Financial Stability Review – March 2006
Recent developments have been largely favourable from a financial stability perspective. With the world economy continuing to expand strongly, financial systems in most countries are in good shape. In Australia, the banking system remains well capitalised and highly profitable, with bad debt levels that are low by both historical and international experience.
Notwithstanding these favourable outcomes, there continue to be a number of puzzles regarding the pricing of risk in the financial system. In global capital markets these include the persistence of low long-term bond yields and compressed credit risk premia. Both these phenomena reflect, in part, the ex ante excess global supply of saving over investment and an associated ‘search for yield’. They also reflect an apparent optimism by investors that inflation will remain low and economic conditions will remain generally stable.
This optimism is also presumably behind the willingness of some investors to take on more leverage and purchase a wider range of financial assets. Examples of this include a resurgence of leveraged buy-out activity in the United States and Europe, very strong growth in assets managed by hedge funds and the enthusiasm of investors for structured finance products. These developments can promote efficiency and risk sharing in the financial system. But the willingness of market participants to price risk ever more finely may rest heavily on the assumption that the macroeconomy, inflation and asset prices will prove to be more stable than in the past. While the current environment of very low volatility may continue, experience suggests that when economic outcomes are consistently favourable over a run of years, investors tend to underestimate, and thus underprice, risk. It would therefore be surprising if there were not at least some element of this type of myopia in financial markets currently.
So far, however, the global financial system has comfortably ridden-out a number of tests of market sentiment. There had been considerable anxiety, for example, that when the US Federal Reserve started raising interest rates, there would be a damaging snap-back in the prices of a range of financial assets. In the event, financial markets responded sanguinely to increases in the US federal funds rate. Similarly, the ‘flight to quality’ that some had feared following the downgrading of a number of high-profile corporate bonds has not occurred.
On the domestic front, the Bank is continuing to pay close attention to household balance sheets. During the period in which house prices and housing credit were increasing at rates of around 20 per cent per annum, the concern was that should growth continue at an unsustainable pace, it could pose significant risks to the stability of the economy. The change of sentiment that occurred at the end of 2003, however, generated a slowdown in household credit growth and a more subdued housing market, with prices at the national level moving sideways. The issue is thus less one of unsustainably fast growth in house prices and household debt, than of the implications of the much higher level of debt that has resulted from more than a decade of strong credit growth.
To date there are few signs that the household sector is struggling with higher levels of debt and interest payments relative to income. While the rate of housing loan arrears has picked up slightly, it remains low by historical standards, and surveys give no indication that households are viewing their finances any less favourably than for much of the past decade or so. Households do, however, seem to be taking a slightly more cautious approach to their finances, with some banks reporting an increase in loan repayment rates. More generally, household spending now appears to be increasing more slowly than growth in household income, after a number of years in which the reverse was the case.
Looking forward, it is difficult to establish benchmarks as to when credit growth and/or debt levels are ‘too high’ or ‘too risky’. A significant number of households still carry little or no debt, and in the years ahead might choose to borrow more. Attitudes towards borrowing also appear to be changing, with people becoming more willing to borrow against assets later in life. As a result, although household credit growth is high relative to that in a number of other countries, it is not necessarily the case that the current pace is unsustainable.
One consequence of the slower pace of household credit growth over the past couple of years has been an intensification of competition amongst Australian financial intermediaries, particularly in lending for housing. As has been discussed at some length in previous Reviews, banks and non-bank lenders have moved away from many traditional lending practices. In particular, lenders now allow much higher debt-servicing and loan-to-valuation ratios, make low-doc loans which incorporate a large element of self-verification in the application process, and provide housing loans to borrowers with impaired credit histories. As a result, many households have obtained cheaper and more flexible finance.
While this greater competition is generally to be welcomed, lenders and investors have had no experience with how a household sector with current levels of debt is likely to behave in less favourable economic circumstances. Similarly, they have had little, or no, experience with how some of the newer types of loans are likely to perform in weaker conditions. In these circumstances, it is important that both borrowers and lenders recognise that the benign credit environment of the recent past may not be the best guide as to how the future unfolds.