Reserve Bank's Financial Stability Report highlights tension between bank competition and resilience

Reserve Bank Deputy Governor Christian Hawkesby says bank profits are the “first line of defence” against financial instability and are contributing to New Zealand’s economic resilience.

The central bank’s biannual Financial Stability Report, released on Tuesday, said rising unemployment would likely trigger an increase in loan defaults but banks had plenty of capital to cope with the losses.  

“Banks have built financial buffers that will help them maintain the supply of credit even if losses grow. They increased their provisions in 2023 when they anticipated an increase in non-performing loans. Strong profitability has also allowed banks to retain earnings and grow their capital positions,” the report said.

This was a stark contrast to commentary on the rest of the economy. Businesses were generally experiencing lower profitability, with weak demand and cost pressures making the trading environment difficult. 

“Reduced profitability is affecting cash balances. Business deposits have declined relative to GDP over the past two years, from a strong position coming out of the pandemic,” it said. 

This gap between the fortunes of banks and the struggles of the businesses they lend to has become an easy target for politicians and their cash-strapped voters.

Across the road from the central bank, members of Parliament have launched an inquiry into bank sector profits and government ministers have promised to spur competition.

Policy pendulum 

Finance Minister Nicola Willis believes the policy balance has swung too far towards financial stability at the cost of competition and more choice for consumers. She is deadly serious about wanting change and seems willing to look at all options. 

Stuart Smith, a National Party MP who chairs the Finance and Expenditure Committee, even raised the prospect of charging banks an excess profit tax in a recent inquiry hearing. 

While this is not government policy, it suggests the party may be willing to consider options that go beyond its usual policy prescription when it comes to banking.

But as elected officials look for ways to disrupt the sector, central bank officials are urging banks to strengthen their safeguards. Through a 2019 capital review the Reserve Bank has required the big four banks to lift their minimum total regulatory capital from 10.5% to 18%, as a percentage of risk weighted exposures, by 2028. Other banks must increase theirs to 16% from 10.5%.

“In part this reflects the fact that New Zealand is a small open economy that is exposed to global events … banks must hold adequate liquid assets to meet expected outflows during liquidity stress,” it said in the report. 

One of the easiest ways for banks to achieve this goal is to retain some profits, which they cannot do if they aren’t earning enough. The sector’s return on capital has actually declined due to some earnings being retained as regulatory capital. 

Hawkesby said the Reserve Bank was doing a lot of work on promoting competition in the sector but profitability was the “first line of defence” against instability. 

“I think it's important not to get too fixated on profitability as a metric of competition. It is one metric,” he told reporters on Tuesday. 

“The only thing worse than a profitable bank is an unprofitable bank; being profitable enables banks to keep their capital levels in good shape”.  

Rewarding risk 

However, he also pointed to previous research done by the central bank which showed the New Zealand banking system was highly profitable relative to the level of risk taken.

This partly explains why the banking sector has remained largely unaffected by the recent economic downturn. Although the recession has been comparable in magnitude to the Global Financial Crisis, levels of bad debt have been only half as high.

Unemployment is much lower and the banks have bigger buffers this time around, but they also have less exposure to volatile sectors and have been enforcing stricter lending standards. 

ANZ's chief executive, Antonia Watson, proudly told the Parliamentary inquiry that there had been only two receiverships in its agri-lending business this decade. However, the committee responded that this surely indicated the bank was charging for risks it wasn't actually taking.

Watson rightly said there was a risk that an economic shock could hit the entire rural sector at once, which was much less likely for household borrowers spread across many industries.

But it does appear true that banks are more risk-averse than they are competitive, and the Reserve Bank comes across more comfortable with that balance than the Government. 

A reverse stress test conducted this year found only an extremely severe recession could cause the big banks to breach their capital requirements. 

The scenarios dreamed up were extreme: a hot war in the Asia-Pacific region or a volcanic eruption in Auckland which pushed unemployment into double digits and slashed house prices by more than a third. 

Among other things, this would result in banks’ net interest margins dropping more than 60 basis points and leaving them “unable to increase capital through retained earnings”.

Interestingly, one of the additional stressors included in two of the banks’ scenarios was a new competitor entering the market and eroding net interest margins.

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