTs and insurers, and are considering how it could be used for FMIs. The objective is to have an overarching framework with appropriate differences for each of the sectors supervised. As part of improving our systems, we have launched a modern customer relationship system to better manage our supervisory activities with regulated entities.

The full implementation of the FMI Act on 1 March 2024 has provided the legal framework for a more rigorous oversight of FMIs, with focus now shifting to formalising and embedding FMI supervisory practices. We intensified our AML/CFT supervision by extending the on-site inspection duration for large reporting entities.

We also strengthened our specialist supervision capabilities by establishing a Licensing and Authorisations team and expanding our Risk Specialists team. Work in the Licensing and Authorisations Team includes preparation for the licensing process that all existing banks and NBDTs will go through from January 2027. The Risk Specialists team is responsible for providing deep supervisory expertise in certain areas. An example of this is actuarial capability, which has been particularly important as insurers transition to IFRS 17. The Risk Specialists team is also establishing frameworks for assessing the operational resilience of regulated entities, including technology risks and cyber resilience (Box A).

Work to embed and strengthen our enforcement function continues. Key responsibilities include:

• formal investigations,

• managing external whistleblower notifications,

• assessing regulatory boundary issues in the NBDT and insurance sectors,

• processing applications for the use of restricted words, and

• taking enforcement action against regulated entities when appropriate.

In December 2023 we issued a formal statutory warning to a regulated entity in relation to failures to comply with the wire transfer identity requirements under the AML/ CFT Act 2009.

Our work in supervisory coordination and regulatory outreach is ongoing, domestically and internationally. We regularly coordinate with other New Zealand and overseas regulators, and other central banks, through channels such as the Council of Financial Regulators (CoFR) and Trans-Tasman working groups. We continue our collaboration with the FMA on responding to the findings of the governance thematic review. Over the coming months, supervisors from the two regulators will continue to engage with firms on self-assessments and action plans to remediate specific findings from the review. We are also discussing with the FMA ways that we can work together in respect of business-as-usual supervisory activities, as we seek to reduce inadvertent regulatory duplication for entities that are supervised by both agencies.

Technology Risks and Cyber Resilience

Operational risk refers to the “risk of loss[es] resulting from inadequate or failed internal processes, people and systems or from external events”.19 A failure to manage operational risks appropriately can result in disrupted services and reputational damage for a financial institution, presenting a risk to financial stability. This box looks at trends in technology risks, which are widely recognised as a key subcategory of operational risk, and our approach to building cyber resilience.

Technology risks are a growing concern for the financial sector

There are multiple types of technology risks. Firstly, failures of IT systems can lead to operational disruptions. A growing threat is cyber risk, which refers to potential losses from unauthorised access leading to the disclosure, disruption, modification or destruction of information or systems.20 This is not only an internal concern for financial institutions. Outsourcing arrangements with third (or fourth) party vendors is another channel through which entities are vulnerable to cyber risk.21

Cyber incidents can be one of the costliest sources of operational risk. Globally, the annual number of cyber attacks has almost doubled relative to the period before the pandemic (figure A.1), while the reported number of direct losses from cyber incidents has similarly increased. Financial institutions are particularly exposed to cyber risk as they handle large amounts of valuable data. This makes them targets of choice for criminals seeking financial gain or disruptions to the economy. According to the IMF’s April 2024 Global Financial Stability Report, between 2004 and 2023 around 15 percent of the reported direct losses from cyber incidents were incurred by

financial institutions, of which over a third were incurred by banks.

Potential losses are also large if cyber risk materialises for third party vendors, including cloud infrastructure providers.22 Cyber incidents not only increase systemic risk from an operational perspective, but also exacerbate other prudential risk categories. By disrupting the ability of financial institutions to trade with each other, market liquidity can dry up. If creditors come to doubt the ability of a bank to meet their payment obligations during a cyber incident, that bank’s liquidity could become threatened, creating financial stability risks.23

Source: University of Maryland CISSM Cyber Attacks Database. Note: Disruptive attacks are those that affect the operations of a victim, while exploitive involve illicitly acquiring information.

19 Basel Committee on Banking Supervision (BCBS) (2023), The Basel Framework at 966.

20 NIST Computer Security Resource Centre, Cyber Risk

21 The Reserve Bank of NZ (2020), Consultation Document – Risk management guidance on cyber resilience and views on information gathering and sharing; Risk.net and BakerMcKenzie, (2022) Top 10 op risks 2022. The Reserve Bank’s Outsourcing Policy (BS11) helps to mitigate this risk.

22 Doerr et al. (2022, Cyber risk in central banking (BIS WP No. 1039)

23 For example, see Grigg and Whyte (2020), Fake Zoom invite cripples Aussie hedge fund with $8m hit, Australian Financial Review

Figure A.1

Global number of cyber attacks

Entities can be vulnerable to cyber incidents due to weaknesses in systems, procedures and controls, or their implementation.24 Threat actors employ a large range of tactics and techniques, including phishing and account manipulation, to exploit or trigger these vulnerabilities.

To manage cyber risk, organisations seek to mitigate the risk of an incident materialising. However, total protection from all vulnerabilities and threat actors is unlikely to be achieved, due to the constant development of the threat landscape. It is therefore important for organisations to pursue a continuous development of cyber resilience, to ensure they can serve customers both during and after a cyber incident.

The benefits of cyber resilience accrue not just to individual entities but to society as a whole, although the costs of investing in resilience are borne privately.25 This indicates a role for public bodies to coordinate and support the private sector.26 International best practice in financial regulation now encourages robust IT frameworks as part of managing operational risks.27

Our 2022 bank solvency stress test assessed banks to be well

placed to withstand a major cyber risk event during a severe economic downturn. However as noted above these risks continue to evolve, and we will reflect this in future stress tests. We plan to stress test insurers on cyber resilience within the next year.

In Australia the RBA has noted an increase in the quantity and severity of cyber attacks in Australia.28 APRA’s cyber security stocktake recently highlighted identification failures and control issues at financial service providers (relative to APRA’s information security standard).29

Our approach to promoting cyber resilience

In addition to our baseline regulatory capital requirements for all types of operational risk, we have an overarching threestep approach to promoting cyber resilience in New Zealand’s financial sector (figure A.2).30

For Step 1, following public consultation we published cyber resilience guidance in April 2021. This provided high-level, principle-based risk management recommendations for our regulated entities.31 The four key components of the guidance are:

• governance: establishing the responsibilities of the board and senior management, having a cyber resilience strategy and framework, and developing culture and awareness

• capability building: the five technical cyber resilience building blocks - identify, protect, detect, respond and recover

• information sharing: the use of the appropriate channels and processes

• third-party management: planning and due diligence, negotiation, ongoing management, review and accountability, and termination S

The Reserve Bank’s three steps to promoting cyber resilience

Risk management guidance Step 2

Information gathering & sharing arrangements

Step 3

Enhanced coordination on response to cyber incidents

24 Vulnerability, NIST Computer Security Resource Center (CSRC)

25 Benoît Cœuré (2019), Cyber resilience as a global public good; Mulligan and Schneider (2011), Doctrine for Cybersecurity, Daedalus 140 (4): 70–92; The Reserve Bank of NZ (2020), Consultation Document – Risk management guidance on cyber resilience and views on information gathering and sharing. In brief, as absolute cybersecurity is impossible (as humans are involved), risk management calculation is challenging (such as valuing information confidentiality, integrity, and the loss incurred when dealing with recovery), it is challenging to conceptualise tail risk events, and externalities arise since a single compromised system can lead to other systems on that network being compromised too (such as during the WannaCry ransomware attack).

26 https://www.imf.org/-/media/Files/Publications/GFSR/2024/April/English/ch3.ashx

27 For example, consider the increased focus on operational resilience in the proposed Basel CP25 (given increasing operational risk).

28 The Reserve Bank of Australia (2023), Financial Stability Review October 2023 — Focus Topic 5.5 Operational Risk in a Digital World.

29 Australian Prudential Regulatory Authority (2023), Insight — Cyber security stocktake exposes gaps.

30 The Reserve Bank of NZ (2020), Consultation Document — Risk management guidance on cyber resilience and views on information gathering and sharing.

31 The Reserve Bank of NZ (2021), Guidance on cyber resilience.

Figure A.2

The guidance emphasises the importance of an organisation’s cyber resilience strategy and framework, appropriately overseen by both the board and senior management. The guidance is not a checklist, and entities can apply the principles proportionately to their own specific needs and technologies.

For Step 2 we recently published consultation feedback and final decisions on cyber data collection requirements and information sharing arrangements.32 Three cyber resilience reporting requirements will be implemented in phases during 2024. Registered banks, licensed insurers and licensed NBDTs are required to:

a. report material cyber incidents to us as soon as practicable, but within 72 hours (from 8 April 2024);

b. report to us all cyber incidents regardless of materiality in 6-month intervals for large entities, and annually for other entities (the first reporting period begins from 1 October 2024); and

c. report to us a self-assessment against the cyber resilience guidance, annually for large entities and biennially for other entities (first survey due 1 October 2024).

These Step 2 requirements support Step 3, which is enhanced coordination in response to cyber incidents.

Key initiatives relevant to this include:

• Cyber attack data collection, an initiative we are establishing with the FMA to remove reporting duplication (and hence unnecessary compliance costs) and support a coordinated response to industry incidents.

• A cyber attack response protocol agreed by CoFR, setting out how financial regulators will coordinate responses to cyber attacks on regulated entities.33

• CoFR as a group coordinating information-sharing on emerging threats with CERT NZ (the Computer Emergency Response Team).

• The Government developing a national cyber security strategy, and including major cyber incidents on Aotearoa New Zealand’s National Risk Register.34

These initiatives support CoFR’s priority theme of economic resilience, which includes maintaining a shared understanding of cyber risk, financial fraud and scams, and developing cyber resilience to these threats.

Internationally, a trans-Tasman playbook has been developed with relevant Australian agencies to coordinate a regulatory response to cyber incidents that impact entities regulated in both countries, as part of the Trans-Tasman Banking Council.35

32 The Reserve Bank of NZ (2024), Cyber Resilience Data Collection.

33 Cyber Resilience Data Collection Proposals (2023).

34 The Department of the Prime Minister and Cabinet, 2019, New Zealand’s cyber security strategy 2019.

35 Trans-Tasman Banking Council.

36 DPMC (2023), Critical Infrastructure Phase 1 Consultation.

We are also coordinating with APRA incident simulations and the harmonisation of incident protocols.

In addition to our three-step approach, a cyber resilience standard for FMIs entered into force in March 2024 as part of the new regulatory framework. The standard sets requirements for how FMIs should manage their cyber resilience.

The future state of cyber resilience

As part of the consultation on standards under the DTA later in 2024 (see Chapter 3), we will consult on a proposal for a deposit takers’ operational resilience standard. This will include proposals relating to the management of IT risk. Cyber risk will continue to be a focus of our supervision of regulated entities and our stress testing programme.

From a whole-of-government perspective, the Department of the Prime Minister and Cabinet will consult further on options for enhancing the resilience of Aotearoa New Zealand’s critical infrastructure, including resilience to cyber risks.36 We will continue to engage with industry and other domestic agencies on this topic, with the ultimate aim of ensuring smooth coordination and collaboration both in businessas-usual operations and during incidents.

Chapter 04

Institutional resilience

The Church of the Good Shepherd. Photo: Esther Bonaparte

Chapter 4 . Institutional resilience

New Zealand’s financial system is resilient to a range of potential shocks. Solvency is strong as banks continue to build capital buffers, and holdings of liquid assets remain historically high. Bank profitability is easing from elevated levels as funding costs increase and banks increase provisioning in anticipation of higher credit impairments. The resilience of non-bank deposit takers varies, and some will face challenges due to their lack of scale. Insurers are navigating changes in the global reinsurance market and to solvency standards. Financial market infrastructures continue to function effectively.

Summary

Banks

Solvency

• Bank capital ratios remain well above the current regulatory minimums and continue to increase. Common Equity Tier 1 (CET1) capital has been growing steadily above the rate of risk-weighted asset growth in the past six months.

• Banks are well progressed towards meeting the higher capital requirements that will continue to be phased in through to 2028 (figure 4.1). The four domestic systemically important banks (D-SIBs) have been required to hold more CET1 capital since July 2023 when the D-SIB buffer rose to 2 percent. The large banks are on course to meet the increased CET1 capital requirements, assuming that profitability and credit growth remain similar to their averages of the past 10 years.37

• Strong capital positions mean banks are well placed to absorb losses in the event of economic shocks. This was demonstrated in the results of the 2023 desktop solvency stress test, in which we estimated the impacts on the four largest banks of a severe stagflation scenario. The stress scenario was closely aligned with the scenario used in our 2022 bank solvency stress test. In the stress test all banks entered the Prudential Capital Buffer, triggering dividend restrictions, but capital ratios remained well above regulatory minimums even before considering any mitigating actions banks may have taken.

37 This analysis assumes banks retain at least 50 percent of their profits.

Asset quality

Profitability

• Borrowers have continued to reprice to higher interest rates, increasing their debt servicing costs. Non-performing loans continue to rise (see Special Topic 1 ).

• Banks’ provisions to cover expected losses have been steady over the past year, having previously risen in anticipation of borrower stress (figure 4.3). In the past six months some portfolios have seen an increase in provisioning, including agriculture and commercial property.

• Banks have indicated they are continuing to identify stressed borrowers proactively and are taking steps to resolve debt serviceability problems at an early stage. While take-up has been limited, lenders are generally willing to support borrowers through offering interest-only lending and extending loan maturities, particularly for borrowers ahead on payments or with low LVRs.

• Slow credit growth and increasing funding costs are putting pressure on banks’ profitability, reducing profitability metrics from elevated levels back towards historical norms (figure 4.4).

• Increasing capital requirements over the next four years are also expected to lead to higher overall funding costs and reduce certain profitability metrics. Return on equity continues to trend lower and is expected to decline further from increased share issuance and retention of earnings.

• Metrics of bank efficiency have improved. Operating expenses including wage costs have continued to decline relative to total income. Banks’ branch networks have continued to reduce in size, a trend which accelerated during the pandemic.

Liquidity and funding

• The core funding ratio, a measure of a bank’s funding stability, remains elevated (figure 4.5).38 Deposit growth has been steady in the past six months. Term deposit balances have grown as depositors move funds from low-yielding call accounts to higher yielding term deposits.

• Mismatch ratios, which are a measure of short-term bank liquidity positions, are near their recent all-time highs (figure 4.6). High holdings of primary liquid assets are supporting the 1-week and 1-month mismatch ratios. Settlement account balances are beginning to decrease as the Large Scale Asset Purchase programme and Funding for Lending Programme (FLP) unwind.

• Although many banks have sufficient funding from deposits to support lending activity, they are continuing to issue debt securities in wholesale markets at both short- and long-term maturities, to maintain a presence and ensure funding can be readily accessed in the future if required. Banks have reported that market conditions are currently accommodative.

• As COVID-era support programmes such as the FLP wind down over the next two years, banks are well positioned to gradually replace FLP funding with retail and/or wholesale funding, although this is costlier and will put pressure on profitability. 38

Non-bank deposit takers (NBDTs)

• New Zealand’s NBDT sector consists of building societies, credit unions and deposit-taking finance companies. With total lending steady, at around $2.2 billion, the sector is very small relative to the banking sector in total lending, but provides services to a relatively large number of customers.

• There has been a broad-based slowdown in new lending by NBDTs in the last 18 months, particularly from building societies and credit unions, driven by the high interest rate environment, subdued demand for credit and an uncertain economic outlook.

• Non-performing loans have increased from their low point in 2022, reflecting the slowing economy (figure 4.9).

• The resilience of NBDTs varies across the sector. Some NBDTs continue to face major challenges from the softening economic environment and their lack of scale, and will need to improve their operational efficiency to support their viability (figure 4.10).

• The Government has signalled its intention to amend the Credit Contracts and Consumer Finance Act 2003 (CCCFA). NBDT industry groups have noted the increased compliance costs that the previous changes to the Act have imposed. We will continue to monitor the impacts of changes in the CCCFA, and the implications for the NBDT sector of the implementation of the Deposit Takers Act (DTA).

Insurers39

• In the past six months, insurers have continued to evaluate and invest in programmes to improve efficiency as well as digital enhancements to support the implementation of IFRS 17. Insurers continued to work on strengthening the stability and resilience of their operations, including the integration of cyber risk and climate risk into their enterprise-wide risk frameworks.

• Property insurers have had to review and increase target levels of capital following last year’s weather events. This is to reflect updated information on risks and material changes in reinsurance arrangements (in particular, significantly higher excesses on reinsurance cover).

• The financial performance of insurers is likely to be impacted by the introduction of IFRS 17 changes to underwriting guidelines and shifts in the insurance needs of the community. The severe weather events in the North Island at the beginning of 2023 have also resulted in higher claims and reinsurance costs, with insurers likely to maintain their focus on improving their internal modelling, risk management and pricing of natural perils, including flood risk (see Special Topic 2).

• We received valuable feedback from insurers on the second amendment of the Interim Solvency Standard (ISS), which resulted in the decision to commission an external review (see Chapter 3). The insurance industry is aware of the challenges in the ISS, including providing prudential data to the Reserve Bank and the need for insurers to maintain a conservative approach to capital management. Other regulatory engagements included discussions of strategic priorities for insurers, governance, regulatory and compliance matters, and financial performance and risk management.

39 Note that the aggregated data underlying the key insurance metrics table in previous Reports are currently unavailable due to the transition to IFRS 17. See https://www.rbnz.govt.nz/regulation-and-supervision/oversight-of-insurers/resources-for-insurers/insurance-dataupgrade.

Financial market infrastructures (FMIs)

Overview

Evolution of the FMI Oversight Framework

• Financial Market Infrastructures (FMIs) are multilateral systems through which financial transactions are cleared, settled and/or recorded. It is important that FMIs operate with minimum risk, are reliable, and are proactively regulated as they underpin the stable operation of the financial system. New Zealand’s systemically important FMIs continue to exhibit high availability and resilience, with no significant incidents recorded in recent months.

• An important part of our oversight role for FMIs is to monitor their performance and identify and respond to potential threats to financial stability originating in, or being transmitted by, these infrastructures. New legislation covering the regulation and supervision of FMIs, the Financial Market Infrastructures Act 2021 (the FMI Act), fully came into force on 1 March 2024.

• The full commencement of the FMI Act signalled the culmination of around 10 years’ work to improve the legal framework for the regulation of FMIs. It began in 2012 when we commenced a review of our payment oversight framework, which recommended the development of new legislation that established a clear, robust and risk-based oversight framework for systematically important FMIs to New Zealand. Following public consultation on the framework, and the parliamentary process between 2017 and 2019, the FMI Act was enacted in 2021, with the commencement date of 1 March 2024 subsequently being set.

Designation of Systemically Important FMIs

• The Reserve Bank and the FMA together regulate FMIs, other than pure payment systems for which we are the sole regulator. Following the enactment of the FMI Act in 2021 we consulted on the implementation of the new oversight framework, including how we would assess whether an FMI was systematically important.

• Under the FMI Act, new designation notices were issued for the five FMIs that were designated settlement systems under the Banking (Prudential Supervision) Act 1989. The new notices specify whether the FMIs are systemically important and what class or classes of FMI they belong to, which determines what regulatory requirements the FMIs are subject to. The new designation notices took effect on 1 March. These five FMIs were deemed to be systemically important:

• Exchange Settlement Account System (ESAS),

• NZClear Settlement System,

• NZCDC settlement system,

• CLS System, and

• ASXCF settlement system.

• Designated FMIs are subject to a comprehensive set of regulatory requirements in the form of standards issued under the FMI Act. The standards are in line with international best practice for the regulation of FMIs, being based on the Bank for International Settlements’ Principles for Financial Market Infrastructures. The regulator has powers available to assist in the management of risks involving FMIs, which addresses a major gap in our previous regulatory arrangements.

• With the FMI Act 2021 and its relevant standards being effective from 1 March 2024, we are now working with the FMA to refine and embed enhanced FMI supervisory practices. We will also be working to determine whether there are other FMIs that are systemically important and need to be considered for designation so that they become subject to the FMI standards.

Source:

Figure 4.2

Figure 4.6

4.7

Source: RBNZ Income Statement survey, Non-bank Deposit Takers survey.

Figure 4.8

Figure 4.9

Source: RBNZ Capital Adequacy survey, Liquidity survey, Income Statement survey, Bank Balance Sheet survey, RBNZ calculations.

Note: Non-performing loans, impairment cost and cost-to-income ratios are presented in inverted scales for readability purposes, so that lower outcomes for these variables are shown on the right-hand side (stronger resilience metrics). Data for Tier 1 capital ratio is as at February 2024.

Liquidity metrics begin in June 2010.

Figure 4.10

Source: RBNZ Non-bank Deposit Takers survey.

Figure 4.11

Source: RBNZ Non-bank Deposit Takers survey.

Note: Operating expenses as a ratio of net interest income plus other operating income.

Figure 4.12 NBDT capital ratios

Source: RBNZ Non-bank Deposit Takers survey.

Source: RBNZ Non-bank Deposit Takers survey.

Table 4.1

Key metrics for registered banks

Source: RBNZ Capital Adequacy survey, Liquidity survey, Income Statement survey, Bank Balance Sheet survey

1 Mismatch ratio (one month) is presented as a three-month moving average to remove short-term volatility.

* Tier 1 capital ratio of 2024 is up to February

** Includes the capital conservation buffer of 2.5 percent of risk-weighted assets, which banks must maintain to avoid dividend restrictions. For domestic-systemically important banks, the capital conservation buffer is 4.5 percent as of July 2023, and the regulatory minimum for their Tier 1 Capital ratio is set at 11.5 percent of risk-weighted assets.

Tier 1 capital ratios have increased in preparation for higher future regulatory requirements

Mismatch ratios are strong, and near an all-time high.

Banks’ core funding ratios remain strong with low credit growth.

Banking sector return on assets has eased from recent highs.

Ongoing capital growth has been a key driver of a decrease in banks’ return on equity over the last 12 months.

Net interest margins remain above the pre-COVID average. However, they have started to decrease in recent months.

The non-performing loans ratio has increased from low levels as borrowers reprice to higher rates.

Impairment expenses have remained low, with steady levels of provision coverage.

Banks’ expense ratios are trending lower, although this has been offset by softer income growth recently.

Key metrics for Non-bank Deposit Takers (NBDTs)

Metric Segment

Source: RBNZ Non-bank Deposit Takers survey.

1 Data for finance companies exclude FE Investments Limited from March 2020, when it entered receivership.

2 Other NBDT refers to Christian Savings Limited.

3 Firefighters Credit Union merged with NZCU Auckland in June 2022, Westforce Credit Union merged with First Credit Union in August 2022, Steelsands Credit Union merged with First Credit Union in December 2022, and Fisher & Paykel Credit Union merged with First Credit Union in October 2023. NZCU Auckland intends to merge with First Credit Union in June 2024.