Financial Stability Review – March 2006 Financial Intermediaries
Australian financial institutions are continuing to benefit from the expansion of the domestic economy. While margins remain under downward pressure, high levels of profitability have been sustained through further reductions in costs, relative to income, and growth in non-interest income. Banks are also seeing balance sheet growth as a result of a pick-up in the demand for credit by businesses, which has helped offset slower growth in the demand for housing finance. Competition amongst banks and other lenders remains strong, with borrowers able to obtain finance at lower margins and on more flexible terms than has been the case in the past. To date, the supportive economic environment has meant that this general lowering of lending standards has not led to an increase in banks' overall bad debts expense, although, in time, an increase is likely to occur.
2.1 Deposit-taking Institutions
Profitability and Balance Sheet Growth
In aggregate, the return on equity for the five largest banks in 2005 was 21.4 per cent (Graph 30). This outcome continues a run of high and stable returns over more than a decade. The other notable feature of recent profit results has been the similarity in the returns earned by the various banks. This reflects, in part, the fact that the balance sheets of the major banks have evolved in a similar way over the past decade, with each of them experiencing very strong growth in their portfolios of residential mortgages. One consequence of this broad similarity in profitability has been a notable increase in the correlation of movements in the share prices of the four largest banks (Graph 31).
The aggregate balance sheet of the banking system continues to grow at a firm pace, reflecting strong domestic credit growth; over the past year, interest-earning assets of the five largest banks grew by around 11 per cent, with the smaller regional banks experiencing considerably faster growth of 16 per cent (Graph 32). However, the composition of balance sheet growth has changed, with growth in lending to businesses picking up significantly and growth in lending to households slowing. APRA data on banks' business lending suggest that much of the growth in business lending has been in loans with a value greater than $500,000 (typically to large businesses), which account for over three quarters of banks' outstanding business loans.
Growth in net interest income continues to be considerably slower than that in assets, reflecting the ongoing decline in net interest margins. Over 2005, net interest income of the five largest banks increased by 6½ per cent, with the ratio of net interest income to interest-earning assets falling by 10 basis points, to 2.35 per cent (Graph 33 and Table 6).
Partly in response to the pressure on margins, banks have sought to diversify their sources of income, including by bolstering their wealth management operations. Income from wealth management (excluding revaluations) increased by 23 per cent over the past year and now accounts for over 13 per cent of the four largest banks' total income, compared to 9 per cent four years ago (Graph 34). While other forms of non-interest income have grown more slowly, total non-interest income accounted for around 45 per cent of banks' total income in 2005.
An important feature of the current environment is the strong competition in both lending and deposit markets.
Over recent years, competition amongst lenders has put considerable downward pressure on margins and has led to an incremental easing of lending criteria. In particular, the increase in competition in the housing market has seen lenders move away from many of their traditional lending practices. These changes have been discussed at length in previous Reviews, with the main changes including:
- higher permissible debt-servicing ratios. Following changes to procedures for assessing prospective borrowers, many lenders are now prepared to make loans with a debt-servicing ratio (the ratio of interest and principal repayments to the borrower's gross income) of 50 per cent, rather than the traditional ‘rule of thumb’ of 30 per cent; 
- an increased reliance on brokers to originate loans. In aggregate, around 30 per cent of new loans are originated through third-party brokers, though this figure varies significantly across banks;
- the granting of low-doc loans which involve a large element of self-verification in the application process; and
- the greater availability of loans with minimal, or no, deposit.
Recently, competitive pressures appear to have intensified, as many lenders have sought to maintain growth in their mortgage portfolios in the face of slower growth in the demand for housing finance. As a result, the downward pressure on housing loan margins has continued, with lenders both advertising and negotiating larger discounts to the standard variable mortgage rate. The average rate paid by new borrowers was around 50 basis points below the banks' standard variable rate in mid 2005, with discounts of 70 basis points common for loans over $250,000 (Graph 35). Strong competition has also been a feature of overseas housing markets, including in New Zealand and the United Kingdom, where Australian banks have significant retail operations (see Box B).
One factor contributing to the fall in lending margins has been a decline in the spreads that investors require to hold residential mortgage‑backed securities (RMBS). Recently, AAA-rated RMBS have been issued at about 14 basis points over the bank bill swap rate, compared with 18 basis points during much of 2005 and 36 basis points a few years ago (Graph 36). Spreads have fallen by an even larger amount on AA-rated securities. These declines have allowed lenders that securitise mortgages to make loans at lower rates than would otherwise have been the case.
Strong competition is also evident in the low-doc housing loan market. While banks generally entered this market later than specialised non-bank lenders, they are now significant participants, with some regional banks targeting this market quite aggressively. Low-doc loans are designed mainly for the self-employed or those with irregular incomes who do not have the documentation required to obtain a conventional mortgage. As such, these loans tend to have higher default rates than standard housing loans (see below). Traditionally, lenders have charged higher interest rates on low-doc loans than on standard loans to compensate for the higher risk. In recent years, however, the margins on low-doc loans have declined markedly, with the average advertised rate on new low-doc loans now only 10 basis points above the advertised standard variable rate. At the same time, maximum allowable loan sizes and loan-to-valuation ratios for low-doc loans have increased.
Competition has also intensified in the credit card market. It has been particularly vigorous in the ‘no frills’ segment of the market, with more than a dozen low-rate cards being introduced over the past three years. These cards offer interest rates in the 9 to 13 per cent range, compared to around 17 per cent on traditional cards. The lowering of interest rates on credit cards has also prompted greater competition in the personal loan market, with a variety of new products being introduced and significant discounts being offered to new customers.
Pricing pressure is also evident in the business loan market, with the spread between the weighted-average variable rate paid by both small and large businesses and the cash rate continuing to fall (Graph 37). Business surveys confirm this increased competition, with the semi-annual survey conducted by JPMorgan and East & Partners reporting that the number of businesses that have recently experienced a reduction in their borrowing spread considerably exceeds the number that have experienced an increase (Graph 38). Margins are also being affected by a change in the composition of banks' business portfolios towards lower-margin products, including loans backed by residential property.
In some respects, parts of the business lending market are beginning to have some of the characteristics of the housing loan market, with a growing focus on price rather than the ‘relationship’ between borrower and lender. Brokers are also starting to play a larger role in business lending and, as in the housing loan market, are acting as a conduit for greater competition.
At the same time that banks are competing intensively for lending opportunities, competition for deposits has picked up, with an increasing number of banks, including each of the five largest banks, now offering high-yield online savings accounts. The average interest rate on these accounts is 5.45 per cent, though some banks offer rates at, or above, the current cash rate of 5½ per cent. The catalyst for this competition was the entry of a number of foreign-owned banks, which were the first to offer high-yield online savings accounts. These banks have increased their share of total bank deposits from less than 8 per cent five years ago, to over 11 per cent as at end 2005 (Graph 39). More recently, foreign-owned banks have also gained a larger share of the personal and housing loan markets.
As a result of the changes in lending practices described above, borrowers have been provided with easier and cheaper access to finance, particularly for housing, which together with other structural changes, have facilitated an increase in debt levels. At the same time, these developments have occurred against a favourable macroeconomic backdrop, with current lending standards, pricing and risk-management systems yet to be tested in an economic downturn.
Credit Risk and Capital Adequacy
Not surprisingly given the economic environment, Australian banks' non-performing assets remain very low, both by historical and international standards. As at December 2005, only around 0.4 per cent of on-balance sheet assets were classified as non-performing (Graph 40). Of these, around half were classified as ‘impaired’ – that is, assets on which payments are in arrears by more than 90 days or otherwise doubtful and the amount due is not well covered by the value of collateral. The remaining non-preforming assets were in arrears, but were well covered by collateral.
Within this aggregate, there has been some decline in the share of business loans that are non-performing, with the arrears rate falling by over 60 basis points over the past two years. This is consistent with the sound balance sheet position of the business sector, which has been underpinned by the favourable operating environment (see The Macroeconomic and Financial Environment chapter). The arrears rate on commercial property lending – the traditional source of major credit quality problems – is also at a historically low level. As at September 2005, only 0.2 per cent of outstanding commercial property loans were impaired, notwithstanding the well-publicised problems surrounding some residential property developers (Table 7). Over the year to September 2005, commercial property lending increased by around 18 per cent, somewhat higher than growth in banks' business loan portfolios. Nonetheless, recent problems at some property developers have resulted in significant losses for small investors, including retail investors, some of whom were acting on the advice of financial advisors. These episodes have been the focus of regulatory attention (see Developments in the Financial System Infrastructure chapter).
In contrast to the decline in business arrears, the share of banks' housing loans on which payments are past due has edged up over the past two years, to over 0.2 per cent, though this share remains low in absolute terms (Graph 41). The arrears rate on securitised housing loans has increased more markedly, to 0.35 per cent. This partly reflects the higher, and increasing, share of low-doc loans – which have higher arrears rates than traditional loans – in the pool of securitised mortgages (Graph 42). Around 12 per cent of loans securitised by all lenders were low-doc as at end 2005, although for specialised non-bank mortgage originators this figure was around 20 per cent.
Non-conforming lending – often referred to as sub-prime lending – is another aspect of housing finance that has attracted attention lately. Non-conforming lenders provide finance to borrowers who do not meet standard lending criteria, including those with impaired credit histories or an irregular income. Reflecting the higher risk of this type of lending, the share of securitised non-conforming loans more than 90 days in arrears was around 4½ per cent in 2005, considerably higher than arrears rates on prime low-doc or traditional loans. While up until recently non-conforming loans were only available from specialised lenders, at least one mainstream lender has now entered the market, and it is possible that others may follow suit.
Australian banks are also exposed to credit risk through their operations overseas. As at December 2005, Australian-owned banks' overseas claims were $366 billion, accounting for 27 per cent of their total assets. Their overseas operations remain concentrated in New Zealand and the United Kingdom, predominantly through lending by branches and subsidiaries located in those countries (Table 8). As noted, many of the competitive pressures faced by banks in Australia are also evident in these countries. One aspect of banks' overseas operations that has attracted attention recently is a renewed interest in developing a stronger presence in Asia, particularly in China. Over the past two years, exposures to China have more than doubled, to $2.6 billion, although they remain a very small share of banks' total foreign exposures. Recently, some Australian banks have also taken equity interests in Chinese banks.
Australian banks remain well capitalised, with an aggregate regulatory capital ratio of 10.4 per cent as at December 2005 (Graph 43). While this ratio has drifted down a little over the past six months, it remains around its average over the past decade. Given the strong profitability in the sector, banks have been able to rely on retained earnings to increase their capital base in line with asset growth, while also conducting periodic share buy-backs. Credit unions and building societies also remain well capitalised, with aggregate regulatory capital ratios in the range of 13 to 16 per cent.
Looking ahead, banks' capital ratios will be affected by the implementation of International Financial Reporting Standards (IFRS), and proposed changes to APRA's prudential standards. These proposed changes would result in additional deductions from the Tier 1 capital of banks with intangible assets relating to their life insurance subsidiaries. APRA has also proposed new limits on banks' use of innovative hybrid funding instruments (instruments which have properties of both debt and equity). These new limits are scheduled to come into effect in 2008, though an additional two-year transition period may be available for materially affected banks.
Australian banks have relatively small net positions in financial markets. This is evident in the four largest banks' aggregate exposure to market risk through their trading operations, as measured by average value-at-risk (VaR). Based on these banks' 2005 results, this measure of risk was equivalent to 0.04 per cent of shareholders' funds, which is low by international standards, and unchanged from 2004 (Table 9). Interest-rate risk remained the largest component of banks' traded market risk.
Liquidity and Funding
For much of the past decade, bank lending growth has outstripped the growth in retail deposits. This largely reflects developments in the household sector, where an increasing share of household savings has been channelled into non-deposit products at the same time as the household saving rate has fallen and the demand for finance, especially for housing, has been strong. As a result of these developments, the share of banks' funding sourced through retail deposits has fallen from about 38 per cent in the mid 1990s to around 23 per cent currently (Graph 44).
A variety of approaches have been adopted by banks to bridge this gap between growth in domestic lending and growth in retail deposits. Some regional banks have made extensive use of securitisation (Graph 45). In contrast, the five largest banks have relied more heavily on issuing securities into wholesale markets, particularly those offshore. As a result, foreign liabilities accounted for 27 per cent of banks' total liabilities (on a domestic-books basis) as at January 2006, compared to 15 per cent a decade ago.
The bulk of offshore borrowing is done through the issuing of negotiable debt securities. The large banks all have both commercial paper and medium-term bond-issuing programs. Over the past few years, an average of around $50 billion in new bonds has been issued each year, up from around $10 billion per year in the second half of the 1990s (Graph 46). The bonds have been issued in a wide range of currencies, while commercial paper is typically issued in US dollars and euro. Additionally, around 15 per cent of the banking system's foreign funding is by way of transfers from related entities, with this form of funding relatively more important for foreign bank branches operating in Australia.
This reliance on foreign funding has not exposed the banking system to foreign exchange risk, as the currency risk on foreign-currency-denominated debt is typically fully hedged using cross-currency swaps and foreign exchange forward contracts. A survey commissioned by the Bank, and undertaken by the Australian Bureau of Statistics last year, confirmed that the net foreign currency exposure on the debt of Australian banks was quite low at $18 billion, and that this was more than offset, in aggregate, by equity holdings in foreign currency (see Box C).
One concern that has sometimes been expressed about the the banking system's heavy use of foreign funding is the potential for problems to emerge in rolling over the debt in times of stress. While this refinancing risk was a significant problem for some Asian countries in the mid-1990s crisis, countries with floating exchange rates and developed capital markets have not experienced this type of problem. For these countries, there is little evidence to suggest that foreign investors are less likely to rollover debt securities than are domestic investors. Moreover, the major banks diversify their funding sources, issuing securities into a range of different markets (Table 10). They also issue at a range of maturities, with the weighted-average maturity on banks' offshore bonds currently around four years.
In addition to diversifying their funding sources, banks manage their liquidity risks through holding liquid assets that can be easily converted to cash. Over the past few years, the ratio of liquid assets – mainly government and bank-issued securities – to total assets has remained stable, at around 11 per cent. The proportion of these assets that can be used in repurchase agreements with the Reserve Bank has also been broadly stable since the eligibility criteria were expanded in March 2004 (Graph 47).
Financial Markets' Assessment
Financial market-based indicators show that market participants continue to view the Australian banking sector favourably. Despite the competitive pressures described above, bank share prices have outperformed the broader market since the previous Review, increasing by more than 12 per cent over the past six months (Graph 48). Option valuations also imply that the expected future volatility of banks' share prices is low, as is the likelihood of large price falls (Graph 49).
Market indicators of credit risk also suggest a relatively benign outlook. The spread between bank bond yields and the swap rate remains low relative to that of earlier years, as do credit default swap premia (that is, the cost of insuring against the risk that a bank will default on its bonds) (Graph 50). In addition, the only adjustments in credit ratings over the past six months have been favourable, with St George Bank upgraded by Standard & Poor's from A to A+, Bank of Queensland upgraded by Moody's from Baa3 to Baa2 and Arab Bank Australia upgraded one notch to A− by Fitch (Table 11). BankWest remains on positive outlook from Standard & Poor's, while AMP Bank, HSBC Bank Australia, Macquarie Bank and St George Bank are on positive outlook from Moody's. There has been no change in any of Moody's financial strength ratings (which, unlike long-term credit ratings, do not take account of the possibility of external support) of any Australian bank over the past year.
2.2 General Insurance
General insurers continued their recent run of strong results in the past year, recording a before-tax return on equity of around 24 per cent in 2005 (Graph 51). This outcome was supported by a favourable claims environment and firm premium revenue, which maintained the combined ratio – claims and underwriting expenses as a share of net premium revenue – at around 85 per cent. Investment returns made a significant contribution to general insurers' profitability, accounting for around 60 per cent of before-tax profits over the year.
Looking ahead, the industry expects competition to place downward pressure on premiums in some business lines, most notably in commercial property, commercial liability and professional indemnity insurance. There are also signs of intensified competition in some personal insurance lines, with growth in premiums moderating, relative to claims, over the past year. Moreover, premiums have fallen in certain personal segments, such as compulsory third-party motor insurance, in some parts of Australia.
There is also some evidence of rising global reinsurance premiums, which may adversely affect domestic general insurers in the period ahead. Most general insurers use reinsurance to offset some of their risks, with the majority of cover in Australia provided by subsidiaries of a small number of large global reinsurers. Recently, the parent companies of these insurers have sought to recoup some of the large weather-related losses incurred in 2005 by raising their worldwide premiums, particularly for property reinsurance – total insured losses from natural catastrophes have been estimated at a historical record of nearly US$80 billion, of which around US$30 billion is expected to be absorbed by reinsurers (Graph 52). The extent to which these rises in reinsurance premiums will affect the domestic insurance industry is, however, difficult to gauge.
Domestic general insurers, in aggregate, improved their capitalisation over the past year, with the industry holding more than twice the regulatory minimum level of capital. Industry surveys suggest that the ratio of provisions to insured losses also remains well above the regulatory minimum.
Reflecting these favourable outcomes, rating agencies continue to take a positive view of the industry, with each of the five largest insurers rated ‘A’ or higher by Standard & Poor's (Table 12). Equity market participants also appear to view prospects for the general insurance industry as relatively good, with share prices increasing by over 20 per cent since the previous Review (Graph 53).
2.3 Wealth Management
Funds in wealth management vehicles continued to grow strongly, increasing by 19 per cent over the past year, to $1.2 trillion as at December 2005, with the assets of superannuation funds increasing particularly strongly (Graph 54).
Superannuation funds' (consolidated) assets increased by 22 per cent over the year to December 2005, to just over $500 billion. Recently, growth has been underpinned by both strong investment returns and new contributions (Graph 55). According to APRA data, most categories of superannuation funds recorded strong growth over the past year, though growth of industry and self-managed funds continued to outpace the rest of the sector: these funds together account for around 40 per cent of superannuation funds' assets, up from 15 per cent a decade ago (Table 13).
Consistent with developments elsewhere in the financial system, competition in the superannuation sector seems to have increased, although it does not appear to be as strong as in mortgage lending. A number of foreign-owned fund managers have begun offering low-cost ‘no frills’ superannuation products directly to consumers (rather than through financial planners) and have been able to gain market share, albeit from a low base.
Life insurers recorded strong profits in 2005, continuing the improvements of the previous two years. The life insurance industry, however, relies heavily on investment returns to generate profits, with policy payments once again exceeding premiums and contributions in 2005 (Graph 56). As noted in previous Reviews, the pressure on net insurance flows partly reflects the shift of superannuation assets away from life offices to superannuation funds. At the same time, life insurers have continued to increase the share of their portfolios invested in domestic equities – to around 51 per cent – and have benefited from strong share market gains in recent years. In line with the relatively favourable environment, most life insurers' ratings have remained stable at ‘A’ or higher in recent times.
Other Managed Funds
The combined (unconsolidated) assets of public unit trusts, cash management trusts, friendly societies and common funds increased by 19 per cent, to $290 billion, over the year to December 2005 (Graph 57). Much of this growth was in assets of unit trusts, reflecting strong gains in domestic and overseas equity markets, as well as in commercial property. Indeed, assets in the listed property trust sector increased by 18 per cent in 2005, to over $80 billion, as listed property trusts expanded offshore and into property development and construction. A notable aspect of this strong expansion has been an increasing use of debt to finance growth. As at end 2005, liabilities (excluding unitholders' funds) accounted for 39 per cent of assets, up from 28 per cent five years earlier, with debt securities now accounting for over 40 per cent of these liabilities.
See Reserve Bank of Australia (2005), ‘Box D: Estimates of Borrowing Capacity from Banks' Online Housing Loan Calculators’, Financial Stability Review, March. 
VaR models use the distribution of historical price changes to estimate the potential for future losses, relative to a confidence level. A confidence level of 99 per cent, for example, indicates a 99 per cent probability that losses will not exceed the VaR estimate on any given day, based on historical performance. 
See page 33 of the March 2005 Financial Stability Review for a further discussion.