Mark Lister, 28 May 2020

The banks are safe, but lower quality lenders could be at risk

Despite significant challenges ahead, the latest Reserve Bank of New Zealand (RBNZ) Financial Stability Report judged the New Zealand financial system to be in good shape, with our banks strong enough to withstand most scenarios. The tier 1 Capital Ratio is 13.4% (compared with 7.9% in 2008), just 7.1% of mortgages have a loan-to-value ratio above 80% (compared with 23.5%) and the Core Funding Ratio is 87.8% (compared with 64.8%).

RBNZ stress tests suggest the banks could withstand a range of scenarios. It would take the most severe scenario (which is that of an 18% unemployment rate and a 48% decline in house prices) for the banks to fall below regulatory capital requirements, and it is very unlikely things become that dire. However, the RBNZ noted that other parts of the financial system were vulnerable even before the COVID-19 pandemic. Some non-bank deposit takers already had low profitability and were operating with low financial buffers.

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Some households would be under pressure if house prices fall too far

High household debt remains a concern for the RBNZ, even though debt servicing costs have fallen dramatically. Rising unemployment is expected to put a relatively small group of households under financial stress, primarily recent entrants to the housing market who have taken on substantial levels of debt at high house prices. This group will be less resilient to any declines in income, and some could be left unable to service their mortgages.

Housing and personal consumer lending accounts for around 61% of banks’ total lending. The RBNZ's baseline scenario assumes house prices will fall 9.0 per cent and won't recover to pre-COVID levels until mid-2022.

The RBNZ is nervous about commercial property

Commercial property was singled out as being quite vulnerable to the crisis, particularly properties exposed to accommodation, hospitality and retail, as well as some office properties. The RBNZ expects a prolonged economic slump to put downward pressure on rents and lead to increases in vacancy rates. An oversupply of property is expected to emerge in some regions (such as in Auckland and Queenstown), which could see the viability of some commercial property loans called into question.

The RBNZ also noted that demand for retail space may be permanently stunted, with social distancing measures likely to accelerate the trend towards online shopping. A positive remote working experience during the pandemic might also encourage firms to extend these flexible arrangements, reducing the demand for office space. The banks’ total exposure to commercial property is around 8% of total lending.

Agriculture in good shape, although highly indebted dairy farmers remain at risk

The agriculture sector has fared well so far, with commodity prices suffering only modest declines. For example, the global dairy trade index is down 10.8% in 2020, and just 3.0% lower in NZ dollar terms. Primary sector businesses have generally been able to continue operating, with the sector at 93% of capacity during level three, and 75% during level four.

However, vulnerabilities remain, particularly when it comes to debt levels. Agriculture represents around 13% of bank lending, with two thirds of that to the dairy sector. The RBNZ notes that there is a tail of highly indebted dairy farmers which require payouts above $6.00/kgMS to break even, which puts these farms at risk of significant stress if prices fell too far. Fonterra has a forecast for the 2020/21 season of between $5.40 and $6.90, which puts the midpoint at $6.15.

Mortgage rates are likely to fall further

The RBNZ sees mortgage rates falling further, despite multiple banks now offering rates well below 3.0%. One could infer that this could also see additional downward pressure emerge on deposit rates. The advertised rate on a six-month term deposit from ANZ is currently just 1.8%t.