Banks well-positioned to withstand COVID-19 hit as loan defaults expected to rise - Reserve Bank report

Banks are in a solid position to weather the impacts of COVID-19, a Reserve Bank report shows.

In a Financial Stability report released on Wednesday, the Reserve Bank said that 'stress tests' were used to illustrate the banks' resilience to withstand a broad range of adverse scenarios. If the economic downturn is prolonged, they would be able to keep lending.

The report acknowledges that households and businesses will face a significant drop in income, particularly those in tourism, accommodation and hospitality. As household incomes come under pressure and wage subsidies come to an end, the number of loan defaults is expected to rise.

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"Loss of income will mean that some borrowers have difficulty repaying their loans. As a result, banks are likely to experience more loan defaults and losses," the report said.

Under a scenario of a larger increase in unemployment and slower recovery than in its May Monetary Policy Statement, the Reserve Bank said that modelling suggests banks are likely to maintain capital ratios above minimum requirements.

"While there remains considerable uncertainty about the economic outlook, stress tests suggest that banks can withstand a broad range of adverse economic scenarios while retaining sufficient capital to continue lending," the report states.

For households and businesses facing loss of income, access to credit must be maintained. The increase in bank capital requirements is delayed for at least 12 months and LVR restrictions have been temporarily removed. Term funding facilities have been introduced, core funding requirements eased to support liquidity and dividend restrictions will ensure banks use current buffers to support lending.

Loan deferrals (repayment holidays) for up to six months have been introduced and small-to-medium business can access partially Government-guaranteed loans to manage short-term income loss. 

"Maintaining the flow of credit to sound borrowers will contribute to the long-term stability of the banking system by reducing borrower defaults and preventing large falls in property prices and other asset values," the report said. 

The report also acknowledged vulnerabilities in certain parts of the financial system which existed before the pandemic. Some non-bank deposit takers have low profitability and operate with low financial buffers and consolidation within the sector is expected.

It specifically acknowledged the impact of COVID-19 on insurers, particularly those exposed to investment losses and the vulnerability of credit insurance providers.

In a media conference following the release of the Financial Stability report, Reserve Bank Governor Adrian Orr addressed specific questions, including house prices, falling interest rates, demand for credit and solvency of insurance companies.

Amidst economist predictions of falling house prices, Orr said that the last Monetary Policy Statement had forecast a drop of around 10 percent. The May Financial Stability Report looked at more severe scenarios.

Referring to stress tests as "useful for creating a narrative", Chris Bloor, manager financial systems analysis at the Reserve Bank, said the latest report illustrates more "significant falls" in house prices. 

"There are two stress tests in the document: in the first 'stress test' we assume that house prices will fall by 36 percent and in the second, a 48 percent decline," Bloor said.

While the number of loan defaults is expected to increase, high and sustainable levels of unemployment were expected to impact bank portfolios the hardest.

"It's household lending that dominates the balance sheet and household incomes that are most important," Orr said.

Tools such as mortgage deferrals, interest-only options and business finance options were available to help customers suffering income loss due to COVID-19. Banks were expected to pass on the effects of monetary stimulus, including through retail interest rates.

"This isn't a time to be increasing your margins, it's a time to be making sure your customers are receiving the full benefit," Orr said.

Ask whether the Reserve Bank wants to see interest rates fall further, Orr said that it could be an option.

"This is only one form of their funding but we do see more room to go," Orr said.

Demand for credit has been low and this is expected to improve as wage subsidies run out.

"Now that we're out of the lockdown [and alert level] 3, we expect credit demand to be picking up...and banks will feel the impact on their customers," Orr added.

In addition to revamping insurance legislation, The Reserve Bank is focusing on capital requirements (solvency standards) for insurance companies, particularly life insurers. 

"We have to look at just not how they are now, but looking ahead, how will they be if this goes on for another year or more," deputy Governor Geoff Bascand said.

Challenges such as low premium growth, low sales, increasing claims and low interest rates on investments put pressure on the industry. Although there's no current weakness, it's important to ensure that insurers stay strong.  

"There are a number of insurers that have 'Very Strong' credit ratings and there are some that are much closer to their 'cliff-edge' [of having no buffer]," Toby Fiennes, head of financial system policy and analysis said.

Responding to questions about deposit insurance, which would give people access to their deposit when a bank fails, the Reserve Bank said it would be reviewed under Phase 2 of the Reserve Bank Act. 

It proposes that the insurance would safeguard a portion of a deposit while bank issues were resolved.

"We see deposit insurance as a way of helping the depositor, rather than saving the institution," Fiennes said.

"People should be able to access their deposit [if] their bank fails."

The Reserve Bank Financial Stability Report is a six-monthly report which reviews the soundness and efficiency of the New Zealand Financial System.