Financial Stability Review – September 20052. Financial Intermediaries
Australian financial intermediaries continue to perform strongly, reaping the benefits of the ongoing expansion of the domestic economy. While the demand for credit from the household sector has slowed and margins remain under downward competitive pressure, the return on equity in the banking sector has been maintained at historically high levels – an outcome that partly reflects ongoing reductions in cost-to-income ratios and strong earnings from wealth management operations. The pressure on margins and slower household credit growth have, however, encouraged some institutions to take on more risk, and at lower margins, than they have in the past. As a result, credit losses can be expected to pick up in the period ahead from the current low levels. As has been the case with banks, insurance companies have performed well over the past year, benefiting from relatively high investment returns, although stronger competition among insurers is also beginning to dampen underwriting returns.
2.1 Deposit-taking Institutions
Banks continued their run of strong results in the most recent half year. In aggregate, the before-tax profits of the five largest banks increased by around 21 per cent compared to the same period a year ago, with the annualised before-tax return on equity equal to 22 per cent, around the highest rate over the past decade or so (Graph 33). Not only have returns in the banking industry been high and remarkably stable over the past decade, there has also been a marked reduction in the variability of returns across banks, as the major banks have come to adopt increasingly similar business strategies with a strong focus on domestic retail lending.
The recent profitability of the Australian banking sector compares favourably with the profitability of banking sectors in other countries. Measured both as a return on assets and as a return on equity, the profits of Australian banks are consistently higher than those recorded by continental European banks and broadly similar to recent returns earned by banks in the United States and United Kingdom (Table 3). When compared to the recent returns made by banks operating in countries with a broadly similar banking structure to Australia's, such as Canada and Sweden, Australian banks have earned significantly higher returns on assets, but comparable returns on equity, an outcome that reflects the relatively low gearing of Australian banks. In terms of volatility, the returns in the Australian banking sector have been remarkably stable compared with those in most other countries.
The strong performance of Australian banks has been underpinned by robust balance sheet growth. Average interest-earning assets of the five largest banks increased by 13 per cent over the past year, with slower household credit growth offset by a pick-up in business credit growth. In contrast, net interest income grew by a more modest 7 per cent – in line with the average outcome over the past decade – with growth held down by the continuing squeeze on margins (Table 4). Reflecting this, the ratio of net interest income to average interest-earning assets fell by a further 6 basis points in the first half of 2005, bringing the cumulative decline since the mid 1990s to around 150 basis points (Graph 34). This decade-long decline is the result of a combination of factors affecting both the asset and liability sides of banks' balance sheets.
On the asset side, competition in the housing loan market has had a significant effect. While the spread between the average standard variable home loan interest rate and the cash rate has been stable at around 1.8 percentage points since 1997 (after falling by around 2½ percentage points over the previous four years), many borrowers now pay considerably less than the standard variable rate. Indeed, widespread discounting of home loans has pushed the average interest rate paid by new borrowers to around 50 basis points below the standard variable rate (Graph 35). Furthermore, over recent months, a number of lenders have begun to more actively promote discounts of about 70 basis points below the standard variable interest rate, typically for loans in excess of around $500,000.
Margins have also been under pressure as a result of banks sourcing a higher share of their loans through mortgage brokers than in the past. On average, lenders typically pay brokers an upfront commission of about 65 basis points of the initial loan value and a trailing commission of around 25 basis points of the outstanding loan balance each year. Although the share of new mortgages originated through brokers varies substantially from bank to bank, it is not uncommon for banks to source a third of their new loans in this way. In response to the erosion of margins, some banks have sought to change the structure of the fees they pay to brokers.
Margins are also under pressure in business lending, where the spread between the weighted-average variable interest rate paid by both small and large business borrowers and the cash rate has continued to fall (Graph 36). While this compression may be partly explained by a shift by borrowers towards lower-cost products – including loans backed by residential property – some lenders are targeting business lending more aggressively than in the past in response to weaker demand for housing finance. The origination of business loans through brokers is also becoming more common, exerting further downward pressure on margins.
Competition and new product offerings are also affecting the margins that banks earn on personal lending, including those on credit cards. In particular, a number of credit card issuers now offer ‘low rate’ cards with interest rates in the 10 to 13 per cent range, compared with an average rate of 16¾ per cent on other cards. In addition, a number of issuers are offering zero per cent deals on balance transfers. Similarly to other products, new entrants, including foreign-owned banks, have been at the forefront of this competition.
On the liability side of the balance sheet, the decline in the share of funding sourced through low-cost retail deposits has also compressed margins. This decline partly reflects households investing a larger share of their savings in non-deposit products, leading banks to turn to both domestic and international wholesale markets to fund their balance sheet growth. It also reflects the increased competition in the retail deposit market. This competition was initially spurred by the introduction of high-yield online saving accounts by a number of foreign-owned banks. More recently, similar accounts have been introduced by many other banks after a number of them initially indicated that they would not do so because they considered that the interest rates being offered were too high. Notwithstanding this, foreign-owned banks have increased their share of the deposit market noticeably over recent years, albeit from a low base (Graph 37). The average online interest rate is currently 5.4 per cent, just below the cash rate of 5½ per cent, with a number of banks offering interest rates at or above the cash rate (Graph 38). In contrast, many traditional transaction accounts attract an interest rate of less than ¼ per cent.
Recently, this pressure on margins has been offset slightly by a contraction of the spread between the 90-day bank bill rate (which provides an indication of banks' funding costs) and the cash rate (to which many loan rates are implicitly linked). In 2004, the spread between these two rates averaged around 23 basis points, but it is currently around 12 basis points, with the fall largely reflecting the market's assessment that the probability of another tightening in monetary policy has declined.
At the same time as lending margins have fallen, banks have generated an increasing share of income from non-banking activities, particularly through their wealth management subsidiaries. Despite this, profits from wealth management activities still account for only 11 per cent of the total (after-tax) profits of the major banks. Total non-interest income, which includes fees and commissions from lending, was boosted in the latest half year by the sale of NAB's Irish operations, though this was partly offset by more moderate growth in total fees and commissions.
The Australian banking system remains well capitalised. The regulatory capital ratio for the system as a whole has been broadly stable over the past decade, although it has drifted up a little over the past year, to 10.7 per cent as at June 2005 (Graph 39). Notwithstanding this increase, the bulk of profits continue to be paid out to shareholders in the form of dividends, with banks being able to obtain the capital required to fund balance sheet growth by retaining only around one quarter to one third of their profits. Credit unions and building societies also remain well capitalised in aggregate, with regulatory capital ratios of around 14 to 15 per cent.
Australian banks' non-performing assets remain at exceptionally low levels. According to APRA data, as at end June 2005, impaired assets – those on which payments are in arrears by more than 90 days, or otherwise doubtful, and not completely covered by collateral – accounted for 0.3 per cent of banks' on-balance sheet assets. When well-secured assets on which payments are more than 90 days past due are added (to measure total ‘distressed’ assets), the figure is still only around 0.5 per cent. This is slightly lower than it was a year ago (Graph 40).
Within this aggregate result, there are slightly divergent trends in the performance of loans to the household and business sectors. In particular, over the past year, the ratio of distressed business loans to total business loans has fallen, while the reverse is true for household loans (Graph 41). To some extent these divergent trends reflect the two sectors' different appetites for borrowing over recent years. Business credit has grown relatively slowly over this period and, with profits up considerably, debt-servicing burdens in the business sector are low by historical standards. In contrast, debt and interest-servicing burdens are at record highs for the household sector (see the Macroeconomic and Financial Environment chapter).
The slight pick-up in housing loan arrears is evident across most banks' portfolios (Graph 42). The aggregate arrears rate, however, remains very low in comparison to both historical and international experience. There has been a slightly more pronounced increase in the share of securitised loans on which repayments are more than 90 days overdue, partly reflecting a rise in the share of ‘low doc’ loans – which have higher default rates – in the pool of securitised mortgages.
The mild pick-up in the rate of housing loan arrears is not surprising given the relaxation of lending criteria seen over the past five or so years. Over this period, as detailed in the previous Review, there has been: an increased reliance on brokers to originate loans; an increase in permissible debt-servicing burdens and loan-to-valuation ratios; strong growth of low-doc loans; rapid growth in lending to investors; and the use of property valuation techniques that do not involve a full external and internal inspection of the property. Competition has also manifested itself in some intermediaries offering non-housing related inducements or expanding their distribution channels into non-traditional avenues. In combination with the changes in household balance sheets over recent years, these developments are likely to have increased the overall riskiness of banks' housing loan portfolios.
Of the changes in lending practices noted above, low-doc lending is an area that has attracted particular attention recently. This segment of the mortgage market has grown rapidly in recent years and the interest margin being earned by lenders to compensate for the extra risk has declined considerably (see Box B). From a risk management perspective, an important consideration is that the credit quality of low-doc loans is yet to be tested in a more difficult economic environment.
The same is true for many of the housing loans that banks have made to investors over recent years. Investor loans currently account for around 35 per cent of banks' total housing loans outstanding, up from 15 per cent in 1990. As noted in the previous chapter, many of these loans were made to investors earning negative running yields, but expecting to make offsetting capital gains. Although the increase in the arrears rate on investor loans has been modest to date, it is possible that it could rise further if the weaker residential property market persists.
Another form of lending to households that has grown strongly in recent years is personal lending. While this type of lending accounts for only 10 per cent of aggregate bank credit outstanding, personal loans, which are often unsecured, tend to have considerably higher arrears and default rates than housing loans, and thus attract higher lending margins. Over the past year, for example, personal lending accounted for around half of banks' total credit losses, or write-offs (Graph 43). In part, this reflects the historically low level of credit losses in aggregate. Furthermore, there is little evidence that the credit quality of banks' personal loan portfolios has deteriorated in recent times – in 2004, the write-off rate on personal loans fell to its lowest level since the mid 1990s, and more recent data show that the share of credit card loans past due has also not increased noticeably.
There are currently few concerns, in aggregate, about the business lending portfolios of authorised deposit-taking institutions (ADIs). This is not surprising given that the business sector is currently in good shape. As noted in the Macroeconomic and Financial Environment chapter, trading conditions and profitability are strong, especially in the mining sector, with debt-servicing ratios remaining low. Despite the generally strong profit results, the demand for external finance has picked up recently due to strong growth in investment – total business credit grew at an annualised rate of close to 14 per cent over the six months to July. Banks have been keen to facilitate this as an offset to the more subdued demand for housing finance. Increased business lending is reflected in data from APRA's survey of bank business credit, which showed that this form of lending increased by 11 per cent over the year to June, compared to an average annual rate of 8 per cent over the past five years (Table 5). By far the largest segment of business lending is for loans in excess of $2 million which are either unsecured or secured against business collateral, including commercial property.
In terms of sector exposures, banks' lending for commercial property is one area that has grown relatively briskly of late, with the latest available data showing commercial property exposures up by 19 per cent over the year to March 2005 (Table 6). While strong growth has been observed across most types of commercial property, a notable feature has been the rapid growth of commercial lending related to residential property despite the slowing in the residential property market more generally. Notwithstanding this, the asset quality of banks' commercial property portfolios remains sound, with only 0.1 per cent of outstanding commercial property loans impaired as at March 2005. Furthermore, as noted in the previous chapter, there are few signs of the excesses in the commercial property market that have created problems for banks in the past.
While growth in business lending has picked up, banks have continued to reduce the number of ‘large’ exposures on their balance sheets, a trend that has been evident since the early 1990s. In particular, banks in aggregate have markedly reduced individual exposures that amount to more than 30 per cent of capital over this period (Graph 44).
Australian banks' most significant overseas exposures are to New Zealand and the United Kingdom, predominantly through lending to residents by branches and subsidiaries located in those countries, rather than from cross-border lending by their Australian-based operations (Table 7). Since the previous Review, the share of offshore exposures to the United Kingdom and Ireland has fallen to a combined 24 per cent, from 28 per cent, largely reflecting NAB's sale of Northern Bank and National Irish Bank. A significant proportion of banks' exposures to New Zealand and the United Kingdom is lending for housing and, as in Australia, there are signs that there has been a cooling in the housing market in these countries after a period of strong growth.
Australian banks continue to have relatively small exposures to market risk. Based on the latest half year results, the average daily value-at-risk (VaR) for the four largest banks was equivalent to 0.04 per cent of shareholders' funds, which is low by international standards, and represents a decline since the corresponding period in 2004 (Table 8). Interest-rate risk accounts for the largest share of banks' traded market risk.
The low level of exposure to traded market risk partly reflects the fact that Australian banks make extensive use of hedging, including through the use of derivatives. The majority of the banks' derivatives exposures are in foreign exchange and interest rate markets, with the value of outstanding contracts being fairly stable over the past two years, at about 9 per cent of on-balance sheet assets (Graph 45). Most of these contracts are arranged in over-the-counter markets, rather than on exchanges. While these markets have the advantage of being better able to tailor products to banks' requirements, they potentially expose banks to other risks such as the potential default of a counterparty. That said, counterparty risk tends to be concentrated in entities which are highly rated.
Liquidity and Funding
As lending growth has outstripped the growth in deposits for much of the past decade, banks have increasingly turned to wholesale markets for funding (Graph 46). This largely reflects developments in the household sector, where the saving rate has fallen and an increasing share of savings has been channelled into non-deposit products, and at the same time, the demand for bank finance by households has grown rapidly. Over the past year, the four largest banks funded less than one quarter of their new lending from retail deposits (Graph 47). For other Australian-owned banks, there is less reliance on offshore wholesale markets to fund balance sheet growth, in part, reflecting the extensive use of the securitisation market by some of the smaller regional banks. In contrast, the inroads that foreign-owned banks have made into the deposit market have seen these banks fund the majority of their recent lending from retail deposits.
Over the past six months, most of the growth in banks' wholesale funding has been through the issuance of debt securities offshore, with the bulk of these having a maturity of greater than one year (Graph 48). While the value of domestic debt securities outstanding has been fairly stable in recent quarters, there has also been some shift into securities with longer maturities. Other things equal, this lengthening of the maturity profile of banks' debt should reduce the potential for difficulties in rolling over their liabilities.
Another important part of managing liquidity risk is ensuring sufficient holdings of assets that can be readily sold in difficult market conditions. Banks that have sufficiently sophisticated and robust liquidity measurement techniques are required to demonstrate to APRA that they hold enough liquid assets to meet their payments for five business days under various adverse scenarios. Other ADIs must maintain a minimum holding of 9 per cent of total liabilities in specified liquid assets. In recent years, banks' total holdings of liquid assets – which include government securities, certain bank bills and certificates of deposit – have remained stable, at around 12 per cent of total assets. The proportion of these liquid assets that can be used in repurchase obligations with the Reserve Bank has also been broadly stable since the eligibility criteria were changed by the Bank in March 2004 (Graph 49).
Financial Markets' Assessment
Financial market-based indicators continue to suggest that market participants have few concerns about the prospects of the Australian banking sector. The spread between bank bond yields and the swap rate remains around the low levels observed over recent years, as does the average credit default swap premium for the four major banks (this premium represents the cost of ‘insuring’ against a bank defaulting on its bonds) (Graph 50). Similarly, the expected future volatility of banks' share prices, measured from options data, remains low, as do the probabilities of large price movements implied by options prices (Graph 51 and Box C).
No bank has had its credit rating reduced in the past six months, and four banks have received upgrades. Standard & Poor's upgraded Bank of Queensland (to BBB+), HSBC Bank Australia (to AA−) and ING Bank (Australia) (to AA) by one notch. Moody's upgraded Arab Bank Australia from Baa3 to Baa2 (Table 9).
While banks' share prices have slightly outperformed the broader market since the previous Review, the banking index has been relatively stable since mid 2005 (Graph 52). This may reflect a slightly more circumspect outlook for banks' future profit growth in the face of the slowdown in the housing market and the competitive pressures discussed above.
2.2 General Insurance
The general insurance industry has continued to benefit from favourable operating conditions, maintaining profits at a high level over the past year. According to APRA data for the first three quarters of the 2004/05 financial year, the general insurance sector earned an annualised aggregate after-tax profit of around $5 billion (Graph 53). This solid profit outcome was underpinned by investment returns, though underwriting results made a significant contribution to profitability for the third consecutive year.
The ongoing strength of the recovery in underwriting results is, however, likely to be tested in the period ahead, largely because of the impact of competition on premiums. Industry surveys suggest that premium rates have already fallen by as much as 20 per cent over the year in some business lines, with competition most intense in commercial rather than personal segments. The effect of this on profits may be compounded if claims return to levels more in line with longer term averages, from the unusually low levels of recent years.
Despite these emerging pressures, in aggregate, the general insurance industry appears to be in a sound financial position. Over recent years, the industry has maintained its capital holdings at over twice the regulatory minimum and changes to prudential requirements introduced by APRA since 2001 have supported improvements in insurers' risk management procedures.
Rating agencies have taken a generally favourable view of the domestic general insurance industry, with the largest insurers each maintaining ‘A’ ratings, or higher (Table 10). Equity market participants also continue to view the sector positively, with insurers' share prices consolidating the strong gains of 2004, despite underperforming the broader market so far this year (Graph 54).
Notwithstanding expected losses from Hurricane Katrina, the global reinsurance industry appears to remain well placed to absorb some of the risk from domestic insurers. Following Hurricane Katrina, some large global reinsurers downgraded their profit forecasts and have been placed on negative credit watch by Standard & Poor's. However, strong premium revenue over recent years has boosted reinsurers' profits and capitalisation, which is likely to leave them well placed to absorb the losses. Although equity prices for some of the largest global reinsurers fell by up to 7 per cent following the disaster, they remain higher than in late 2004. Similarly, domestic insurers have announced relatively modest exposures to Hurricane Katrina, compared to provisions for such events.
Aside from current conditions, an issue facing the insurance industry, both at home and abroad, is the regulatory investigations into the misuse of financial reinsurance arrangements. These investigations have led to a number of regulatory initiatives, which are discussed in the Developments in the Financial System Infrastructure chapter.
2.3 Wealth Management
Funds in wealth management vehicles have grown strongly in Australia over the past 15 years, at an average annual rate of around 10½ per cent. The assets of superannuation funds have increased particularly strongly, up by a factor of seven over this period, to nearly $500 billion (Table 11).
Superannuation funds' (unconsolidated) assets increased by 18 per cent over the year to March 2005, supported by both strong returns on existing assets and substantial new contributions (Graph 55). Much of this growth was in assets managed by industry and self-managed funds, which have increased their share of superannuation assets significantly over the past decade, to a combined 38 per cent (Graph 56). At the same time, the share of superannuation assets managed by corporate and public sector funds has declined. Flows between funds may be given further impetus following the introduction of ‘choice of fund’ on 1 July, which gives a large proportion of the Australian workforce the right to choose the fund into which their compulsory superannuation contributions are deposited.
The profitability of life insurers improved further over the past year, following difficult conditions in 2002 and 2003 (Graph 57). This improvement was almost exclusively driven by investment returns, reflecting the strong performance of equity markets. Like other wealth managers, life insurers have increased the share of their investment portfolios held in equities, to around 60 per cent of total domestic investments, up from less than one third a decade ago.
In contrast to the strong investment returns, income from new premiums and contributions was broadly offset by policy payments. The relative weakness of net insurance flows highlights the pressure the life insurance industry has been under for some time. In part, this is due to the gradual shift of superannuation assets away from life offices to superannuation funds. While around 40 per cent of total superannuation assets were invested through life offices in the early 1990s, this share has now fallen to around one quarter. As noted in the previous Review, this trend may be reinforced following the phasing out of some tax concessions for life insurers which occurred in July this year. A further factor weighing on the life insurance industry is the extent of ‘legacy’ business on their books – policies written in the past at comparatively less profitable terms than modern policies, thereby placing downward pressure on net insurance flows.
Other Managed Funds
Growth of assets managed by unit trusts, cash management trusts, common funds and friendly societies has picked up over the past two years, though it remains well below the very rapid growth of the late 1990s (Graph 58). Like other wealth managers, this pick-up largely reflects the strong growth of the domestic share market over the recent period. Equities now account for the largest share of assets held by these ‘other’ managed funds, following a shift away from cash and interest-bearing securities over the past decade (Graph 59). The share of assets held in real estate has also picked up since 2001, as listed property trusts have benefited from strong contributions of new funds and the attraction of relatively favourable commercial property yields in the generally low-yield environment.