New Zealand: Financial Sector Assessment Program
Financial System Stability Assessment

This paper presents an assessment of the stability of the financial system in New Zealand. Imbalances in the housing market, banks’ concentrated exposures to the dairy sector, and their high reliance on wholesale offshore funding are the key macro-financial vulnerabilities. The banking sector has significant exposure to real estate and agriculture, is relatively dependent on foreign funding, and is dominated by four Australian subsidiaries. A sharp decline in the real estate market, a reversal of the recent recovery in dairy prices, deterioration in global economic conditions, and tightening in financial markets would adversely impact the system. Despite these vulnerabilities, the banking system is resilient to severe shocks. Strengthening the macroprudential framework is important.


This paper presents an assessment of the stability of the financial system in New Zealand. Imbalances in the housing market, banks’ concentrated exposures to the dairy sector, and their high reliance on wholesale offshore funding are the key macro-financial vulnerabilities. The banking sector has significant exposure to real estate and agriculture, is relatively dependent on foreign funding, and is dominated by four Australian subsidiaries. A sharp decline in the real estate market, a reversal of the recent recovery in dairy prices, deterioration in global economic conditions, and tightening in financial markets would adversely impact the system. Despite these vulnerabilities, the banking system is resilient to severe shocks. Strengthening the macroprudential framework is important.

Executive Summary

Imbalances in the housing market, banks’ concentrated exposures to the dairy sector, and their high reliance on wholesale offshore funding are the key macrofinancial vulnerabilities in New Zealand. The banking sector has significant exposures to real estate and agriculture, is relatively dependent on foreign funding and is dominated by four Australian subsidiaries. A sharp decline in the real estate market, a reversal of the recent recovery in dairy prices, a deterioration in global economic conditions, and a tightening in financial markets would adversely impact the system. The key risks faced by the insurance sector relate to New Zealand’s vulnerability to natural catastrophes.

Despite these vulnerabilities, the banking system is resilient to severe shocks. Results of stress tests and sensitivity analysis across all relevant risk factors indicate that the solvency and liquidity of the banking system can withstand adverse and severe shocks. In addition, there is a limited impact of solvency and liquidity contagion from direct exposures to banks and nonbank financial institutions, common holdings of securities, and market contagion. That said, the results from stress tests, although a useful supervisory tool, need to be interpreted with caution and the authorities can strengthen the financial sector oversight and crisis preparedness frameworks to further improve the resilience of the system.

Strengthening the macroprudential framework is important. The financial system is dominated by four major banks with similar business models in which the majority of assets are associated with housing loans. Direct exposures among them are relatively limited, but the potential for spillovers is elevated. Credit has resumed strong growth during the last few years, putting pressure on funding and increasing concerns with the housing sector. So far, the authorities have applied exposure limits to loans with high loan-to-value ratios (LVR) which, while strengthening the profile of banks’ portfolios, have had limited effects given rising housing prices. Adding a debt-to-income cap to the macroprudential toolkit would enhance systemic resilience by limiting the risks from growing household indebtedness. Imposing additional loss-absorbency requirements for domestic systemic banks, and allowing an effective accountability of the RBNZ without jeopardizing the integrity and independence of its macroprudential decision-making process are also recommended.

The approach of the RBNZ to supervision should be strengthened by increasing the weight of regulatory discipline in its three-pillar framework. The RBNZ approach to supervision relies on three pillars: self, market, and regulatory discipline. The authorities have strengthened regulatory discipline since the last FSAP, but the three-pillar framework should be improved by adopting a more intensive approach to supervision. This would increase the ability of supervisors to be proactive to exercise regulatory discipline and obtain reliable information to enforce self- and market-discipline. The RBNZ is encouraged to issue enforceable supervisory standards on key risks, review the enforcement regime to promote preventive action, and initiate on-site programs targeted on areas of high risk. In addition, clarifying the responsibilities of the Treasury and RBNZ on financial sector issues and reinforcing the role and autonomy of the RBNZ as prudential regulator and supervisor would enhance the ability of the RBNZ to respond swiftly to ongoing and emerging risks.

Increasing supervisory resources for all financial sectors is key. This would support the highly qualified RBNZ staff in improving the effectiveness of the supervisory process, enhancing their knowledge of financial institutions’ operations, and deepening risk assessment of supervised entities—and strengthening their ability for early preventive action.

The proposed reforms to the regulatory and oversight framework for Financial Market Infrastructures (FMIs) will get New Zealand broadly on par with international standards. The proposed regime will provide the authorities with the legal basis for the oversight of systemically important FMIs, and with a graduated range of enforcement, crisis management, and regulatory powers. The authorities are encouraged to adopt international principles for FMIs in secondary legislation to provide for a transparent set of requirements to the industry and allow a consistent implementation of international standards among all systemically important FMIs.

The reform of securities market regulation significantly improved the framework, but further enhancements are required. The review of the regulatory framework was instrumental in implementing key reforms, including the establishment of the FMA as conduct regulator. The new regime governs how financial products are offered, promoted, issued and sold, and introduces licensing for providers of certain products, including managers of retail funds. The regulatory perimeter could be reviewed to include wholesale asset managers and custodians, whose activities will become more relevant as the asset management industry matures, bringing potential new risks. There is also a need to enhance conduct regulation in the insurance sector.

The crisis resolution framework needs to be enhanced further. The Open Bank Resolution (OBR) framework, which aims to avoid the use of public funds when resolving systemically important banks, is a step in the right direction. To enhance its credibility and strengthen the financial safety net, the introduction of deposit insurance would be the best option. Absent support for deposit insurance, a second option is to legally establish a de minimis exemption from freezing and haircutting deposits in OBR, set at an appropriate level. The decision-making process in a crisis and the exercise of resolution powers need to be clarified. The RBNZ should be the sole resolution authority, with clear mandates and responsibilities, requiring the approval of the Minister of Finance (MoF) only for resolutions with fiscal or systemic implications.

The home-host relationships between Australia and New Zealand are well above international practice, but stronger collaboration would enhance synergies. The RBNZ could take a more proactive role in collaborative supervision. The scope of the Memorandum of Cooperation on Trans-Tasman Bank Distress Management (MOC) could be extended to include insurance companies and FMIs. Moreover, further work on the trans-Tasman framework for assessing systemic importance and discussing possible coordinated responses would support timely and effective decision-making in an actual crisis.

Table 1.

2016 New Zealand FSAP: Key Recommendations

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C = continuous; I (immediate) = within one year; ST (short-term) = 1–3 years; MT (medium-term) = 3–5 years.

Macrofinancial Setting and Risks

1. Since 2011, New Zealand has enjoyed an expansion that has recently gained momentum (Table 2). Construction has been a major driver, with strong net migration and low interest rates amplifying the momentum. Growth is expected to remain at above 3 percent in 2017, well above trend. In the medium term, growth is projected to moderate in the face of net migration normalizing, earthquake reconstruction spending declining, and interest rates rising. Inflation is expected to gravitate toward the mid-point of the 1–3 percent target range of the RBNZ. External shocks are the main source of downside risks.

Table 2.

New Zealand: Selected Economic Indicators, 2012–2022

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Sources: Data provided by the New Zealand authorities; OECD and IMF staff estimates and projections.

OECD Income Distribution and Poverty Database. New definition, post- taxes and transfers.

Calendar year.

Fiscal balance equals revenue less expenditure; expenditure includes net capital investment.

2. The financial sector in New Zealand is dominated by banks, focuses its activities on lending to the domestic private sector, and is characterized by the importance of four Australian subsidiaries. Banks represent about 75 percent of total financial assets (Figure 1). The sector seems well capitalized and liquid, nonperforming assets are low, and profitability has remained broadly stable (Table 3 and Figures 2 and 3). Foreign funding accounts for almost 20 percent of banks’ liabilities. The system is concentrated on four subsidiaries of the largest Australian banks, whose share in the banking sector’s total assets was 86 percent at end-2016 and represent a significant share of parents’ assets. The systemic importance of these subsidiaries for the parent banks, which are all systemic for the home supervisor as well, makes New Zealand-Australian interdependence unique among other countries with high foreign bank presence (Figure 4). Nonbank financial institutions (NBFI) have more than halved in size since 2007. Nonbank lending institutions (NBLI) are savings institutions (credit unions and building societies), deposit-taking that fund their activities via deposits or debentures issued to the public and non-deposit taking finance companies. Most are domestically-owned.

Figure 1.
Figure 1.

New Zealand: Financial Sector Overview

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ and IMF staff calculations.
Table 3.

New Zealand: Financial Soundness Indicators, 2010–20161/

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Sources: Data provided by the New Zealand authorities and IMF staff estimates.

Capital adequacy measures, NPLs net of provisions to capital, liquid assets, 1-month mismatch ratio, core funding ratio, and return on equity are calculated for locally incorporated banks only.

proxied by the share of foreign-currency-denominated liabilities to total liabilities

Figure 2.
Figure 2.

New Zealand: Financial Soundness Indicators for Banks and Insurance Companies

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ and IMF staff estimates.
Figure 3.
Figure 3.

New Zealand: Banking Sector: Profitability and Balance Sheet

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ and IMF staff estimates.
Figure 4.
Figure 4.

New Zealand: Banking Systems with Significant Presence of Foreign Banks

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Source: IMF staff estimates.

3. The insurance sector is small and characterized by high concentration and an extensive presence of foreign (mainly Australian) insurers. There are 96 licensed insurers, with 76 percent of premium income being from branches or subsidiaries of foreign insurers. The largest insurer, an Australian group, accounts for almost half of total non-life premium income. Only about half of non-life premium income is written by the private sector, reflecting the migration of savings from insurance to investment products and the important role played by government in coverage of particular risks which it finances by levies: the Accident Compensation Commission (ACC) provides extensive coverage for personal injury insurance, and the Earthquake Commission (EQC) provides first loss cover for losses from earthquakes and other specified natural hazards for insured residential properties.1

4. The capital market of New Zealand is small but has been growing in recent years, with an increase in managed funds. The listed stock market capitalization was 42 percent of GDP in 2015, and the total amount of bonds outstanding in the local market was 50 percent of GDP. The bond market is dominated by central government issues and financial institutions. Since 2004, the share of primary listings’ holdings by domestic institutional investors increased 9 percentage points to around 40 percent in 2014. The number of transactions in secondary markets increased since 2010—almost threefold on the main stock market index in New Zealand (NZX 50). This increase has been fostered by the creation of the KiwiSaver scheme, partial privatization of state-owned enterprises and low global and domestic interest rates.

5. FMIs are of systemic importance at a national level, while the derivatives market is increasingly dependent on FMIs that are operated abroad. Several domestic and foreign FMIs are relevant for the economy in New Zealand (Table 4 and Figure 5). Derivative transactions of New Zealand banks are increasingly cleared by foreign central counterparties (CCPs). This is a direct consequence of the G20 mandate to clear standardized over-the-counter derivatives through CCPs. Although New Zealand is not a G20 member, many foreign derivative counterparties are required to clear centrally and so New Zealand banks are ensuring that they have the same capability.

Table 4.

New Zealand: Systemic Indicators for FMIs

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Figure 5.
Figure 5.

New Zealand: Landscape of Systemically Important Financial Market Infrastructures

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Source: IMF staff analysis.

6. The vulnerabilities of the New Zealand financial system are largely associated with concentrated exposures to the real estate and agriculture sectors, dependence on wholesale funding, and the similar business models of the four Australian subsidiaries. In particular:

  • The banking sector exposure to residential mortgages reached over 50 percent of total claims at end-2015. Low global and domestic interest rates for the last few years are a main driver behind the observed increases in mortgage lending.2 While low interest rates facilitate debt repayments by the existing mortgage borrowers, rising housing prices have elevated the debt-to-income ratios of new house buyers. The rise in real estate prices has been most rapid in Auckland (Figure 6). The property boom has been driven also by increased investor activity.

  • The banking sector has a large concentration of loans to the agricultural sector. Agriculture credit exposure, with the dairy industry accounting for more than two-thirds, stood at 15 percent of total exposures in 2015. Low global milk prices have put significant financial pressure on dairy farms, with half of the sector having experienced a second consecutive season of operating losses. However, prices have recently recovered and, according to the most recent forecasts, the effective payout for the dairy industry will increase above the break-even price in the next season. Nonetheless, the already high dairy-farm debt relative to trend income has increased recently, and remains a source of risk.3 Credit risk concerns in other sectors are limited, with corporate lending growing at around 5 percent in 2016 (compared to 15.6 percent during January 2007-July 2008), and low debt-to income ratios hovering around 16 percent.

  • The financial system is highly concentrated on a few Australian-owned players, with similar business models and vulnerabilities. As a result, there is a strong correlation in the financial soundness of the subsidiaries among themselves and with their parents.

  • The banking sector depends to some extent on wholesale funding, including foreign-currency funding sourced from offshore markets, and is exposed to liquidity risk from maturity mismatch. The main liquidity risk has traditionally been a reliance on offshore wholesale funding relative to domestic deposits. Rollover liquidity risk has been mitigated by the introduction of the core funding ratio (CFR) in 2010. However, because over 50 percent of banks’ assets are long term housing financing, the maturity mismatch is still a concern. Banks have also reduced their reliance on non-NZD funding to below 20 percent of total liabilities.4 While this development mitigates concerns over vulnerability to FX risk and increases the availability of foreign currency swap counterparties, pushing down hedging costs, banks might be vulnerable to risks related to hedging techniques under a stress event. As New Zealand’s banks looking for offshore funding use mostly the primary market, funding liquidity on global markets is relatively more important than market liquidity. Yet, heightened volatility in global financial markets may contribute to a pick-up in wholesale funding spreads.

Figure 6.
Figure 6.

New Zealand: Financial Sector Vulnerabilities

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ and IMF staff estimates.

Financial Stability and Resilience

7. The analysis of resilience is linked to the four major macrofinancial risks that might challenge the solvency or liquidity position of the banking system (Table 5). These are: (i) a strong correction in the real estate market; (ii) depressed dairy prices; (iii) deterioration in global economic conditions; and (iv) tight conditions in global financial markets. The stress tests results indicate that New Zealand banks are generally resilient to these risks.

Table 5.

New Zealand: Risk Assessment Matrix (RAM)

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8. The resilience of the New Zealand banking system was assessed under a 5-year solvency test (with interlinkages between funding costs and stressed capital ratios), a set of liquidity stress tests, a broad range of sensitivity tests, and a contagion module (Appendixes II and III). The sensitivity analysis was informed by supervisory reverse stress tests conducted by the four major banks which yielded insights into business vulnerabilities and potential system-wide effects from correlated losses in the banking system. To enhance the consideration of systemic risk in the stress testing exercise, the contagion module included: (i) a network analysis drawing on bilateral exposure data to assess how credit and funding risk propagate given the network of exposures, and (ii) a contagion analysis based on market-based data to evaluate contagion through financial markets from transactional exposures, common holding of securities and investors’ correlated strategies.

A. Solvency Stress Tests

9. The IMF team and the RBNZ ran parallel solvency stress tests, covering credit risk, market risk, funding risk, and interest rate risk in the banking book under two macroeconomic scenarios (Figure 7).5 The baseline scenario reflected the 2016 October IMF WEO macroeconomic projections. The adverse scenario captured the key risks identified in the RAM using a stressed macroeconomic scenario and idiosyncratic funding shocks. The scenario simulates a balance sheet recession triggered by deteriorating global conditions, tighter and more volatile financing conditions, a credit cycle downturn in China, and persistently lower commodity prices.6 The global downturn directly impacts Australia and New Zealand, creating additional spillovers in New Zealand through financial linkages with Australia and a sharp correction in the New Zealand property and equity market and triggering a private domestic demand-driven contraction. The funding shock includes bank-specific stressed spreads over the projected benchmark rate for wholesale debt issuance. In addition, it incorporates a ‘systemic’ funding shock component linking bank-specific funding costs to the stressed capital position of the rest of the banking system.

Figure 7.
Figure 7.

New Zealand: FSAP Stress Test Scenarios

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ, IMF, and IMF staff estimates.1 The number quoted as Dairy Payout Price includes the price paid for milk and total distributable profit.

10. The stress test included the interaction between solvency risk and funding costs as well as contagion from weaker banks in funding markets. The projection of bank funding costs followed an iterative process. In the first stage, the initial projection of bank-specific funding costs was informed taking into account aggregate projections for the reference rate in debt markets, bank-specific stressed spreads for wholesale issuance benchmarked against the behavior of their actively traded bonds during the Global Financial Crisis (GFC), and the bank structure of liabilities as of June 2016. Stressed funding costs were used to project bank-specific stressed Tier 1 ratios. In the second stage, the forecast of funding costs was revised driven by macroeconomic variables, bank-specific variables (including stressed Tier 1 ratios from stage 1), global variables, and a contagion risk factor from the rest of New Zealand banks which is unexplained by systematic risk factors. This component captured the ‘systemic funding risk’ shock from idiosyncratic shocks in peer banks to each individual bank, and led to a revised path of capital ratios.

11. The results suggest that major New Zealand banks are resilient to a severe global economic downturn, although most would need to use the capital conservation buffer (CCB) under stress (Figure 8). The IMF stress test results are broadly comparable to those produced by RBNZ using the commonly agreed scenario and RBNZ’s in-house credit risk models in combination with expert judgment (Appendix IV). Under the baseline scenario, the capital of all banks is above minimum requirements and the CCB with the aggregate CET1 at around 10.5 percent by 2021. In addition, while the RBNZ has not implemented the Basel III regulatory leverage ratio, this was projected for stress testing purposes, and the aggregate Tier 1 leverage ratio settles around 7.2 percent. Under the adverse scenario, all banks meet minimum requirements with the aggregate CET1 ratio at 7.7 percent at the low point of the stress, but four banks would breach their total capital CCB in 2018. The shortfall in aggregate capital ratios under the stress test is mainly driven by stressed risk-weighted assets (RWAs), credit losses, and funding costs. Banks are able to retain capital through profitability despite the erosion in margins, supporting capital ratios during the downturn.

Figure 8.
Figure 8.

New Zealand: Results of the FSAP Solvency Stress Test – Adverse Scenario

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Source: IMF staff estimates. The sample of banks included the five major New Zealand locally incorporated banks. Boxplots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 90th percentiles (whiskers). The dashed line indicates the minimum capital regulatory ratio. The solid line includes the capital conservation buffer.

12. In addition to scenario-based solvency tests, sensitivity tests further explored bank vulnerabilities to wider shifts to risk factors (Figure 9). Drawing on insights from reverse stress tests, the direct impact on capital ratios from pressures on effective margins is significant, while the impact from a sharp hike in risk-free rates, pushing down asset valuations, is more limited. The effect of a sharper decline in housing prices on mortgage Loss-Given Default (LGD) rates is mitigated by improved LTV ratios. A severe collapse of real estate prices by 50 percent would push up bank LGD ratios on mortgage loans to about 30 percent. Most of the impact comes from recent vintages, despite improved LVRs at around 65 percent, due to the larger impact of the housing price correction. A separate sensitivity test on credit concentration suggests that this risk is moderate: by simulating the default of the largest counterparties of each of the 5 largest banks, including other banks, other financial institutions, and corporates,7 banks would be able to meet their regulatory capital ratios following the default of their three largest counterparties.

Figure 9.
Figure 9.

New Zealand: Sensitivity Tests

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Source: IMF staff estimates.

13. Stress tests are a useful supervisory tool but should be interpreted with caution. Stress test scenarios replicate historical events or express extreme “tail events” based on historical loss distributions, even though the nature of crisis is to have unanticipated shocks where the past offers limited guidance. The RBNZ could usefully expand data collection and modelling efforts to develop structural models for credit risk in CRE and corporate portfolios.

B. Liquidity Stress Tests

14. A set of liquidity tests was performed jointly by the RBNZ and the IMF team based on commonly agreed assumptions. They helped assess banks’ short-term resilience to an abrupt and sudden withdrawal of funding as well as banks’ structural exposure to liquidity risk. While all locally incorporated banks are required to comply with RBNZ liquidity policy, Basel III liquidity requirements have not been implemented in New Zealand. The RBNZ adopted quantitative liquidity requirements in April 2010. The one-month mismatch ratio is broadly aligned with Basel III liquidity coverage ratio (LCR) whereas the CFR has a similar structure to the Basel III net-stable funding ratio (NSFR).

15. The top-down liquidity stress tests were undertaken using Basel III liquidity standards and the current RBNZ regulatory framework. The team and the RBNZ conducted a range of Basel III quasi-LCR tests over 2 different horizons and 3 separate scenarios.8 These scenarios included the standard 2013 LCR prescribed haircuts, rollover and run-off rates, and 2 additional scenarios tailored to New Zealand banks, which are more severe than those prescribed by the Basel III regulatory framework: 30-day quasi-LCR test, and 5-day quasi-LCR test run on three stress scenarios (namely “LCR scenario,” “New Zealand retail” scenario, and “New Zealand wholesale” scenario).9 The liquidity stress tests under the RBNZ’s liquidity regulatory framework included: (i) one-month mismatch ratio to assess banks’ resilience to a withdrawal of funding; and (ii) the CFR to evaluate banks’ reliance on short-term wholesale funding.

16. Despite significant reliance on wholesale funding, New Zealand banks’ funding structure appears resilient, partly due to strengthened regulatory and supervisory standards since the last FSAP. Originally set at 65 percent in 2010, banks are now required to have at least 75 percent of their loan portfolio financed using core funding. The weighted average CFR for the banking system was 85 percent in August 2016. Banks would have sufficient liquid buffers to withstand a 1-week and 30-day liquidity stress scenario. Under Basel III assumptions, the 30-day weighted average LCR ratio was 113 percent in August 2016. Under the “New Zealand retail” scenario, the aggregate LCR ratio fell to 73 percent with 6 banks falling under the threshold. While the aggregate LCR ratio improves under the “New Zealand wholesale” scenario to 78 percent, the aggregate liquidity is larger at 2.8 percent of the total assets as this scenario hits the major banks harder (Figure 10). These tests should be interpreted with caution as they do not stress the effectiveness of cross-currency swaps used to hedge wholesale funding issued in foreign currency.

Figure 10.
Figure 10.

New Zealand: Liquidity Stress Test Results

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: RBNZ and IMF staff estimates.Note: The sample of banks included in the liquidity stress test includes all fifteen New Zealand locally incorporated banks. Boxplots include the mean (yellow dot), the 25th and 75th percentiles (grey box, with the change of shade indicating the median), and the 10th and 80th percentiles (whiskers) for the quasi-LCR ratios, and the 10th and 90th percentiles for RBNZ liquidity regulatory ratios. The red line indicates the lowest acceptable ratio value (hurdle rate).

C. Contagion Analysis

17. A contagion module assessed the potential for distress in a financial firm to create risks to overall financial stability. The transmission of distress from an individual firm to the broader banking sector is spread through bilateral exposures and market contagion. Network analysis is used to examine bilateral exposures, where counterparties with significant exposures to the failing firm may suffer material losses resulting in their inability to satisfy their obligations spreading distress to other parts of the financial system in the form of cascading defaults down the credit chain.10 Under market contagion, market participants’ revise their expectations on the solvency of other firms exposed to the firm in distress, conditional on the broader economic and financial environment.

18. The network analysis captures the potential for cascading defaults throughout the New Zealand interbank market. It includes a credit shock simulation whereby one credit counterparty defaults at a time. It also includes a funding shock simulation whereby the default of a funding counterparty might induce a liquidity shortfall. The potential fire-sale of assets in a stressed market was linked to the LCR prescribed haircuts for liquid assets. The analysis was based on RBNZ’s large exposure data template.11 The coverage of the network analysis included all 15 locally incorporated banks.

19. The risk of contagion from a bank default through interbank exposures appears to be limited, but results need to be interpreted with caution. Interbank exposures are relatively small compared to banks’ capital levels. Under the baseline calibration there are no banks whose default would lead to consecutive defaults of other institutions. A loss of the 3 largest cross-bank exposures leads to a cascade default of one locally-incorporated bank, while a loss of three largest corporate and exposures to other nonbank financial institutions results in cascade defaults of four banks. However, if LGD on defaulted exposures increases to 90 percent, the simulated default of one bank leads to a cascade default of 1 more bank and 5 institutions default following the loss of their 3 largest exposures. While the results are sensitive to changes in the LGD assumptions, they are robust to changes of the discount on asset sales and of the share of non-replaceable funding. These results need to be interpreted with caution, as fire-sale assets are calibrated exogenously using LCR prescribed haircuts, so spiral effects from deeper discounts in prices of non-liquid assets are not modeled explicitly. Moreover, contagion effects from a bear-market sentiment to banks following similar business models to the bank in distress are excluded.

20. The analysis of market contagion is complementary to the network analysis. Contagion effects are measured using market-implied asset returns capturing spillovers unrelated to credit exposures (i.e., due to common exposures or driven by banks with similar business models). In addition, systemic contagion can be transmitted by internationally active banks. The analysis is performed for Australian banks due to the lack of market data for New Zealand subsidiaries. For the large Australian banks, instability can spread from their global counterparts, given their active presence in offshore debt markets and derivative markets. While the analysis is conducted at the consolidated level, distress is expected to trickle down at the subsidiary level due to the tight correlation between Australian banks’ equity returns and New Zealand banks’ funding spreads. Lower equity returns at the consolidated level are associated with widening funding spreads for New Zealand banks in wholesale markets (Figure 11).

Figure 11.
Figure 11.

New Zealand: Cross-Border Spillovers

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: Bloomberg, RBNZ data, IMF staff estimates.1 The blue line shows monthly-averaged weekly equity returns of the four big Australian banks weighted by their asset size. The red line shows the monthly average wholesale funding spreads in domestic and offshore markets for New Zealand banks.

21. The Conditional Value at Risk (CoVaR) framework is used to assess whether individual distress could pose a material risk to financial stability.12 Although there is not a unique definition of financial distress, a firm is assumed to be in distress when it reaches its Value at Risk (VaR). The quantification of contagion effects depends on the definition of the financial system and the financial conditions under which a firm’s failure arises. Two financial systems were defined: (i) a global banking system covering the 30 G-SIBs as of November 2015,13 and (ii) an Australian banking system including the four largest Australian banks. The set of conditioning state variables is guided by their role in affecting global returns in financial markets.

22. Inward cross-border spillovers from distressed G-SIBs to New Zealand banks are significant. The analysis suggests that Australian banks have become increasingly exposed to European banks. The transmission of distress is more severe to tail equity returns than to market-implied asset returns during stressed times due to fire sales effects and contagion in funding costs. The reverse is true during calm periods suggesting flight-to-quality rebalancing of investors’ portfolios.

Financial Sector Oversight

A. Macroprudential Framework

23. New Zealand has a good institutional framework for macroprudential policy, but decision-making procedures could be strengthened. There is a clear mandate for financial stability, operationally clarified by a Memorandum of Understanding (MoU) signed between the RBNZ and the MoF. The MoU, however, created a narrow framework, limiting actions to banks and including just four instruments in the toolkit. This has constrained RBNZ’s macroprudential actions, should risks arise which require a different set of tools. To amend the toolkit, the RBNZ needs to obtain the agreement of the MoF, but procedures for that are not transparent to the public. To make the process more transparent, the RBNZ’s advice and the opinions of the MoF on the need for adjustment should be publicly disclosed within an appropriate timeframe.14 Furthermore, a more regular review of the macroprudential toolkit prescribed in the MoU than the current five years (e.g., biannually) may be useful. In addition, timely prudential action requires a decision-making processes free from financial industry and political pressures. The accountability framework should allow effective accountability without jeopardizing the integrity and independence of the macroprudential decision-making process, reviewing actions already taken but also safeguarding against influence on actions in advance.

24. New Zealand has actively used macroprudential tools to address systemic risks in the housing sector, but more may be needed (Figure 12). In mid-2013, rules were introduced requiring banks to reduce the volume of high-LVR lending to below 10 percent of new commitments. Real estate prices and credit expansion continued to grow strongly, particularly in the Auckland area, leading the RBNZ to tighten further the LVR restriction to Auckland investors at end-2015. Despite the financial stability benefits generated by the reduction of the LVRs, growth in house prices and credit has remained elevated, reducing the resilience effects of the framework and causing the RBNZ to extend investor restrictions nationwide starting in October 2016. The new restrictions eliminate the regional differences and impose tighter limits on investor loans and owner-occupier lending. Nevertheless, imbalances in the sector still generate systemic risk: long-term declining rental yields and a still rising price-to-income ratio suggest overvaluation, and household debt-to-income has edged up further. The persistence of imbalances suggests that the potential benefits from LVR measures have reached their limits and other tools are needed.

Figure 12.
Figure 12.

New Zealand: Housing Sector Risks

Citation: IMF Staff Country Reports 2017, 110; 10.5089/9781475598834.002.A001

Sources: NZ authorities and IMF staff estimates.

25. Since housing loans represent more than half of banks’ assets, limits on debt-to-income could usefully become part of the macroprudential toolkit. It is still not possible to assess the full effects of the October 2016 LVR adjustments in the housing market. If the measures do not substantially reduce current risks, as the recent experience with LVR measures seems to suggest, authorities should complement the current measures with Debt-to-Income (DTI) limits. The RBNZ is discussing with the MoF the introduction of DTI limits in the macroprudential toolkit. Caps on DTI (or measures of similar nature such as debt servicing to total income (DSI)) can usefully complement the LVR restrictions and would help addressing remaining risks and targeting more directly risks derived from high household indebtedness. Considering that risks can build up relatively quickly, the expansion of the macroprudential toolkit is an important precautionary measure for the RBNZ to be ready to respond should the need arise. The reliance on multiple tools may also reduce distortions when compared to the use of one conservatively calibrated tool. First-time home buyers, for instance, tend to be more affected by LVR restrictions because they do not have the equity gain arising from the increase in house prices, though they tend to be in a relatively better position in terms of servicing debt in relation to investors. In addition, authorities are encouraged to maintain efforts to reduce distortionary tax benefits and facilitate housing supply.

26. The concentration of the financial sector generates structural vulnerabilities that need to be addressed and capital buffers should reflect this systemic risk. Direct exposures among the four largest banks are relatively limited, but the potential for spillovers is elevated. One of the important channels for spillovers is the reliance on overseas funding, which could lead to a tightening in the system in case of problems in one bank. Furthermore, due to their size, the deleveraging or fire sales of assets by one bank could contaminate the whole system due to the depression of asset values and economic activity. The RBNZ have been making efforts to increase the effectiveness of bank resolution regimes to better manage these risks should they crystalize.15 Nevertheless, the largest banks are systemically important and should be required to hold capital commensurate with the magnitude of the externalities of any future distress. It is recommended that the current review of capital requirements being undertaken by the RBNZ should increase capital buffers to reflect the prevalence of SIFIs in the financial system.

B. Banking and Insurance

27. The RBNZ has a non-intrusive approach to supervision and does not conduct on-site inspections to verify and determine compliance with regulations and guidelines or the effectiveness of management, systems, and data.16 The RBNZ’s supervisory approach relies on three pillars: market discipline, based on public disclosure; self-discipline, based on sound corporate governance and (for banks) directors’ attestations of public information; and regulatory discipline, based on a simple and conservative regulatory framework, off-site monitoring, and disciplinary actions. Enhanced formal and informal cooperation with APRA reflects the unique interdependence of the two financial systems (APRA conducts a more intrusive supervisory approach, from a home perspective, towards the New Zealand operations of Australian banks and insurers).17

28. Since the last FSAP, the RBNZ has increased attention to strengthening regulatory discipline, but the approach still has shortcomings. For banks, the RBNZ has adopted Basel II and III capital standards, introduced its prudential liquidity policy ahead of Basel III, issued additional supervisory guidance and increased regulatory reporting. The RBNZ took on prudential supervision of the insurance sector under legislation enacted in 2010, broadly applying the three-pillar approach developed for banking and developing a set of prudential requirements. In 2016, the RBNZ began the final stage of a multi-year upgrade of its supervisory reporting from banks, but improving supervisory data collection from insurers is a particular need. Conduct supervision has been enhanced through broadening the scope of FMA responsibilities to include insurance products, but there are significant gaps in the framework for insurance conduct regulation.

29. The overall framework for prudential regulation is well-developed, though there is scope to extend the powers of the RBNZ and develop enforcement practices. While the RBNZ has extensive powers in relation to licensing, supervision and enforcement, its effectiveness would be strengthened with broader powers to impose binding standards in all areas of prudential regulation (powers are limited to solvency and fit-and-proper requirements). The framework for licensing of overseas insurers (branches) could be strengthened to ensure the RBNZ assesses the equivalence of foreign regulatory regimes. Supervisory engagement, particularly with large institutions, needs to move towards communicating supervisory expectations and requiring action.

30. While RBNZ staff are highly competent, insufficient resources are an impediment to enhancing the effectiveness of the three pillar approach, even if the low-intensity approach is retained. The competence and professionalism of staff is recognized by market participants, but the RBNZ operates under specific resource constraints and numbers are insufficient Strengthening the regulatory discipline pillar will require increased resources, including technical capacity to develop prudential requirements and guidelines, deepen the analysis that supports the supervisory ratings, and to develop a supervision policy that reflects a balance between risk and efficiency costs of supervision. The FMA, in turn, needs to build more insurance expertise to promote adequate conduct supervision of the sector.

31. The non-intrusive approach to supervision of the RBNZ stands in contrast with the Basel Core Principles for Effective Banking Supervision (BCP) and Insurance Core Principles (ICP) and can impair the effectiveness of market and self-discipline (Annexes V and VI). The effectiveness of the RBNZ approach—and its convergence with the BCP and ICP—is hindered by: (i) the absence of supervisory testing to determine compliance and the effectiveness of risk management, and (ii) limited supervisory guidelines and regulations that could serve as benchmarks for the three pillars. While policy implementation will take significant time, there is a need to close the most significant gaps by:

  • Issuing enforceable supervisory standards on key risks. Such standards, tailored to reflect the complexity and risk profile of the institutions and the system, would provide transparency to market participants regarding the supervisor’s expectations in the areas being attested to by directors. Standards also help support supervisory judgment to implement preventive enforcement. Regulation of governance, risk management and controls and undertaking risk assessment in these areas need to be strengthened to promote the effectiveness of governance in practice.

  • Reviewing the enforcement regime to promote preventive action. Compliance with the guidelines issued by the RBNZ should serve as evidence of prudent banking and insurance. Also, in the case of banking, the legal need for the consent of the MoF to issue directions in cases not involving a systemic impact should be removed.

  • Initiating on-site programs to test the foundation of the three-pillar approach and directors’ attestations. The RBNZ has performed off-site thematic reviews to profile banks’ risk management in areas of concern, such as dairy and real estate. The off-site process (PRESS and iPRESS) rates financial institutions based on their risk profile (and their systemic impact). The on-site activity, which could be undertaken by the staff of RBNZ or by external experts, should be targeted to areas of high risk, to issues identified through off-site analysis, or to determine how banks and insurers are managing new risks and products. It is also important to test the accuracy of the regulatory reports.

  • Clarifying the responsibilities of the Treasury and RBNZ for financial sector issues, reinforcing the RBNZ’s role as prudential regulator and supervisor. Unclear boundaries could potentially compromise RBNZ independence and limit its ability to fulfill its supervisory role. Further delineating the boundaries with the Treasury would enhance the ability of the RBNZ to undertake effective supervision by responding swiftly to ongoing and emergent situations (Appendix V).

32. While the RBNZ has a close home-host relationship with APRA, further strengthening the collaboration with APRA would help support the key role played by home-country supervision in New Zealand. The Australian presence has been a source of strength, including the parental support received following the Canterbury earthquakes. The low intensity approach of RBNZ is partly mitigated by APRA’s intensive home-supervision. The RBNZ is encouraged to be more active in the joint on-site visits, focusing on work that serves the objectives of home and host supervisors. This would help prepare both supervisors for effective coordination also in times of stress. In addition, the interdependence also exposes New Zealand to shocks originating in Australia (there is a particular exposure in the case of life insurance because of the significant Australian presence in branch form, the exemption given to branches from many RBNZ prudential requirements, and the direct dependence on Australian insolvency law and practice in case of failure).

C. Capital Markets

33. The capital markets regulatory framework has gone through a major overhaul since the last FSAP, and the supervision of the asset management industry started only recently. Many capital market players were not licensed or supervised at the time, including asset managers. Regulatory reform created the FMA as conduct regulator of the financial sector and determined a licensing regime for managers of Managed Investment Schemes (MIS). Retail offers of MIS are now regulated and subject to governance, disclosure and eligibility requirements. The FMA completed initial licensing of MIS managers and is refining a risk-based approach to supervision of the sector.

34. Private entities, called Financial Markets Supervisors (Supervisors), are now licensed and are expected to play a role in the monitoring of MIS managers. Under the old regime, trustees were appointed to act on behalf of the unit holders of investment funds. Under the new regulatory framework, MIS offered to retail investors are required to appoint a Supervisor. These are private companies licensed by the FMA to carry out certain statutory supervisory activities, including primary oversight of significant features of the MIS framework, such as monitoring the adequacy and use of asset valuation policies, custody, leverage and liquidity risk management. There are challenges and benefits from leveraging off the work of Supervisors and the FMA is encouraged to keep the risks and appropriate responses under constant review. The FMA needs to ensure that it has oversight of areas relevant to the stability of the sector, where more technical expertise and a macro perspective are required, and ensure the quality of Supervisors work.

35. The overall regulatory framework for asset management is well developed, but there is scope to consider broadening its perimeter. The provision of custody services does not require a license in New Zealand and, therefore, falls outside of direct supervision by the FMA—or by any other authority. The government could usefully require that these entities be subject to licensing and supervision. Also, wholesale asset management activities are not covered by the FMC Act. This sector may not be significantly larger than the retail sector, but there is insufficient data to assess its risks.

D. Financial Market Infrastructures

36. FMIs are heavily dependent on the four largest banks and a potential failure of one of the main banks would put severe stress on all FMIs and the market as a whole (Box 1). In this context, the reform of the regulatory and oversight framework for FMIs is welcomed. The RBNZ and the FMA, which are jointly responsible for the regulation and oversight of FMIs, currently lack sufficient legal powers to identify and address risks building up in FMIs, partly because the regime is voluntary and the authorities do not have the appropriate toolkit. Proceeding with the proposed reforms will make New Zealand better aligned with international standards. The proposed regime will provide the authorities with legal powers for the oversight of systemically important FMIs, a gradual range of enforcement powers, and crisis management and regulatory powers. Implementation of the new regime will need more oversight resources than those currently planned.

Network Analysis of FMIs and their Members

The landscape for FMIs is densely interconnected, with many FMIs having the same members. Members can be banks, other financial institutions and government agencies. High interconnectivity suggests that financial or operational failures of a given FMI, or a critical member, could quickly propagate through the financial system if proper safeguards are not in place.

The figure in this box shows different clusters within the network. The largest overlap of members exists between ESAS, SBI, and HVCS. NZ Clear and NZCDC largely form their own “network clusters.” Banking groups are most heavily centered in the ESAS/SBI/HVCS cluster, but are highly connected to NZ Clear as well. By contrast, nonbank financial groups are largely uninvolved with ESAS/SBI/HVCS but are connected to NZ Clear and NZCDC.

The size of the arrows between the FMIs and their members represents the settlement volume. Banking groups are the dominant share of New Zealand FMI transactions. Nonbank financial groups and domestic government bodies are the next most active sectors, but their share of transaction volume is low by comparison (measured in NZD). Overall, membership in New Zealand FMIs is dominated by Australian banks, followed by New Zealand banks. Three Australian banks have a membership in all FMIs, whereas the four Australian banks represent 80 percent of total settlement volume. Although trading volumes of New Zealand members are lower, they are highly connected with all domestic FMIs.

Source: IMF staff.

37. Adopting international principles for FMIs in secondary legislation, formalizing supervisory practices, and increasing staff resources are important. Detailed requirements support FMIs, their owners, and operators, in understanding oversight expectations and provide guidance in the drafting of public self-assessments, increasing transparency. In addition, although the quality of the oversight staff is high, their low number results in an ‘ad hoc’ approach to supervision. Supervisory staff does not conduct supervisory standard assessments, and has limited time for the analysis of broader themes that are relevant for financial stability, such as cyber resilience of FMIs, crisis management arrangements and risks related to the use of overseas FMIs. Thus, significantly stepping up resources is key. Furthermore, the FMA is encouraged to publicly disclose their role and responsibilities in relation to the oversight of domestic and foreign FMIs.

E. Financial Integrity

38. Since the 2004 FSAP, the AML/CFT regime of New Zealand was assessed by the Financial Action Task Force (FATF) and strengthened by the authorities. The authorities notably amended the AML/CFT Act addressing the main deficiencies identified by the FATF, and assessed the country’s ML/TF risks. Professional services/gatekeepers and legal persons with complex ownership structures were identified as highly vulnerable to ML, with drug crimes, fraud, tax evasion and foreign predicate crimes generating the most significant levels of illicit proceeds. The authorities are taking steps to align the legal framework with the FATF 2012 standard by mid-2017, updating the ML/TF risk assessments, and preparing for the next FATF assessment scheduled for 2019.

39. While significant progress was made, shortcomings remain and further strengthening the AML/CFT regime is necessary. Several designated non-financial businesses and professions are not fully subject to AML/CFT requirements. In particular, lawyers and accountants (who perform customer due diligence obligations on behalf of more than 40 percent of financial institutions) should be subject to AML/CFT measures and supervision in line with the standard – although the Government has recently introduced legislation to address the issue. Moreover, additional measures should also be taken so that the authorities have timely access to up-to-date beneficial ownership information of legal persons and arrangements.

F. Correspondent Banking Relationships

40. New Zealand banks have closed accounts of Money Transfer Operators (MTOs) and the authorities have taken an active approach to help enhance remittance corridors. Average transfer costs are trending up and available data suggests that the MTO market has become more concentrated, with the volume of remittances to Small Pacific States remaining broadly stable over the last few years. The RBNZ issued a statement in 2015 clarifying Anti Money Laundering (AML) obligations and advocating a measured risk management approach by banks. In addition, government agencies are providing technical assistance to Small Pacific States, including on combating money laundering and the financing of terrorism (ML/CFT), modernizing payments infrastructure in several islands, and supporting innovative remittance transfer solutions.

Crisis Management

41. There are several unique considerations on contingency planning and crisis management arrangements in New Zealand. These include the minimally resourced approach to supervision and emphasis on self-discipline and market discipline, strong interdependence with Australia, and a long-standing decision not to introduce deposit insurance arguing that it would weaken self-discipline by banks and market discipline by depositors.18 The Council of Financial Regulators (CoFR), comprised of the FMA, the RBNZ, the Treasury, and the MBIE (portfolio responsibility for the FMA), is an advisory and coordinating body.

42. Domestic crisis managements arrangements should be strengthened and greater clarity is required on the decision-making process for dealing with a crisis and exercise of resolution powers. The detailed planning undertaken in trans-Tasman work-streams must be supported by a similar domestic process to ensure logistics and communication plans are pre-positioned. Work on preparing procedural guidance for the use of resolution tools needs to be completed, as does the development of rosters of potential statutory managers and staff from government, agencies and the private sector that could be mobilized to deal with a crisis. In addition, the RBNZ Act and Insurance (Prudential Supervision) Act 2010 (IPSA) should be revised to require post-reporting by the RBNZ on performance against resolution objectives to enhance accountability. The RBNZ Act should be revised to have the same power as in the IPSA to apply for the appointment of a liquidator. A special resolution regime paralleling that in the IPSA should be introduced for nonbank deposit-takers. Most importantly, the RBNZ should be the sole resolution authority, with clear mandates and accountabilities, requiring the approval by the MoF only for resolutions with fiscal or systemic implications. The Treasury’s role should focus on whether and how to provide a guarantee or public funds in support of a resolution recommended by the RBNZ, and provision of advice to the Minister in this respect.

43. From June 2013, large banks have been required to comply with the RBNZ’s OBR Pre-positioning Requirements Policy. The OBR was developed to provide a credible alternative to the use of public funds when resolving systemically important banks. OBR does not actually resolve a failing bank, but rather is a tool to take control of the institution and continue operations while seeking a resolution. The goal of the OBR is to allow a distressed bank to continue its core banking services to retail customers and businesses, while placing the cost of a bank failure on the bank’s shareholders and creditors rather than the taxpayer. All banks with over NZD 1 billion of deposits are required to participate. There are many complexities to be addressed if the OBR is to be seen as a credible alternative to a bail-out. These arise from policy choices with respect to the RBNZ’s supervisory approach and absence of one of the usual safety-net components, deposit insurance, absence of some direct legal powers, and the challenges of dealing with any large failing institution.

44. The introduction of a deposit insurance framework is the first-best element to complete the financial safety net. OBR involves freezing a portion of balances—including deposits—to cover any losses beyond what the bank’s capital position could absorb. As the authorities have reiterated their long-standing opposition to deposit insurance, it is recommended, as a second best option, to introduce limited deposit preference to provide a clear legal foundation for a de minimis exemption from freezing and haircutting deposits in OBR. The RBNZ public consultation has suggested a de minimis exemption of NZD 500, but it is recommended that a higher amount, established in legislation, would provide some of the benefits of deposit insurance – such as mitigating against runs and reducing the political pressure to bail out depositors. Authorities’ analysis suggests that NZD 10,000 per depositor would exempt the full amount of 80 percent of the number of bank deposits, while still leaving the bulk by value of deposits at risk.19 Moreover, the issuance of additional capital instruments with write-down and convertibility features could be considered, to provide a further buffer of bail-inable liabilities. However, caution is needed as the majority of these instruments have been purchased by individual investors who may not fully appreciate the assumed risks.

45. Further work on the trans-Tasman framework for assessing systemic importance and discussing coordinated responses would help support decision-making in an actual crisis. There is no ex-ante consensus on the single-or multiple-point of entry resolution strategies. While there has been progress on a framework for assessing systemic importance, and discussions on coordinated responses, the authorities involved have national mandates and accountabilities, which may constrain their ability to agree in advance on measures to deal with a potential crisis whose precise details are unknown. In addition, the Trans-Tasman MOC should be expanded (and renamed) to include insurance and FMIs.

Appendix I. New Zealand: Implementation Status of 2004 FSAP Recommendations

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Parties to the memorandum are: the RBNZ, New Zealand Treasury, the FMA, RBA, APRA, Australian Treasury, and ASIC.

Statutory provisions relating to NBDTs were later carved out into a separate Act – the NBDT Act 2013.

Appendix II. Overview of FSAP Stress Testing

Appendix III. Stress Test Matrix (STeM): Solvency and Liquidity Risks

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Appendix IV. The RBNZ and the IMF Stress Tests

The RBNZ stress test results are broadly comparable to the IMF stress test results using the commonly agreed scenario and RBNZ’s in-house credit risk models in combination with expert judgment. Under the RBNZ test, results are computed for the aggregate balance sheet of the big four banks. Under the adverse scenario, aggregate Tier 1 capital is projected at around 8.4 percent at the low point, and total capital ratios reaching about halfway through the conservation buffer at the worse point. This is broadly comparable to IMF aggregate results with stress tests conducted on individual balance sheets covering the five largest banks.

  • Credit risk losses are substantial with a weighted-average cumulative bad debt expense over the 5-year horizon of around 4.0 percent relative to starting loans under the IMF test and 3.6 percent of starting assets under the RBNZ test. The aggregate projection masks some dispersion in loss rates across credit portfolios, ranging between 1.4 percent of bad debt expense for housing loans, 5.4 percent for real estate and SMEs, 7.0 percent for the rural portfolio, and 12.3 percent for personal loans under the IMF test, relative to projected loss rates of 2.1 percent for housing loans, 6.0 percent for CRE, 9.0 percent for the rural portfolio, and 10.0 percent for personal loans under the RBNZ test.

  • Market risk losses are larger under the IMF stress test as trading securities and AFS securities suffer marked-to-market losses. This is driven by a widening in money market spreads due to credit risk shocks and the steepening of the yield curve triggered by term premium shocks across debt markets. Given the composition of banks’ securities portfolio as of June 2016, market shocks lead to an accumulated asset valuation loss of around 10 percent. This is a very conservative estimate as hedges assumed are to not operate under stressed market conditions. By contrast, liquid assets were treated as HTM securities under the RBNZ test and were hit by an accumulated loss rate of 0.3 percent.

  • Interest risk losses are material as bank funding costs increase under stressed money market conditions and banks’ ability to pass funding shocks through to lenders is constrained, being capped at 50 percent in the IMF test. The sharp rise in funding costs is driven by the combined effect of a shock to the reference rate, credit risk concerns over bank debt as capital buffers are eroded under stress, and system-wide contagion from weaker banks. However, the impact of funding shocks on banks’ capital buffers is somewhat mitigated by thin maturity gaps in the banking book and sound interest rate repricing schedules.1 Overall, net interest margins compress by around 60 bps at the low point of the stress from 2.2 percent in June 2016.

Reverse stress tests conducted by the four large banks reveal that bank capital ratios are robust to a severe macroeconomic downturn but could be exposed if there was also a compression of margins and a spike in operational risk. While the loss rate reported by banks under their bespoke extreme scenarios are not too different from the FSAP macro stress test and the 2015 common ICAAP scenario, net profits reported by some banks are hit by a compression of margins of around 100 bps over the 3-year scenario. Capital buffers are also eroded by an increase in operational risk losses reaching an average 11 percent of credit losses, and leading to rising regulatory capital requirements.

Appendix V. Report on the Observance of Standards and Codes: Basel Core Principles for Effective Banking Supervision—Summary Assessment1

A. Introduction

The primary goal of this assessment of the implementation of the BCP by the RBNZ is to focus authorities on areas needing attention. The BCP are a framework of minimum standards for sound supervisory practices which are considered universally applicable, and are mainly intended as a common benchmark to assess the quality of supervisory systems and to provide input into a country’s reform agenda. The current assessment was conducted against the standard issued by the Basel Committee on Banking Supervision (BCBS) in 2012.2 This assessment is part of the FSAP undertaken by the IMF in 2016. The assessment is based on the regulatory and supervisory framework in place at the time of this visit.

The scope of the assessment is RBNZ supervision of the registered banks. Other financial industries supervised by the RBNZ are not covered in this assessment. In addition, the assessment is not intended either to represent an analysis of the state of the banking sector, the macroprudential policy framework, or crisis management framework, which are addressed in dedicated technical notes of this FSAP.

The supervisory approach of the RBNZ reflects the characteristics of the local banking industry and the authorities’ goal to limit moral hazard by relying on market discipline and not offering deposit insurance. The RBNZ approach relies on three pillars: market discipline, based on public disclosure; self-discipline, based on bank directors’ attestations of public information; and regulatory discipline, based on a simple and conservative regulatory framework, off-site monitoring, and disciplinary actions. It also relies on synergies with APRA home-country supervision of Australian banks’ operations in New Zealand. In practice, though, the RBNZ approach is in conflict with the BCP requirements, which expect granular regulatory guidance and on-site independent verification work by the supervisor.3 The RBNZ aims to strengthen supervision while retaining its current approach. Against this backdrop, the purpose of the exercise was to assess the effectiveness of New Zealand’s banking supervisory systems and practices against the Core Principles, which are neutral with regard to different approaches to supervision, so long as the overriding goals set by each Principle are achieved.

The assessment was conducted taking into account the unique characteristics of the New Zealand banking industry. The banking market is highly concentrated and dominated by four large Australian subsidiaries, whose share of total banking sector assets was 83 percent as at June 2016. The four subsidiaries are significant to their parents as well (about 15 percent of group earnings and total assets on average). Enhanced formal and informal cooperation arrangements with APRA reflect the unique codependence of the two banking systems and are aimed at providing substantial synergies in support of the RBNZ fulfilling its prudential responsibilities. There is one large state-owned bank and the rest are small banks, both foreign- and domestic-owned. The supervisory approach for those institutions differs from that for the larger banks, but although small, they can still pose reputation risk for the RBNZ.

The mission held extensive meetings with RBNZ officials, as well as the Treasury, FMA, APRA, the industry, and relevant third parties who generously shared their views. The assessment team visited the cities of Wellington and Auckland in New Zealand, as well as Sydney and Melbourne in Australia. The assessors would like to acknowledge the very high quality of cooperation received from all the authorities. In particular, the team extends its thanks to RBNZ staff who provided a very comprehensive, high-quality self-assessment, and who responded promptly and comprehensively during the mission to the extensive information requests from the team.

B. Overview of the Institutional Setting and Market Structure

The RBNZ is the prudential supervisory authority of New Zealand. Its responsibilities include the prudential regulation and supervision of registered banks and insurers, regulation of NBDTs, the oversight of the payment system (and settlement systems jointly with the FMA), and AML/CFT supervision for banks, NBDTs and life insurers. The RBNZ acts as lender of last resort and exercises crisis management powers. Some crisis management powers and the power to make regulations are exercised together with the MoF and the Governor-General acting on recommendation from the RBNZ. In 2013 the RBNZ introduced a framework for macroprudential policy vis-à-vis the banking sector under its existing objectives and powers.

The GFC had a mild negative impact on the New Zealand banking sector, but a significant number of finance companies had difficulties over 2006–2010 and were put into receivership. While liquidity pressures arising from the GFC were the trigger for closures in some cases, failures were caused well before then, mainly by problems with asset quality, connected lending, and credit management. Although the New Zealand banking sector was relatively unscathed during the GFC, several factors not necessarily related to bank supervision contributed to the maintenance of financial stability. Among other factors, banking business models in New Zealand are simple and the parent banks of the large subsidiaries were in a position to support their New Zealand operations and were subjected to an effective and intensive home-country supervision.4

The banking sector focuses its activities on lending to the domestic private sector and providing traditional products. The sector seems to be well capitalized and to have sufficient liquid assets, the quality of assets is high, and profitability has remained stable over the last 10 years. Nevertheless, the financial sector is relatively dependent on wholesale funding, including foreign currency funding sourced from offshore markets. While foreign funding has declined since the GFC, it still accounts for 19 percent of banks’ liabilities. As of October 2015, over 80 percent of banks’ liabilities (including deposits and minus equity) had a maturity of below one year, and 65 percent was on demand or with maturity of less than 3 months.

C. Preconditions for Effective Banking Supervision

New Zealand is a small open economy, underpinned by strong policy frameworks.5 New Zealand’s modern economy benefits from a strong commitment to open-market policies that facilitate vibrant flows of trade and investment. Transparent and efficient regulations are applied evenly in most cases, encouraging dynamic entrepreneurial activity in the private sector.

The fiscal and monetary policy authorities are independently responsible for their respective areas of policy. The Treasury is responsible for maintaining a stable and sustainable macroeconomic environment, and fiscal policy is one of its main tools. The RBNZ, for its part, is responsible for ensuring price stability as defined by the Policy Targets Agreement signed between the MoF and the Governor. The RBNZ is operationally independent regarding monetary policy formulation. The RBNZ Act also enables the Governor-General, on the advice of the MoF, to direct the RBNZ to formulate and implement monetary policy for any economic objective, other than ensuring price stability, for a period not exceeding 12 months.

New Zealand has a defined institutional framework for financial stability policy formulation.6 The RBNZ has independent decision-making power vis-à-vis macroprudential policies empowered by the RBNZ Act. A MoU signed in May 2013 outlines the governance arrangements for the use of macroprudential tools. During the 2008–2009 crisis the RBNZ established a new committee, the Macrofinancial Committee, to focus explicitly on macrofinancial stability issues. New Zealand has actively used macroprudential tools to address systemic risks.

New Zealand has a well-developed public infrastructure to support its financial system. New Zealand ranks in the 97–100th percentile of all countries for the World Bank key indicators of governance.7 They are Voice and Accountability, Political Stability and Lack of Violence, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption. While all six indicators are important settings for financial stability and other regulatory purposes, government effectiveness, regulatory quality and the rule of law are particularly important In this regard New Zealand has:

  • An adaptable and responsive legislature able to maintain ongoing law reform.

  • Quality laws relating to business organization, business and personal insolvency, personal and real property registration and transfer, and consumer protection.

  • An independent judiciary of high standing.

  • Institutions responsible for and able to administer and enforce market conduct and competition law (FMA and the Commerce Commission).

  • Strong independent professions (legal, accounting and actuarial) and adherence to international and professional standards (IFRS, actuarial standards, etc.).

  • Support for freedom of contract, property rights and the rights of the individual and protection from arbitrary action by the government, consistent with a developed economy.

  • A well-developed corporate and commercial law.

The prudential regime provides a number of triggers under which the RBNZ may apply failure resolution or crisis management powers. The legal framework for resolution of banks is established in the RBNZ Act. Upon identifying an institution as failing or likely to fail, the RBNZ recommends to the MoF initiation of resolution through the appointment of a statutory manager. In addition, OBR has been developed as a tool, not tested yet, to provide a credible alternative to a bailout should it become necessary to resolve a systemically important institution. Nevertheless, greater clarity is required on the decision-making process for dealing with a crisis and the exercise of resolution powers.8

The RBNZ has a statutory lender-of-last-resort role. To mitigate liquidity risks, the RBNZ introduced a prudential liquidity policy in 2010 designed to encourage banks to self-insure against funding-liquidity risks. The Australian parents could previously provide contingent funding to the New Zealand subsidiaries up to 50 percent of the parent’s Tier 1 capital. APRA has since tightened its prudential requirements relating to related party exposures to the New Zealand subsidiary banks reducing their non-equity exposures to 5 percent of Tier 1 parent capital. New Zealand banks are also required to set up contingent funding arrangements that are secured by instruments that are exempt from resolution actions in New Zealand, such as covered bonds which were introduced to help manage and diversify funding liquidity. Banks started issuing covered bonds in 2010 due to difficult market conditions.

There is no ex ante depositor protection insurance in New Zealand. This reflects both current government policy and the RBNZ’s long-standing view that the emphasis should be on reducing the moral hazard attached to any public perception of the government backstopping all or part of the financial system (implicit guarantee). In addition, the RBNZ considers that deposit insurance is challenging in a highly concentrated system. It is also not well suited to dealing with systemic failures. That said, a temporary opt-in retail deposit scheme was introduced in 2008 in order to give assurance to New Zealand depositors (of registered banks and NBDTs) in light of financial market instability. Initially for two years, the scheme was subsequently extended until December 2011. The government plans on considering the merits of an explicit depositor protection scheme, in conjunction with crisis governance, in due course.

The regulatory and commercial environment in New Zealand supports market discipline. This is particularly the case in those industries that operate under free-market conditions.9 In addition, the RBNZ is committed to bank disclosure, and there are no restrictions on the ability to move deposits and other investments from bank to bank. Market discipline in the banking industry of New Zealand is less idiosyncratic than it is assumed in the RBNZ supervisory approach. Large maturity mismatches make banks’ financial structures extremely fragile worldwide, threatening massive losses and the disruption of financial services to the broad economy. To protect the economy from systemic risks, governments provide public safety nets. To break a systemic crisis, there is commonly no other option than to call on public resources. This is more so in the context of welfare state systems. Recent experience in New Zealand with the public policy response to the GFC and the crisis of the finance companies may well illustrate the case.10 For free-market processes to operate in an unfettered way in the banking industry and play a beneficial disciplinary role, all sorts of implicit and explicit public safety nets would need to be dismantled, and socially and economically critical payments and settlement systems should be able to continue their operations despite a bank failure. Otherwise, market discipline in the banking industry has to be complemented by, and often replaced by, effective regulatory discipline.

D. Main Findings

Since the last FSAP, the RBNZ has increased attention to strengthening regulatory discipline, following international standards in substance. For example, the RBNZ has adopted the new Basel capital framework, issued supervisory guidance and increased regulatory reporting. In 2016, the RBNZ began the final stage of a multi-year upgrade of its supervisory non-public statistical and prudential reporting from banks. The supervisory policies published are, for the most part, related to “conditions of registration” and, thus, enforceable. The RBNZ has performed off-site thematic reviews to profile banks’ risk management in areas of concern, such as dairy and real estate. An off-site process (PRESS) is in place that rates banks based on their risk profile and their systemic impact. An AML/CFT supervision process has been implemented.

The effectiveness of the current approach to supervision is limited by the heavy weight placed by RBNZ on market discipline as compared to regulatory discipline (and to intensive supervision in particular). A defining feature of RBNZ’s approach is the absence of independent testing of prudential returns and risk management practices for prudential purposes. In particular, the RBNZ avoids detailed on-site inspections, either by its own staff or external experts, concerned that this would weaken bankers’ incentives to ensure robust controls.11 The RBNZ needs to re-evaluate whether the lack of a more intensive approach, including an increased on-site program, may undermine market and self-discipline. In addition, the current approach makes it difficult for supervisors to develop expertise on bank operations, hampering the effectiveness of their analysis and policy development.

The assessors were very impressed with the quality and competence of the RBNZ staff; however, insufficient resources are a serious impediment to achieve compliance in-substance with the BCP. The RBNZ’s staff operate under resource constraints and a mere reallocation would not be enough, even if the current low-intensity approach is retained. Strengthening the regulatory discipline pillar will require a reassessment of resources and technical capacity. To continue enhancing the supervisory process, an increase in staffing is required to a level that would at least enable the RBNZ to develop an on-site program that tests the foundation of the three pillar approach, to deepen the analysis that supports the PRESS ratings, and to issue supervisory guidelines that promote preventive actions.

The self-discipline pillar relies on directors’ attestations to the fact that the bank has adequate risk management systems in place. However, the RBNZ has issued limited guidance as to what constitutes adequate risk management. The vacuum created by the RBNZ not stating its expectations on adequate risk management is likely filled by foreign banks basing their attestations on home-country supervisors’ standards. For domestic-owned banks, it is likely that each may be following standards adopted from different sources. The RBNZ is very familiar with the Australian standards, but for the next tier of foreign-owned banks (as well as for the tier of domestic-owned banks) it would need to review standards on-site. Not issuing standards may result in an uneven playing field as some banks may be following stricter standards than others, thus diminishing the value of disclosures as directors are attesting to different standards.

An effective self-discipline regime needs to be supported by a well-developed regulatory framework and swift enforcement when banks violate the rules. The RBNZ has broad enforcement powers, but the lack of regulatory benchmarks mentioned before and the high legal threshold for issuing directions (orders) make swift enforcement less likely. To issue directions under section 113(1)(e) of the RBNZ Act when a bank is conducting business in a non-prudent manner the consent of the MoF is required. Demonstrating imprudent behavior based on, for example, inadequate risk management or insufficiently developed risk appetite statements, is made difficult by the lack of supervisory standards. As a result, the RBNZ’s enforcement is currently based primarily on breaches that have already occurred and is not preventive.

Recommended actions in this report seek to improve compliance with the BCP, and enhance the effectiveness of the RBNZ three-pillar approach. Key recommended actions as developed in this report, include: (i) amending section 78 of the RBNZ Act to make compliance with RBNZ-issued supervisory policy evidence of prudent banking; (ii) issuing supervisory policy documents as warranted (for example on credit risk); (iii) carrying out targeted on-site programs (directly or through external experts) to verify regulatory reports, risk management, and the quality of credit exposures; (iv) enhancing proactive cooperation within the trans-Tasman agreements to support cross-border synergies in supervision; (v) considering options to facilitate the taking of enforcement action based on supervisory judgment; and (vi) improving analysis to support PRESS ratings by retaining work papers to document determinations on adequacy of risk mitigants.

An important precondition for effective banking supervision is the willingness to act. As is well-established IMF policy,12 a positive assessment of the supervisor’s ability to act—based on its resources, authority, organization, constructive working relationships, and as evidenced by actions taken to impose corrective action—is not sufficient to ensure effective supervision. This must be complemented by the “will” to act in order to take timely and effective preventive actions in normal times, and corrective actions in times of stress. Developing this “will to act” requires a clear and unambiguous supervisory mandate, operational independence coupled with supervisory accountability and transparency, skilled staff, and an arm’s-length relationship with the industry that avoids “regulatory capture.” The Principle by Principle assessment reflects on the supervisor’s “ability to act” and the conditions needed for their “will to act.” However, effective supervision also requires as a catalyst a political will that cannot be measured nor evaluated externally.

This section summarizes the main findings of the detailed assessment conducted in the context of the FSAP. Built on these main findings, Table 1 below presents briefly a sense of the degree of compliance with each of the 29 principles that comprise the BCP.

Table 1.

New Zealand—Summary Compliance with the Basel Core Principles

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Responsibilities, Objectives, Powers, Independence, and Cooperation (CPs 1–3, and 13)

While the responsibilities of RBNZ as banking supervisor are defined in law, there are ambiguities at an operational level. The statutory objectives of the RBNZ are broadly defined as “promoting the maintenance of a sound and efficient financial system; or avoiding significant damage to the financial system that could result from the failure of a registered bank.” Broad definitions of concepts such as “sound and efficient financial system,” “significant damage,” or a focus on “systemic implications” only, have allowed the RBNZ to develop over time a particular hands-off supervisory philosophy that departs from conventional, more resource-intensive supervisory practices.13 For example, the current approach has limited appetite for independent verification of supervisory returns and first-hand knowledge of the soundness and risk management of individual banks. The supervisory objectives have to be clarified at an operational level. Towards this end, the RBNZ is currently defining its risk appetite framework, which will reinforce the RBNZ’s statutory objectives by translating them into practical outcomes, and clarify how supervision has to be conducted in practice.

RBNZ staff are highly qualified, but numbers are clearly insufficient to conduct effective supervision, even if on-site work was conducted by external experts under RBNZ prudential mandates and guidance. Insufficient resources are a serious impediment to developing an effective and intrusive supervisory approach carefully tailored to the characteristics of New Zealand’s banking industry and bearing in mind potential synergies stemming from the trans-Tasman agreements. The RBNZ should reassess the adequacy of the resources assigned to its banking supervisory function. This will make it possible to address the recommendations of this assessment that are oriented toward strengthening the supervisory process, enhancing knowledge and risk assessment of supervised entities, facilitating early action and preparedness for crisis management, and allowing staff to analyze broader themes relevant for financial stability.

While coordination and collaboration with the government is defined in law and supported by a MoU, boundaries between areas of responsibility may need to be further clarified in practice. The Act provides the RBNZ with powers to operate at arm’s length from the government and MoF, subject to control functions and checks and balances embedded in the legislation. However, the role of the Treasury as adviser to the Minister in relation to the RBNZ’s primary responsibility for prudential supervision, as governed by an MoU signed in 2012, creates ambiguities in practice with regard to the respective roles of the RBNZ and Treasury that need to be clarified. In addition, the authorities may wish to consider aligning the RBNZ Act with the IPSA and Nonbank Deposit Takers (NBDT) Act by removing the role of the Minister in issuing directions (as discussed below regarding CP11). At the moment, lack of clarity on roles and attributions have mostly manifested in deficiencies in effective coordination on policy advice. However, ambiguities have the potential to lead to undue delays in issuing prudential regulations or government interference in prudential issues, if RBNZ technical expertise on prudential matters is not clearly recognized.

Strengthening the collaboration with APRA will support the reliance of the RBNZ on synergies from home-country supervision. The RBNZ has a unique and close home-host relationship with APRA, which reflects the heightened co-dependence between the financial systems of Australia and New Zealand. This is underpinned in legislation and further given effect through bilateral MoUs and the Trans-Tasman Banking Council (TTBC), set up in 2005.14 That said, arrangements for cooperation and collaboration could be used proactively to further serve RBNZ’s and APRA’s joint interests as well as helping each to achieve their own objectives in a cost-effective manner for the supervisors and the industry. For example, RBNZ could seek proactive engagement during the on-site visits conducted by APRA, in order to gain knowledge of, and confidence in, the home supervisory approach and the techniques that are central to APRA’s supervisory model.15 Building sound cross-border relationships takes time and will prepare both supervisors for an effective coordination in times of stress. The need for a more coordinated approach by the two supervisors was a widely-held view among the stakeholders who met with the assessors.

Methods of Ongoing Supervision (CPs 8–10, and 12)

The New Zealand banking system has some unique characteristics which have influenced the supervisory process followed by the RBNZ. The largest four banks are subsidiaries of Australian banks and individually represent a significant investment and earnings source to the parents. As a result, the home-country supervisor (APRA) maintains robust monitoring of the subsidiaries as part of their consolidated supervision. Accordingly, a strong home-host relationship has been established between APRA and the RBNZ, providing the RBNZ with sufficient information to develop a high level of comfort on the regulatory standards met by the Australian banks and their financial condition. In this context, the RBNZ is able to tailor their supervision-by-risk to reflect their higher risk tolerance, and not incorporate some supervisory standards considered essential in the BCPs.

Ongoing supervision by the RBNZ is based on the three pillars of market, self and regulatory discipline. Market discipline is accomplished through public disclosure and publication of financial information. The main elements of self-discipline are corporate governance, particularly the RBNZ requirement that bank directors attest in the published financial statements that risk management systems “are in place to monitor and control adequately all material risks of the banking group.” Regulatory discipline has increased since the 2004 BCP assessment with the issuance of supervisory rules and guidelines in areas viewed as significant by the RBNZ. These areas include but are not limited to: capital (Basel II and III), liquidity, outsourcing, related party lending, and corporate governance. In addition, to support regulatory discipline, an off-site financial analysis system (PRESS) has been put in place to identify, measure, and monitor risk areas and arrive at a risk rating for registered banks.

The RBNZ follows a non-intrusive approach to supervision. In particular, guidelines and regulations avoid establishing hard limits or prescriptiveness in most areas, and detailed on-site inspections are not conducted. It is the supervisory philosophy of the RBNZ that the banks’ management and directors are in the best position to design risk management systems and establish limits based on the risk appetite and capital available to support those risks. Through off-site reviews of risk appetite statements, financial information, reports submitted to bank management, and on-site visits to meet with bank management and directors, conclusions are drawn about the reliability of directors’ attestations and compliance with RBNZ guidelines.

The guidance issued by the RBNZ does not sufficiently communicate its expectations on the elements it considers necessary in management systems to monitor and adequately control material risks. Therefore, directors’ attestations may be based on differing benchmarks and expectations. It is likely that foreign-owned banks are filling the vacuum left by the lack of RBNZ guidelines with their home country supervisors’ guidelines and requirements. For the locally-owned and incorporated banks, the vacuum may be filled from various sources. Without its own detailed review of individual banks’ operations, the RBNZ is, in essence, relying on the adequacy of home country standards for the foreign-owned banks. For the locally-owned banks, testing of attestations through bank-specific reviews is required to determine the adequacy of standards being followed.

The RBNZ does not conduct inspections, and on-site interaction with banks takes the form of prudential meetings and primarily focuses on the 10 largest banks. The meetings provide an opportunity to discuss results of supervisory analyses and other issues that may have been identified by the RBNZ. Thematic visits have also been conducted to review systemic issues in deeper detail. The scope of the thematic visits does not include direct access by supervisors to bank records or files, with the review relying on increased information requests and questionnaires. The RBNZ participates as an observer during on-site inspections by APRA. Overall, the lack of first-hand independent verification of prudential returns and assessment of banks’ risk management practices prevents the RBNZ from having a thorough understanding of the banks.

PRESS serves as the risk assessment tool for measuring and monitoring risks. The PRESS process incorporates 10 risk areas and adds a systemic impact factor to arrive at an aggregate numerical rating for the bank, reflecting its risk profile and systemic impact. Macroeconomic factors and stress testing results (conducted by RBNZ or individual banks) add a forward-looking aspect to PRESS. Information reviewed includes bank internal reports and, increasingly, information from regulatory reports. Although some forward-looking elements may be included, the ratings are primarily results-oriented. The analysis conducted to support the ratings is not well documented and is based primarily on banks’ internal risk reporting.

The RBNZ does not conduct effective consolidated supervision. The supervisory approach, risk and prudential reporting requirements, and monitoring and analysis are based on the registered bank’s banking group as defined in conditions of registration. The conditions of registration allow supervision to be conducted on a subconsolidated basis, i.e., to focus on the registered bank and its subsidiaries. The wider banking group or conglomerate would not be supervised. Nevertheless, the corporate structures of New Zealand banking groups are simple and there are no material foreign operations of New Zealand incorporated banks. The four banking groups with more complex structures are large Australian banking groups supervised by APRA. Attention to consolidated supervision is focused on the assessment of “parent support” as a PRESS risk factor, as well as maintaining good communication with the insurance supervisory function of the RBNZ and FMA. The RBNZ has the ability to change its approach to consolidated supervision if the risk profile of the banking groups changes.

Ownership, licensing, and structure (CPs 4–7) are not areas of particular concern at the time of this assessment. Registration by the RBNZ is what constitutes a bank, and not what business an entity carries on. This situation may have created lack of clarity in the past as many other entities were carrying on bank-like activities such as accepting deposits. But since 2013, all NBDTs are licensed by the RBNZ. Their supervision is entrusted to their private sector trustee companies based on RBNZ sectoral regulations. Transfer of significant ownership happens very infrequently in New Zealand, because ownership of most of the registered banks is concentrated in single banking groups, and because of the small number of institutions. Major acquisitions were not a significant activity at the time of the assessment.

Corrective and Sanctioning Powers of Supervisors (CP11)

The RBNZ has broad powers for imposing corrective action or sanctions, but issuance of directions requires the prior consent of the MoF. Under section 113 of the RBNZ Act, with the consent of the MoF, the RBNZ may issue directions requiring banks to take corrective action, remove or replace directors, auditors, or management and cease any unsafe business activity. Directions may be imposed to correct violations, but also to address actions not considered prudent by the RBNZ. Enforcement powers have been recently used to require disclosure re-publication, impose additional conditions of registration or to require additional reporting.

The RBNZ has issued limited guidance establishing a framework for identifying banking activities and practices considered unsound and not prudent. The lack of a detailed regulatory framework supporting supervisory judgment makes issuance of preventive directions more difficult. Directions may be issued when the bank or associated persons are conducting business in a manner prejudicial to the soundness of the financial system, or the business of the bank is not being conducted in a prudent manner. The threshold to issue a direction is high and the lack of supervisory guidance on what constitutes prudent banking (other than the broad description in section 78) makes use of supervisory judgment more difficult. Additionally, even bank-specific directions not having systemic implications require the prior consent of the MoF.

Although largely untested, the enforcement (directions) process may result in the RBNZ being reactive with its corrective action. Use of supervisory judgment is enhanced when the supervisor has issued enforceable guidelines on risk management processes. Also, the requirement that the Minister consent to bank-specific directions (section 113(1)(e)) may impose additional burdens and reduce the timeliness of enforcement actions.

Corporate Governance (CP14)

Although not enforceable by the RBNZ, the Companies Act of 1993 establishes requirements on corporate governance and the RBNZ has issued prudential requirements (Document BS14) providing additional guidance to banks. BS14 incorporates fit-and-proper principles from the Basel Committee’s 2010 paper: Principles for enhancing corporate governance. BS14 also addresses Board composition and the inclusion of independent directors. Although BS14 refers to the Basel paper, only areas directly linked to conditions of registration are enforceable.

The RBNZ monitors compliance through off-site reviews, but the scope is not sufficiently detailed to meet the BCP standard. Supervisory activities do not include determining the level of engagement by boards and their oversight of senior management, nor does it include a review of governance structures, management selection, remuneration decisions and whether the Board adequately communicates corporate culture or establishes a strong control environment.

Prudential Requirements, Regulatory Framework, Accounting, and Disclosure (CPs 15–29)

The RBNZ does not impose direct requirements on banks to have comprehensive risk management policies and processes, except in the areas of capital adequacy and liquidity. The RBNZ relies on the required attestation provided by directors with every financial statement disclosure that: “the bank had systems in place to monitor and control adequately the material risks of the banking group, including credit risk, interest risk, currency risk, equity risk, liquidity risk, operational risk, and other business risk, and that those systems are being properly applied.” Accuracy of the disclosure is tested off-site by the RBNZ through report analysis and by on-site interviews with bank management.

Liquidity policy (BS13) requires banks to comply with a number of quantitative and qualitative standards. The policy establishes a number of quantitative measures based on balance sheet ratios and cash flows to arrive at one-week and one-month percentages of liquidity outflow to total funding. Also computed is a one-year core funding ratio, required to be not less than 75 percent. The results of the liquidity requirements yield broadly similar results as application of Basel III.

Connected (Related) Party Exposures Policy (Document BS8) establishes requirements on related party transactions, including limits and transactions being on market terms. The policy establishes an aggregate limit on all related party exposures of 125 percent of Tier-one capital and 15 percent on aggregate nonbank related party exposures, by condition of registration. The aggregate limit on net exposures (under robust bilateral netting agreements) is set according to the bank’s rating, with a maximum of 75 percent of Tier 1 capital. The policy does not require that transactions with related parties and their write-off receive prior Board approval, and the definitions do not cover all types of related party that are required by Principle 20. Compliance is monitored off-site, but information is aggregated and is not adequate to monitor related party lending risk.

The RBNZ seeks to follow the Basel guidance for capital adequacy to the extent that the guidance is appropriate for New Zealand (BS2 A and B). The RBNZ has implemented the Basel II Internal Models Based Approach (BS2B: four banks are accredited to use the IRB approach) and Standardized approaches (BS2A). The RBNZ takes a simple and conservative approach to capital adequacy. The main conceptual divergence from the Basel framework is the implementation of the leverage ratio, which the RBNZ has not considered at this stage, and is kept under review in light of other countries’ experiences. Other departures from the Basel framework (such as, Pillar 2, Pillar 3, SIFI surcharges) can be considered examples of regulatory policy decisions tailored to national circumstances. The capital framework is currently under review.

New Zealand’s legal framework ensures that the financial statements of every bank are prepared in accordance with New Zealand equivalents to internationally recognized accounting standards (NZ IFRSs). The financial statements are audited by a qualified external auditor in accordance with auditing standards applicable in New Zealand that are equivalent to internationally recognized auditing standards (ISAs).16 The RBNZ relies on the external auditing process and director attestations to determine for prudential reasons whether banks use valuation practices consistent with IFRSs. The RBNZ routinely meets with the external auditor of the 10 largest locally incorporated banks. However, these meetings do not cover valuation practices, an area specifically trusted to external auditors. Other areas of supervisory responsibility delegated to external auditors are normally not covered in these meetings either.

E. Recommended Actions

Table 2 below lists the suggested actions for improving compliance with the BCPs and the effectiveness of regulatory and supervisory frameworks.

Table 2.

New Zealand—Recommended Actions

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F. Authorities’ Response to the Assessment

The New Zealand authorities (the FMA, MBIE, RBNZ, and Treasury) wish to thank the IMF and the banking assessors for their thorough assessment of New Zealand’s compliance with the Basel Core Principles for Effective Banking Supervision. The authorities welcome the opportunity to comment on the IMF’s Detailed Assessment Report (DAR).

The New Zealand authorities strongly support the FSAP as a means of promoting and improving both the quality of financial sector regulation and the outcomes that this regulation aims to achieve.

By way of context, the New Zealand banking system is highly concentrated and largely foreign owned, with subsidiaries of the four large Australian banks accounting for a large share of total banking assets. New Zealand is not a member of either the BCBS or the Financial Stability Board (FSB). Nevertheless, New Zealand looks to adopt the recommendations of international standard setting bodies when they are appropriate for New Zealand circumstances, and these are often customized to deliver outcomes that best meet New Zealand’s needs.

The last New Zealand FSAP was conducted during 2003–2004. Since that time there have been significant developments in the New Zealand regulatory landscape, including to banking sector regulation and supervision. Some developments can be traced to the recommendations of the previous FSAP, while others are tied to separate factors such as the global financial crisis.

The New Zealand financial system weathered the crisis comparatively well – the banking system did not experience a major deterioration in asset quality and nonperforming loans remained low by international standards. The crisis did, however, highlight the reliance of the New Zealand banking system on wholesale market funding. In response the Reserve Bank introduced a new prudential liquidity policy in 2010 designed to ensure banks self-insure against short-term funding pressures.

The Reserve Bank was quick to adopt the new global solvency standard for banks embodied in Basel III, implementing the new higher minimum capital requirements at the start of 2013. The crisis also prompted the accelerated development and subsequent implementation of a policy designed to minimize the damage to the financial system from the failure of a large bank. This policy, OBR, was introduced in 2012.

Complementing these policy developments, the Reserve Bank has also stepped up its supervisory intensity since the crisis, reflected in the degree of engagement with banks, and improvements in its supervisory analysis and data. The DAR acknowledges these significant improvements in the Reserve Bank’s ‘regulatory’ pillar.

The DAR notes that the Reserve Bank’s approach to banking sector regulation rests not only on a regulatory pillar’ (formal enforceable rules and requirements) but also on ensuring that bank directors and senior managers have the right incentives to manage their bank’s risks (self-discipline), and that market participants have the appropriate information, incentives and mechanisms to help influence the behaviour of banks in a way that also contributes to a sound and efficient banking sector (market discipline).

The New Zealand authorities recognize that, despite a rebalancing towards more regulation post-crisis, New Zealand’s banking regime remains somewhat unusual given the emphasis that the Reserve Bank places on self-discipline and market discipline, and its relatively low-intensity supervisory approach.

The findings and recommendations contained in the DAR provide an opportunity for the Reserve Bank to reflect on its current model and the extent to which, together, the three pillars’ might better contribute to a sound and efficient New Zealand banking system. The recommendations imply extensions or adjustments to the Reserve Bank’s current model in the following areas:

  • There should be common benchmarks and enforceable requirements against which banks should measure, monitor and manage all the key risks facing their business in order to facilitate corrective or enforcement action.

  • In conjunction, there should be a greater willingness to take supervisory or enforcement actions, not just in response to formal regulatory breaches, but also on a more preventive basis (based on a greater use of supervisory standards) to mitigate ‘imprudent behaviour’ that could lead to more serious consequences.

  • Supervisory and disclosure information should be subject to more verification either by the Reserve Bank or by external experts.

  • Market discipline has more limitations than the Reserve Bank’s approach suggests.

  • There should be a reassessment of the resources needed to adequately fulfil the Reserve Bank’s responsibilities for banking supervision.

The Reserve Bank, in conjunction with other relevant New Zealand authorities, will consider the recommendations in these and other areas identified in the DAR. It is too early to provide a definitive response, but the Reserve Bank believes that those recommendations tied more explicitly to improving self-discipline and market discipline merit particular attention. As an example the Reserve Bank recently initiated a thematic review of the attestation framework, partly in response to the IMF’s findings.

The DAR also acknowledges the importance of trans-Tasman cooperation given the significant presence of Australian-owned banks in New Zealand. The New Zealand authorities believe that the current home-host arrangements established with Australian authorities are very sound and consistent with international best practice. Nevertheless, the authorities will continue to develop and deepen the work with their Australian counterparts on areas of common interest.

The IMF assessment places considerable importance on the principle of ensuring the continued independence of the Reserve Bank in the performance of its regulatory and supervisory functions. While the DAR does not point to any examples of government interference, New Zealand authorities will work together to consider the recommendations in this area and to ensure that an appropriate degree of separation is maintained between the Reserve Bank and the executive branch of government.

In conclusion, the New Zealand authorities found the FSAP a valuable process with many potentially useful insights for the Reserve Bank’s prudential framework. The New Zealand authorities will be considering the recommendations systematically over the coming months with a view to ensuring that New Zealand’s approach to banking sector regulation continues to be cost-effective while promoting the soundness and efficiency of the financial system.

Appendix VI. Report on the Observance of Standards and Codes: Insurance Core Principles—Summary Assessment1

A. Introduction

This assessment of insurance regulation and supervision in New Zealand was carried out as part of the 2016 New Zealand FSAP. The assessment is benchmarked against the ICPs issued by the International Association of Insurance Supervisors (IAIS) in October 2011, as revised in November 2015.

The assessment excludes personal accident and earthquake schemes provided by government entities. There are two bodies (with the status of “Crown agents” under the New Zealand Crown Entities Act 2004) responsible for damages due to natural disasters and accidental injuries:

  1. The EQC, established under the Earthquake Commission Act 1993, provides natural disaster coverage in relation to residential property and associated land up to specified limits.

  2. The ACC, established under the Accident Compensation Act 1972, provides no-fault personal injury coverage for all New Zealand residents and visitors.

Both have been excluded from the scope of this assessment due to the nature of their functions which is similar to social insurance schemes. These schemes are, however, included in the market statistics in this report because they form an integral part of financial protection in New Zealand and excluding them would understate overall available insurance and hamper international comparison.

B. Information and Methodology Used for Assessment

The assessment is based solely on the laws, regulations and other supervisory requirements and practices that are in place at the time of the assessment in August 2016. While this assessment does not reflect new and ongoing regulatory and supervisory initiatives, key proposals for reforms are summarized by way of additional comments. The authorities provided a comprehensive self-assessment, supported by examples of actual supervisory practices and assessments, greatly enhancing the robustness of the assessment.

C. Overview of the Institutional Setting and Market Structure

The RBNZ adopts a principles-based, low-intensity supervisory philosophy. The RBNZ commenced prudential supervision of the insurance sector in 2010 after the passage of the IPSA The supervisory emphasis is on the board’s accountability and the consumer’s responsibility in selecting financial products and providers. Consistent with this philosophy and with its powers under IPSA, the RBNZ has issued standards and guidelines for insurers, and has consciously refrained from conducting in-depth on-site supervision, with a view to encourage self-discipline on the part of insurers’ boards and management.

The responsibility for insurance market conduct supervision lies with the FMA. The FMA’s oversight of insurers and insurance intermediaries is embedded in its general oversight of financial advisers and financial products. Established in 2011, the FMA took over the functions of the former Securities Commission of New Zealand and the Government Actuary.

New sales of life insurance are for protection only, without savings elements. Most life insurers have established fund management subsidiaries and now provide insurance and fund management out of separate entities. New life business is mostly confined to pure protection. KiwiSaver, a tax efficient (non-insurance) work-based retirement savings product with some early withdrawal flexibility, has attracted savings that might have otherwise gone into insurance.

There is no compulsory class of non-life insurance because of the role of the ACC. The ACC provides universal no-fault protection against work and non-work related injuries. Consequently, there is no compulsory insurance often seen in other markets, such as motor and workers’ compensation insurance. Individuals may take up additional private insurance to supplement the ACC’s coverage. Premiums/levies collected by ACC and EQC account for 45 percent of total non-life premiums.

The industry is highly concentrated. The total number of licensed insurers was 96 at the end of 2015, 35 of which are branches of foreign insurers. The industry is also highly concentrated in a few insurers. Australian-owned operations in New Zealand (branches and subsidiaries combined) represent 66 percent of market by premium and 75 percent by assets. The RBNZ has extensive cooperative arrangements with the Australian authorities as the home supervisor.

The non-life insurance sector is exposed to earthquake and other natural disasters. New Zealand is highly vulnerable to natural catastrophes: earthquake, volcanic eruption, and the resulting landslide, tsunami, fire, flood, etc. The Canterbury earthquakes in 2010–2011 resulted in the government bail-out of one insurer and the failure of another. Most of the Canterbury claims fell to the private insurance market, as the EQC only covers residential properties up to limits.

D. Preconditions for Effective Insurance Supervision

There is a well-established and transparent macroeconomic and financial sector policy framework. The primary responsibilities of the RBNZ include macroprudential policy; the oversight and designation of payments systems; and monetary policy. The Treasury is responsible for execution of the government’s economic policy. The FMA is responsible for oversight of organized financial markets and conduct of business across the financial sector.

There is a well-developed public infrastructure. The laws on business organisation, insolvency, property registration and transfer and consumer protection are well-established. Property and contract law is well developed, through statute or common law, and is enforced by the courts. The judiciary is independent and of high standing and there is a developed legal profession. The accounting and auditing frameworks follow international standards and there is a well-developed profession. Auditors and audit work are subject to oversight and disciplinary processes. The New Zealand Society of Actuaries is an independent professional body.

There are extensive general corporate governance standards in laws, codes, and guidelines. The Companies Act 1993 sets outs the role and responsibility of the board, the rights of shareholders (including in relation to the appointment and removal of directors) and the conduct of general meetings. It includes disclosure requirements in relation to staff remuneration. The FMC Act sets out governance obligations that apply to issuers of debt securities, managers of managed investment schemes and their supervisors. The FMA has also published corporate governance principles and guidelines that are addressed to a wide set of entities. The New Zealand Exchange has issued corporate governance principles applicable to its listed companies.

There are disclosure requirements associated with company law and regulation and listing on the stock exchange. There is a general requirement for audited financial statements to be produced and made available to the public via the Companies Office register. Entities that do not have public accountability (and smaller for-profit public sector entities) may choose to be subject to reduced requirements. Listed companies are subject to the stock exchange’s disclosure requirements.

In line with the general regulatory philosophy, there is no insurance policyholder protection scheme that would provide a safety net in the event of insurer failure. The policy framework emphasizes the need for consumers to make informed decisions, the avoidance of moral hazard, and reducing public perception of any implicit government guarantee. Regulation places particular emphasis on the importance of appropriate disclosure. However, insurers and intermediaries are required to be members of a dispute resolution scheme, except where they are undertaking only wholesale business.

There are deep and liquid financial markets, although they are relatively small by international standards, and limited (for debt issues) to shorter maturities. New Zealand insurers invest largely in NZD-denominated assets and mostly in debt securities. Equity and bond markets are small by international comparison and the range of instruments limited. Government and financial institutions dominate debt issuance. Government securities are issued only out to ten years and the resulting lack of long-term risk-free benchmark rates constrains longer term private issuance. There are limited inflation-indexed products which would help insurers to manage inflation risks. There are no restrictions on foreign investment. Given the significance of foreign-owned insurers to the New Zealand market, many insurers make use of their head office or parent company to source and manage foreign investments.

E. Main Findings

Table 1.

New Zealand—Summary Compliance with the Insurance Core Principles

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F. Recommended Actions

Table 2.

Recommendations to Improve Observance of the ICPs

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