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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2007

Overview

The past couple of months have seen a marked tightening in conditions in global credit markets. This tightening comes after several years in which credit was generally available on very favourable terms and risk was widely considered to be underpriced. It has been associated with a retreat from risk taking and the emergence of liquidity pressures in inter-bank markets in a number of countries. The effects have been felt in a wide variety of markets, with credit spreads having risen and volatility in currency and equity markets increasing. Overall, market conditions have been characterised by considerable nervousness, and investor confidence – particularly in structured credit products – has been dented.

These adjustments reflect, to a large extent, an increase in the compensation that investors require for holding risk as well as an increase in the perceived riskiness of some mortgage-related investments, rather than a fundamental reassessment of the risks to the global economy. The catalyst for the adjustment was the difficulties in the sub-prime mortgage market in the United States. The effects have, however, been amplified by the resulting uncertainty regarding the value of a wide range of securities, particularly those related to housing loans. Investors have been unsure about both the size of the losses arising from the sub-prime problems, and who will ultimately bear these losses. As a result, many have taken a cautious approach, preferring cash and government securities over assets where liquidity and pricing transparency are poor. A lack of confidence over where spreads will eventually settle has also reduced investor demand. In this environment, financial institutions have placed a premium on liquidity, unsure as to future funding commitments, including future drawdowns of existing commitments.

Viewed in a medium-term context, some adjustment in risk spreads is to be welcomed, increasing the likely durability of the current global expansion. However, the nature of the adjustment process has taken many observers by surprise. Not only have investors required more compensation for a given risk, but many have also been reluctant to commit their funds for other than very short terms. Banks have found themselves at the centre of the current stresses, in part because a significant amount of the financing of recent years that occurred through capital markets has had to be brought back onto banks’ balance sheets.

While conditions in global markets remain tight, the past week has seen inter-bank spreads decline appreciably and some easing in funding conditions. This is a welcome development, though it is too early to be confident that there will not be further bouts of market turbulence and strained liquidity conditions in the period ahead. Underlying this improvement is the fact that the credit quality of corporate borrowers in most countries is sound and that the core financial institutions around the world typically have healthy balance sheets. Also, the outlook for the world economy remains positive, notwithstanding prospects for slower growth in the United States. It is, however, both likely and appropriate that credit spreads on a wide variety of assets will settle at higher levels than those seen over recent years, and that credit will not be available on as generous terms as has been the case recently.

The Australian financial system has also been affected by the strains in global credit markets, with inter-bank interest rates for term funding rising, credit spreads increasing, and both the currency and equity markets exhibiting greater volatility. The effects, however, have not been as pronounced as in some other countries, despite Australia having a large securitisation market and some banks relying heavily on capital markets for their funding. This reflects a number of factors, including the very limited exposure of Australian banks to the US sub-prime market and the very small size of the Australian non-conforming loan market (the closest equivalent to the US sub-prime market). In addition, arrears rates on Australian mortgages remain low by international standards. Australian financial institutions have been able to roll over maturing liabilities, albeit at higher interest rates than previously, and some have shifted their funding from offshore to domestic markets.

Overall, the Australian banking system remains highly profitable and is well capitalised. Balance sheets have continued to grow strongly over the past year, bad loan expenses remain low, and banks have benefited from strong growth in income from their funds management operations. Looking forward, the current increase in funding costs is likely to have some impact on the nature of competition in the financial system. Traditional lenders that rely relatively heavily on retail deposits to fund their loans are likely to see their competitive position improve, and this in turn is likely to see more loans funded on the balance sheets of financial institutions, rather than in the capital markets.

More generally, the domestic economic and financial environment remains supportive of financial stability; the Australian economy is continuing to grow at a strong pace, with household and business balance sheets, overall, being in good shape. The share of households experiencing financial difficulties remains low, although it has increased over recent years, largely reflecting the much wider availability of credit over the past decade. Households are benefiting from strong income growth and low unemployment, with household wealth rising solidly recently. While there are some pockets of stress, particularly in western Sydney, most households are reasonably positive about their personal finances. Business balance sheets also remain in good shape overall, with debt-servicing ratios and arrears rates remaining low.