Financial Stability Review – March 2008
The global financial system is currently under more strain than it has been at any time since at least the early 1990s. It is dealing with both a significant repricing of many financial assets and the unwinding of some of the leverage built up during the preceding boom. There has also been a marked rise in uncertainty about the economic outlook and the strength of financial institutions, particularly in the United States. While the strains originated in the US sub-prime residential mortgage market, they have become much more pervasive over recent months.
The current repricing of assets reflects a sharp increase in risk aversion, a re-appraisal of the underlying risks of many investments, and the sale of assets as some borrowers are required to reduce their leverage. These adjustments follow a prolonged period during which credit risk was widely perceived to be low, and during which investors were prepared to finance the purchase of assets with high levels of debt. It has also led to a number of the world’s major financial institutions announcing significant write-downs. In addition, conditions in many financial markets – particularly the asset-backed-paper markets – have been very unsettled, with issuance of new securities falling markedly.
As a result of these developments, confidence in the global financial system is more brittle than it has been for some time. Bank share prices in many countries are down by around one third from their levels of a year ago, and spreads on bank debt have increased significantly. Investors have also exhibited a strong preference for short-term assets, requiring especially large premiums on long-term debt. Further, in the United States and Europe, changes of ownership have been required for a small number of financial institutions experiencing difficulties.
The various strains have led to a tightening of credit conditions in many developed countries and interest rate margins over risk-free rates have also increased significantly. Many financial institutions have also had pressure on their funding and capital positions as they have provided financing to previously off-balance sheet vehicles that were unable to continue funding their illiquid assets in the short-term money markets. Against this general background, many central banks have modified their liquidity operations in domestic money markets, and monetary policy has been eased significantly in the United States.
In Australia, the financial system has coped better with the recent strains than have the financial systems of many other countries. The banking system remains highly profitable and well capitalised, with the banks having minimal direct exposure to the sub-prime problems in the United States. The credit ratings of the larger banks remain high, with none of them having been put on negative credit watch or having their ratings downgraded. This strong standing of the banks has contributed to rapid growth in their deposits over the past six months, and they continue to be able to raise significant volumes of funds in both domestic and international capital markets.
The solid position of the Australian banking system partly reflects the high quality of its assets, with the banks having considerably less risky portfolios than banks in many other countries. Ratios of non-performing loans to total loans remain at low levels, with arrears rates having declined over the past six months. While lending criteria were relaxed over recent years, credit standards in Australia did not fall by nearly as much as they did in the United States. The banks also typically take relatively small open positions in financial market instruments relative to the size of their balance sheets, and relative to many international banks.
Notwithstanding this favourable position, the changed credit environment has had a significant impact on the Australian financial system. As is the case in other countries, bank share prices are down considerably and funding costs have risen significantly. These higher funding costs have been largely passed through to business borrowers. Lenders have also increased their mortgage indicator rates by more than the rise in the cash rate, after these rates had moved together for the past decade. In addition, lenders have tightened credit standards, particularly to firms with complex and highly leveraged balance sheets.
These changes in the cost and availability of funding are having a significant effect on the nature of competition within the system. In particular, the market for securities backed by housing loans has been disrupted, with new issuance drying up. As a result, lenders that rely on this market for their funding are finding conditions much more difficult than those that rely more heavily on deposit and other markets.
The tighter financial conditions in Australia are having an impact on both household and business finances, although overall balance sheets remain in good shape. Recently, the household sector has benefited from favourable labour market conditions and strong income growth and, over the past decade, has experienced a significant increase in its net wealth relative to income. Reflecting these developments, the share of households not able to meet their debt obligations is low by both historical and international standards. There are, nonetheless, some pockets of stress, with higher interest rates and weaker asset markets putting more pressure on many households’ finances than has been the case in recent years, and loan arrears are likely to rise from the current low rates in the period ahead.
The favourable macro-economic conditions of recent years have also meant that, at the aggregate level, business balance sheets are in a healthy shape: profitability is high, and both debt-servicing requirements and arrears rates are at relatively low levels. Notwithstanding this positive picture, the recent sharp increase in risk aversion and higher funding costs have created difficulties for some firms, particularly those with highly leveraged balance sheets, and those that have relied heavily on short-term funding.
Despite the strains in global financial markets, the underlying resilience of the Australian financial system, together with the relatively favourable outlook for the domestic economy, means that the system is much better positioned than the financial systems of many other countries to cope with the current difficulties.