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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2007

The Australian Financial System

Financial institutions in Australia continue to report high levels of profitability and strong capital positions. In the banking sector, non‑performing loans remain at low levels and balance sheets have expanded strongly over the past year, particularly as a result of a pick-up in business credit growth. Profitability also continues to be supported both by restraint in costs and solid growth in income from funds management activities. Reflecting these positive developments and the ongoing strength of the Australian economy, the average credit rating of both banks and insurance companies has increased over the past couple of years.

Notwithstanding these favourable outcomes, the strained conditions in the global financial system, particularly since early August, have also been evident in Australian financial markets. Given the generally healthy state of financial institutions in Australia, and the balance sheets of both businesses and households, these strains have been largely the result of the global repricing of risk, rather than concerns about the credit quality of Australian institutions or mortgage-backed securities.

As has been the case internationally, the funding costs for banks (particularly at shorter maturities) increased appreciably in August and early September, conditions in the market for asset‑backed commercial paper became markedly tighter, and financial institutions have been keen to preserve high levels of liquidity. More generally, credit spreads have widened for all borrowers and volatility increased notably in a range of markets. Banks’ share prices also fell, although less so than in a number of other countries, reflecting the relatively high credit quality of the Australian banks and their limited direct exposure to the sub‑prime problems in the United States.

This chapter of the Review first discusses recent developments in funding conditions in Australia and the increased volatility in financial markets and then discusses broader balance‑sheet developments for banks and insurance companies.

Funding Conditions and Credit Markets

In line with the tightening of conditions in global credit and money markets, short-term funding costs for banks in Australia have risen substantially since early August, as have yields on asset-backed commercial paper. In the first half of August, banks reported a significant rise in the cost of raising short-term funds offshore, with the three‑month Australian-dollar LIBOR rate – the benchmark rate for their offshore funding – rising by more than 50 basis points, to a peak of 7.2 per cent. Yields also rose significantly in domestic markets, with yields on three-month bank bills rising above 7 per cent in early September (Graph 15). This rise meant that the spread between the yield on three-month bank bills and the overnight index swap rate for the same maturity reached around 50 basis points. While this spread is historically high, it has remained lower than equivalent spreads in major overseas markets. Over the past week, yields on bank bills have fallen as more settled conditions have returned to global money markets, with three-month bank bill yields currently standing at 6.84 per cent.

As has been the case in international markets, conditions have been particularly difficult in the asset‑backed commercial paper (ABCP) and residential mortgage‑backed securities (RMBS) markets. As at end June 2007, there was around $70 billion of rated ABCP issued by Australian entities outstanding (with around one half of this issued onshore). Around half of this paper is directly backed by prime housing loans. Up until quite recently, it was possible to issue ABCP in Australia at a margin of 2 to 5 basis points over the bank bill rate. In contrast, recent issues have been at 30 to 40 basis points over the bank bill rate which, as noted above, has itself risen significantly. Even at these higher rates, a number of issuers have had difficulties rolling over maturing paper and have had to rely on the lines of credit provided by banks to repay the maturing debts. Where paper has been able to be issued, it has typically been for a shorter maturity than was the case up until recently. (Box A provides more information on the Australian ABCP market.)

The difficulties in the ABCP market have been compounded by a sharp decline in investor appetite for RMBS, even those of the highest credit quality. Over recent years there has been strong demand for these securities, both domestically and internationally. This has been reflected in a decline in the spread between the yield on the AAA-rated tranches of RMBS and the bank bill swap rate from around 35 basis points in 2003 to around 15 basis points in mid 2007, and a sharper decline still in the spreads on the lower-rated tranches (Graph 16). In contrast to the consistently strong volume of issuance in recent years, there have been no issues of RMBS since mid July. The increase in risk aversion, and the existence of considerable uncertainty about where the spreads on these securities will eventually settle, has meant that traditional investors in RMBS have preferred to wait until more settled conditions return.

The use of the RMBS and ABCP markets varies significantly across the many mortgage lenders in Australia. Non-bank lenders finance almost all their loans through these markets, with those that have relied heavily on rolling over ABCP, rather than issuing long-dated RMBS, experiencing the more severe liquidity pressures. In contrast, the largest banks make relatively little use of securitisation markets, with the securitised loans of these banks accounting for just 7 per cent of their housing loans outstanding (although they do provide back-up lines of credit to the issuers of ABCP) (Graph 17). Among the other banks operating in Australia, the reliance on these markets varies considerably, although a number of these banks finance more than half their loans through securitisation.

Given the much tighter conditions in credit markets, both the Australian Prudential Regulation Authority (APRA) and the Reserve Bank recently stepped up their monitoring of liquidity and funding of both institutions and markets. It is clear that the tighter conditions in the ABCP and RMBS markets contributed to a significant tightening in funding conditions for all financial institutions, but particularly for those that rely heavily on these markets, or provide significant back-up lines of credit to issuers of ABCP. While the four largest banks are estimated to have in place lines of credit to rated ABCP issuers of $24 billion, this is equivalent to only 2.2 per cent of their risk-weighted assets.

Some loans financed via conduits have been brought back onto banks’ balance sheets and more may be brought back in the period ahead. However, unlike banks in some other countries, the difficulties have not been compounded by large exposures to private equity and leveraged buyout deals; a number of overseas banks have had to retain sizeable business loans on their balance sheets owing to the problems some private equity funds have had in raising debt in capital markets.

The large Australian banks continue to be able to issue securities in overseas markets, although at higher spreads than was the case a few months ago. Offshore markets have become increasingly important to these banks over the past decade, with foreign liabilities currently accounting for around 27 per cent of all banks’ total liabilities, compared with about 15 per cent in the mid 1990s (Graph 18). The available data indicate that around one third of outstanding offshore debt securities were issued with an initial term to maturity of less than one year, with this share having risen since 2005 (Graph 19). As noted in previous Reviews, the foreign exchange risk associated with foreign borrowings is typically fully hedged, so that movements in the exchange rate do not affect the cost of funding. Nonetheless, the higher spreads in these offshore markets, if sustained, will have a noticeable effect on the cost of funding for these banks. This is notwithstanding the fact that some banks have benefited from increased deposit inflows, as some investors liquidated other investments.

Like many other central banks, the Reserve Bank responded to the sharp increase in the demand for liquidity around mid August by increasing the aggregate supply of exchange settlement balances. After the Bank significantly increased the scale of its operations in domestic markets, these balances peaked at around $5½ billion in mid August, and have averaged $4 billion since then, compared with average balances of $750 million over recent years (Graph 20). These operations have meant that the cash rate has remained very close to its target of 6.50 per cent through this period. This is in contrast to the experience of some other countries where the relevant interest rates have moved considerably away from the level targeted by the central bank.

As noted above, while these operations have kept the cash rate – which is the rate for overnight unsecured borrowing – very close to the target, inter-bank lending rates for longer maturities have increased significantly. In part, this reflects the concerns that financial institutions have regarding their future liquidity needs and thus their desire to ‘lock in’ term funding so as to avoid the relatively risky strategy of funding a significant share of their balance sheet by rolling overnight inter-bank funds. While borrowers have sought slightly longer-term funding, lenders have been reluctant to lend for these longer terms.

In an environment where the future calls on bank-provided lines of credit are uncertain, institutions have a preference for maintaining high levels of liquidity. Over recent years, banks’ holdings of liquid assets have averaged around 13 per cent of total assets, with a little over half of these assets being eligible for repurchase transactions (repos) with the Reserve Bank as part of its market operations (Graph 21). These repo-eligible assets have included Commonwealth Government securities, securities issued by State and Territory borrowing authorities, securities issued by certain supra-national and foreign government agencies and bills and certificates of deposit (CDs) issued by some Australian banks. As conditions tightened in mid August, a number of banks issued bank bills to one another to generate additional repo-eligible assets, and the Reserve Bank’s holdings of bank bills under repurchase agreements increased significantly. This use of the bank bill market to generate liquid assets has added to the upward pressure on bank bill rates, particularly given the credit limits that banks impose on one another.

On September 6, the Reserve Bank announced that the list of securities eligible for repurchase transactions would be widened. In future, eligible securities include all bills and CDs issued domestically by any ADI which holds an exchange settlement account, certain Australian dollar bonds issued by ADIs, and top-rated RMBS and ABCP backed by prime, domestic ‘full doc’ residential mortgages.

The increase in market interest rates over recent months has meant that all lenders have experienced an increase in their funding costs. The increases in costs are particularly significant for those lenders that are heavily reliant on the securitisation markets for funding. A number of these lenders have already announced increases in their lending rates, most notably for low-doc and non-conforming loans. To date, however, no lender has increased its indicator rate on prime full-doc loans, although some lenders have reduced the size of discounts that they offer new borrowers, and have tightened lending criteria (for further details see below).

Other Financial Markets

The difficulties in credit markets and the associated increase in risk aversion led to a significant increase in volatility in a number of financial markets in mid August (Graph 22). The Australian dollar depreciated sharply in the first half of August, as the general rise in global risk aversion triggered an unwinding of carry trades. The depreciation was especially large against the Japanese yen, with the AUD/JPY exchange rate falling by around 11 per cent in mid August. Since that time, the Australian dollar has tended to appreciate; on a trade-weighted basis it is around 8 per cent higher than in mid August, and around 1 per cent lower than its level in late July.

Bond markets have also been more volatile than in the recent past, although unlike in the United States there has not been a flight to short-term government bonds; despite this volatility, there has been little net change in the level of bond yields since mid August. The stock market was also characterised by considerable volatility in August, with daily volatility reaching its highest level since December 1997. Like the Australian dollar, the equity market was weakest in mid August, with the decline from the peak in late July equal to around 12 per cent. Since mid August, the market has tended to strengthen, and is currently only just below its July peak.

The share prices of the Australian commercial banks also declined in mid August, although they have subsequently increased and are around 5 per cent higher than at the beginning of the year; in contrast, share prices of similar banks in the United States are about 5 per cent lower over this period (Graph 23). The Australian commercial banks have slightly underperformed the broader market since mid July. Equity market analysts expect financial institutions’ earnings growth to remain strong, with earnings per share forecast to grow by around 10 per cent over the current financial year, and 8 per cent in 2008/09. The share prices of Australian institutions which focus on investment banking have faired less well; they are generally a little lower than they were at the beginning of the year, but have outperformed their US counterparts.

Credit default swap premia for Australian commercial banks have also risen quite sharply, although this is likely to reflect primarily a change in the required compensation for risk, rather than a fundamental re-evaluation of the probability of one of these banks defaulting. The increase in these premia has again been less than for equivalent banks in many other countries (Graph 24).

Deposit-taking Institutions

Profitability

The recent strains in financial markets have occurred against a backdrop of an Australian banking system that is highly profitable. The five largest banks recorded aggregate pre-tax profits of around $13.6 billion in the latest half year, an increase of 13.5 per cent compared with the same period a year earlier (Table 1). The annualised pre-tax return on equity was 28.1 per cent, slightly higher than the 2006 full-year result and around the average of the past decade or so (after adjusting for a change in accounting standards) (Graph 25).

The banking sector’s strong performance continues to be underpinned by robust balance sheet expansion, with total assets (excluding intra-group activities) on banks’ domestic books increasing by around 18 per cent over the year to July 2007. This mainly reflects the ongoing strength of domestic lending, particularly to the business sector, with the assets of foreign-owned banks growing particularly strongly (Graph 26).

The effect of lending growth on bank profits has been partly offset by declining interest margins. The ratio of net interest income to average interest-earning assets for the five largest banks fell by a further 6 basis points in the latest half year, to 2.2 per cent (compared with 3.9 per cent in the mid 1990s) (Graph 27). For much of the past decade, the effect of declining margins on profitability has been partly countered by a rising share of income from wealth management operations. This form of income rose by 21 per cent over the past year, underpinned by solid growth in funds under management, and now accounts for nearly 15 per cent of the five largest banks’ total income, compared with 9 per cent five years ago. Growth in profits has also been supported by slower growth in costs than in assets, with the aggregate cost-to-income ratio falling further in the latest half year, to 45 per cent. Banks have also benefited from a decline in bad debts expense over recent years to very low levels, although the declining trend seen since 2001 appears to have come to an end, largely due to a modest increase in bad debts expense for household loans (see below). Over the most recent years, the ratio of bad debts expense to total loans was 0.2 per cent, around half the level seen earlier this decade (Graph 28).

Credit Risk and Capital Adequacy

Credit Risk

In aggregate, the asset quality of Australian banks remains sound. As at June 2007, the ratio of banks’ non-performing assets to on-balance sheet assets stood at 0.5 per cent, a slight increase over the past six months, but still low by historical and international standards (Graph 29). Of these non-performing assets, less than half are classified as ‘impaired’ – that is, repayments are in arrears (or otherwise doubtful) and the amount owed is not well covered by collateral. The remainder are considered to be well covered by collateral, though payments are in arrears by 90 days or more.

The modest increase in non-performing assets is largely accounted for by a rise in the ratio of non-performing housing loans to total housing loans. In aggregate, 0.41 per cent of housing loans on banks’ domestic balance sheets were non-performing as at June 2007, up from the very low level of 0.2 per cent four years ago (Graph 30). Around three quarters of these loans are considered by banks to be well covered by the value of collateral. While almost all banks have experienced an increase in non-performing housing loans, the increases have been most pronounced for the foreign-owned and regional banks (Graph 31). This is consistent with the relatively rapid growth of lending by these banks in recent years which, in some cases, has been associated with lending to more marginal borrowers than in the past.

The arrears rate on business loans has also picked up slightly over the past six months, although, at 0.95 per cent as at June 2007, it remains low, and below the average of recent years. Problem loans in banks’ commercial property portfolios are also low, with only 0.2 per cent of outstanding commercial property loans classified as impaired as at March 2007. This compares with 1.9 per cent in 1997, and a much higher figure in the early 1990s (Graph 32).

Banks are also exposed to credit risk through their operations overseas. Total foreign exposures grew by 9 per cent over the six months to June 2007, largely due to an ongoing expansion of activities in New Zealand and the United Kingdom (Table 2). These two countries account for 45 per cent and 25 per cent of total foreign exposures, respectively, mainly reflecting the activities of Australian branches and subsidiaries rather than cross-border lending. Exposures to the United States account for a further 10 per cent of foreign claims, with Australian banks’ US-located operations focusing on institutional and business banking, rather than lending to the household sector. More generally, Australian banks have only minimal exposures to the US sub-prime mortgage market and any exposures are generally through indirect channels, such as lines of credit to funding vehicles.

Capital Adequacy

Australian banks and other ADIs remain well capitalised. The aggregate capital ratio for the banking system has fluctuated in a narrow range over the past decade or so, and stood at 10.4 per cent as at June 2007 (Graph 33). The aggregate capital ratio of the credit union sector has increased over recent years and is around 16 per cent, while the aggregate ratio of the building society sector has fallen slightly, to 13.5 per cent.

For banks, the Tier 1 capital ratio has been broadly stable for some time, at 7.5 per cent, and remains well above international minimum requirements. There has, however, been a slight change in the composition of Tier 1 capital in recent years, with an increasing share accounted for by innovative capital instruments, including hybrid securities (Graph 34). The Tier 2 capital ratio has increased slightly in recent years, largely due to term subordinated debt increasing at a faster rate than risk-weighted assets. As discussed in the Developments in the Financial System Infrastructure chapter, the combination of APRA’s revised capital adequacy framework – which comes into effect from 1 January 2008 – and the recent changes to accounting standards is likely to affect the composition of capital going forward. Among other things, these changes will impose limits on banks’ use of innovative hybrid funding instruments, though an additional two-year transition period may be available for banks that are affected by this change.

Market Risk

Australian banks have traditionally had only small unhedged positions in financial markets. This is demonstrated by the fact that the value-at-risk – which measures the potential loss, at a given confidence level, over a specified time horizon – for the four largest banks has been broadly stable at around 0.05 per cent of shareholders’ funds for the past five years. Consistent with this low exposure to market risk, Australian banks are not heavily reliant on trading income for profitability. This form of income accounted for only around 5 per cent of total operating income of the four largest Australian banks in the latest half year, which is considerably lower than for some of the large globally active banks (Graph 35).

Notwithstanding this low exposure, banks have been very active in the growth of derivative markets, which they use both to provide risk-management services to their clients as well as to manage risks on their own balance sheets. An indication of the overall growth in banks’ derivatives activity is provided by the gross notional principal value of their outstanding derivatives, which has risen from a little over $2 trillion in the mid 1990s to $12 trillion as at June 2007 (Graph 36).

Recent events in credit markets have focused attention globally on banks’ use of credit derivatives in particular. In Australia, this market remains relatively small by international standards, despite rapid growth over the past few years. According to the Australian Financial Markets Association, there was $77 billion of credit derivatives outstanding in the Australian market as at June 2006, with banks accounting for around two thirds of annual turnover in this market. Despite this, credit derivatives account for only a small share – around 1 per cent – of banks’ outstanding derivatives positions.

Lending and Competition

As noted above, recent events in credit markets are leading to higher funding costs for financial intermediaries, with the increases being greatest for those intermediaries that rely on securitisation markets. To the extent that this differential impact on funding costs is sustained, as seems probable, it is likely to have an impact on competition in the mortgage market over the period ahead. Over recent years, this competition has led to a marked contraction in loan margins and significant changes in lending practices, including: an increase in permissible debt-servicing ratios; an increased reliance on brokers to originate loans; the wider availability of low-doc loans; and an increase in allowable loan-to-valuation ratios. As a result of this competition, the vast majority of new full-doc borrowers over recent years have been charged an interest rate less than the major banks’ standard variable home loan indicator rate, with discounts of 70 basis points having become common. The strong competition has also been reflected in a high rate of refinancing, which has led to sustained pressure on margins on banks’ outstanding housing loans.

The pressures on margins over recent years have been especially strong in the low-doc market. Late last year, the interest rate on new low-doc loans was, on average, around 20 basis points higher than the average rate on full-doc loans, compared with 90 basis points in late 2002. This meant that the average interest rate on low-doc loans was around 45 basis points below the major banks’ standard variable indicator rate, whereas earlier in the decade it was common for lenders to charge a premium over the indicator rate for these loans. Currently, low-doc loans account for around 10 per cent of new housing loans, though this share is significantly higher for some non-bank lenders and some smaller ADIs (Table 3).

One factor that sustained this competition was the narrowing of spreads on residential mortgage-backed securities. The willingness of investors to purchase these securities at ever finer spreads allowed lenders that rely on securitisation for their funding to offer lower interest rates to borrowers. The global repricing of risk is putting upward pressure on these funding costs. A number of lenders in the low-doc market that rely heavily on securitisation markets have already responded to the higher funding costs, increasing their rates on low-doc loans, not just for new borrowers, but also for existing borrowers. Lenders that rely on more traditional and diversified sources of funding have felt less immediate need to increase their rates and, in at least one case, have sought to expand their low-doc lending portfolio.

The higher funding costs have also caused a number of providers of non-conforming loans (the closest equivalent to the US sub-prime mortgage market) to increase their rates by more than the recent 25 basis point rise in the cash rate; the three largest non-conforming lenders (all non-ADIs), which account for over 70 per cent of the market, have increased their rates by up to 90 basis points. The market for non-conforming loans in Australia remains small, with this form of lending accounting for only around two per cent of new housing loans in 2006, and one per cent of outstanding loans; specialised non-bank lenders account for almost all of these loans.

While lower funding costs have been an important factor promoting competition in the Australian financial system over recent years, another factor has been the increased activity of foreign-owned banks in the retail market.1 This activity has been facilitated, in part, by the more widespread distribution of banking services via the internet. In the late 1990s, foreign-owned banks introduced high-yield online savings accounts, significantly increasing competition in deposit markets. Initially, the major Australian banks were reluctant to offer such accounts, although they all have done so over recent years and there is now a wide variety of online accounts that pay an interest rate at, or close to, the cash rate. Foreign-owned banks have also recently added to competition in the mortgage market, with these banks experiencing above-average growth in housing credit and one foreign-owned bank recently announced plans to significantly expand its branch network (Graph 37).

Strong competition has also been evident over recent years in the personal lending market, especially in credit cards. Most issuers, including the five largest banks, now offer low-rate cards with interest rates in the range of 9 to 14 per cent, compared with 17½ per cent on traditional cards. Reflecting the competition from smaller institutions – including non-banks and foreign-owned banks – the market share of the five largest banks has fallen to around 72 per cent of outstanding credit card debt, from nearly 85 per cent five years ago. As discussed in the Household and Business Balance Sheets chapter, margin lending is another component of personal credit that has grown particularly strongly of late. This reflects not only the generally strong performance of the equity markets, but also the stronger competitive environment which has seen an increase in the range of securities eligible for purchase with a margin facility, and an increase in the maximum allowable loan-to-valuation ratio on ‘blue chip’ shares from around 70 per cent to 75 per cent.

Another notable characteristic of the recent competitive environment has been an increase in competitive pressures in the business loan market. Bank business credit grew by 20 per cent over the year to July 2007, compared with 13 per cent growth in bank credit (including securitisation) to households (Graph 38). Growth has been strongest in loans with a value greater than $2 million, with the total value of these loans increasing by around 31 per cent over the past year, and now accounting for around two thirds of total business loans outstanding. Average spreads on these large loans have also continued to fall over recent years, while spreads on smaller loans have changed little.

The rapid growth of large-sized loans is consistent with a significant amount of business debt having been raised in the syndicated loan market. A record $124 billion of syndicated loans were approved in 2006/07, an increase of 48 per cent compared with the previous year (Graph 39). Refinancing accounted for just under 40 per cent of syndicated loan approvals over the past two years, compared with an average of 30 per cent over the preceding decade, suggesting that borrowers have taken advantage of the favourable funding conditions during this period to obtain more attractive rates. A further 26 per cent of syndicated loans approved in the past year were to finance mergers and acquisitions.

As noted in the previous Review, competition in business lending has been spurred by a number of factors, including the activities of some more recent entrants into the market. Foreign-owned banks, for example, increased their share of total bank business loans outstanding to 21 per cent as at June 2007 from 17 per cent two years ago, after a couple of years of below-average growth. The recent increase reflects the prominence of foreign-owned banks in the market for large-value business loans, with their share of this segment rising to around 28 per cent (Graph 40).

In the market for smaller-value business loans, an important contribution to the increase in competition has been the growth of business loan brokers. Although precise data are unavailable, indications are that broker-originated lending has grown strongly recently, albeit from a low base, with some observers estimating that more than 20 per cent of SMEs now access finance through this channel. At the same time, banks are making greater use of automated approval systems for certain types of loans in order to help streamline the processing of business loans. Banks have also increased the number of business banking staff in recent years.

At this stage it is too early to fully assess the impact of the recent credit market turbulence on business lending growth and competition. There is, however, likely to be some tightening of the very favourable funding terms enjoyed by businesses in recent years.

Credit Ratings

Throughout the recent turbulence, rating agencies have continued to take a positive view of Australian banks, having issued a number of statements to this effect. The four largest banks were upgraded by Standard & Poor’s in February to AA, from AA- (Table 4). Internationally, very few banks of a similar size have higher credit ratings. Moody’s has also maintained its financial strength ratings of the Australian banks which, unlike long-term credit ratings, do not take account of the possibility of external support. As discussed above, this is consistent with the sound underlying condition of Australian banks, with problem loans remaining low by historical and international standards, and profitability having been very strong for more than a decade.

General Insurers

The general insurance industry, in aggregate, remains highly profitable. Pre-tax return on equity was 27 per cent in the 2006/07 financial year and, while this was slightly lower than in the previous year, it was above its decade-average of 14 per cent (Graph 41).

Insurers have continued to benefit from a relatively favourable claims environment. Aggregate claims increased by only around 2 per cent in the latest financial year, notwithstanding estimated insured losses in excess of $1 billion from the severe storms that hit coastal New South Wales in June. Reflecting this, the combined ratio – claims and underwriting expenses relative to net premium revenue – has remained relatively stable and stood at 84 per cent over the year to June 2007.

The general insurance industry, in aggregate, continues to hold capital considerably in excess of regulatory minima. As at June 2007, domestic general insurers had aggregate net assets of twice the regulatory minimum. They generally have a conservative investment approach with 70 per cent of their total investments held in fixed interest or similar assets. The main providers of lenders’ mortgage insurance have strong capital positions and appear to be well placed to absorb any further rise in claims.

Competitive pressures have also been evident to some extent in the general insurance industry in recent years, with premiums in commercial insurance lines having been under downward pressure. In personal insurance lines, industry analysts generally expect modest increases in premiums in the period ahead.

Ratings agencies also continue to hold a favourable view of the general insurance industry, with Standard & Poor’s upgrading Allianz Australia by one notch, to AA-, in July and Suncorp-Metway Insurance by one notch, to A+ in March. The financial strength ratings of the four largest general insurers are all A+ or higher. Share prices of the major Australian general insurers fell noticeably around the middle of the year, in part, reflecting some downgrades to the profit outlook following the June storms in New South Wales and a number of firm-specific factors. Recently, insurers’ share prices have risen by slightly more than the broader market, and are now around 6 per cent higher than at the beginning of the year (Graph 42).

Global reinsurers – which absorb some of the risk from domestic insurers – have faced a more favourable claims environment recently, after the sector experienced record natural catastrophe losses in 2005. Although it is still too early to gauge the full impact of the heavy flooding in the United Kingdom in June and July, some of the largest global reinsurers have recently reported strong profit results and are well placed to deal with a rise in claims.

Wealth Management

The wealth management industry continues to grow strongly, with total consolidated assets increasing by 22 per cent over the year to June 2007, to stand at $1.3 trillion (Table 5). Superannuation funds, which account for nearly 60 per cent of total assets, expanded their funds under management by 28 per cent over the year to June. In recent years, superannuation funds have benefited from both strong investment returns and, as discussed in the Household and Business Balance Sheets chapter, increased inflows of new funds.

Life insurers’ assets under management grew by 11 per cent over the year to June 2007, with these institutions accounting for 17 per cent of total assets of the wealth management industry. In contrast to the previous three years, net insurance flows (premiums and contributions less policy payments) made a small positive contribution to asset growth (Graph 43). Nonetheless, investment income continues to account for the vast bulk of life insurers’ asset growth. The strong growth in investment income in recent years largely reflects the performance of share markets, with life insurers currently investing around 50 per cent of their statutory fund assets in Australia in equities and units in trusts, compared with around 30 per cent a decade ago. As such, the future performance of life insurers is likely to be closely linked to movements in equity markets. With only 10 per of life office assets now related to writing life risk insurance, prospects for this sector are heavily tied to developments in superannuation.

Outside of superannuation funds and life offices, the vast bulk of funds under management are invested in public unit trusts, which grew by nearly 18 per cent over the year to June 2007. This growth largely reflected the performance of equity trusts and listed property trusts.


Footnote
  1. For more details see Reserve Bank of Australia (2007) ‘Box C: Foreign-owned Banks in Australia’, Financial Stability Review, March.