Financial Stability Review – September 2008The Australian Financial System
The Australian financial system is well placed to weather the current difficulties in the global financial system. In contrast to many banking sectors around the world, the Australian banking sector continues to be highly profitable. The system is soundly capitalised and the banks have high credit ratings and relatively little exposure to US sub-prime related assets or to market risk from trading activity. Problem loans also remain low by both international and historical standards, although they have increased recently.
Despite this positive performance, bank share prices are down considerably and funding spreads are up noticeably, with this more difficult financial environment making banks more cautious. Reflecting this, the banking sector's holdings of liquid assets have increased significantly, lending standards have been tightened, particularly to higher-risk borrowers, and banks are putting more resources into managing their funding. These developments, together with a reduced demand for credit by borrowers, have seen the pace of expansion of banks' balance sheets slow, after the very strong growth last year.
Profits and Capital of the Banking System
In contrast to many other banking systems around the world, the Australian banking system continues to be highly profitable. For the five largest banks, headline profits after tax and minority interests were around $10 billion for the latest half year (to the end of March for four of these banks and to the end of June for the other) (Table 4). This represents an increase of 12 per cent compared to the same period a year ago and an annualised post-tax return on equity of around 19 per cent which, after adjusting for changes in accounting standards, is around the average of the past decade (Graph 18). The smaller Australian-owned, ‘regional’, banks have also continued to report solid profits on their banking activities.
The banking sector's strong performance continues to be underpinned by growth in net interest income. For the five largest banks, net interest income increased by 10 per cent over the past year as a result of the expansion of these banks' balance sheets (see below). The regional banks' net interest income increased by 13 per cent over the same period. As has been the case for much of the past decade, the interest-rate margins that banks earn on lending has continued to contract. The ratio of net interest income to average interest-earning assets for the five largest banks declined by 13 basis points over the past year, to around 2 per cent, down from almost 4 per cent in the mid 1990s (Graph 19). The most recent decline reflects, in part, the fact that banks did not initially pass on to some borrowers the higher funding costs arising from the turmoil in credit markets.
In contrast to the increase in aggregate net interest income over the past year, there was a decline in headline income from wealth management operations, after several years of strong growth. Much of the fall was accounted for by investment losses on assets held in one bank's life insurance operations, with most of these losses ultimately borne by policy holders rather than shareholders of the bank. The other large banks' wealth management operations are, on average, less exposed to equities, and these banks' pre-tax income from wealth management was around 10 per cent lower in the latest half year than in the first half of 2007.
Another factor influencing recent profit results has been a rise in provisioning charges. The five largest banks reported charges for bad and doubtful debts of $3.1 billion over the latest half year, compared with $1.2 billion in the same period a year earlier. This outcome, together with recent trading updates and analysts' expectations for the second half, suggest that these banks' total charges for bad and doubtful debts for the current year as a whole will be equivalent to around 0.3 per cent of their assets (Graph 20). This is up from the very low charges over recent years – when the ratio of both individual and general provisions to assets fell to unusually low levels – but well below the expense for bad and doubtful debts incurred in the early 1990s.
This recent increase in the aggregate bad debts expense reflects a number of factors. One is a rise in banks' collective provisions due to the general deterioration in the credit environment, both in Australia and overseas. Another is a substantial increase in individual provisions, primarily against exposures to highly leveraged companies that have experienced difficulties in the current environment. In addition, one bank has announced higher provisions arising from a liquidity facility that it provided to a conduit holding CDOs.
These higher charges are likely to see the banking system's aggregate post-tax profits decline in the near term, with analysts generally anticipating that the aggregate profits of the five largest banks will be around 10 per cent lower in the second half of 2008 than in the same period a year ago. If this were to occur, the annualised post-tax return on equity over this period would be around 16 per cent which, while lower than the average return over the past decade, would be much higher than that being earned in many other banking systems around the world and many other industries in Australia.
While provisioning charges have increased, the Australian banking system continues to experience a low level of problem loans. As at June 2008, non-performing assets accounted for around 0.7 per cent of banks' on-balance sheets assets, which is below the average since the mid 1990s (Graph 21). Only around half of the non-performing assets are classified as ‘impaired’, in that payments are in arrears by more than 90 days (or are otherwise doubtful) and the outstanding amount is not well covered by the value of collateral.
Although the non-performing assets ratio is low, it has nonetheless increased over the past six months, with the rise evident across all the main segments of the domestic loan portfolio (Graph 22). The most notable increase has been in the non-performing business loan ratio, with this increase largely accounted for by a small number of exposures to highly geared companies with complicated financial structures and/or exposures to the commercial property sector. In banks' commercial property loan portfolios, the impaired assets ratio stood at 0.9 per cent as at March 2008 (the latest available data), up from the unusually low levels of recent years (Graph 23). Much of the recent rise has been accounted for by loans for residential development and, particularly, retail property, with no apparent rise in the arrears rate on loans for office property. Developments with respect to commercial property are discussed in more detail in the Household and Business Balance Sheets chapter and in Box A.
In the mortgage and personal portfolios, non-performing loan ratios have also risen, but remain around, or only slightly above, their levels of a year ago. As at June 2008, non-performing housing loans accounted for 0.4 per cent of Australian banks' outstanding on-balance sheet housing loans. For credit unions and building societies, non-performing housing loan ratios are slightly above their levels in June 2007 but, in aggregate, are below the level in the banking sector.
The modest increase in housing loan arrears rates over recent years was not unexpected given the increase in financing costs for borrowers, and the easing of credit standards that took place over the past decade. Importantly though, this easing of standards was not nearly as marked as that in some other countries, most notably the United States. Reflecting this, the non-conforming housing loan market in Australia (the closest equivalent to the sub-prime market in the United States) has remained very small, with ADIs having virtually no presence in this market. Non-conforming loans account for less than one per cent of outstanding mortgages in Australia – compared with about 12 per cent in the United States – with the vast majority of these loans having been provided by a small number of specialist, non-ADI, lenders. More broadly, even on prime housing loans, arrears rates have historically been considerably lower in Australia than in the United States and the United Kingdom.
As in their Australian operations, there has recently been a modest increase in measures of problem loans in Australian banks' foreign operations, although again from a low base. Entities in New Zealand account for the largest share of Australian-owned banks' foreign exposures, at around 40 per cent, with these exposures largely arising through the four largest banks' New Zealand-based operations (Graph 24). These operations continued to account for around 10–20 per cent of the four largest banks' group-wide profits in the latest half year. US exposures account for less than 10 per cent of Australian-owned banks' total foreign claims, and typically do not arise through lending to the US household sector. While some banks have reported that they have exposures to the US sub-prime market through holdings of financial instruments, these remain small when compared to the size of these banks' balance sheets.
Another factor that has stood the Australian banks in good stead throughout the recent turmoil is that they have traditionally not relied heavily on income from trading activities for profitability. For the five largest banks, trading income accounted for only around 6 per cent of their total income in the latest half year, which is well below the equivalent share for some of the large globally active banks. Consistent with this, Australian banks have traditionally had only small unhedged positions in financial markets, with the value-at-risk – which measures the potential loss, at a given confidence level, over a specified time horizon – for the five largest banks equivalent to 0.03 per cent of shareholders' funds in the latest financial year.
Reflecting the strong profitability of recent years, the Australian banking system remains soundly capitalised, with the aggregate total capital ratio standing at 10.6 per cent as at June 2008, and the Tier 1 ratio at 7.3 per cent (Graph 25). Similarly, the credit union and building society sectors remain well capitalised, with aggregate capital ratios of 16½ and 14½ per cent, respectively. For the banking system, the introduction of Basel II on 1 January this year resulted in a fall in measured risk-weighted assets, the effect of which on the measured capital ratio has been significantly offset by accounting changes associated with the introduction of IFRS and changes to the definition of regulatory capital. Unlike many of their international peers, the Australian banks have not been forced to raise new capital to offset writedowns. Strong profitability has meant that retained earnings remain an important source of banks' Tier 1 capital, with issues of preference shares and the dividend reinvestment plans of the five largest banks adding to Tier 1 capital over the past year.
Balance Sheet Growth
After the strong growth last year, the Australian banking system's aggregate balance sheet has grown more slowly in the most recent six months (Table 5). Nonetheless, growth remains faster than that being experienced in many other countries.
The strong growth in the system's assets over the second half of 2007 is partly explained by re-intermediation, as capital market funding tightened up and banks honoured lines of credit, including to vehicles that had previously funded themselves in the commercial paper market. Over the six months to December 2007, bank business credit grew at an annualised rate of around 30 per cent, with loans with a value greater than $2 million accounting for much of the pick up in growth during this period (Graph 26). More recently, growth in lending to businesses has slowed significantly, to an annualised rate of around 7 per cent over the six months to July 2008, with this slowing reflecting both demand and supply factors. As discussed in the Household and Business Balance Sheets chapter, many businesses are taking a more cautious approach to gearing in the current environment, and there has been some tightening in the terms and conditions on which credit is available, particularly to riskier borrowers, including those who are already highly leveraged.
The growth of banks' lending to households has also moderated over the past six months, though the deceleration has not been as pronounced as that for business lending. Household credit (including personal loans, and housing loans no longer held on banks' balance sheets because they have been securitised) extended by banks grew at an annualised rate of around 9½ per cent over the six months to July 2008. This is a faster rate than the overall growth in household borrowing, due to an increased share of housing credit being originated by banks than was the case prior to the credit turmoil (see below).
Another factor that has underpinned the growth in banks' aggregate balance sheet is a marked rise in the banking system's holdings of liquid assets – particularly in the second half of 2007 – reflecting a more cautious approach to liquidity management in the challenging environment (Graph 27). Since mid 2007, the system's total holdings of liquid assets (including cash, deposits and highly rated securities) has increased by around 50 per cent, with their share of total domestic assets increasing from about 13 per cent to 16 per cent, the highest level for over a decade (Graph 28).
The higher holdings of liquid assets have largely taken the form of short-term paper issued by other banks, reflecting the limited supply of alternative liquid assets in Australia. The attractiveness of holding these assets has increased over time, with the RBA accepting bank bills and certificates of deposit as eligible securities for repurchase agreements since March 2004. In September last year, the RBA further widened the list of repo-eligible securities to include highly rated RMBS and ABCP backed by prime, domestic full-doc loans, as well as a broader range of securities issued by ADIs. More recently, the RBA and APRA have also been working with industry participants to strengthen the arrangements for liquidity management in the event of extreme market disruptions. In such circumstances, the RBA would be prepared to conduct repurchase agreements in RMBS backed by mortgages originated by the institution undertaking the repo (so-called ‘self securitisations’). To date, 11 institutions have created these self-securitisations, with the total stock of these currently standing at around $58 billion.
While the aggregate assets of the banking system have grown strongly over the past year, there has been some dispersion across broad bank types. Most notably, growth in the combined balance sheets (excluding intra-group transactions) of foreign-owned banks has slowed by more than that for the Australian-owned banks over the past six months or so (Graph 29). This follows a number of years during which foreign-owned banks, as a group, had been expanding at an above-average pace, reflecting strong growth of business lending and, to a lesser extent, attempts to gain a greater share of the retail market. In the early months of the current turmoil, growth in foreign-owned banks' assets picked up further, partly reflecting the acquisition of securities issued by ABCP vehicles as a form of liquidity support to these vehicles. More recently, the slowing of these banks' asset growth mainly reflects developments in the business loan market, with a number of foreign-owned banks significantly curtailing their activities in Australia over the past six months or so.
Funding Conditions and Competition
The tighter conditions and increased uncertainty in financial markets have led banks to increase their focus on liquidity and funding risks. Whereas in previous years the main consideration in most lending decisions was the ability of the borrower to repay, funding risk has recently become a consideration in many decisions to extend credit. At the same time, the Australian banks have continued to be able to tap both domestic and international wholesale markets, albeit at considerably higher spreads than was the case prior to the turmoil.
The spread between the yield on three-month bank bills and the overnight index swap rate for the same maturity has averaged around 45 basis points over the past six months, compared with an average spread of less than 10 basis points in the first half of 2007 (Graph 30). While this spread had narrowed a little in recent months, it has risen markedly over the past week or so, to around 80 basis points, reflecting the renewed bout of uncertainty in global markets.
In response to this uncertainty, the RBA significantly increased the supply of Exchange Settlement balances to assist in the smooth functioning of the cash market, with these balances reaching a peak of nearly $7 billion in mid September, compared with average balances of around $1½ billion in recent months (Graph 31). In addition, to further enhance the flexibility of its domestic liquidity operations, the RBA this week announced a term deposit facility under which it will auction term deposits at the RBA on a regular basis. This facility will be available to all institutions holding an Exchange Settlement Account and to ADIs that are members of RITS. The RBA also announced that it and the Federal Reserve had agreed to a US$10 billion swap facility as part of the co-ordinated international effort to address the elevated pressures in the US dollar short-term funding markets in the Asian time zone.
Reflecting the reduced willingness by investors to commit their funds for an extended period, spreads on term debt have increased by more than those on short-term debt. The spread to the benchmark rates (the swap rate for fixed-rate bonds and the bank bill rate for variable-rate bonds) on three- and four-year bonds that have recently been issued by some of the largest banks has been around 100 basis points, compared with around 50 basis points in late 2007, and less than 20 basis points prior to the disturbances in credit markets. Despite the higher spreads, declines in the relevant benchmark rates have meant that bank bond yields are currently around 130 basis points lower than in June 2008 (Graph 32). The spreads on offshore funding also remain much higher than in recent years, with, for example, the effective Australian dollar spread on issuing three- to five-year bonds in the United States around 80 basis points higher than prior to the credit market turmoil.
As noted in the March 2008 Review, conditions have been difficult in both the ABCP market and the RMBS market. ABCP markets around the world were among the first to be affected by the repricing of risk, with the offshore ABCP market remaining virtually closed to new issues. As at July 2008, the outstanding value of offshore ABCP issued by Australian entities was just over $7 billion, around 80 per cent lower than its peak in May 2007. Over the second half of 2007, outstandings in the domestic market grew strongly, although issuance has since moderated and outstandings are around 20 per cent below their level at the end of last year. The spread on ABCP over the bank bill rate is also significantly higher than a year ago. Prior to mid 2007 it had been possible to issue ABCP in Australia at a spread of less than 5 basis points over the bank bill rate, compared with current spreads of around 60 basis points.
Conditions in the RMBS market also continue to be difficult. While there have recently been a number of small public issues, activity remains well below previous levels, with quarterly issuance averaging around $2½ billion since mid 2007, compared with $18 billion per quarter over the previous year (Graph 33). All of the recent issues have been in the domestic market. This is in contrast to prior years when there was strong offshore demand for Australian RMBS, partly reflecting the high quality of Australian mortgages. Recently, many of these offshore investors have been selling these RMBS as they attempt to reduce their leverage, and this has kept spreads on RMBS elevated, with recent issues at spreads to the bank bill swap rate of around 110–130 basis points, compared with less than 20 basis points immediately prior to the market turbulence (Graph 34). At these spreads, funding mortgages by issuing RMBS is unlikely to be profitable for many types of loans at existing mortgage rates. As discussed below, the difficulties in the RMBS market are having a noticeable impact on those lenders whose business models are centred on securitisation.
Despite the strains of the past year, banks, in aggregate, have continued to be able to raise funds in the capital markets on a regular basis. In the initial months of the turmoil, banks issued a large volume of bank bills and certificates of deposit in the domestic market, with the outstanding value of banks' securities with a maturity of less than one year increasing by $132 billion over the second half of 2007 (Table 6). A little over $80 billion of this increase reflected banks issuing short-term securities to one another, as they sought to increase their holdings of repo-eligible securities. But issuance to the non-bank sector was also strong during this period, with banks shifting a higher share of their short-term wholesale funding onshore and a higher share of their domestic funding to the short-term market.
In the most recent six months, the outstanding value of these short-term liabilities has declined. As it became increasingly apparent that the repricing of credit risk was more than just a short-term phenomena, banks increased their issuance of longer-term securities in the domestic market, with the value of outstanding (domestic) securities with an original maturity of over one year increasing by $26 billion, to $104 billion, over the first half of 2008. Banks have also continued to tap offshore markets, although the pace of offshore issuance has slowed from early 2008, when offshore issuance reached record levels (Graph 35). Over the six months to September 2008, the five largest banks have issued, on average, around $7 billion of bonds per month, compared to an average of around $4 billion over the same period in 2007. With banks recently issuing more longer-term debt, the average maturity of their outstanding bonds (both on- and offshore) has fallen only slightly since the onset of the market turbulence.
Over the past year, banks have also benefited from strong growth in deposits, particularly from households, with total deposits increasing by around 20 per cent over the 12 months to July 2008 (Graph 36). Households' term deposits have grown even more rapidly, by around 40 per cent over the year to July 2008. This strong growth reflects both supply and demand factors. As discussed below, banks have been competing more vigorously for deposit funding, and the volatility of alternative investments in the current environment has increased demand; the latest Westpac and Melbourne Institute Survey of Consumer Sentiment showed that nearly 30 per cent of surveyed households viewed bank deposits as the ‘wisest place for savings’, which is around the highest share in over 15 years.
The recent developments in credit markets have had a noticeable impact on the competitive dynamics of the Australian financial system, particularly affecting lenders that rely heavily on securitisation for funding. These lenders have lost market share to institutions that have more diversified funding bases, and there are signs that credit has become less readily available for higher-risk mortgage borrowers. Financing conditions have also tightened for some business borrowers, particularly those with complicated, and already highly leveraged, balance sheets and those with heavy exposures to commercial property.
In the mortgage market, non-ADI mortgage originators have been the most affected by the strains in the RMBS market, having funded themselves almost entirely through securitisation. As a result, the share of owner-occupier loan approvals accounted for by these lenders fell to around 4 per cent in July 2008, compared with around 12 per cent in mid 2007 (Graph 37). Conversely, the share of new loans accounted for by banks has increased from around 80 per cent to 90 per cent over the past year. This represents a sharp turnaround in the longer-run trend, which had seen mortgage originators increase their share of total outstanding housing loans from around 2 per cent in the mid 1990s to a peak of about 10 per cent in mid 2007.
The changes in the financial environment more generally have had a noticeable effect on the pricing of home loans, and on the availability of finance for some borrowers. Since mid last year, the five largest banks have increased their advertised standard variable indicator rates on full-doc loans by an average of 55 basis points more than the increase in the cash rate over the same period. Mortgage originators have, on average, increased their advertised rates by around 80 basis points more than the increase in the cash rate. Interest rates on some non-standard loans have risen by even more, with rates on non-conforming loans, for example, rising by around 210 basis points, or 135 basis points more than the increase in the cash rate, over the same period. In addition, many lenders have re-examined their relationships with mortgage brokers; in recent years around one third of new housing loans have been originated through third parties, with brokers enabling lenders without large branch networks to compete across geographical boundaries. Some of the largest banks, for example, have cut upfront commissions by around 20 basis points, and ‘trailing’ commissions by 5–10 basis points.
Conditions in business lending markets have also tightened since mid 2007, after a number of years of strong competition. This tightening partly reflects a change in the activities of some of the newer entrants into the market, including foreign-owned banks. As a group, these banks had expanded their lending to businesses at an above-average rate over recent years, with the most notable gains in market share being in the high-value end of the business loan market. More recently, some of these banks have scaled back their involvement in the Australian market, with foreign-owned banks' business credit growth decelerating by significantly more than that of the Australian-owned banks over the past six months or so. Industry liaison suggests that conditions have tightened by somewhat less for smaller business loans than for large-value corporate loans, with some lenders seeking to increase their share of the small business loan market.
Recent developments have also had an effect on competition in the deposit market, with banks seeking to increase the share of their funding sourced from deposits. Most notably, competition for term deposits has picked up over the past six months, which has seen deposit rates equal, or in some cases higher, than rates in wholesale markets at some maturities.
Falling prices and heightened volatility have been features of many financial markets since mid 2007, with the overall domestic share market currently around 30 per cent below its peak in November 2007 (Graph 38). The banking sector has declined by a similar amount to be 32 per cent below its peak, also in November last year.
There has also been a very pronounced increase in the volatility of bank share prices since mid 2007 (Graph 39). The daily absolute movement in the banking index has averaged 2.3 per cent over this period, compared with an average of 1 per cent over the previous 10 years. The largest movements occurred in July, when the banking index fell by around 15 per cent over three days, after the market was surprised by a couple of banks announcing higher provisioning charges. The fall in the Australian banking index since its peak has, however, been slightly less than the falls in the European and US banking indexes since their respective peaks, with these markets having declined by about 40 per cent. Over a longer horizon, Australian banks have significantly outperformed many of their international peers. The share prices of the companies included in the ASX ‘diversified financials’ index have been more volatile than for Australian commercial banks, with the relevant index declining by around 60 per cent since its peak mid last year.
The movements in banks' share prices have resulted in significant changes in market-based valuation measures, with the banks' price/earnings ratio falling to its lowest level since the mid 1990s and dividend yields rising equivalently (Graph 40).
Consistent with the general deterioration in sentiment, credit default swap (CDS) premia on Australian banks remain elevated relative to historical averages. For the four largest Australian banks, the current annual premia for insuring their senior debt averages around $95 per $10,000 insured, compared with $5–$10 for much of the past few years. While this is a significant increase, CDS premia on Australian banks remain lower than those for the largest US financial institutions, reflecting Australian banks' smaller exposure to structured securities and the US mortgage market. CDS premia for the largest Australian banks also remain within a relatively narrow range, in contrast to a number of other countries where there is wide dispersion in these premia across banks.
Notwithstanding these movements in market prices, Australian banks continue to be viewed favourably by rating agencies. Each of the four largest Australian banks is rated AA by Standard & Poor's, with these ratings having recently been affirmed (Table 7). Of the world's largest 100 banks, only a handful have higher ratings (Graph 41). Moreover, unlike some of the large financial institutions abroad, no Australian-owned bank has had its rating downgraded since the onset of the credit turmoil. A couple of foreign-owned banks operating in Australia have had their ratings downgraded.
Australia's financial infrastructure has handled the increased volatility and turnover during the past year effectively. In recent months, trading volumes in Australian equity markets have remained close to their record highs, at around 400,000 trades per day (Graph 42). Traders have, however, scaled back their positions on the Sydney Futures Exchange (SFE). Reflecting this, the total value of initial margins held for SFE derivatives has fallen to $2–3 billion, down from a peak of around $4½ billion in June 2007.
One aspect of this infrastructure that has attracted attention is the settlement practices for equities. This follows a delay to equities settlement in late January this year. In response to this delay, the RBA's Payments System Board initiated a review into settlement practices in the Australian equity market and suggested a number of changes to current arrangements (see the Developments in the Financial System Infrastructure chapter). The Bank is continuing to discuss these suggestions with the ASX.
The Australian general insurance industry, in aggregate, continued to report solid profits over the 2007/08 financial year, recording an aggregate pre-tax return on equity of around 15 per cent. While this was lower than during the previous few years, it is in line with the average over the past decade (Graph 43).
Income derived from the investment of insurance premiums was around 25 per cent lower than in the previous year, reflecting the more difficult conditions in financial markets. In general, however, Australian insurers have a relatively conservative investment mix, with around 70 per cent of assets invested in fixed-income securities and only a small proportion invested in equities. Consistent with this, Australia's largest general insurers have not reported any direct exposure to US sub-prime risk through their investment portfolios.
Australian general insurers also faced more difficult underwriting conditions over the past year than they have for some time. Aggregate claims (net of reinsurance and other recoveries) increased by 17 per cent, compared with an average annual rise of around 2 per cent over the previous three years. These higher claims partly reflect storms in Australia's eastern states in late 2007 and early 2008. At the same time, however, growth in industry net premium revenue – gross premium revenue less reinsurance expenses – was broadly in line with previous years, at around 3 per cent. Over the year, the effect on total premiums of an ongoing reduction in premium rates for some commercial lines of insurance, including public liability insurance, was only partly offset by higher premium rates for some personal lines. Reflecting these factors, the industry's net underwriting result was weaker than it has been for a number of years. The combined ratio – claims and underwriting expenses relative to net premium revenue – increased by 8 percentage points over the year, to 92 per cent. While this is the highest level since 2002, a combined ratio of less than 100 per cent indicates that insurers, in aggregate, reported an underwriting profit for the year.
The aggregate capital position of the general insurance industry remains sound, with insurers holding capital of around twice the regulatory minimum as at March 2008 (the latest available aggregate data). APRA has also recently strengthened the prudential framework for general insurers by raising the regulatory capital charge for foreign reinsurance recoveries, equities and unlisted investments. These changes became effective on 1 July 2008.
While the insurance sector, in aggregate, remains in a sound position, developments in global housing markets have focused attention on lenders' mortgage insurance (LMI). This type of insurance provides protection for lenders against borrower default, and is also a form of credit enhancement in the RMBS market. In Australia, the largest non-captive LMIs are PMI and Genworth, which account for around three quarters of industry revenue. Until recently, both were subsidiaries of US insurers, and the US mortgage insurance industry has come under considerable pressure lately as house prices there have fallen and defaults have risen. In contrast, Australian LMIs have continued to report solid profits owing to the relatively good performance of the Australian housing market, though the difficulties experienced by their US parents have had an impact on their ratings. In particular, following downgrades to their parent companies, rating agencies lowered PMI Australia's rating from AA to AA-, with Moody's downgrading Genworth equivalently. In August, PMI announced the sale of its Australian operations to QBE, a move that further divorces the Australian LMI industry from the difficulties in the United States. Rating agencies have recently affirmed PMI Australia's rating following the announcement of the sale.
The downgrades of the two US mortgage insurers and the follow-on effects on the Australian subsidiaries resulted in around 190 Australian subordinated RMBS tranches being downgraded to AA- from AA. However, the ratings of all senior tranches (AAA) were affirmed as they were deemed to have sufficient protection from subordination to withstand a one notch downgrade of the LMI provider. Since subordinated tranches only make up a small share of the total value of an RMBS, the overall effect of these downgrades on the RMBS market has been small, with less than 5 per cent of the value of outstanding RMBS affected.
More generally, rating agencies continue to hold a favourable view of the Australian general insurance industry. The four largest insurers are all rated A+ or higher by Standard & Poor's, though Insurance Australia Group was downgraded by one notch to AA- in May (Table 8). The rating agencies' outlooks on these four insurers are stable. Despite this, share prices of the largest listed Australian general insurers have fallen by around 25 per cent over the past year and have underperformed the broader market over this period (Graph 44). This underperformance mainly reflects the storm-related profit warnings late last year and in the early part of 2008. More recently, insurers' share prices have moved broadly in line with the overall market. Negative sentiment arising from the difficulties at the US insurer AIG has not had a significant impact on the local market, with AIG having only small operations in Australia.
Australian general insurers cede around one quarter of gross premium revenue to reinsurers, with the majority of this placed with large global reinsurers. The global reinsurance industry entered the current period of market turmoil in generally good shape after a number of years of strong profitability. While claims have risen over the first half of 2008 and some insurers have reported valuation losses on investments, the large global reinsurers have typically continued to report solid profits. While the recent difficulties experienced by the US insurer AIG have attracted considerable attention, its reinsurance operations have remained profitable, and the support package announced by the US authorities means that any reinsurance cover provided by the company will continue to be effective. More generally, rating agencies continue to maintain a sound industry rating profile for the reinsurance industry, with the majority of companies rated A or higher by Standard & Poor's, and the largest rated AA or higher.
The turbulence in financial markets over the past year or so has had a marked impact on the performance of the funds management industry. Managed fund institutions' consolidated assets under management fell by around 3 per cent over the year to June 2008, to stand at $1.3 trillion, reflecting investment losses over the second half of the year (Table 9).
According to ABS data, superannuation funds' (consolidated) assets under management fell by 0.4 per cent over the year to June 2008, compared with a decade-average annual growth rate of around 15 per cent. This fall primarily reflects lower valuations on investment assets in the first half of 2008, with APRA data showing that superannuation funds recorded an aggregate loss of $63 billion on their investment portfolios in the March quarter (Graph 45). While aggregate APRA data on returns for the June quarter are not yet available, the continued downturn in global and Australian equity markets has meant superannuation funds have reported further losses since March. Inflows of new funds have also been lower than in recent years, as investors have shied away from market-linked assets in the current environment. In the March quarter, net inflows into superannuation funds were $7.7 billion, compared with a quarterly average of $9.4 billion since 2004 (after excluding the very strong flows in June 2007 associated with changes to taxation arrangements).
Superannuation funds' investment returns have been particularly affected by the downturn in global and Australian equity markets, as around half of superannuation funds' assets are held in equities and units in trusts (Table 10). Notwithstanding this, Australian superannuation funds have limited exposures to US sub-prime related debt, though several funds have modest holdings of CDOs backed by US sub-prime debt. Aggregate data shows that only 4 per cent of superannuation funds' financial assets are invested in offshore bonds (including CDOs).
Life insurers account for around 14 per cent of the funds management industry. Life insurers' assets declined by 11 per cent over the year to June 2008, after having increased at an average annual rate of around 4 per cent over the previous decade. Superannuation assets continue to account for around 90 per cent of life insurers' total assets, and returns on these investments have typically accounted for a significant share of life insurers' asset growth. Over recent years, this has reflected strong growth in the equity market, with around half of life insurers' statutory fund assets held in the form of Australian equities and units in trusts. With the Australian share market having fallen considerably, investment losses were $17 billion in the March quarter 2008 (Graph 46). As only around 10 per cent of life insurers' income is derived from ordinary ‘risk’ business, the performance of the industry will remain closely tied to developments in the superannuation sector.
Public Unit Trusts and Other Managed Funds
Outside of superannuation funds and life offices, the majority of funds under management are invested in public unit trusts. Assets of public unit trusts declined by around 8 per cent over the year to June 2008 (on an unconsolidated basis) (Table 11). With most asset classes having come under pressure since the onset of the market turmoil, the declines in asset values have been broadly based across the various types of public unit trusts. As discussed in Box A, developments in the listed property trust sector have attracted particular attention lately, given the high levels of gearing in that sector.