Financial Stability Review – September 2009The Australian Financial System
The Australian financial system has continued to perform relatively strongly over the past six months. The Australian banking sector has reported solid profits, and has further strengthened its capital position; the largest banks have maintained their high credit ratings. Funding conditions have also improved as the extreme risk aversion prevailing around the turn of the year has abated. Banks have ready access to debt funding and, with investor risk appetite returning, the higher-rated banks have increased issuance of debt not supported by the Government guarantee. Deposit growth has slowed in recent months, but remains firm. While the outlook has improved, the banking system continues to face some important challenges, including the prospect of problem loans rising further from the very low levels of recent years.
Profits and Asset Quality of the Banking System
In contrast to those in many other countries, the Australian banking system has reported solid profits throughout the financial turmoil. The four major banks recorded total headline profits after tax and minority interests of around $8.6 billion in the latest half year (to March for three of them and to June for the other), which represents an annualised post-tax return on equity of around 13½ per cent (Graph 27). Although this was a strong outcome, profits were around 14 per cent lower than in the same period a year earlier, after adjusting for recent mergers. The smaller banks, including the regionals, have also remained profitable in recent years, but have reported a more pronounced downturn in aggregate profitability (Graph 28).
A number of interrelated factors have contributed to the relatively strong performance of the Australian banking system in the face of the challenges of the past couple of years. One is that Australian banks typically entered the financial turmoil with only limited direct exposures to the types of securities – such as CDOs and US sub-prime RMBS – that led to losses for many banks abroad. Moreover, they have typically not relied on the income streams most affected by recent market conditions: trading income only accounted for around 5 per cent of the major banks' total income prior to the turmoil. Banks' wealth management operations have been affected by market developments, but the major banks still reported net income of around $2.3 billion from these activities in the latest half year.
One reason why Australian banks garnered a relatively low share of their income from trading and securities holdings is that they did not have as much incentive as many banks around the world to seek out higher-yielding, but higher-risk, offshore assets. In turn, this was partly because they were earning solid profits from lending to domestic borrowers, and already required offshore funding for these activities. As a result, Australian banks' balance sheets are heavily weighted towards domestic loans, particularly to the historically low-risk household sector. While domestic non-performing loan ratios have risen recently, they remain lower than in many other countries, reflecting a stronger economy, better lending standards and a proactive approach to prudential supervision (see below).
Because Australian banks focus on domestic lending, their profits continue to be underpinned by growth in net interest income. For the major banks, net interest income increased by 22 per cent over the past year (after adjusting for mergers) as a result of the ongoing expansion of their balance sheets (Graph 29). Net interest income also accounted for most of the regional banks' profits, though its growth has moderated over the past year or so. After a decade of declines, the interest rate margin that the major banks earned on their domestic lending increased slightly over the past year, from 2.11 per cent to 2.24 per cent. In contrast, overall interest margins at some of the smaller banks still appear to be under downward pressure, reflecting strong competition for deposits, higher wholesale funding costs and their generally higher share of assets in housing loans, where margins have not widened as much as on business loans.
The recent decline in bank profits has been mainly due to a rise in provisioning charges. The major banks reported charges for bad and doubtful debts of $6.2 billion in the latest half year, compared with $2.8 billion in the same period a year earlier (Graph 30). This is up from the low charges over recent years, but well below the expense for bad and doubtful debts incurred in the early 1990s (see Box A) and by major banks in the United States and Europe. This recent rise in the bad debts expense partly reflects an increase in the collective provisions that banks hold against a general deterioration in their loan portfolios, such as that arising from the downturn in economic conditions, both in Australia and overseas. It also reflects higher individual provisions, including against exposures to highly leveraged companies that are often the first to experience difficulties when economic conditions turn for the worse. Provisioning expenses have also increased at the regional banks from a low base: they reported a $360 million rise in provisioning charges over the past year.
The major banks' trading updates and analysts' expectations suggest that provisioning charges are likely to rise further in the near term, to a peak equivalent to around 0.6 per cent of their average assets for the 2010 financial year, before improving thereafter. Consistent with their anticipated profile for bad debt charges, analysts generally expect banks' return on equity to increase a little in the 2011 financial year.
The higher provisioning charges reflect a rise in banks' non-performing assets. The ratio of these to total on-balance sheet assets stood at around 1.5 per cent as at June 2009, compared to 0.7 per cent a year earlier (Graph 31). It is around 80 basis points above its average over the past decade, but still well below the early 1990s peak of over 6 per cent. Around one quarter of these non-performing assets are classified as ‘past due’ but not impaired, meaning that the outstanding amount is well covered by the value of collateral, even though repayments are overdue by at least 90 days.
The rise in non-performing loans (NPLs) has been evident across each of the main segments of the domestic loan portfolio, but it has been most pronounced in lending to businesses. The business (including financials) NPL ratio rose from 0.9 per cent to 2.9 per cent over the year to June 2009 (Graph 32). This increase was initially mainly due to a small number of exposures to highly geared companies with complicated financial structures and/or exposures to the commercial property sector, but it has become more widespread recently as the economy has slowed.
In banks' commercial property loan portfolios, the impaired assets ratio stood at around 4½ per cent as at June 2009, compared to around 1½ per cent in early 2008 (Graph 33). This ratio is now higher than it has been for some time, but is lower than the levels reached in the early 1990s. Much of the rise has been accounted for by loans for retail property and, more recently, residential development. In contrast to the early 1990s, there has been only a relatively small rise in impaired loans for office property. The rise has been less pronounced for the majors than the smaller banks.
In the mortgage portfolio – which accounts for over half of banks' on-balance sheet loans – the aggregate NPL ratio has also continued to rise, to 0.62 per cent as at June 2009, compared to 0.49 per cent a year earlier. There has, however, been an improvement in NPL ratios across some banks' housing loan portfolios over the past three months, with nearly half of the locally incorporated banks reporting a decline over the June quarter 2009 (Graph 34). Housing loan arrears rates for Australian credit unions and building societies are lower than for banks and, at 0.15 per cent and 0.35 per cent, are around the same levels as in 2005. While the recent declines in interest rates have helped to alleviate debt-servicing pressures for some borrowers, higher unemployment represents a source of risk to authorised deposit-taking institutions' (ADIs) housing portfolios.
Despite the recent increase in the bank housing NPL ratio, it remains low by international standards. In the United States and United Kingdom, which have experienced both a housing market correction and banking sector problems, the comparable NPL ratios were around 5.7 per cent and 2.4 per cent (Graph 35). As discussed in detail in the previous Review, there are several factors that have contributed to the relatively strong outcome in Australia, including:
- Lending standards were not eased to the same extent as elsewhere. For example, riskier types of mortgages, such as non-conforming and negative amortisation loans, that became common in the United States, were not features of Australian banks' lending.
- The level of interest rates in Australia did not reach the very low levels that had made it temporarily possible for many borrowers with limited repayment ability to obtain loans, as in some other countries.
- All Australian mortgages are ‘full recourse’ following a court repossession action, and households generally understand that they cannot just hand in the keys to the lender to extinguish the debt.
- The legal environment in Australia places a stronger obligation on lenders to make responsible lending decisions than is the case in the United States.
- The Australian Prudential Regulation Authority (APRA) has been relatively proactive in its approach to prudential supervision, conducting several stress tests of ADIs' housing loan portfolios and strengthening the capital requirements for higher-risk housing loans.
Part of the increase in Australian banks' bad debts has been due to their overseas operations, particularly in New Zealand and the United Kingdom where economic conditions have weakened significantly. As at June 2009, the Australian banks' overseas exposures accounted for around one quarter of their total assets, with New Zealand and the United Kingdom together accounting for about two thirds of these foreign exposures. The recent downturn in economic conditions in these two countries has been associated with falls in property prices, contractions in lending, and increases in non-performing loans and provisions. In New Zealand, the major banks' subsidiaries have remained profitable, despite the increase in non-performing loans, because of solid net interest income (Graph 36).
Capital and Liquidity
The Australian banking system remains soundly capitalised. The sector's Tier 1 capital ratio rose by 1.3 percentage points over the 12 months to June 2009 to 8.6 per cent, its highest level in over a decade (Graph 37). In contrast, the Tier 2 capital ratio has fallen by around 0.7 percentage points over the same period, mainly because term subordinated debt declined. As a result of these developments, the banking system's total capital ratio has risen by almost 0.7 percentage points over the past year, to stand at 11.3 per cent as at June 2009. A similar pattern has been evident in a simpler measure of leverage – the ratio of ordinary shares to (unweighted) assets – which has risen by around half a percentage point over the past six months. The credit union and building society sectors are also well capitalised, with aggregate total capital ratios of 16.4 per cent and 15 per cent.
The rise in the banking system's Tier 1 capital ratio largely reflects the significant amount of new equity that has been issued over the past year or so. In 2009 to date, the major banks have issued a combined $12 billion of ordinary equity, with recent placements being heavily oversubscribed and priced at only modest discounts to share prices (Graph 38). These banks have also scheduled a further $2.1 billion of issuance of other Tier 1 capital instruments in the near term. The regional banks have issued around $1.9 billion of ordinary equity this year. These initiatives have seen the share of banking system capital accounted for by ordinary equity rise to around 45 per cent as at June 2009, after this share had fallen to 32 per cent a few years ago. In large part, these developments reflect procyclical market pressure for listed banks to raise additional equity, in contrast to earlier years when there was little new issuance, and some ordinary equity buybacks. At the same time, markets are focusing on the composition of banks' capital, which has seen a fall in outstanding Tier 2 capital instruments such as term subordinated debt, after strong issuance in the earlier part of the decade.
In response to falling profits, many banks have cut their dividends (Graph 39). Despite these lower dividends, the major banks' dividend payout ratio increased to around 80 per cent over the past year.
Banks are also holding significantly more liquid assets than they were prior to the onset of the financial turmoil, reflecting an increased focus on liquidity in the current environment. Following a step-up in the second half of 2007, the share of their total domestic assets accounted for by cash, deposits, and highly marketable domestic securities has been broadly unchanged at around 16 per cent; if banks' ‘self securitisations’ are included it would be around 22 per cent as at July 2009 (Graph 40). Whereas the bulk of the earlier rise in the liquid assets ratio reflected increased holdings of securities issued by other ADIs, the share of liquid assets accounted for by government securities has risen recently, from a low base. Banks' holdings of government securities are equivalent to around one quarter of the current stock outstanding.
Financial Markets' Assessment
Reflecting their ongoing strong performance and sound capital positions, the largest Australian banks continue to be highly rated. Australia's four largest banks are all rated AA by Standard & Poor's (S&P) and these ratings have been unchanged throughout the financial turmoil (Table 1).
In contrast, many large international banks have been downgraded over the past couple of years and, as a result, only five of the other largest 100 global banking groups have an equivalent or higher rating from S&P (Graph 41). S&P and Fitch recently reaffirmed their stable outlook for the major Australian banks' ratings, while Moody's has maintained the negative outlook that it assigned in March this year. The only Australian-owned bank to have been downgraded by S&P since mid 2008 is Suncorp-Metway, though several subsidiaries of foreign banks have been downgraded, in line with their parent ratings.
Equity markets have also taken a positive view of the Australian banks over the past six months, even when compared with the general improvement in market sentiment. The Australian banking index has risen by around 75 per cent since early March, compared with a 48 per cent gain in the broader market. While the recent rally has been broadly based across the banking sector, the regional banks' share prices remain around 50 per cent lower than they were in early 2007, with the major banks' 10 per cent lower (Graph 42). Throughout the crisis period, share prices of the major Australian banks were more resilient than their counterparts in other advanced economies. As market uncertainty has eased, volatility for both banks and the market as a whole has declined, after it rose to very high levels late last year. The daily movement in banks' share prices has averaged 1.8 per cent since March, compared to peaks of over 4 per cent late last year.
The increase in banks' share prices has led to a marked turnaround in market-based valuation measures. For instance, banks' forward price/earnings ratio is currently 14.7, which is around its long-run average and well above the low of 7½ that it reached in January (Graph 43). Similarly, banks' dividend yields have fallen to average around 5½ per cent, after peaking at just under 10 per cent in January, with this fall reflecting both higher share prices and lower dividends.
The firmer tone is also reflected in Australian banks' CDS premiums – the price paid by investors to insure debt – which have generally narrowed to levels prevailing prior to the collapse of Lehman Brothers. The cost of insuring the senior debt of the four major Australian banks is currently around 65 basis points per annum, compared to peaks of over 200 basis points earlier this year, but still well above the 5 to 10 basis points in the years preceding the financial turmoil.
Funding Conditions and Guarantee Arrangements
Funding conditions have improved considerably over the past six months as market sentiment has recovered from the extreme risk aversion of late 2008 and early 2009. As discussed in the previous Review, despite their relatively good performance, Australian banks were not immune from the acute uncertainty about the health of the global banking system that was precipitated by the collapse of Lehman Brothers in September last year. This uncertainty led to pressures on the cost and availability of funding, with capital market investors and some depositors showing signs of nervousness. In October 2008, the Australian Government responded to these developments by announcing that all deposits of $1 million or less in eligible ADIs would be automatically guaranteed by the Government under the Financial Claims Scheme, and that it was introducing a fee-based Guarantee Scheme for Large Deposits and Wholesale Funding. These measures were successful in assuaging investor unease, and funding conditions have improved steadily over the course of 2009 as risk aversion has abated. Banks have issued a large volume of long-term debt in domestic and offshore markets, increasingly without the backing of the Government's guarantee, and deposit growth remains firm. There have only been limited signs of improvement in the securitisation market for new issues relying solely on private investors, but developments in recent weeks have been positive.
The recovery in sentiment over recent months has been evident in the domestic money market, with the spread between the yield on 3-month bank bills and the overnight index swap rate for the same maturity having narrowed to an average of around 20 basis points over the past couple of months, compared with the peaks of around 100 basis points at the height of the global market uncertainty in late 2008 (Graph 44). As this uncertainty has dissipated, the RBA has reduced the supply of Exchange Settlement (ES) balances, after these balances had been increased significantly to assist in the smooth functioning of markets. ES balances have averaged around $1½ billion since June, which is well below the peaks around the end of 2008 (Graph 45).
Spreads on long-term bank debt in domestic and offshore markets have also narrowed over the past six months or so, though they remain higher than prior to the onset of the market turmoil. For example, the spread between 3-year bonds issued domestically by AA-rated banks and Commonwealth Government Securities (CGS) is currently around 95 basis points, compared to a peak of 225 basis points in late 2008, and 55 basis points in mid 2007 (Graph 46). At this horizon, spreads on domestic unguaranteed debt have narrowed to the extent that it is now slightly cheaper for AA-rated banks to issue unguaranteed than guaranteed, after taking into account the guarantee fee. For these banks, the all-in costs of guaranteed and unguaranteed debt have also converged at longer horizons. It is still, however, relatively more expensive to issue unguaranteed for lower-rated institutions.
Since the guarantee arrangements for wholesale funding became operational on 28 November 2008, Australian banks have issued around $185 billion of long-term debt, with $142 billion of this having been issued under the Guarantee Scheme (Graph 47). Around 60 per cent of the bonds have been issued offshore, mainly in the US market. While demand for government guaranteed paper remains strong, banks have recently stepped up their issuance of unguaranteed debt, in both the Australian and overseas markets. In the domestic market, unguaranteed paper has accounted for around half of total issuance over the past few months, compared to 10 per cent in the March quarter 2009. Several banks have tapped offshore markets for unguaranteed debt in recent months, particularly for longer-dated maturities beyond the 5-year limit of the Guarantee Scheme.
Banks have also used the Guarantee Scheme for short-term debt and large deposits (greater than $1 million), but investor appetite to pay for the guarantee for these liabilities has been lower than for term debt. In August 2009, the average value of outstanding short-term guaranteed debt was $17.2 billion, which is equivalent to roughly 5 per cent of total short-term debt outstanding (Graph 48). The majority of this had been issued by foreign-owned banks. Total guaranteed large deposits stood at just under $17 billion, only around 1½ per cent of total deposits. Both guaranteed short-term debt and large deposits have declined over the past six months.
More generally, the recent pattern of wholesale debt issuance is consistent with banks having lengthened the maturity profile of their liabilities, after they had shortened it in the early stages of the financial turmoil. As a result, the share of banks' outstanding debt with an original maturity greater than one year increased from 63 per cent to 78 per cent over the year to June 2009 (Graph 49). In recent months, the average tenor of new bond issues has been around 4½ years, and the average maturity of outstanding bonds has been broadly stable at just over 3 years.
Deposit growth for the ADI sector as a whole has been strong through the crisis period, though it has moderated over recent months as investor appetite for alternative assets has returned. Over the six months to July 2009, total deposits increased at an annualised rate of 10 per cent, compared to rates of around 25 per cent earlier this year (Graph 50). Most banks are endeavouring to increase their share of funding from deposits, in response to markets' increased focus on funding liquidity risk. For some of the smaller banks, it is also because of a lack of alternative funding options, given the difficulties in the securitisation market. These factors have led to strong competition for deposits, especially for term deposits, and deposit spreads have widened. For instance, the average rate paid by the major banks on their term deposit ‘specials’ is currently around 175 basis points above the 90-day bank bill rate, compared to about 75 basis points as at end December 2008.
While banks have been able to tap capital markets and attract strong inflows of new deposits, conditions in the asset-backed commercial paper (ABCP) and residential mortgage-backed securities (RMBS) markets have been difficult. As discussed in detail in previous Reviews, ABCP markets around the world were the first to be affected by the repricing of risk. While they remain strained, there have been some signs of improvement in recent weeks. As at June 2009, the outstanding value of ABCP issued by Australian entities (on and offshore) was around $32 billion, 55 per cent lower than its peak in mid 2007. It is estimated that the spread on domestic ABCP over the bank bill rate is currently around 55 basis points, whereas it had been possible to issue ABCP at spreads of around 5 basis points before mid 2007.
Conditions in the RMBS market have also been quite difficult, though there have recently been signs of improvement and increased investor appetite. RMBS issuance had averaged just $2.7 billion per quarter since mid 2007, compared to a quarterly average of $15 billion over the previous two years. While most of the issuance that has taken place since October 2008 has been purchased by the Australian Office of Financial Management (AOFM), two recent RMBS issues were purchased entirely by private investors. Secondary market spreads have also narrowed over recent months, to around 150 to 250 basis points above the bank bill swap rate, compared with 350 to 550 basis points around the turn of the year, and 15 basis points before the onset of the financial turmoil. The narrowing spreads are consistent with the generally firmer tone in financial markets, and the ongoing good credit quality of Australian RMBS. Losses on prime Australian RMBS (after proceeds from property sales) have been very low throughout the crisis, averaging around 5 basis points per year. Moreover, these losses continue to be largely covered by credit enhancements such as lenders' mortgage insurance, and no losses have been borne by investors in a rated tranche of an Australian RMBS.
Lending Growth and Credit Conditions
Domestic credit growth has continued to moderate over the past six months, largely because demand for intermediated debt from businesses remains weak, and there has also been a general tightening in the terms and conditions under which credit is being extended. The tightening in credit standards has partly reflected a turnaround of the marked easing that took place in some areas in earlier years and is not an unexpected development at this stage of the economic cycle. Banks' appetite for risk may have declined, but they have good access to funding and credit remains available for good quality borrowers.
Bank business credit fell at an annualised rate of 6¾ per cent over the six months to July 2009, although the rate of decline has stabilised in more recent months (Graph 51). These outcomes follow the very strong growth in business credit over the second half of 2007, when access to capital markets dried up and companies increasingly turned to banks for funding. As discussed in more detail in the Household and Business Balance Sheets chapter, the recent moderation in business credit growth is consistent with weak demand for new borrowing and businesses paying down debt to reduce their leverage, as well as some corporates issuing debt in wholesale markets.
It is also consistent with an easing of the very strong competition that was evident in some areas of the business loan market in the middle years of this decade, which was associated with a narrowing of margins and a general easing in the availability of credit. More recently, banks have sought to increase their risk margins as well as strengthen non-price conditions such as collateral requirements and loan covenants. While it is difficult to generalise, the available evidence suggests that margins on new and refinanced corporate loans are at least 100 basis points higher than in mid 2008.
Indications are that loan conditions have been tightened more for larger companies than for their smaller counterparts. All industries appear to have experienced some tightening, but the commercial property sector has been especially affected, reflecting ongoing uncertainty about asset quality and property valuations. Tighter loan terms have not, however, generally prevented property companies from refinancing their debt as it falls due.
Bank business credit has turned down across all types of bank, but more so among the foreign-owned banks than others. The activities of these banks had been one of the factors underpinning the previous strong growth in business lending, especially in the large-value segment where they had made notable gains in market share. Despite the recent slowing, however, there is little evidence of a generalised withdrawal from the Australian market and foreign-owned banks have continued to participate in recent syndicated loans. Lending by non-bank financial institutions has also contracted noticeably, partly because some foreign non-bank entities have pulled back from the domestic market. At the same time, credit extended by the major banks has fallen by less than total business credit, and their lending to unincorporated businesses has continued to grow (Graph 52).
In contrast to business credit, bank household credit growth has strengthened recently, to an annualised rate of 10 per cent over the six months to July 2009, compared to 8 per cent over the six months to January. Although many households are taking a more cautious approach to their finances than in recent years, first-home buyers' appetite for borrowing has been strong: they accounted for 28 per cent of new housing loan approvals over the six months to July 2009, compared to an average of 16 per cent over the five years to December 2008. This demand has, however, been starting to ease somewhat.
While housing credit growth has firmed, lending standards have continued to tighten a little and banks are paying close attention to credit risk. Many banks have lowered their maximum loan-to-valuation ratios (LVRs) further over the past six months, with most of the largest lenders no longer offering loans with LVRs greater than 90 per cent to new customers. Most lenders have also announced higher ‘genuine savings’ requirements (not including the first-home owner grant), often to a minimum of 5 per cent.
Recent developments in the mortgage market have occurred against a backdrop of significant changes in market shares. Most of the new lending over the past year or so has been by the major banks, which have increased their share of new owner-occupier loan approvals to 81 per cent as at July 2009, from around 60 per cent in mid 2007 (Graph 53). In contrast, lenders that had previously relied on securitisation for funding have lost market share, with the share of approvals accounted for by mortgage originators falling to around 2½ per cent in July, compared to around 12 per cent in mid 2007. The smaller banks and, to a lesser extent, credit unions and building societies have also lost market share. These movements follow a lengthy period when the major banks had been losing market share as securitisation markets expanded.
The Australian general insurance industry recorded solid profits over the latest financial year, despite facing a challenging operating environment. Total pre-tax profit was $3.6 billion in the year to June 2009, which was around 4 per cent lower than in the previous year. The industry's pre-tax return on equity was around 13 per cent over the same period, compared to a 10-year average of around 17 per cent (Graph 54).
Profits were derived from returns on invested premiums, with investment income increasing by 50 per cent, to $4.7 billion, over the year to June 2009. The industry benefited most from higher prices of fixed-income securities, which account for around two thirds of their financial assets. At the same time, Australian general insurers were relatively insulated from the sharp falls in equity markets in late 2008 and early 2009, because direct holdings of equities accounted for only around 5 per cent of their financial assets in mid 2008.
In contrast to the improved investment performance, underwriting conditions remain difficult. Total claims incurred by Australian insurers (net of reinsurance and other recoveries) increased by 21 per cent over the year to June 2009, which is well above the average annual rise of 9 per cent over the previous five years. The factors that contributed to this outcome included: a number of significant ‘natural hazard’ events, most notably the Victorian bushfires; a rise in the size and frequency of small claim events across a number of business lines; and higher measured claim liabilities arising from the reduction in risk-free rates (which are used to discount expected future claim payments). These higher claims were only partly offset by stronger growth in net premium revenue, which rose by 6½ per cent over the same period, compared with an average annual rise of around 3 per cent over the previous five years. This pick-up was due to an increase in premium rates for some business lines, as well as a decline in reinsurance expenses. A summary measure of the industry's underwriting performance is the combined ratio – claims and underwriting expenses relative to net premium revenue – which rose by 8 percentage points over the year to June 2009, to around 100 per cent. This is the weakest result since 2001/02 and indicates that, in aggregate, insurers roughly broke even on their underwriting business.
Despite the recent pressures on their underwriting operations, the Australian general insurance industry remains well capitalised, with the industry holding capital equivalent to around 1.8 times the regulatory minimum as at March 2009 (the latest available aggregate data). Several of the large Australian insurers have recently sought to further strengthen their capital position, and have raised around $1.9 billion of equity so far in 2009.
As discussed in previous Reviews, the lenders' mortgage insurance (LMI) segment of the global insurance industry has attracted particular attention because of the pressures arising from developments in global housing markets. LMI provides protection for lenders against borrower default, and is also a form of credit enhancement in the RMBS market. In the United States, for example, LMIs have continued to report large losses due to the very weak US housing market. In contrast, the two largest LMIs in Australia, QBE and Genworth, have continued to report solid profits, despite claims rising from a low base. Consistent with developments in the banking sector, the Australian LMIs have also tightened their underwriting standards: they have increased their premiums for loans with higher loan-to-valuation ratios, as well as introduced ‘genuine savings’ requirements and lowered maximum LVRs for loans that they are willing to cover.
More generally, analysts anticipate that listed insurers' profits will rise somewhat over the next financial year, partly because of higher average premium rates across some business lines as insurers respond to the higher claims rates of recent years. This more positive outlook has been reflected in insurers' share prices, which have risen by around 25 per cent since March, to be back around the levels of late 2008 (Graph 55). While share prices remain around 40 per cent lower than their peak in February 2007, this compares to around 60 per cent and 50 per cent for the US and European insurance indices. In contrast to many of their international peers, the four largest Australian insurers have also maintained high credit ratings throughout the financial turmoil: all of them are rated A+ or higher by Standard & Poor's and are on stable outlooks (Table 2).
The turbulence in financial markets over the past couple of years has greatly affected the performance of the funds management industry, though there have been signs of improvement more recently. On a consolidated basis, the industry's assets under management increased at an annualised rate of around 4 per cent over the six months to June 2009, but are still 13 per cent lower than the peak in September 2007 (Table 3). The recent rise has been due to the stronger performance of superannuation funds, which account for over 60 per cent of total assets under management.
According to ABS data, superannuation funds' (consolidated) assets under management increased at an annualised rate of around 11 per cent over the six months to June 2009, following an annualised fall of 20 per cent over the second half of 2008. This turnaround has been due to stronger growth across most domestic asset classes, especially equity holdings which have increased in value over recent months as the share market has rallied (Table 4).
The recent rise in funds under management follows a prolonged period of declining asset valuations. The latest available APRA data on industry returns show that superannuation funds recorded losses on their investment portfolios of about $140 billion over the year to March 2009, compared to an average yearly gain of around $65 billion over the five years to mid 2007 (Graph 56). Since the onset of the market turmoil, inflows of new funds into superannuation have also generally been slightly lower than in prior years, as some investors became more wary of market-linked assets. While aggregate figures for the June quarter 2009 are not yet available, industry data suggest that inflows have picked up. This likely reflects improved sentiment, as well as a temporary boost ahead of changes to superannuation rules that became effective on 1 July 2009, such as the reduction in the concessional contribution cap – the maximum amount that individuals can contribute to superannuation at the concessional tax rate.
Life insurers (consolidated) assets fell by $20 billion, or 11 per cent, over the year to June 2009, with the majority of this occurring in the second half of 2008. Much of this decline has been due to lower valuations on superannuation assets held in life offices, which account for around 90 per cent of the industry's total assets. APRA figures show that life insurers recorded investment losses of around $33 billion over the year to March 2009 (the latest data available), compared to average annual net income of around $20 billion over the five years to mid 2007 (Graph 57). In turn, this outcome is consistent with the falls in share prices over the past couple of years, because life insurers held around three quarters of their assets in domestic equities and units in trusts at the end of 2007. Most of these investment losses were, however, borne by policy holders rather than the life insurers themselves, and the industry reported aggregate profits of $1.4 billion over the year to March 2009. While prospects for the life insurance industry remain closely tied to those for the superannuation sector, there are also indications that demand for traditional life insurance products has strengthened recently.
Public Unit Trusts and Other Managed Funds
Outside of superannuation funds and life offices, the majority of assets under management are invested with public unit trusts. These entities have also been significantly affected by the recent financial turbulence, and their (consolidated) assets fell by 10 per cent over the year to June 2009. Asset values have declined across all of the main types of public unit trusts, as the prices of most asset classes have fallen since the onset of the market turmoil (Table 5).
As discussed in the previous Review, one sector that has been particularly affected by recent developments is the mortgage trust industry. Many of these trusts experienced outflows of funds in 2008, and most responded by suspending redemptions because of the illiquidity of their underlying assets. Following this, ASIC introduced provisions allowing investors to withdraw funds based on hardship grounds, such as if they would be unable to meet immediate living or medical expenses. As at mid August 2009, frozen mortgage trusts had paid out around $38 million to investors under these provisions. ASIC has also recently relaxed these hardship provisions by increasing the annual withdrawal limit for investors, permitting more frequent withdrawals by investors, and allowing a wider range of investors to access funds.
As conditions in financial markets have stabilised in recent months, there has been some recovery in activity in Australia's cash equity and derivatives markets. With lower volatility and reduced counterparty credit concerns, the central counterparties supporting Australia's financial markets have also been able to reverse the sharp increases in margin levels implemented in late 2008, and reduce the intensity of their participant-monitoring activities. Settlement of high-value payments and securities trades has continued to proceed smoothly.
Having declined sharply during the period of market turbulence in late 2008 and early 2009, the volume and value of trades executed in the Australian cash equity market increased by 20 per cent and 30 per cent in the June quarter 2009. The removal of the ban on short selling of financial stocks in late May might also have contributed to some recovery in activity. Over the financial year as a whole, however, the average daily value of trades in the cash equity market fell by more than 30 per cent, largely reflecting the decline in share prices over the year.
Turnover also recovered on the Sydney Futures Exchange (SFE) during the first half of the year, at least for the major interest rate contracts. For example, after an unusually large fall of more than 40 per cent in the final quarter of 2008, average daily turnover in the 90-day bank bill futures contract rose by 21 per cent in the first quarter of 2009 (Graph 58). Turnover in the 3-year government bond futures contract rose by 19 per cent in the first quarter and continued to rise through to end July. There was also a modest rebuilding of open positions across a number of contracts late in the financial year.
Despite the recovery in activity, the scale of risk exposure assumed by the central counterparties supporting the equities and futures markets has declined. One measure of risk exposure is the value of margin held by the central counterparties in respect of participants' positions. Both central counterparties increased initial margin levels sharply late in 2008, as market volatility increased (Graph 59). In most cases, these increases have been reversed more recently, leading to a sharp decline in total margin held by both central counterparties. Initial margin held by SFE Clearing Corporation declined from a peak of $5.7 billion in December 2008 to $2.4 billion at end-June, while total initial and mark-to-market margin held by the Australian Clearing House peaked at $2.1 billion in February 2009, before declining to $1.2 billion at end-June. The frequency of intraday margin calls was also much lower during the first half of 2009, again reflecting lower market volatility. Also, as counterparty credit risks receded, the central counterparties upgraded several participants within their internal credit-rating framework and removed a number of participants from their ‘watch list’ for more intensive monitoring.
Settlement has proceeded smoothly in the cash equity market in recent months, with some evidence that new arrangements to deal with settlement fails improved settlement performance. As recommended in the Reserve Bank's Review of Settlement Practices for Australian Equities in May 2008, ASX increased the penalty fee for failed settlements in September 2008, and in March 2009 introduced a regime requiring that any trades remaining unsettled on the fifth day after trade date be closed out. The rate of settlement fails had already begun to decline in anticipation of these measures, and has averaged less than 0.1 per cent since the end of March.
While there has been some recovery in market activity in recent months, the value of settlement activity in Australia's high-value payment system, RITS, remains significantly below levels seen prior to the market turbulence (Graph 60). The average daily value of settled payments during the June quarter 2009 was $170 billion, down by 16 per cent from its peak in the March quarter 2008. RITS is used to settle both ‘clean’ payments and fixed-income securities transactions submitted via Austraclear. Much of the recent decline in settlement values is associated with clean payments, and is consistent with the downturn in foreign exchange market activity over the same period. In contrast, the average daily volume of payments settled through RITS has tended to increase over the same period, due mainly to continued growth in the number of lower-value payments settled in the system.
Despite earlier concerns that credit issues might spill over to payment settlements activity, this critical part of financial market infrastructure has continued to function efficiently. In particular, greater liquidity held in the form of Exchange Settlement account balances has enabled some settlements to be brought forward during the day. As a result of this and the decline in values, the typical peak in settlement activity that occurs late in the day has moderated somewhat (Graph 61). Moreover, there has been no indication of any unusual settlement activity or operational dysfunction, such as might cause an increase in the number of extensions to RITS operating hours or require greater recourse to the Reserve Bank's overnight repo facility.