Financial Stability Review – September 2006Financial Intermediaries
Consistent with the underlying strength of the domestic economy, Australian financial intermediaries continue to perform strongly. Banks are well capitalised and highly profitable and other financial institutions, including insurance companies, are recording generally positive results. Profitability in the banking sector continues to be supported by very low levels of bad debt expenses although mortgage arrears have increased recently, partly reflecting the general lowering of credit standards over the past decade. Competition remains very strong, and has recently intensified in lending to businesses, with business credit currently growing at its fastest pace since the late 1980s.
2.1 Deposit-taking Institutions
The Australian banking sector remains highly profitable. In the latest half year, aggregate before-tax profits of the five largest banks were around 10½ per cent higher than in the corresponding period a year earlier (Table 8). The annualised pre-tax return on equity for these five banks was 28 per cent, significantly higher than the outcomes over the past decade or so, although this increase largely reflects changes arising from the implementation of the International Financial Reporting Standards (IFRS) (Graph 32). Amongst other things, these changes have seen some hybrid capital instruments classified as debt, whereas previously they were classified as equity (see Box A). An alternative measure of profitability which is less affected by the accounting changes is the return on assets; this measure suggests that the recent outcomes are broadly in line with those recorded over the past decade or so.
The banking sector's strong profit growth has been associated with robust balance sheet expansion. Total assets on the domestic balance sheet of the banking sector increased by around 16 per cent over the year to June 2006, with the assets of foreign-owned banks growing particularly strongly, by around 25 per cent over the period. The composition of the balance sheet growth has, however, changed somewhat, with growth in business credit now exceeding that in household credit. Over the past year, banks' lending to businesses increased by 19 per cent. In contrast, on-balance sheet lending to the household sector grew by around 12 per cent over the same period, compared to annual growth of around 20 per cent at the peak of the housing market in 2003.
Banks' interest margins continue to be under downward pressure, although the accounting changes associated with IFRS make comparisons with the past difficult. In the latest half year, net interest income for the five largest banks was the equivalent of 2.3 per cent of their interest-earning assets (Graph 33).
Somewhat offsetting the pressure on margins, banks have benefited from stronger growth in non-interest income, particularly from wealth management activities. In the latest half year, wealth management income accounted for around 13 per cent of the five largest banks' total income, with other forms of non-interest income accounting for a further 28 per cent of total income (Graph 34). In the latest half year, income from wealth management was over 20 per cent higher than in the same period a year ago, partly reflecting increases in equity prices.
Lending and Competition
An important factor contributing to the erosion of net interest margins is the strong competition amongst lenders, and increasingly, amongst banks, for deposits. This strong competition has also been associated with a number of changes to lending practices. These changes have been particularly pronounced in the housing loan market and have been discussed at length in previous Reviews. They include: an increase in permissible debt-servicing burdens and loan-to-valuation ratios; an increased reliance on brokers to originate loans; the use of alternative property-valuation methods; and the wider availability of ‘low doc’ loans.
As growth in the demand for housing finance has slowed over the past couple of years, competition amongst lenders has remained intense, with many lenders attempting to maintain strong growth in their mortgage portfolios. The vast majority of new borrowers now pay less than the major banks' standard variable home loan indicator interest rate. While discounts are sometimes negotiated by customers, they are increasingly featuring in banks' product advertising. The average rate paid by new borrowers was around 60 basis points below the major banks' standard variable rate as of late 2005, compared to an average discount of 40 basis points two years earlier, and discounts of around 70 basis points are now common on loans for more than $250,000 (Graph 35).
Another notable development in the mortgage market has been the emergence of lenders that focus on direct distribution of housing loans via the internet or telephone. These online lenders (some of which are owned by banks) tend to have lower administrative and distribution costs than do many other lenders. As a result, they offer discounts as high as 125 basis points to the major banks' standard variable rate, although the range of home loans they offer is often relatively limited.
There have also been strong competitive pressures in the low-doc housing loan market. Low-doc loans involve a large element of self-verification in the application process, particularly around earnings, and are designed for those borrowers, such as the self-employed, who do not have the documentation required to obtain a conventional ‘full doc’ mortgage. The interest rate premium charged on these riskier loans has fallen substantially, with the margin between the average interest rate paid on new low-doc loans and that on full-doc loans falling from over 100 basis points five years ago, to around 50 basis points at the end of 2005 (Graph 36). In aggregate, low-doc loans are estimated to have accounted for just under 10 per cent of new housing loans in 2005. While these loans account for up to 30 per cent of some regional banks' housing loan portfolios, banks were generally later to enter this market than were a number of specialised non-bank lenders.
The competition in the mortgage market is being sustained, in part, through the ability of banks and non-banks to tap the capital market for attractively priced funding through the issuance of residential mortgage-backed securities (RMBS). The spreads that investors require to hold RMBS have fallen consistently in recent years. For example, AAA‑rated RMBS have recently been issued at spreads of around 15 basis points over the bank bill swap rate, compared to around 35 basis points a few years ago (Graph 37).
Another factor affecting competition in the housing loan market is the presence of third-party brokers. Amongst other things, brokers have allowed smaller, regional banks to compete more effectively outside their traditional geographical areas. Reflecting this change, regional banks have increased the share of their on-balance sheet housing loans to borrowers outside their home State to around 39 per cent, from around 32 per cent four years ago. In aggregate, around one third of new housing loans are originated through brokers, though this figure varies significantly across banks.
Robust competition in personal lending, particularly credit cards, is also evident. An increasing number of lenders, including each of the five largest banks, have begun offering low-rate credit cards with interest rates between 9 and 13 per cent, compared to around 17 per cent on traditional cards. These are often ‘no frills’ products, though some low-rate cards offering reward points have recently been introduced.
With housing lending growth having slowed considerably from its peak in early 2004, banks have refocussed their attention on lending to the business sector. Over the year to July 2006, bank business credit grew by 19.4 per cent, up from 10.6 per cent over the preceding year, and faster than the 16.2 per cent growth in bank housing credit (including securitisations) (Graph 38). Data from APRA's survey of bank business credit suggest that this strong growth was most pronounced in loans with a value of over $2 million, which are typically to large businesses and account for over 60 per cent of outstanding business lending (Table 9).
As in other segments of the loan market, increased competition in business lending has, in part, been spurred by newer entrants. Foreign-owned banks in Australia have been expanding their lending to businesses at a rapid rate recently, and have accounted for much of the increase in bank business credit growth so far this year (Graph 39). In addition, domestic banks are facing increased competition for lending opportunities from banks located offshore, with cross-border lending to Australian businesses increasing by nearly 30 per cent over the past year.
These competitive pressures are evident in narrower margins on business lending, with the spread between the weighted-average variable interest rate on small and large business loans having fallen by 17 and 15 basis points, respectively, over the year to June 2006. It is also evident in the latest survey of business lending conditions by JPMorgan and East & Partners, which reported that the number of businesses that recently experienced a fall in the margins they are charged by lenders considerably exceeded the number that experienced an increase (Graph 40).
One factor driving the compression of margins, particularly on loans to smaller firms, is a shift into lower-margin products, including loans backed by residential property. Another is the increasing share of business loans that are originated through brokers. Though precise data are unavailable, some observers have estimated that up to one quarter of small- to medium-sized borrowers are now accessing finance through this channel. As in the housing loan market, brokers often act as a conduit for competition by facilitating the capacity for borrowers to ‘shop around’ for a better deal.
Banks have responded to this environment in a number of ways, including by bolstering the number of business banking staff. Some banks are also seeking to speed up their processing of business loans, including by making greater use of automated approval techniques for certain types of borrowers.
Overall, robust competition and the associated changes in lending standards have resulted in borrowers having wider, and cheaper, access to finance than in the past. This is a welcome development from an efficiency perspective, provided that the compensation that lenders receive is commensurate with the risks they are taking on. An important issue in this regard is that many of the changes in pricing, lending standards and risk management have occurred against a favourable macroeconomic backdrop and are yet to be tested in more difficult times.
Credit Risk and Capital Adequacy
In aggregate, Australian banks' non-performing assets remain very low both by historical and international standards, an outcome that largely reflects the ongoing expansion of the domestic economy. As at June 2006, only 0.4 per cent of on-balance sheet assets were classified as non-performing (Graph 41). Of these non-performing assets, just under half were classified as ‘impaired’ – that is, assets on which payments were in arrears by more than 90 days or otherwise doubtful and the amount due was not well covered by the value of collateral. The remainder of these assets were in arrears, but were well covered by collateral.
While the aggregate arrears rate has been broadly unchanged over the past year, there have been divergent trends in the various segments of banks' loan portfolios. In particular, the arrears rate on business loans has continued to decline, while that on residential mortgages has increased (Graph 42).
As at June 2006, the arrears rate on business loans stood at 1.2 per cent, down from 1.4 per cent a year ago and 1.8 per cent three years ago. When bill financing is included, the current business arrears rate is lower still, at around 0.9 per cent. Within the commercial property loan portfolio, the arrears rate as at March 2006 was a low 0.2 per cent, while that on commercial lending for residential construction and investment was 0.5 per cent (Graph 43). While this latter figure has recently picked up slightly, it too remains low in absolute terms. These outcomes are consistent with the sound position of the business sector's aggregate balance sheet as described in The Macroeconomic and Financial Environment chapter.
In contrast to movements in business loan arrears, the arrears rate on banks' housing loans has edged up, although in absolute terms, and relative to historical experience, it remains low. Over the past two years, the share of housing loans on banks' balance sheets on which payments are past due by at least 90 days has increased by 0.13 of a percentage point, to stand at 0.3 per cent as at June 2006 (Graph 44). This higher arrears rate has not, however, translated into increased provisioning costs for banks. In addition, net write-offs on loans secured by real estate have fallen in both dollar terms and as a share of outstanding loans over the past few years for the four largest banks (Graph 45). In part, this very benign experience reflects the fact that, for many of their housing loans, banks can claim against their mortgage insurers for losses arising from foreclosures on defaulting borrowers.
The arrears rate on housing loans that have been securitised – by both banks and non-bank lenders – has also risen, with the increase being more pronounced than for loans on banks' balance sheets. As at July 2006, around 0.4 per cent of outstanding securitised loans were in arrears, up 0.23 of a percentage point on the level two years ago. This more pronounced increase is partly explained by a higher share of low-doc loans in the pool of securitised mortgages. The arrears rate on these loans has increased more markedly than that on full-doc loans, with 0.85 per cent of securitised low-doc loans in arrears (by at least 90 days) as at July 2006, compared to 0.35 per cent of full-doc loans. Another segment of the home loan market that has tended to have a higher arrears rate is interest-only loans, which have become more popular in recent years (see Box B).
As discussed in The Macroeconomic and Financial Environment chapter, the increase in housing loan arrears is not unexpected, given the structural changes in the housing loan market over recent years. These changes have seen credit become more freely available and, as a result, the average level of arrears is likely to be higher in the future than it has been over the past decade or so.
Australian-owned banks are also exposed to credit risk through their overseas operations, with foreign exposures increasing by around 11½ per cent over the past six months, to stand at $408 billion – equivalent to 28 per cent of total assets – as at June 2006 (Table 10). Over 90 per cent of the overseas claims of Australian-owned banks are on developed countries, and are concentrated in New Zealand and the United Kingdom. Exposures to these two countries are primarily the result of lending by branches and subsidiaries located there, rather than cross-border loans from Australian-based operations. As noted in the previous Review, the types of competitive pressures evident in Australia have also been a feature of the financial landscape in New Zealand and the United Kingdom. According to securitisation data, as in Australia, housing loan arrears have picked up in both these countries.
Australian deposit-taking institutions are well capitalised, with capital ratios that remain above regulatory minima. The aggregate regulatory capital ratio for the banking system was largely unchanged over the past six months, standing at 10½ per cent as at June 2006 (Graph 46). In contrast, the aggregate capital ratio for the credit union sector has steadily increased over recent years to over 16 per cent, while the aggregate ratio for the building society sector has declined marginally to around 14 per cent.
For banks, the highest-quality (Tier 1) capital was equivalent to just under 8 per cent of risk-weighted assets as at June 2006. This figure has been relatively constant over recent years, with retained earnings growing broadly in line with growth in risk-weighted assets. There has, however, been an increase in the share of innovative capital instruments such as hybrid securities – which have characteristics of both debt and equity – in Tier 1 capital. In the late 1990s, these instruments accounted for around 3 per cent of Tier 1 capital; today the figure is around 11 per cent (Graph 47). The Tier 2 capital ratio has also been relatively constant over recent years at around 3.6 per cent, with an increasing proportion accounted for by term subordinated debt.
Going forward, changes to APRA's prudential standards are likely to influence the composition of banks' regulatory capital. In particular, from 2008, innovative capital instruments will be restricted to 15 per cent of net Tier 1 capital (i.e. after Tier 1 deductions), down from the current limit of 20 per cent of gross Tier 1 capital (a limit that is equivalent to about 26 per cent of net Tier 1). In aggregate, banks' current use of such instruments is within this new limit, though some banks are likely to be materially affected by the changes. For these banks, an additional two-year transition period may be available.
Australian banks have traditionally had only small unhedged positions in financial markets. This is illustrated by the fact that the value-at-risk (VaR) – which measures the potential loss, at a given confidence level, over a specified time horizon – for the four largest banks was equivalent to 0.03 per cent of shareholders' funds in the latest half year (Table 11).
Consistent with this low exposure to market risk, Australian banks do not rely heavily on trading income for profitability. This form of income, in aggregate, accounted for around 5 per cent of total operating income of the five largest Australian banks in the latest half year, a share that has been stable over the past decade (Graph 48). In comparison, some of the large globally active banks derive as much as one third of their income from trading activities.
Funding and Liquidity
Bank credit growth has consistently outstripped growth in bank deposits for more than a decade. In large part, this reflects the fact that the household sector's strong demand for credit over the period has coincided with a decline in the share of household savings placed on deposit with banks. As a result, banks now source less than one quarter of their funding from retail deposits, compared to nearly 40 per cent in the mid 1990s (Graph 49).
At the same time, banks are competing more intensely and, hence, are having to pay more for traditionally low-cost retail deposits. In particular, many financial institutions are now offering the high-yield online savings accounts first introduced by some foreign-owned banks, beginning in the late 1990s. The average interest rate on these accounts is 5.8 per cent, only slightly below the current cash rate of 6 per cent. While these online accounts have added to the downward pressure on banks' net interest margins, they have also increased the attractiveness of bank deposits as a financial asset for the household sector. Bank deposits are currently growing at an annual rate of around 10 per cent, compared to rates of around 5 per cent per year over much of the 1990s. The higher return on these accounts may be one reason why survey evidence from Westpac and the Melbourne Institute shows that the proportion of households who view bank deposits as ‘the wisest place for savings’ has increased from around 10 per cent at the end of the 1990s to 21 per cent as at September 2006, though this share remains well below previous peaks.
Banks have used a variety of approaches to bridge the gap between retail deposit growth and lending growth. Some regional banks – as well as building societies and, to a lesser extent, credit unions – have made extensive use of securitisation markets over recent years. As a result, the ratio of securitised assets to on-balance sheet assets for Australian-owned banks, excluding the four largest banks, increased to 34 per cent as at June 2006, compared to 16 per cent four years earlier (Graph 50). In aggregate, however, the most notable change since the 1990s has been an increased reliance on foreign funding; foreign liabilities accounted for 27 per cent of total liabilities (on a domestic books basis) as at July 2006, up from 15 per cent 10 years ago.
Of these foreign liabilities, around 70 per cent are in the form of negotiable debt securities, primarily reflecting the issuance of offshore bonds and commercial paper by large banks (Table 12). A further 12 per cent are in the form of deposits from non-residents, while much of the remainder is accounted for by intra-group transfers. Foreign bank branches operating in Australia tend to make relatively more use of such transfers.
The majority of debt securities have been issued into the US and UK markets, though the locations of the ultimate holders of these securities are likely to be more disparate than these figures suggest (Table 13). Over 90 per cent of offshore debt securities have been issued in foreign currencies, with the US dollar the largest individual currency of denomination. The preponderance of foreign-currency denominated debt has not, however, exposed the banking system to significant foreign-currency risk, with most of this risk fully hedged, or offset by foreign equity holdings.
Banks manage their liquidity risks, in part, through holding liquid assets. Over the past few years, the ratio of highly liquid assets – mainly government and bank-issued securities – to total assets has remained stable, at around 11 per cent (Graph 51). The proportion of these assets that can be used in repurchase agreements with the Reserve Bank has also been broadly steady since the eligibility criteria were expanded in March 2004. APRA's prudential guidelines require certain banks to use a scenario-based approach to show that they would be able to meet their payments for five days under adverse conditions.
Financial Markets' Assessment
Since the previous Review, the bank share price index has tended to move in line with the broader market, to be around the same level as in March 2006 (Graph 52). As in financial markets more generally, market-based indicators of banking sector performance have been more volatile over the past six months than has been the case in recent years. Expectations of future volatility of banks' share prices, implied from options price data, rose somewhat between May and July, but subsequently returned to around the low levels of six months ago (Graph 53).
Market-based indicators of bank credit risk have also edged up over the past six months, although they remain low. The spread between bank bond yields and swap rates has increased marginally over this period, though it remains low by the standards of recent years (Graph 54). There has been a similar modest rise in the premia on credit default swaps over subordinated debt. In contrast, credit default swap premia on banks' senior debt continued to drift downwards.
Rating agencies also continue to view the banking sector favourably, with Standard & Poor's, for example, maintaining a ‘AA-’ rating for each of the four largest banks. In addition, in the past six months, the long-term rating of BankWest was raised one notch by Standard & Poor's, to AA‑, while HSBC Bank Australia was upgraded a notch by both Moody's and Standard & Poor's. Moody's also upgraded St George Bank's long-term rating to A1 (Table 14).
2.2 General Insurance
The general insurance sector has, in aggregate, been very profitable in recent years. According to APRA data, the annualised before-tax profit of general insurers was $6.5 billion in the first three quarters of 2005/06, with return on equity equal to 25.8 per cent (Graph 55). While the aggregate return on equity was around 2 percentage points lower than in the previous financial year, it remained above the average return recorded over the past five years of just over 21 per cent.
Investment revenue accounted for nearly three quarters of aggregate before-tax profit, with general insurers benefiting from the strong gains in equity markets over the period (equities account for 34 per cent of general insurers' financial assets). The industry is also enjoying a relatively favourable claims environment. While the combined ratio – claims and underwriting expenses as a ratio to net premium revenue – has risen to around 90 per cent, it remains low by the standards of recent years. Cyclone Larry, which hit north Queensland in March, does not appear to have had a significant effect on general insurers' profits – insured losses from the cyclone are estimated at around $425 million, which is well within the provisions that insurers hold for such claims.
Like other parts of the financial sector, competitive pressures are having an impact on the general insurance industry and are likely to add to downward pressure on premiums going forward. Recently, premiums have come under the most pressure in some commercial business lines, including public and product liability and professional indemnity insurance. In public and product liability insurance, for example, APRA estimates that premiums fell by around 13 per cent in 2005. In personal insurance lines – where general insurers earn roughly half of their premium revenue – growth in net premium revenue was slower than the growth in net claims in 2005 (Graph 56). Moreover, premium rates have reportedly fallen in some personal insurance lines, including compulsory third-party motor vehicle insurance.
Domestic general insurers, in aggregate, have also continued to build up their capital buffers, with direct insurers holding nearly 2½ times the regulatory minimum level of capital as at December 2005, compared to 2.2 times a year earlier.
Rating agencies have maintained their positive view of the general insurance industry in Australia, with each of the five largest insurers – which together account for just over 40 per cent of industry assets – rated ‘A’ or higher by Standard & Poor's. In the past six months, Standard & Poor's upgraded the second largest insurer, Allianz Australia, from A to A+, while Fitch Ratings revised QBE's outlook from stable to positive. General insurers' share prices have marginally outperformed the broader market over the past six months and are slightly higher than in March (Graph 57).
Most domestic insurers use reinsurance to offset some of their risks, with around 20 per cent of gross claims in 2005 recovered through reinsurance. This cover is typically provided by the subsidiaries of a small number of large global reinsurers which have faced mounting weather-related losses in recent years – insured natural catastrophe losses in 2005 were estimated at a record of around US$80 billion, of which around half was expected to be covered by the reinsurance industry. While there is evidence that the reinsurance industry is seeking to recoup some of these losses through higher premiums, it appears that premium increases have largely been confined to the regions and business lines most affected by natural catastrophes. Despite the more difficult conditions, the largest global reinsurers have maintained their relatively high ratings, and Standard & Poor's has recently reaffirmed its stable outlook for the reinsurance industry. This is consistent with the strong profit results recorded by some of the large reinsurers in the recent half year.
2.3 Wealth Management
The wealth management sector continues to record rapid growth, with total (consolidated) assets under management increasing by around 18 per cent over the year to June 2006, to stand at just over $1 trillion (Table 15). Superannuation funds account for 53 per cent of funds under management and, as for much of the past few years, recorded the strongest growth over the recent period.
Superannuation funds' (consolidated) assets increased by 22.4 per cent over the year to June 2006, to stand at $545 billion. While the majority of recent growth has come from buoyant investment returns, net contributions have also been strong, averaging $14.3 billion per quarter over the year to March 2006 – the highest on record (Graph 58). By fund type, industry and self-managed funds have recorded the strongest growth in assets under management over recent years. These funds, together, account for nearly 40 per cent of industry assets, compared to around 23 per cent five years ago (Graph 59). At the same time, there has been a decline in the share of total superannuation assets held in public sector and corporate funds.
A recent influence on the superannuation industry is the new licensing regime, under which all trustees operating after 1 July 2006 are required to be licensed by APRA. The transition to this regime appears to have accelerated the trend towards consolidation within the superannuation industry that has been under way for a number of years. The number of APRA-regulated superannuation funds fell from 12,285 in 2001 to 8,732 in 2005, a decline of nearly 30 per cent.
Life insurers performed well in the latest financial year, with industry assets growing by $28 billion (on an annualised basis) in 2005/06, nearly double the increase in the previous financial year (Graph 60). As in the previous two years, this outcome was solely due to higher investment returns, with policy payments again outstripping premiums and contributions. With over half of their total assets invested in domestic equities, life insurers have benefited from the strong share market gains in recent years. An ongoing challenge for the life insurance industry is that households are shifting relatively more of their retirement savings into superannuation funds, away from life insurers; life offices currently manage around 22 per cent of total superannuation assets, down from 36 per cent a decade ago.
Other Managed Funds
The combined (consolidated) assets of other managed funds – including public unit trusts, friendly societies, common funds and cash management trusts – increased by nearly 20 per cent over the year to June 2006, to $279 billion, continuing the run of strong gains over the past few years (Graph 61). By fund type, assets held in public unit trusts contributed the vast bulk of growth in aggregate assets of other managed funds, mainly reflecting the strong performance of share markets and rising commercial property prices; 57 per cent of public unit trusts' total assets are held in equities and a further 28 per cent are held in property.
See Reserve Bank of Australia (2006), ‘Box B: Competition in Household Lending in New Zealand and the United Kingdom’, Financial Stability Review, March.