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Special Topic: Global financial stress and implications for New Zealand
Global banking stresses are expected to lead to higher borrowing costs and tighter bank lending standards. This could lead to less tightening by central banks. This note looks at international measures of financial conditions, outlines the competing influences from financial stability and assesses the implications for New Zealand.
Financial stability concerns drive market turmoil…
Financial stability concerns have moderated since UBS’s takeover of Credit Suisse and actions by global authorities to enhance liquidity. These developments capped a tumultuous 10 days for banks and financial markets following the collapse of Silicon Valley Bank (SVB), the largest US bank failure since the 2007/08 financial crisis, and Signature Bank, another mid-sized US lender. Their failure created nervousness among investors about their exposures in other banks that rippled through banking sector equities and resulted in a loss of confidence in Credit Suisse.
The turbulence in markets saw measures of financial market stress increase, and financial conditions tighten, but not materially so. Beyond the banking sector, equity valuations have not been much affected, while higher spreads between corporate and sovereign bonds (credit spreads) have been broadly offset by lower sovereign bond yields. However, these market-based measures of financial conditions do not immediately capture changes in banks’ lending standards or risk appetite, which is where recent stresses are expected to have their greatest impact.
…creating trade-offs for central banks…
Central banks will be evaluating what weight to give financial stability concerns in their decisions. Since mid-2021, and especially from the US Fed’s first rate hike in March 2022, central banks have tightened policy at a very rapid pace from extremely low rates and after years of quantitative easing in the major advanced economies. Nonetheless, inflation remains well above target, and continued labour market tightness is support demand in many countries.
Commenting on the 23 March decision to raise the Fed funds target rate 25bps to a range of 4.75% to 5.00%, Fed Chair Powell observed that the anticipated tightening in credit conditions could have similar effects to their policy tool and that the two may be seen as substitutes. On the other hand, if the effects on credit conditions are modest, further monetary policy tightening will likely be appropriate. He also announced that the Fed is reviewing the case for stronger banking regulation. In sum, the case for further monetary policy tightening will depend on the extent that market and regulatory pressure on banks reduces bank lending, and how strongly this flows through to weaker activity, labour market loosening and reduced inflation pressure.
…with less monetary policy tightening now priced by financial markets
In New Zealand, volatility in financial markets has picked up but more importantly NZ banks are strong with capital and liquidity positions well above the regulatory minimums. Nonetheless, tighter US financial conditions could affect the cost of borrowing for NZ banks through upward pressure on funding costs either from higher offshore funding costs, or from increased competition for deposits if banks seek to avoid tapping overseas markets. Non-bank lenders may be squeezed by an increase in deposit competition. RBNZ data shows that banks funding requirements have declined as the weak housing market has slowed loan growth while deposit growth has been steady. In addition, the share of long-term funding has increased, reducing exposure to near-term volatility. A 25bps rise in the Official Cash Rate (OCR) is widely anticipated at the Monetary Policy Committee’s 5 April meeting, however the likelihood of subsequent hikes has fallen materially from a month ago.
Following the Fed’s March announcements, financial markets see a 50/50 chance of a further rate rise, with expectations of the peak rate now around 50bps lower than prior to the failure of SVB (Fig 1). With New Zealand less directly affected, the expected peak OCR has also fallen, but by less than expected Fed policy rates.
Figure 1: US and NZ policy rate expectations
Financial conditions are likely to tighten
The daily Financial Stress Index (FSI) published by the US Office of Financial Research (OFR) is a market-based measure of 33 indicators across 5 categories – credit, equity market valuations, funding, safe-haven assets, and volatility. The FSI is positive when stress levels are above normal and negative when they are below normal. Figure 2 shows the index has increased, driven by greater volatility, but the peak on 20 March was low relative to the period from mid-2022, and much lower than the peak of 10 in March 2020 and nearly 30 early in the 2007/08 global financial crisis. The OFR index for the US, while higher remains below recent peaks in October 2022.
Figure 2: Global Financial Stress Index
The relatively modest increase in stress likely reflects actions by authorities in the US, Europe and elsewhere to preserve liquidity. In the US, the Fed’s new Bank Term Funding Program provided liquid funds for banks in return for US Treasuries and other high-quality collateral at their par value to reduce their vulnerability to the unrealised losses on their holdings of securities generated by higher interest rates.
Widely available financial conditions indexes, such as those published by Goldman Sachs, include interest rates, credit spreads, equity volatility and exchange rate movements, have not tightened materially despite the turmoil, as lower bond yields offset equity market volatility and widening credit spreads (Figure 3).
Figure 3: Financial Conditions Indexes
Source: Goldman Sachs
While timely, these measures do not capture the flow through to bank lending practices, which can have a significant impact on the cost of borrowing. In the US, commentators consider that lending standards will be tighter at small- and medium-sized banks, and loan growth will be slower. Meanwhile, deposit outflows from smaller or less well capitalised banks to larger banks will tighten credit conditions in some areas or sectors. This is likely to prevail even if stresses remain contained and there are no further bank failures. Lenders may independently tighten standards for fear of greater regulatory oversight and a deteriorating economic environment. One lens to view these developments is the Fed’s Senior Loan Officer Opinion Survey (SLOOS). This quarterly survey, most recently available for the December 2022 quarter, shows a tightening in standards for loans to business and households, and especially for construction (Figure 4). Whether these standards tighten further will be key to determining the direction of monetary policy.
Figure 4: SLOOS measures of loan supply
Source: US Federal Reserve
Overall, when it comes to the transmission of monetary policy, policy makers consider not only the level of the policy interest rate, but also the availability of credit, the spread between policy rates and bank lending rates, and the terms and conditions of household and business lending. In part, the repricing in central bank interest rate expectations reflects the view that financial conditions will tighten independently of monetary policy.
Global central banks are evaluating the risks of further monetary policy tightening
Much of the immediate focus has been on downside risks to the outlook stemming from contagion and broader financial sector stresses, but policy makers need to remain attuned to the inflation risks.
In the Bank for International Settlements (BIS) March quarter Review, researchers observed that “experience over the past five decades reveals that, under broadly similar circumstances, monetary policy tightening could usher in financial stress”. The risk is that financial sector fragility could constrain central banks’ pursuit of lower inflation – so called “financial dominance”.
Clearly, with hikes from the Fed, European Central Bank (ECB) and other central banks over the past two weeks, we are not currently in this environment. Moreover, as Chair Powell has noted, it is appropriate to focus on using the right tools for the job. That is, addressing financial stability concerns with prudential regulation powers, supervisory oversight, and lender-of-last resort tools. For macroeconomic stability, use the policy interest rate and, secondarily the balance sheet. In practice, there are powerful interactions between financial and economic conditions and in times of high uncertainty it can be appropriate for central banks to pause their hiking cycle and watch how things develop. This was reflected in a change of guidance from both the ECB and the Fed. Where previously ongoing policy hikes were seen as needed to quell inflation, the ECB is now watching data to see if further hikes are warranted, while the Fed advised that “some additional policy firming may be required”.
Impacts on New Zealand…
The direct implications for New Zealand so far have been limited. There are no banks with similar balance sheet structures to the US banks or with ongoing market confidence issues like those that affected Credit Suisse. Moreover, NZ banks are strong with capital and liquidity positions well above the regulatory minimums (Figure 5).
Figure 5: NZ banking system resilience indicators
Indirect channels may exert an influence on the NZ economy. Consumer and investor confidence could weaken, although the impacts are unclear and difficult to quantify.
…may be seen in higher bank funding costs
A key channel is through the impact on bank funding costs. NZ banks typically face a gap between depositor funding and lending. The RBNZ produces a measure of the funding gap that captures the extent to which the banking system needs to seek funding from non-deposit sources, such as wholesale markets, to meet its lending activity. Figure 6 shows this gap has narrowed over the 12-months to September 2022. More recent data shows lending growth continuing to be weighed down by the weak housing market, while deposit growth has remained stable, suggesting the funding gap has narrowed further.
Figure 6: Banking system funding gap
Banks get around three quarters of their funding from deposits, while market funding is split between domestic sources (45%) and offshore sources (55%). The share of market funding from domestic sources is at its highest level in over a decade. In addition, the share of market funding with a year or more to maturity has increased to around 60% from below 50% prior to 2016. With low funding needs, banks are well placed to manage through a period of market volatility. Nonetheless, banks may face a higher cost of funding new loans when they need to access wholesale markets or through increased competition for deposit funding.
Banks may also look to tighten their lending standards, although expectations of a weaker economic outlook may already be influencing decisions, which could see lending to the riskiest sectors curtailed. The exchange rate is a further channel. The NZD has been stable to date, but that could change quickly should financial stress broaden. Typically, periods of investor risk aversion drive increased demand for safe-haven assets such as USD, CHF and JPY and reduces demand for the NZD.
In sum, absent broader financial stresses, the main implications for the outlook will depend on how much financial conditions tighten and how much that tightening weighs on activity, labour markets and inflation. It is too early to say how large those impacts will be and therefore how that will affect policy decisions.
- Boissay, F., Borio, C., Leonte, C., Shim, I., “Prudential Policy and financial dominance: exploring the link”, BIS Quarterly Review, March 2023.
- Measures of new funding costs are discussed in Cook, B., and Steenkamp, D., “Funding cost pass-through to mortgage rates”, RBNZ Analytical Notes, AN2018/02.