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RESERVE BANK OF AUSTRALIA

Financial Stability Review – March 2009

Overview

The global financial system has continued to experience significant stress. Confidence in many large global financial institutions has been fragile, investors have been highly risk averse, and banks, businesses and households have been looking to reduce their leverage and restructure their balance sheets. Not surprisingly in this environment, many major economies are contracting, credit growth has slowed, and lending standards have been tightened significantly in many countries.

A notable feature of the current crisis has been a marked increase in the price of risk, after risk had been underpriced in many markets for a number of years. This repricing of risk has resulted in large falls in the prices of many financial assets, often by considerably more than can be explained by changes in the expected underlying cash flows. A number of the major international banks have been particularly affected given that, over recent years, they had increased their holdings of securities with carrying values that are directly affected by market pricing of risk. While this worked to these banks’ advantage when risk premiums were being compressed in earlier years, it has greatly amplified the scale of the current adjustment.

The difficulties in the global financial system have led to substantial public-sector support being provided to financial institutions and markets in a number of countries. These actions have helped support depositor confidence and have ensured that banks are able to tap capital markets to meet their funding needs. They have also helped improve the functioning of short-term money markets. Notwithstanding this, investors have remained concerned about the underlying balance-sheet strength of many banks. Credit spreads remain elevated, the market value of many banks’ equity is significantly below book value, and there is continuing uncertainty about the quality and valuation of banks’ assets. In this environment, banking systems in a number of countries are having difficulty playing their central role of intermediating between savers and borrowers. As a result, an adverse feedback loop has developed, with the troubles in the financial sector weighing on the real economy, which is in turn making it more difficult to solve the problems in the financial system.

There is a broad consensus that addressing these problems in the financial system is a prerequisite for a sustained recovery in the major economies. This is likely to require the de-risking of bank balance sheets, through the removal of troubled assets, and a bolstering of bank capital by the private and/or public sectors. Against this background, the recently announced US Government plan to support private-public investment funds to purchase troubled loans and securities, together with previously announced capital-injection programs, has received widespread market support. Despite this, it could be some time before it is clear whether these initiatives have been sufficient to put the financial sector on the path to recovery.

In contrast to the experience in many countries, the Australian banking system has performed well over recent times. The banks continue to report solid profits, albeit lower than in recent years, are soundly capitalised, and the larger banks have high credit ratings. The Australian banks had not accumulated large holdings of high-risk securities, and their lending standards were not eased to the same extent as occurred in some other countries in the middle years of this decade. While loan arrears have risen from their unusually low levels of recent years, and a further increase is expected in the period ahead, the Australian banking system is considerably better placed to weather the current challenges than many other systems around the world.

Over recent months the Australian banks have found strong demand for debt issued under the Government guarantee arrangements. These arrangements were announced in mid October, after similar schemes were introduced in several other countries following the failure of Lehman Brothers. In addition, many Australian banks have raised additional capital from private shareholders. Together with a tightening in lending standards, a lengthening in the maturity of their liabilities, and increased holdings of liquid assets, this has helped strengthen their balance sheets.

Overall credit growth has slowed over the past year. This partly reflects a tightening of credit standards, particularly by those lenders – including some of the foreign and regional banks as well as the non-banks – that had been more aggressive in pursuing market share over recent years. However, much of this slowdown reflects reduced demand for credit, particularly by businesses, with the number of business loan applications falling considerably. Over recent times, many businesses have taken a more conservative approach to their finances, by paying down debt and raising equity. This is despite the business sector, as a whole, having entered the current period of financial turmoil with its balance sheet in good shape after a number of years of solid profit growth.

The household sector has also reduced its appetite for debt as it has reassessed the economic outlook. This is particularly noticeable in a marked drop in the value of margin loans outstanding, as well as a slowing in the growth of credit card debt and spending. In contrast, housing credit growth, while having slowed, is broadly in line with the longer-run growth of household income. More generally, households have responded to the combination of falling asset values, strong income growth over the past year, and lower interest rates, by significantly lifting their saving, and increasing their holdings of bank deposits.