A new IMF paper on New Zealand's financial system says while the country's four major banks – ANZ, ASB, BNZ and Westpac – have significant high-quality capital, shocks to residential mortgages and corporate lending would put them under pressure.
The working paper includes stress tests – calibrated on the Irish crisis experience – which show New Zealand's four big banks could largely sustain stand-alone shocks to either residential mortgages or corporate lending.
"However, sizable combined shocks to both mortgages and corporate lending would have more pressure on the banks' capital.
"For example, a hard landing in China, and thus Australia, would consequently reduce demand for New Zealand exports, worsen terms of trade and could trigger a sudden decline in house prices.
"This could in turn weaken consumer demand and growth, and negatively affect banks' balance sheets."
The paper says the negative impact of this on the wider economy could be substantial.
While New Zealand's banking regulations are more conservative than in many countries, the vulnerability of the sector should be continually assessed to minimise the risk that banks pose to the economy.
However, it says supervision of the sector will only do so much, and higher minimum capital requirements should be considered.
"Given their size, they are perceived as too big to fail and pose a potential fiscal risk.
"More robust capital levels for systematically important domestic banks would be beneficial, particularly in times of market uncertainty and given their large wholesale funding needs."
The paper warns that any "distress" in one of the four banks could have significant negative affects on the entire financial system, and in turn New Zealand's economy as a whole.
It says banks' exposure to highly indebted households and to the agriculture sector is a key vulnerability.
"Household debt remains high at over 140% of disposable income, and a rise in mortgage rates together with an increase in unemployment could lead to an increase in non-performing loans.
"A large fall in commodity prices would impair the quality of agricultural loans, but the capital requirements for these loans have been strengthened since mid-2011."
Despite the warnings, the working paper says overall, New Zealand's four major banks are in good health.
"The soundness of the New Zealand banking sector was crucial to the resilience of the economy during the global financial crisis.
"Bank profits are strong and non-performing loans are less than 2% of total loans, low by advanced country standards."
It says the banks have high-quality capital well above the regulatory requirements.
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