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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2008

Overview

The operating environment facing many financial institutions around the world, particularly in the United States, is more difficult than it has been for many years. Risk aversion has increased markedly, confidence in a number of the world’s largest financial institutions has fallen considerably, and the prices of most financial assets have declined. In mid September, uncertainty in financial markets became particularly acute due to concerns about the viability of a number of large financial institutions in the United States. In response, the US authorities announced a series of significant measures aimed at bolstering the stability of the US financial system. While these measures have helped stem the deterioration in confidence, conditions remain strained.

The problems in the global financial system are proving to be much more pervasive and costly than was anticipated by many observers a year ago. While the losses associated with the sub-prime problems are equivalent to only a small fraction of global wealth, these losses have been concentrated on the balance sheets of highly leveraged institutions, particularly banks, amplifying their effects. Somewhat paradoxically, the growth of the securitisation and credit transfer markets over the past decade – which was supposed to lead to credit risk being more widely dispersed throughout the global financial system – has contributed both to an increase in aggregate credit risk and to significant concentrations of this risk on some highly leveraged balance sheets.

The recent difficulties have been compounded by a straining of the bond of trust between many banks and investors. Given the difficulties with valuing structured credit products, many investors remain wary about the valuations being used by some banks. While standards of disclosure have improved over the past year, further improvements are required to rebuild the trust that is a cornerstone of a well‑functioning financial system. Concerns about the capital position of some banks are also weighing on investor confidence, with bank share prices down considerably and the spreads that banks pay when raising funds up significantly on the levels of just over a year ago.

Reflecting these developments, the smooth functioning of the credit supply process has been disrupted in some countries. This has increased the risk of a damaging feedback loop running from the financial sector to the economy and back to the financial sector. How powerful this loop ultimately turns out to be will depend to a significant extent on what happens to property prices in the United States over the period ahead, as well as on the ability of banks to retain the confidence of investors. From this perspective, recent support efforts by the authorities in the United States are to be welcomed.

The Australian financial system has coped better with the recent turmoil than many other financial systems. The banking system is soundly capitalised, it has only limited exposure to sub-prime related assets, and it continues to record strong profitability and has low levels of problem loans. The large Australian banks all have high credit ratings and they have been able to continue to tap both domestic and offshore capital markets on a regular basis. Credit standards in Australia over the past decade were not eased to anywhere near the same extent as in the United States. In Australia, non-conforming housing loans – the closest equivalent to US sub-prime loans – account for less than 1 per cent of outstanding housing loans, with virtually all of these loans made by specialist non-bank lenders. Moreover, arrears rates on prime Australian mortgages have historically been lower than in many other countries and remain so.

Notwithstanding this positive position, the Australian financial system has felt the impact of the difficulties in the global financial system. As has occurred internationally, bank share prices are down considerably and banks’ funding costs have increased significantly. The general increase in uncertainty has also meant that most banks are taking a more cautious attitude to lending and paying increased attention to their funding. Some banks have also recently reported higher provisions, largely reflecting exposures to a relatively small number of highly geared firms, as well as some indirect exposures to the sub-prime problems in the United States. It is important to note, however, that the ratio of banks’ problem loans to total assets remains below the average since the mid 1990s, a period of unusually low credit losses.

The tighter financial conditions have resulted in the household sector entering a period of balance-sheet consolidation, although households are continuing to benefit from a firm labour market and solid growth in nominal incomes. Reflecting this consolidation, the demand for credit has slowed, as has the pace of consumption growth. While some households are facing more difficult financial conditions than has been the case for some time, the overall arrears rates on housing loans has shown little change over the past year, and remains low by historical and international standards. In the business sector, the various indicators suggest that the balance sheets of most firms remain in good shape, having benefited from strong profit growth over recent years. There are, however, a relatively small number of companies, particularly those that are highly leveraged and that have relied heavily on short-term funding, that have found the current financial environment particularly difficult.

Overall, the past year has been a very challenging one for many financial systems. A return to more settled conditions will require a rebuilding of confidence in many overseas financial institutions and further steps to strengthen their balance sheets. In this difficult environment, Australia has benefited from having strong and profitable financial institutions with few problem assets on their balance sheets, and a sound regulatory regime. While the Australian financial system has not been completely insulated from developments abroad, it is weathering the current difficulties much better than many other financial systems.