This is more than double their existing levels but lower than the defaults seen after the global financial crisis (GFC). 

The prediction is in the Reserve Bank’s latest six-monthly Financial Stability Report. The RBNZ’s  analysis of loan performance also suggests a similarly negative outlook, based on the August Monetary Policy Statement, with unemployment rising to 5.3%.

It says if economic conditions deteriorate by more than projected, then lending stress could be more severe.

“There is considerable uncertainty about future lending stress and these forecasts should be interpreted with caution,” the report says.

Bank lending quality has improved overall since the GFC. Business lending and high loan-to-value ratio residential mortgage lending comprise a smaller share of total bank lending. As a result, projected lending stress could be less severe than expected based on previous experience.

The report says the combination of high interest rates and low unemployment makes the existing economic environment unique in recent history, and as a result the pattern of lending stress may differ from what is projected.

In addition, lending stress may not rise smoothly as unemployment rises and may accelerate when unemployment rises above some threshold, although this relationship has changed over time.

Indicators suggest that financial stress will continue to increase. Consumer and business confidence remains weak, reflecting increased debt servicing burdens and the weaker outlook for the economy.

Consumption is expected to decline as household budgets continue to tighten. A range of forward-looking indicators, such as measures of confidence and negative news sentiment, suggests continued weakening in loan performance in the short-to-medium term

Overall, the RBNZ says financial distress amongst households or businesses is rising from a low level as budget pressures increase for many borrowers.

Households have been able to adapt by reducing discretionary spending and working with their banks to manage the increased debt servicing burden. Even so, financial stress is expected to rise, based on our projections and those of banks.

Vulnerabilities emerging in commercial property

In the commercial property sector, high interest rates and other market developments have placed significant downward pressure on capital values, the Financial Stability Report says. 

This is particularly the case for lower-quality office properties due to ongoing structural trends, such as increased prevalence of working from home. Vacancies for lower-grade office properties are beginning to rise, putting downward pressure on rents.

With the large increase in debt servicing costs seen over the past two years, interest coverage ratios have also fallen. These factors have contributed to an elevated level of lending being closely monitored by banks. Serviceability stress in the sector could increase if the economy contracts and vacancies increase further, the report says.

Weaker demand and high construction costs mean there are few viable commercial property development projects at present.

Several factors support the debt serviceability of commercial property operators. Commercial property loans generally have lower LVRs than residential property, usually less than 50% and lenders require a buffer of net earnings above interest payments.

In addition, banks have reported that some stressed commercial property operators have other income sources to continue to meet debt servicing requirements.

Nevertheless, some property owners may need to sell portions of their portfolios to reduce debt levels if market conditions allow. Banks have increased provisions to prepare for future losses, which will help to buffer the impact on the financial system of a severe downturn.