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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2005

Overview

The Australian financial system remains in good shape. The banking sector, in particular, is continuing to perform strongly, supported by the ongoing expansion of the Australian economy. Banks remain well capitalised, are experiencing historically low levels of bad debts and, despite a pick-up in competition, are continuing to record high rates of return on equity.

As noted in previous Reviews, this strong performance of the Australian banking sector over the past decade owes much to a business strategy focused on lending to households. Since 1996, bank lending to households has grown at an average rate of 13 per cent per year, and housing loans now account for more than half of banks' loans. As has been well documented, the rapid expansion of household credit – reflecting lower and more stable interest rates as well as financial innovation – has been associated with significant increases in house prices, with prices more than doubling between 1996 and the end of 2003.

Over the past year and a half, however, there has been a significant change in housing markets and household borrowing. In particular, house prices at the national level have stabilised over this period after they increased by almost 20 per cent in 2003. In addition, growth in household credit has slowed, as turnover in the housing market has declined and households have taken a more cautious approach to their finances. To date, these adjustments have occurred smoothly, without damaging either the economy or the financial system. From the standpoint of financial stability they are a welcome development, since they reduce the chance of a potentially costly correction at some point in the future. While the changed dynamics of the housing market are acting as a mild restraining influence on consumption growth, an important offsetting influence for the economy as a whole is the stimulus to incomes from the significant increase in the terms of trade.

At the international level, the global financial system is benefiting from above-average growth in the world economy. The past year has been characterised by relatively strong profits in many banking systems and stable financial markets, with earlier fears about a sudden reassessment of risk leading to excessive volatility not, thus far, being realised. Overall, financial markets remain generally sanguine about future prospects.

Despite these favourable outcomes, risks, as always, remain. These can usefully be characterised into three broad groups.

The first are those relating to the international environment. A striking characteristic of the global economy over recent years has been the simultaneous occurrence of low and stable goods and services price inflation, and significant upward pressure on many asset prices. One example of this pressure is that long-term bond yields in many countries are at very low levels, notwithstanding the favourable growth outcomes and the progressive increase in policy rates in the United States. Low interest rates and low volatility have encouraged many investors to seek out alternative assets and increase leverage in an effort to maintain returns – a sequence of events which, amongst other things, has led to a significant compression in credit risk premia in many markets. Residential property prices have also risen steeply in a number of countries, most recently in the United States. As has been the case in Australia, this increase in prices has been associated with a pick-up in household indebtedness.

From a financial stability perspective, the concern is that the combination of elevated asset prices and increased levels of debt in many markets could be sowing the seeds for future problems. As with the Australian house price and household borrowing booms, the longer leverage builds up at historically high prices, the greater is the potential for costly adjustments at some point later on. As such, the earlier any corrections take place, the less likely it is that the outcomes will be detrimental to the stability of the global economy and financial markets.

A possible catalyst for these adjustments could be a sudden reassessment of risk in global financial markets. This could occur for a number of reasons including a sudden shift in international capital flows, a further increase in oil prices, the default of a significant borrower, or an unexpected pick-up in inflation. Such a reassessment of risk could turn out to be relatively benign, although given that leverage in markets has built up significantly and many assets appear fully priced, the pre-conditions are in place for quite abrupt swings in sentiment and a disruptive snap-back in pricing.

The second group of risks are domestic and are rooted in the expansion of household balance sheets that went hand-in-hand with the run-up in Australian house prices. While the adjustment to date has proceeded smoothly, the household sector remains vulnerable to a deterioration in the economic climate, and there remains a possibility that the adjustment could turn out to be much larger than currently anticipated. The probability of this occurring, however, has declined somewhat over the past year.

Finally, the Australian banking system has entered a period of intensified competition. Competition for household savings is increasing in response to a number of banks offering high interest rates on online savings accounts. And as the housing market has softened and the growth in household credit has slowed, there is also evidence that competition in lending markets has increased as banks seek to bolster, or simply maintain, market shares. While this increase in competition is to be welcomed – so long as the underlying risk is appropriately priced – it will bear careful monitoring in the period ahead, given that historical experience may not be a good guide to future developments.