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RESERVE BANK OF AUSTRALIA

Financial Stability Review – March 2005

Overview

The Reserve Bank's overall assessment is that the Australian financial system is in sound condition. Banks – the most important intermediaries from a systemic risk perspective – are well capitalised, highly profitable and experiencing levels of bad debts that are very low by both historical and international experience. Further, there are no signs of the excesses in the commercial property market that were the cause of significant problems for the banking system in the early 1990s. Corporate balance sheets are in very good shape, with interest-servicing burdens around the lowest level for many years. The insurance sector is also performing better than it has for some time, notwithstanding the emergence of competitive pressures in some business lines and claims returning closer to long-term averages.

Given these favourable outcomes, attention has been focused on household balance sheets, which have expanded rapidly. Over 2003, both household debt and house prices increased by around 20 per cent, and this followed large increases in previous years. The Bank's concern at the time was that a continuation of these trends would increase the likelihood of quite large corrections in house prices and household behaviour at some point in the future. This concern was not so much that these adjustments would imperil the health of financial institutions, but rather that they could lead to a period of weak economic growth.

In the event, 2004 unfolded favourably. Sentiment in the housing market finally turned in late 2003, with house prices falling slightly in some areas over the first three quarters of 2004 before recovering a little. Household credit growth also moderated from the rapid pace of 2003, although it remains quite high relative to the growth of incomes and, hence, servicing capacity.

Despite these welcome developments, the current environment is not without its vulnerabilities. At the global level, low interest rates in the major financial centres, combined with reasonable economic outcomes, have encouraged borrowing and led investors to perceive risk as very low and/or to accept less compensation for holding risky assets. The resulting concern is that in the benign environment of the past few years investors may have underestimated risks and borrowed too much. The corollary of this is that the prices of some assets may have been pushed to unsustainable levels. If this turned out to be the case, developments of recent years could have created the basis of future difficulties.

While the recent benign conditions in financial markets may well continue, if history is any guide, a reappraisal of risk and debt levels is likely at some point in time. Exactly what the trigger for any reappraisal might be is unpredictable. But there are a number of possible candidates. One is an unanticipated rise in inflationary pressure in the global economy, leading to a significant increase in interest rates. Other, but less likely, triggers include a sharp fall in the US dollar due to concerns about the sustainability of the US current account and fiscal deficits, disorderly adjustments in exchange rates in Asia, and a confluence of credit events, including the default or downgrading of a major borrower. A year or so ago, tightening of US monetary policy would have been added to this list, although to date the tightening, if anything, appears to have reinforced the perception that risk is low, rather than the reverse.

Although disruptions in global capital markets arising from an abrupt reappraisal of risk would undoubtedly have effects on Australia, domestically, the main risks continue to revolve around the behaviour of households and their willingness to take on debt, particularly for housing. On one hand, there is the possibility that last year's favourable developments turn out to be only a temporary reprieve and that the housing market reignites, an outcome that would throw the possibility of a future costly correction back into sharp focus. On the other, there is a risk that the weakening in the housing market could become more pronounced and that households, after taking a more cautious approach to their finances over the past year, may attempt to shore up their balance sheets appreciably. On the basis of how events have evolved to date, both these risks seem to be relatively low, but they cannot be ruled out.

Another uncertainty is the response of Australian financial intermediaries to the slowdown in household credit growth. The concern here is that some intermediaries may be responding to this slowdown by taking on more risk, and at lower margins, in an attempt to preserve lending volumes and market shares. In a number of areas, lending practices are diverging some way from the tried-and-tested methods of the past: far more use is now being made of brokers; ‘low-doc’ lending, which involves a strong element of self-verification in the loan application process, is growing rapidly; and the discounting of home loan rates is much more widespread. To the extent that these various changes are the outcome of a more competitive market they are to be welcomed, provided that lending institutions fully understand the risks involved and are pricing those risks appropriately. Whether or not this is the case will only be evident in a weaker economic environment, when the risk now being built up materialises. While these recent developments do not represent an immediate threat to the financial system, they nonetheless need to be closely watched in the period ahead.