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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2004

Overview

As has been the case for some years now, the Australian financial system remains in good shape, with recent developments generally being favourable from a financial stability perspective. The continuing expansion of the Australian economy, in particular, is providing financial intermediaries with a robust business environment. The banking system continues to record strong profitability, partly as a result of very low bad debts expense, and the insurance industry has benefited from better underwriting results and a pick-up in investment returns.

A notable development over the course of 2004 has been a turnaround in the housing market and a slowing in household credit growth. After house prices increased by around 20 per cent in 2003, and at an average annual rate of 13 per cent over the previous four years, prices have declined a little in 2004. Similarly, household credit growth has slowed from an annualised rate of 21 per cent over the second half of 2003, to 16 per cent over the latest six months.

These are welcome outcomes from a financial stability perspective. By mid last year, the Bank had come to the view that further significant increases in house prices, relative to income, would increase the prospect of costly adjustments at some point in the future. In particular, had the trends in 2003 continued into 2004, household balance sheets would undoubtedly be more vulnerable to a change in economic circumstances than is now the case.

In contrast to the early 1990s when house prices fell, and as discussed in the August Statement on Monetary Policy, the adjustment on this occasion has taken place against the backdrop of a strong economy and an unemployment rate at around 20-year lows. While it is still early days, the decline in house prices appears to have had little effect on households' perceptions of the health of their personal finances.

Despite the favourable outcomes to date, risks remain – although these relate more to the macroeconomy than to the financial system. Household credit continues to grow strongly, notwithstanding the recent slowing. And standard measures of financial vulnerability of the household sector, including the ratios of debt, house prices and interest payments to income, have recently reached record highs. A pronounced fall in house prices or a deterioration in economic conditions could prompt a broad reassessment by the household sector of the structure of its balance sheet, leading to a sharp fall in credit growth and a period of unusually weak consumption. In the other direction, there is a risk that the continued strong growth of the economy and favourable labour market conditions could again reignite the housing market, increasing the potential for a difficult adjustment in the future. How things evolve in this area warrants close attention in the period ahead.

The expansion of household sector balance sheets over recent years has led to an increase in the riskiness of banks' mortgage portfolios. Wider access by households to credit, the development of new loan products and rapid growth in lending to investors have contributed to an increase in credit risk in these portfolios, notwithstanding the very low level of problem loans currently. Overall, however, it remains difficult to envisage scenarios in which problems with banks' housing loans could cause major difficulties for the Australian financial system. As discussed in the previous Financial Stability Review, this assessment is supported by an extensive stress-test exercise conducted by APRA last year. In addition, banks can derive comfort from their business loan portfolios, where credit quality is generally high. Business profitability is good, gearing has declined and interest payments as a share of profits are around the lowest level for many years.

The change in the housing market is, nevertheless, posing some challenges for banks and other lenders. As growth in housing credit slows, growth in lenders' balance sheets and earnings is also likely to ease. This is leading to an increase in competition in some product areas as banks seek out, or protect, sources of earnings growth. In this environment it will be important that pricing is commensurate with risk.

Looking overseas, the condition of the international banking system has improved recently, assisted by a stronger world economy. This, however, does not mean that the global situation is without risk. Geopolitical factors of the kind surfacing periodically in world oil markets are obviously one shadow over financial markets. Another is the capacity of market participants to handle the tightening of monetary policy that is now underway in the United States. The concern here is that investors who have borrowed heavily on the assumption of continuing low interest rates may need to unwind their positions quickly – a turn of events that could lead to an abrupt repricing of financial assets and, potentially, market instability. To date, however, the adjustment to tightenings in the United States, and elsewhere, has been benign. These market risks are less pronounced in Australia, partly reflecting the fact that interest rates were never cut to very low levels here – although, of course, it is impossible for local markets to be quarantined from overseas events.