Resilient NZ banking sector could use deeper capital buffers, IMF says

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New Zealand's major banks should be able to withstand a severe economic downturn, with profits helping cushion the blow, but could use deeper capital buffers, says the International Monetary Fund.

In one of two reports on New Zealand, the global body of 189 member countries set up to foster international monetary cooperation, recommends the Reserve Bank raise the minimum levels capital lenders need to hold to absorb losses to help strengthen the macroprudential framework, with the system dominated by the four Australia-owned banks.

"Direct exposures among the four largest banks are relatively limited, but the potential for spillovers is elevated," the IMF report said. "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."

The Reserve Bank is currently reviewing its capital adequacy rules and is expected to move in tandem with its trans-Tasman counterpart, the Australian Prudential Regulation Authority which is looking at the same issue in Australia. The heads of Westpac New Zealand and Bank of New Zealand were relatively sanguine about the need for capital review, which is following an international trend demanding greater financial backstops for lenders.

IMF stress testing found New Zealand's major banks could withstand a severe shock where a global slowdown and slump in commodity prices triggered a deep recession, driving up unemployment and causing a slump in house prices. The modelling found the banks' capital ratios would meet minimum standards, but breach the regulated buffer as they absorbed credit losses and funding costs.

"Banks are able to retain capital through profitability despite the erosion in margins, supporting capital ratios during the downturn," the report said. The local units of Australia & New Zealand Banking Group, Westpac Banking Corp and National Australia Bank had total quality capital ratios of 13.8 per cent, 12.8 per cent and 13.3 per cent respectively as at March 31, comfortably above the Reserve Bank's 10.5 per cent minimum, which includes a buffer.

The stress tests indicate the banks could face bad debt costs of about 4 percent of their starting loans over five years, which would equate to about $16 billion of lenders' $410b of gross loans as at the end of February. Stressed credit markets would increase the cost of international funding, which the IMF estimates would shrink net interest margins by about 60 basis points from the 2.2 per cent level they were at in June of last year.

The local banking sector's dependence on wholesale funding was cited among the financial system's vulnerabilities, mitigated to a degree by the introduction of a core funding ratio in 2010, meaning banks had to attract a certain proportion of their funding from more secure sources such as domestic deposits.

While the IMF only sees a medium likelihood of a dislocation in overseas wholesale funding over the next three years, the impact would be high, eroding net interest margins and reducing their ability to borrow, creating the risk of a credit crunch.

The IMF found Reserve Bank staff to be "highly competent", but that they had "insufficient resources" which were "an impediment to enhancing the effectiveness of the three pillar approach. It recommended the RBNZ's resources be beefed up and that it take a more hands-on role to its prudential oversight than what's currently non-intrusive supervision.

"The Reserve Bank is considering the FSAP (financial sector assessment programme) findings and recommendations in its areas of responsibility and the degree to which these might further its statutory purpose of promoting a sound and efficient financial system," the RBNZ said.