FINANCIAL STABILITY REVIEW

March 2004

The material in this Financial Stability Review was finalised on 23 March 2004.

The foreword and overview to this Review are provided below. The complete Review can be viewed as a 612K PDF file.

Foreword

As part of its longstanding responsibility for the stability of the Australian financial system, the Reserve Bank has periodically outlined its assessment of the state of the financial system, including in its Annual Report. This Financial Stability Review is the first occasion on which a more detailed assessment has been published in a stand-alone publication – a practice that will be continued half-yearly from now on.

In publishing the Financial Stability Review, the Reserve Bank has joined a growing number of central banks that are addressing their stability mandates through publishing a formal report. In some cases, including that of Australia, the introduction of such reports partly reflects changes in the structure of financial regulation that have thrown the role of central banks in safeguarding financial stability into sharper relief. In Australia's case, the supervision of individual financial institutions was transferred to the Australian Prudential Regulation Authority (APRA) in 1998, with the Reserve Bank maintaining its responsibility for the overall stability of the financial system.

The Financial Stability Review will be tabled at the March and September meetings of the Council of Financial Regulators, and published shortly thereafter. The Council, which is chaired by the Reserve Bank, was established in 1998 to promote co-operation between the main financial regulators in Australia – the Reserve Bank, APRA and the Australian Securities and Investments Commission. Its charter was revised in June last year to provide for a stronger focus on stability issues, including the promotion of co-ordination arrangements between regulators for handling any episodes of financial instability. At the same time the Commonwealth Treasury became a member of the Council.

This inaugural issue of the Financial Stability Review has three main parts. The first provides an assessment of the macroeconomic environment in which the financial system is currently operating, concentrating on the balance sheets and net income flows of the household and business sectors. The second provides a reading on the strength of the financial system itself. The third summarises some of the initiatives underway in Australia and overseas to improve the regulatory infrastructure of the financial system. The Review also contains two articles.

Overview

The Reserve Bank's overall assessment is that the Australian financial system is currently in good shape. Banks – the most important financial intermediaries from a systemic risk perspective – are in a particularly strong financial position: they are profitable, carry few bad debts and hold capital considerably in excess of their minimum regulatory requirements. This outcome is largely the legacy of the long-running expansion of the domestic economy, now in its thirteenth consecutive year of growth, but it also reflects improvements in banks' systems for managing credit risks following problems in the early 1990s.

Over this period there has been a significant shift in banks' assets away from business lending towards lending to households – traditionally a much lower risk activity for financial intermediaries. Both demand and supply factors have been at work here. On the demand side, the shift to a low-inflation, low-interest-rate economy has increased the capacity of households to borrow, with many households willingly taking up this extra capacity. On the supply side, financial intermediaries have been keen to increase their portfolios of relatively low-risk residential mortgages and are providing cheaper, more innovative mortgage products, including those specifically tailored for investor housing.

These developments have resulted in striking growth in both residential property prices and household indebtedness since the mid 1990s. House prices have risen at an average annual rate of 12 per cent since the beginning of 1996 and growth in household debt has been similarly rapid. Over recent years, prices and indebtedness have increased at even faster rates. Although the pace of growth is now slowing, it is too soon to know whether it will return to a sustainable rate within a reasonable time.

One consequence of these changes is that the overall riskiness of the mortgage portfolios of financial institutions is likely to have increased. Residential property prices are high relative to historical benchmarks, household debt levels are much higher relative to income than they have been in the past, borrowing by investors has grown rapidly, competition for loan origination has been very strong, and some borrowers who previously would not have been able to obtain mortgages can now do so. These developments raise the possibility that future default rates may not be as benign as those in the past. Notwithstanding this, there are currently few signs that households are having difficulty meeting their financial obligations, with default rates on residential mortgages at very low levels despite the aggregate debt-servicing burden standing at a record high.

While there are indications of an increase in risk in mortgage portfolios, it remains difficult to envisage scenarios in which developments in the housing market alone could cause major difficulties for the Australian financial system. Recent work by APRA indicates that even if house prices fell by 30 per cent and mortgage default rates increased dramatically, more than 90 per cent of authorised deposit-taking institutions would continue to meet minimum regulatory capital requirements. For the small number of institutions that fell below the minimum, the breach is estimated to be small.

Taking a somewhat broader perspective, a more medium-term risk is that, after borrowing heavily for a number of years, the household sector will decide to consolidate its balance sheet. If that were prompted by a deterioration in economic conditions it could amplify what might otherwise have been a relatively mild downturn – an outcome that, in turn, would increase the credit risk in the balance sheets of financial institutions. Assessing the likelihood of such an outcome is complicated by the fact that there have been few instances, either in Australia or elsewhere, in which balance-sheet adjustment by the household sector has been a major factor shaping an economic downturn. In previous episodes, it has been adjustments by the corporate sector and by financial institutions that typically have been the source of difficulties – and the risks of problems emanating from that front currently look quite small on this occasion.

Looking beyond Australia, global financial markets are currently subject to some unusual forces. Nominal interest rates in all the key financial centres are at very low levels and have been so over an extended period. Official capital flows from Asia to the United States, motivated not so much by underlying rates of return but by exchange rate considerations, have been unusually strong. The search for yield by private investors has pushed down risk spreads for corporate and emerging market borrowers alike, to levels last seen before the 1998 crisis.

While this combination has doubtless acted to spur growth in the world economy, which is welcome, several questions hang over the outlook. Not least among them is whether global investors have accurately priced the risk to which they are exposed, and how this constellation of yields, capital flows and exchange rates will respond when international short-term interest rates begin, at some stage, to rise to levels more in line with historical experience.

These issues, together with those closer to home arising from the changed financial behaviour of households described above, will bear close watching over the period ahead.