Financial Stability Review – September 2004 2. Financial Intermediaries

The continuing expansion of the Australian economy is providing financial intermediaries with a strong business environment. The banking system remains highly profitable and well capitalised, and problem loans are at their lowest levels for many years. The health of the insurance sector has also improved recently, with better underwriting results and from higher investment returns generated by a strong share market.

It needs to be recognised, however, that a number of these measures of performance and financial strength reflect developments in the past. Looking forward, a return to more sustainable rates of credit growth is likely to see slower growth in banks' earnings, particularly in an environment in which interest margins are likely to be further compressed. More normal rates of bad debts expense, should they occur, would also put some downward pressure on profitability. Notwithstanding these potential pressures on earnings, the banking system remains highly resilient and well placed to deal with future developments. Similarly, while a return to more usual claims levels would put pressure on insurers' profitability, the recent strengthening of their balance sheets means that they are better placed to withstand such a development than has been the case for a while.

2.1 Deposit-taking Institutions

Profitability

In the most recent half year, the five largest banks earned, in aggregate, an annualised before-tax return on equity of 20.3 per cent (14.3 per cent after tax). This is the latest in a run of impressive results starting in the mid 1990s (Graph 26). Over this period, the before-tax return on equity has been sustained at around 20 per cent despite a significant decline in average interest margins. To a large extent this reflects the success that banks have had in driving down costs. Over the past five years, for example, reductions in costs increased the annual return on equity by more than 10 percentage points, which has more than offset the effect of declining interest margins (Graph 27). Profitability has also been sustained by historically low levels of problem loans.

Measured as a return on assets, the profits of Australian banks are well above those earned by European banks, although in line with the largest banks in the United States (Table 3). The before-tax return on equity, however, is similar to that in a number of other countries, reflecting the fact that the large Australian banks tend to be less highly geared than banks elsewhere.[2] Profits in Australia have tended to be more stable over the past decade than in most other countries.

The latest half-year results for Australian banks show that the pressure on margins evident for at least a decade has continued (Graph 28). A number of structural factors have contributed to this. The first is the shift in the composition of the banks' loan books towards housing lending, which, on average, earns a lower margin than unsecured personal lending and business lending. In the early 1990s, less than a third of banks' total loans were housing loans; today the figure is over 50 per cent (Graph 29).

The second is that margins on a variety of loan products have narrowed. In particular, ongoing strong competition within the home loan market, spurred initially by mortgage managers, has compressed home loan margins. The standard home loan rate is now 1.8 percentage points above the cash rate, compared with over 4 percentage points in 1992. Average margins on business loans have also declined, partly due to an increase in the share of business lending secured by residential property (which carries lower risk premia).

The third is a decline in the share of banks' liabilities accounted for by low-cost retail deposits. Over the past decade, households have placed more of their savings with non-deposit-taking intermediaries, particularly managed funds, while at the same time they have significantly increased their demand for funds from banks, mainly for housing. As a result, banks have increased their recourse to wholesale markets, particularly offshore, to fund the growth in their assets (Graph 30).

The fourth is an increase in competition in the retail deposit market. As in many other areas of banking, an important catalyst for this has been the entry of new players and the expansion of institutions with very small market shares. In particular, competition has been spurred by the introduction of high-yielding internet-based deposit accounts by a number of foreign-owned banks. While the market share of these banks remains quite small, the larger banks have responded with more competitive retail offerings, particularly for customers prepared to conduct their banking electronically (Graph 31).

In addition to these structural developments, there has been pressure on margins this year from a cyclical steepening of the short-term yield curve as financial markets priced in increases in the cash rate. This reflects the fact that banks' variable lending rates are typically priced as a constant margin over the cash rate, whereas funding costs move more closely in line with bank bill rates.

Looking ahead, further pressure on margins is expected. As housing credit growth has slowed, there have been signs of more intense competition in a range of banking markets, including mortgages, business lending and transaction deposit accounts. Indeed, a number of financial institutions have indicated that the biggest risk they face at present is that of ‘irrational competition’. In this environment, and with the banking system adjusting to slower growth in balance sheets, it will be important for financial institutions to ensure pricing remains commensurate with risk.

As a result of the decline in margins, net interest income fell slightly as a share of assets over the latest half year (Table 4). This was partly offset by strong growth in non-interest income. Some of this reflected one-off factors, in particular National Australia Bank's sale of its stakes in AMP and St George Bank. But growth in non-interest income was also supported by growth in loan fees (on the back of ongoing loan growth) and trading income. Growth in other fees and commissions was relatively subdued.

As has been the case for some years now, banks' costs grew more slowly than their assets over the latest reporting period, with underlying costs up 6 per cent. While growth in staff costs (which account for half of all operating expenses) and building occupancy costs remains subdued, expenditure on information technology has outpaced asset growth by a considerable margin.

Capital Adequacy

The Australian banks remain well capitalised. Over the past year, the regulatory capital ratio for locally incorporated banks has edged up slightly to 10.6 per cent, although it remains within the relatively narrow range seen since the mid 1990s (Graph 32). The recent increase is largely due to the National Australia Bank, which issued $2.6 billion in subordinated debt (included in Tier 2 capital) in early 2004 to meet the higher capital adequacy requirements imposed by APRA following the bank's foreign exchange options trading losses.

In the face of consistently strong profits over recent years, share buybacks by banks have largely offset their equity issuance (Graph 33). The domestically listed banks' buybacks amounted to $6.3 billion between mid 2000 and end 2003, to leave net issuance at just $0.8 billion (excluding ANZ's rights issue used to finance its acquisition of the National Bank of New Zealand). So far this year, the banks have conducted buybacks of $1.3 billion, leaving net issuance of $1.7 billion.

Asset Quality

The asset quality of Australian banks is currently particularly strong. At end June, impaired assets accounted for only 0.33 per cent of banks' on-balance sheet assets – the lowest level in at least a decade (Graph 34). This is also a very low level by international standards. In the housing loan portfolio, the impaired assets ratio is lower still, with 0.16 per cent of housing loans in arrears by 90 days or longer (see Box C).

One issue that has attracted attention recently has been the level of banks' provisions. Not surprisingly, given the further decline in impaired assets, specific provisions (relative to on-balance sheet assets) have fallen to very low levels. But general provisions – which are held to cover the likelihood that some loans not currently recognised as impaired will default in the future – are also relatively low. In part, this reflects the adoption of dynamic provisioning models by the major banks, under which through-the-cycle loss estimates for various types of loans are used to determine the appropriate level of general provisions. Because housing loans have low loss estimates, they attract lower rates of general provisions than other loans. So, as the share of housing loans has increased, general provisions have fallen. Declines in expected losses for some types of business loans have also contributed to the reduction in general provisions.

Nonetheless, despite the very low level of impaired housing loans, the overall riskiness of banks' mortgage portfolios has increased over recent years. One reason for this has been the surge in lending to investors. While historically such loans have had only slightly higher average default rates than loans to owner-occupiers, going forward the differences could be more significant. This is particularly likely given the increase in the number of investor households, low rental yields and higher debt-servicing burdens.

Another reason for the increase in risk is the growth in loan products designed to ease access to finance for those who in the past were not easily able to borrow. Amongst these products, ‘low-doc’ loans have grown particularly strongly recently, albeit from a very low base. These loans are tailored to borrowers who are not able to provide the documentary proof of income or savings history normally required by lenders. According to industry sources, they have accounted for around one fifth of the loans underlying mortgage-backed securities issued so far this year. They are also more likely than the average mortgage to be interest-only loans. The growth in the mortgage broking industry also may have contributed to greater overall risk by making it easier for borrowers to refinance their loans and, in so doing, increase the value of their debt (see Box D).

These changes in the mortgage market, together with the changes in the structure of household balance sheets discussed in the Macroeconomic and Financial Environment chapter, mean that average default rates calculated from previous cycles may not be a good guide to future default rates. But as discussed in the previous Financial Stability Review, stress testing by APRA suggests that mortgage default rates would have to be many times higher than in the worst years in the past to cause major difficulties for the banks.

One potential vulnerability is the reliance of the Australian banks on a small number of mortgage insurers. The three largest insurers (one of which is no longer writing any new business) account for around 80 per cent of the total value of outstanding policies. The other 20 per cent is mostly written by captive insurers, who provide insurance only to the banks that own them. Around one fifth of all outstanding bank-originated home loans have been directly insured, reflecting banks' credit risk policies requiring insurance for high risk loans, including those with high loan-to-valuation ratios. In addition, most securitised loans are insured on a portfolio basis and these loans account for about 10 per cent of all bank-originated home loans. Although the mortgage insurers operating in the Australian market have a strong credit standing (carrying an average credit rating of AA), it is not as strong as the government backing provided in overseas markets. A major downturn in the housing market, in which mortgage default rates increased markedly, could result in difficulties for the industry. Accordingly, APRA has recently released proposals for an improved capital framework for mortgage insurers.

In contrast to mortgage portfolios, the creditworthiness of the banks' business loan books has probably strengthened over recent years. As discussed in the previous chapter, corporate profitability is high, gearing and interest burdens are low, and the business outlook remains favourable. According to the loan grades the four major banks allocate to their business loans for internal management purposes, about three quarters of corporate and business loans are assessed as being of investment grade quality, i.e. rated BBB or better.

The traditional source of problems in the business loan portfolio has been commercial property lending. On this front, credit risks currently look to be quite low. At present, the credit quality of the domestic commercial property portfolio is strong, with impaired assets at 0.4 per cent of outstanding exposures, near the lowest levels seen in the past decade (Table 5). The impaired asset ratio for loans to residential property developers is only slightly higher, although a slowing in the residential property market might be expected to affect the credit quality of this part of the portfolio.

Over the past two years, the growth in the banks' domestic commercial property exposures has been a little faster than overall business credit, with the latest available data showing growth of 11 per cent over the year to March.

Based on their reported large exposures, the concentration of the banks' credit exposures remains low compared with the levels seen in the late 1980s.[3] In addition, the large exposures tend to be to highly rated counterparties (Graph 35). For the five largest banks, 98 per cent of their large exposures are to entities rated A+ or higher. This reflects the fact that, by value, one third of their large exposures are to government entities, with exposures to financial institutions accounting for a further 46 per cent of the total.

Liquidity Risk

Just as capital is a vital line of defence, the bank's liquidity is also important from a stability perspective. Traditionally, a key focus has been banks' holdings of liquid assets – that is, assets that can be readily converted into cash to meet the redemption of liabilities. The most liquid are assets that can be sold to the Reserve Bank in its daily open market operations (so-called ‘eligible securities’). In addition, banks hold a range of other assets with a high degree of liquidity, including deposits at other financial institutions. Over the second half of the 1990s, overall holdings of liquid assets (as a share of total assets) declined markedly, although they have since stabilised, averaging just over 11 per cent of total assets since March 2002 (Graph 36). For the most part, the decline during the 1990s is attributable to a decline in banks' holdings of government bonds.

An important factor explaining this decline is the fall in the stock of government bonds on issue. In response to this fall, the Reserve Bank has broadened the range of assets that it accepts as eligible securities (Graph 37). In July 1997, the Bank began to accept securities issued by State and Territory governments, and in October 2000 it began to accept Australian dollar securities issued by certain supranational organisations (such as the Asian Development Bank). More recently, in March this year, it added bank bills and certificates of deposit issued by highly rated Australian banks to the list of eligible securities. As a result, the share of banks' assets that qualified as eligible securities rose from 1 to 7 per cent.

Banks have responded to the decline in the stock of government bonds on issue by increasing their holdings of bonds issued by other counterparties (Graph 38). Nevertheless, Australian banks' holdings of bonds remain low by international standards.

More broadly, banks' liquidity management approaches and financial market innovation have considerably reduced the usefulness of simple liquid asset ratios in the assessment of liquidity. As a result, APRA allows those banks that have sufficiently sophisticated and robust liquidity measurement techniques to apply a scenario-based approach requiring them to demonstrate they would be able to continue to meet their payments for five business days under adverse conditions. One facility that a major bank could draw upon under such conditions is the Interbank Deposit Agreement. Under this agreement, if one of the four major banks is experiencing liquidity problems, the others are required to deposit equal amounts of up to $2 billion each for a month with that bank. At the end of the month, the recipient of the funds may choose to repay the deposits either in cash or by the assignment of mortgages. Of course, the Interbank Deposit Agreement is not designed for a systemic event, in which the major banks simultaneously experience liquidity pressures.

Market Risk

Excluding the expansion and subsequent wind-back of National Australia Bank's foreign exchange options trading, the banks' aggregate market risk exposure (measured on the basis used in the capital adequacy standards) has been broadly stable in recent years (Graph 39). With assessed market risk standing at just 1 per cent of risk-weighted assets, the banks' market risk exposures are small relative to the credit risk they carry. These exposures are also quite low by international standards (Table 6).

Derivatives transactions are an important part of the banks' traded market activities. Although the market value of banks' derivatives exposures picked up in the June quarter, these exposures have remained fairly steady relative to the banks' on-balance sheet assets in recent years (Graph 40).

Market-based Measures of Bank Risk

While financial markets continue to regard the banks as having low credit risk, they have scaled back their expectations of future profitability. Bank share prices have fallen by around 7 per cent over the past six months and are roughly unchanged from their level a year ago (Graph 41). In contrast, the overall market has risen by 6 per cent over the past six months. Notwithstanding the banks' recent strong earnings results, the slowdown in the housing market and pressure on interest margins have weighed on the share market's assessment of future prospects. Despite this, the expected future volatility of banks' share prices (as implied by options market valuations) remains low (Graph 42).

Similarly, bond-market participants assess bank credit risk as low. After rising sharply in May, the credit default swap premium for the four major banks (which represents the cost of insuring against the risk that a bank defaults on its bonds) has steadily declined to be at its lowest level in two years (Graph 43).

The banks' credit ratings have generally remained stable over the past six months, with two banks having had ratings upgrades. In March, Fitch upgraded Bank of Queensland's financial strength rating from C to B/C. In the past two months AMP Bank has had its long-term credit rating upgraded by Standard & Poor's and Moody's in line with the upgrading of the overall group (Table 7). Adelaide Bank, BankWest and Bendigo Bank remain on positive outlook from Standard & Poor's. Moody's has Arab Bank on a positive outlook and Adelaide Bank under review for possible upgrade. By international standards, the Australian banks enjoy high financial strength ratings (which, unlike long-term credit ratings, do not take account of likely external support) although they are slightly below those of a number of the major banks in the main industrialised countries (Table 8).

2.2 Insurers

While the banks' recent results follow a decade of consistently strong profitability, insurers' recent favourable profit results represent a marked recovery from prior years' weakness. This recovery has been aided by firmer underwriting conditions and stronger share markets. Nevertheless, uncertainties remain. In particular, a return of claim severity and frequency to levels more in line with historical averages and an end to the recent rises in premium rates could weaken insurers' underwriting results.

General Insurers

The general insurance industry has enjoyed much better conditions over the past couple of years, with many of the major insurers recently posting strong results. Industry consolidation (the number of authorised insurers has fallen by one third in the past five years) and ongoing consumer demand for insurance have seen a steady rise in premia and sales volumes in recent years. Over the past few months, however, there have been some signs that strengthening competition is beginning to see growth in premium rates slow. For example, a recent JP Morgan and Deloitte survey found that commercial premium rates had fallen by 5 per cent over the year to June 2004, with sharp declines being observed in the property and commercial vehicle classes.

A greater focus on cost control and more stringent policy terms and conditions have also contributed to improved profitability. This is reflected in underwriting profits, which have improved noticeably. In 2002/03, underwriting results were positive for the first time in more than a decade and they rose further in 2003/04 (Graph 44). Changes to professional indemnity laws are likely to reduce claims costs in the future.

Investment revenue has also recovered strongly following weakness in 2002. Over the past few years, general insurers have rebalanced their investment portfolios towards interest-bearing instruments, reducing their exposure to share markets (Graph 45). Currently, interest-bearing instruments account for 60 per cent of general insurers' holdings of financial assets, up from just above 50 per cent in the late 1990s. Conversely, equity holdings, which represented around 40 per cent of financial assets in 1999, have fallen to 30 per cent.

The more benign operating conditions in 2004 have facilitated balance sheet consolidation. General insurers' aggregate capital base is around 14 per cent above its level in mid 2003 and more than twice the minimum regulatory requirement.

Global reinsurers, which take on some of the risk incurred by the domestic general insurers, have also benefited from a more benign claims environment over the past few years. Their combined ratio (underwriting and claims expenses relative to premium revenue) has improved significantly since 2001, moving below 100 per cent in 2003 (Graph 46). The industry has also experienced a broad tightening of underwriting terms and conditions. In particular, there has been a widespread increase in terrorism exclusions, use of narrower definitions of natural catastrophe events and a reduction of exposures to contingent business interruption.

The reinsurance industry has also sought to mitigate risk through greater business diversification. As further growth in core property and casualty lines becomes harder to achieve, reinsurers have started to increase their exposure to other business lines, particularly direct insurance and life reinsurance. Geographic diversification has also increased, with many reinsurers seeking higher exposure to Asian and European markets.

Life Insurers

The life insurance industry has continued to recover from the low point that it reached in the first half of 2003. In particular, following the demerger with its loss-making UK operations, AMP has returned to profitability. More broadly, the share market recovery has contributed to an improvement in domestic insurers' investment revenue.

The general improvement in conditions has seen life insurers' balance sheets strengthen. Capital adequacy ratios remain around the highs of recent years and the solvency ratio (which measures the capital available to meet claims if the insurer is closed to new business) has risen further. Consistent with this, the sector's credit ratings have stabilised. Since end 2003, there have been just two downgrades by Standard & Poor's, both of which reflected changes in the rating of the foreign parent institution rather than any deterioration in the financial health of the domestic insurer (Graph 47). In contrast, in 2002 and 2003, Standard & Poor's downgraded five of the 14 rated domestic life insurers and reinsurers (often more than once), while none was upgraded.

2.3 Superannuation

Superannuation assets (excluding the balance of life office statutory funds) increased by over 22 per cent to $579 billion in the year to March 2004 – the largest annual percentage increase in ten years (Graph 48). Including statutory funds, the growth rate was 18 per cent. Superannuation assets now amount to 75 per cent of GDP, and comprise almost half of households' total financial assets.

Both net inflows and net investment income, but mainly the latter, have contributed to recent growth. Net inflows over the year to March were strong, amounting to 9 per cent of total assets, 3 percentage points above the previous year. Additionally, after declining from a peak of 42 per cent in 2000, the proportion of discretionary member contributions has stabilised at around 30 per cent of total superannuation inflows (Graph 49). Reflecting life offices' role in the provision of retirement savings products, around one fifth of the total inflow arises from assets being transferred into superannuation funds from life offices. This inflow is ultimately sourced from a mix of employer and discretionary member contributions.

After losses in the year to March 2003, strong performance in underlying investment markets has led to a rebound in superannuation funds' investment income. This saw net investment income contribute 15 percentage points to the overall growth in funds' assets.

In the past financial year, superannuation funds recorded strong investment returns, largely due to the performance of share and property markets (Table 9). According to InTech Financial Services, ‘growth’ funds (i.e. funds that invest a significant proportion of their assets in shares) earned a median return of around 14 per cent in the year to end June 2004. Conservative, or capital stable, funds produced median returns of around 7 per cent in the same period. These are the best financial-year ended median returns for seven years.

Of the various types of superannuation funds, ‘do-it-yourself’ (DIY) funds have grown the fastest over the past few years. They now account for almost a quarter of total superannuation assets, up from 14 per cent in 1999, with fund membership increasing at almost twice the overall industry rate over the same period.

APRA data show that, on average, DIY funds have performed well compared to the other types of superannuation funds. Over the five years to March 2004, they earned an average annual return of 5.8 per cent, compared with 3.9 per cent earned by all other types of funds.

DIY funds differ from the rest of the industry in three main ways. First, the average DIY member balance of $250,000 is far larger than the industry average of $22,000. Second, a much higher share of DIY funds' assets is invested directly rather than with an investment manager or life office (Table 10). This means that the members retain day-to-day control over their investments. Third, DIY funds invest relatively little in overseas assets, compared with the rest of the industry, instead investing more heavily in domestic shares and trusts than other funds. Additionally, DIY funds typically exhibit high investment concentrations; over 50 per cent of DIY funds have more than 70 per cent of their assets in one asset class.

Footnotes

Unlike regulatory capital measures, the simple equity-to-asset ratios focus on shareholder funds rather than a broader measure of capital. They also use aggregate assets rather than risk-weighted assets. [2]

Australian banks are required to report to APRA their 10 largest exposures and any additional exposures greater than 10 per cent of their capital base. [3]