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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2009

The Global Financial Environment

Conditions facing the global financial system have improved markedly over the past six months. The extreme risk aversion prevailing in the wake of the failure of Lehman Brothers has eased, and investors have become more confident that the earlier feared worst-case scenarios have been avoided. The turnaround in financial market sentiment has relieved some of the pressure on asset valuations and financing activity evident during the period of extreme pessimism, and has contributed to increased confidence more broadly.

An important catalyst for the improvement in sentiment since March has been the run of stronger macroeconomic data, particularly in the Asian region, as fiscal and monetary stimulus have taken hold. Also influential is that a number of large international banks have, after sustaining heavy losses in 2008, returned to profitability and undertaken successful private capital raisings. Earlier steps taken by authorities to bolster the funding and, in some cases, capital position of the financial sector have also been supportive. The outlook nonetheless remains challenging: macroeconomic conditions continue to weigh on loan quality, lending conditions remain tight and confidence is potentially fragile. A particular issue is how the emergency official actions to stimulate economies and support financial sectors will be unwound and how this might affect financial institutions and markets.

Profitability and Capital

Financial market data clearly show the improvement in confidence in the global financial system. Since the trough in March, bank share price indices in the United States, Europe and the United Kingdom have recovered around one third of the fall over the preceding 18 months (Graph 1). Similarly, credit default swap (CDS) premiums have fallen sharply over the period, and have generally returned to around the levels prevailing prior to the collapse of Lehman Brothers (Graph 2).

The improved profit performance of banks has supported this recovery in sentiment. After a significant deterioration in performance in 2008, including large losses at some banks, the global banking system as a whole has returned to profitability in 2009, which has helped rebuild capital and reduce leverage (Graph 3). Both the fall and the subsequent turnaround in profitability have been broad based. In the United States, Federal Deposit Insurance Corporation (FDIC) insured institutions collectively posted profits of US$1.8 billion for the first half of 2009, having recorded a net loss of US$12 billion for the 2008 calendar year. In the United Kingdom, the five largest banks recorded combined profits of around £12 billion for the first half of 2009, after a loss of £20 billion in the second half of 2008. And in Europe, most large banking groups posted profits in both the first and second quarters of 2009.

One reason why profits have rebounded is that write-downs of securities have fallen. Data compiled by Bloomberg show that crisis-related losses on securities at around 100 large banks in the United States, Europe and the United Kingdom have fallen from around US$215 billion in the second half of 2008 to US$60 billion in the first half of 2009 (Graph 4). This has been driven by the sharp turnaround in many asset prices – just as the drop in confidence and the increased price of risk had undermined asset values through 2007 and 2008, the recent easing of risk aversion has supported valuations of risky assets. Favourable accounting treatment has also played a role in reducing write-downs, with rule changes allowing banks to avoid mark-to-market accounting on a broader range of assets. Large banks have generally been more affected by swings in securities values than smaller banks, as they tend to have a higher share of their assets in securities, after having grown these holdings significantly in the years preceding the crisis.

Another recent boost to profits, again particularly at large banks, has been the recovery in investment banking activity since markets began to thaw earlier this year. Banks with investment banking operations reported record income from debt and equity underwriting, as the backlog of debt issuance began to clear in the first quarter, and equity issuance picked up in the second quarter (as discussed below in the section on credit and wholesale funding markets). Banks also reported that profits have been boosted by strong client trading volumes and wider bid/ask spreads.

Loan loss provisions, however, have remained a significant drag on bank profitability in most countries. After lagging the increase in securities write-downs last year, loan write-offs have continued to increase as the challenging macroeconomic and financial conditions weigh on loan quality. A selection of large global banks for which data are available set aside aggregate provisions of US$142 billion for the first half of 2009, a 70 per cent increase on the same period in 2008, and an 8 per cent increase on the second half of 2008 (Graph 5). These banks’ loan loss reserves now total around 3 per cent of loans, with the ratio higher for large US banks. For all US FDIC-insured institutions, the ratio of reserves to loans is at its highest level since the data series began in 1984.

The high loan losses reflect both high levels of non-performing loans and high write-off rates on those loans. In the United States, loan performance has deteriorated across all categories, although write-off rates on household exposures are particularly high compared to previous downturns, consistent with lax lending practices and large house price falls (Graph 6). Outside the United States, write-off rates are much lower, although many analysts forecast a rise in the period ahead. Because commercial property prices have fallen significantly in many countries, loans to this sector are expected to be among the worst performing. Future performance of banks’ loan portfolios will depend on earlier lending practices and future developments in the macroeconomy and asset prices (discussed further below in the section on financial condition of the household and business sectors).

Higher profits have helped banks repair some of the damage done to balance sheets over the past two years. Banks have actively sought to reduce the levels of leverage and risk in their balance sheets by retaining profits, selling non-core assets and raising capital. In total, a collection of 21 large banks have raised around US$430 billion of capital since the fourth quarter of 2008, the bulk of this by US banks (Graph 7). While most of these funds initially came from government capital injections, around one third has been raised from private investors, much of this following the results of the US authorities’ stress tests of 19 large US banks. Another way that banks have been bolstering their capital position has been by shrinking their balance sheets. While moves to reduce assets and de-risk balance sheets may be sensible from the perspective of an individual institution, collectively, aggressive balance sheet reduction could depress asset prices and constrain the real economy, which would then feed back onto the financial sector.

Other parts of the financial system have also benefited from the better conditions. A number of large US and European insurance companies have returned to profit in the first half of 2009, after losses in the second half of 2008 flowing from asset price falls. Accordingly, share price indices and CDS premiums of insurers have retraced part of the movement from the peak of the crisis (Graph 8). US mortgage insurers, however, continue to be affected by weakness in the US housing market, with many still reporting losses in the first half of 2009. Hedge funds returned to profitability in the second quarter of 2009 and, following record levels of redemptions during the second half of 2008, the value of funds under management has steadied in 2009.

Credit and Wholesale Funding Markets

Greater confidence in banking systems is also evident in global bank funding markets. In all major short–term money markets, risk spreads have returned to levels prevailing in 2007, taking market interest rates to very low levels (Graph 9). In global long-term markets, risk spreads on bank bonds have retraced much of the widening seen over 2008, though they are closer to returning to levels preceding the crisis for higher-rated institutions than lower-rated institutions (Graph 10). These developments have encouraged banks to make greater use of normal funding arrangements, and to reduce their use of the support measures introduced by authorities when funding conditions were strained (as discussed below in the section on efforts to support the financial sector).

With the extreme pressure on the financial sector alleviated, earlier widespread fears of a debilitating feedback loop running from the financial sector to the economy and back to the financial sector have somewhat abated. Nonetheless, the credit supply process in the major economies remains significantly challenged. Banks in the United States and euro area continued to report a net tightening of lending standards for business and housing loans around mid-year, although the share of banks reporting tighter standards is below earlier peaks (Graph 11). A majority of US banks continued to report that they increased risk spreads on business loans in the June quarter. Demand for credit is also weak, with many households and businesses looking to strengthen their financial position by reducing their leverage.

Consistent with these supply and demand conditions, credit growth remains weak. Over the recent six-month period credit growth has continued to fall in the major markets and is now in low single digits or negative on an annualised basis (Graph 12). Both housing and business credit growth are well below their decade averages. Leading indicators generally suggest some signs of stabilisation in housing credit growth though there are fewer signs of this for business credit growth, partly because some businesses are increasing their funding through wholesale markets.

Some caution among lenders and borrowers also remains evident in non-financial wholesale debt markets. As with bank bonds, risk spreads have narrowed sharply from their post-Lehman collapse peaks, though investors have discriminated by credit quality; for example, spreads on AAA corporate bonds are back to their mid 2007 level, while those for lower-rated bonds remain well above. This has been reflected in issuance patterns; issuance of collateralised debt obligations (CDOs) and non-agency mortgage-backed securities (MBS) remains negligible, but issuance of conventional corporate bonds in 2009 to date already exceeds 2008 (Graph 13). Much of the corporate bond issuance in the United States occurred early in 2009, partly reflecting pent-up demand and willingness to lock in funding following the post-Lehman turmoil.

Commercial mortgage-backed securities (CMBS) and leveraged buyout (LBO) transactions are further examples of markets where, in the lead-up to the crisis, strong growth in debt had been used to finance activity in rising asset markets, but investors now remain cautious. Issuance of CMBS globally has been minimal, at around US$25 billion in 2009 to date, down from annual volumes of US$300 billion at the peak (Graph 14). In addition, investors are carefully scrutinising maturity profiles of existing borrowers for refinancing risk. Firms which participated in LBO transactions around the market peak are also facing close monitoring. In some regions, these firms have found that they have only limited access to their traditional bank and syndicated lending financing methods. Unsurprisingly, the value of new LBO deals remains subdued, with only US$24 billion announced and completed globally so far this year, well down from the annual totals in 2006 and 2007 of more than US$700 billion.

Given shocks to balance sheets and operating conditions, many firms are looking to raise equity and reduce their leverage rather than take on debt. The stronger tone in equity markets since March has enabled a strong pick-up in equity issuance by listed firms, though initial public offerings (IPOs) remain very subdued (Graph 15). Much of the equity raised has been used by firms to pay back debt or otherwise bolster balance sheets so as to lower refinancing risk. Firms have also sought to increase capital by lowering dividends.

Efforts to Support the Financial Sector

Actions by the authorities have been important in turning sentiment around and restoring confidence in the financial sector. In addition to the broader support from the fiscal and monetary stimulus introduced over the past couple of years, the financial sector has benefited from a range of specific actions implemented in a number of countries throughout the crisis period, particularly in the wake of the Lehman Brothers collapse in September 2008. As detailed in the March 2009 Financial Stability Review, authorities had widely moved to strengthen bank funding with extraordinary central bank liquidity support, increased depositor protection arrangements and provision of government guarantees for wholesale funding. Further, authorities in a number of countries had stepped in to support the capitalisation of financial institutions by injecting public funds, and to address concerns about risk exposures by absorbing some of the risk on troubled assets.

As improved sentiment has taken hold since March, there have been fewer new financial sector support initiatives, and some of the previously implemented assistance is being wound back. Removal of support arrangements, however, remains a significant policy challenge. It is in the long-run interest of the financial system for institutions to rely on their own credit standing rather than official sector support, as long as the withdrawal of arrangements can be accomplished without destabilising markets and confidence.

A noteworthy action, addressing concerns about capital levels of banks that persisted earlier in the year, was the US authorities’ stress tests of 19 large US banks. The results, released by the US Federal Reserve in May, found that 9 of the 19 banks did not require further capital to meet target capital adequacy ratios in a severe downturn scenario. Of the 10 that did, most implemented or announced measures that allowed them to achieve their target soon thereafter (Graph 16). The results, and the subsequent rapid private capital raisings by some banks, were viewed favourably by investors.

In a number of cases, earlier public equity injections have been returned. As US banks have raised private capital, they have repaid around one third of the total funds previously invested by the US Government as part of its capital purchase program. However, many smaller banks are yet to repay their funds and new public capital injections into smaller banks are still occurring, indicating a broad dispersion in the health of US banks. There have also been examples of private capital replacing public in other countries. The Swiss Government has begun withdrawing its support of the large bank UBS, by converting CHF6 billion of mandatory convertible notes into UBS shares, which were subsequently sold to institutional investors at a considerable overall profit to the Swiss Government given dividends paid. AEGON, a large Dutch insurer, has recently raised €1 billion in equity with the aim of partly repaying a loan extended by the Dutch Government in October 2008.

There have been some further actions by authorities on programs to deal with financial institutions’ troubled asset exposures, though improved market conditions and higher prices for many assets seem to have reduced the urgency of authorities and potential participants in pursuing these often complex measures. In March, the US authorities announced further details of the program to remove troubled loans and securities from banks but the program is yet to be fully implemented and the arrangements have been revised. In April and May, Ireland and Germany joined the list of countries that have announced troubled asset schemes, though the Irish scheme is not yet operational and the German scheme has not been used. In the United Kingdom, there have been no further deals under its program since the two transactions in February and March. In general, these troubled asset schemes have been less utilised than capital injection programs, raising concerns among some commentators about complacency in dealing with these exposures.

As risk spreads have narrowed, financial institutions have made less use of official support for wholesale funding. In many cases these support measures were designed so that their use would become increasingly unattractive as markets returned to more normal conditions.

In short-term funding there has been less drawing on central bank liquidity facilities. For example, assets purchased under liquidity facilities at the US Federal Reserve have fallen from as high as US$1.6 trillion in late 2008 to around US$410 billion in September, and from around £190 billion to £50 billion at the Bank of England (Graph 17). Nonetheless, balance sheets of these central banks remain considerably larger than normal. The fall in short-term liquidity facilities has been offset by an increase in assets that have been purchased directly by the central banks, such as mortgage-backed securities, to assist market functioning and the monetary policy transmission mechanism by promoting the pass-through of lower rates to end borrowers. As a result of these purchases, many borrowing rates are lower than would otherwise be the case.

The amount of term debt issued by banks and backed by government guarantee schemes has also slowed, particularly in the United States and United Kingdom, compared to the first quarter of 2009 (Graph 18). This partly reflects that some, mainly higher-rated, banks have been issuing unguaranteed debt as the risk appetite of investors has increased and risk spreads have narrowed, although the overall cost of guaranteed issuance appears to remain cheaper for most banks (i.e. the yield spread between unguaranteed and guaranteed bonds is wider than the fee for using the guarantee). Lesser use of the government guarantees also partly reflects that issuance earlier in the year included banks’ pent-up demand for funding. With lending growth currently slow, banks have less overall demand for funding, as suggested by lower total bond issuance by US financial firms (Graph 19). In addition, actions by authorities have sometimes worked against the use of the guarantees. In the United States, institutions must stop using the guarantee program in order to repay public capital and thereby eliminate restrictions on executive remuneration. In Europe, the ECB initiated a €60 billion covered bond purchase program that has enabled banks to raise funding in this market, rather than issuing guaranteed debt.

Attention is moving to how to exit from these government support arrangements. The US authorities have recently confirmed their intention to close the existing US scheme at the end of October. In many other countries, authorities have previously stated that issuance under the schemes will end in 2009, though the French Government recently announced a one-year extension of its scheme. Exit strategies from the guarantee arrangements have been a focus of discussion in international fora (see the Developments in the Financial System Architecture chapter). The broader issues of addressing the underlying causes of the crisis, and how to exit from highly stimulatory fiscal and monetary policies while balancing competing concerns about growth, inflation, crowding-out of private borrowers and, in some cases, the health of government finances, are other challenging policy issues being considered that will have important implications for financial institutions.

Financial Condition of the Household and Business Sectors

The crisis period has been marked by sharp swings in sentiment, both in financial markets and among households and businesses. In late 2008 and early 2009, measures of consumer and business confidence fell sharply, threatening a highly contractionary fall in spending that could, in turn, aggravate financial sector weakness (Graph 20). In the past six months confidence indicators have recovered somewhat, in line with the improved tone in financial markets, although in most countries they remain below their pre-crisis levels, consistent with the lingering negative effects of lower asset prices and slower macroeconomic growth on balance sheets and incomes. In this environment, households and businesses continue to take a more cautious approach to borrowing and spending than in recent years, and measures of loan quality have generally continued to deteriorate.

A significant drag on the financial position of households has been the weaker labour markets, particularly the rise in unemployment. Of the major countries this has been most pronounced in the United States, where the unemployment rate has risen by 5 percentage points in 18 months to reach 9.7 per cent in August, the highest since the early 1980s, with a further increase anticipated (Graph 21). In Europe and the United Kingdom, the rise in the unemployment rate to date is around 2 percentage points. Growth in underlying household income in these countries has weakened accordingly, though government transfers and lower interest rates have generally cushioned the effect on disposable income growth rates.

Household balance sheets remain negatively affected by developments in asset markets over recent years. The value of financial asset holdings has fallen sharply and prices of housing – typically the largest asset class for the household sector – have also registered large falls in many countries, with prices in the United States and United Kingdom down 30 and 20 per cent from their peaks (Graph 22). More recently, the fall in household assets has been arrested, as a result of gains in financial markets and signs of stabilisation in some housing markets, with some recent monthly house price gains in the United States and United Kingdom.

With higher unemployment and lower house prices impeding households’ ability to service and repay debt, mortgage arrears are rising in a number of countries. Of the major countries, the United States stands out as having the worst-performing housing loans. The 30+ days arrears rate on all mortgages has risen to 9.2 per cent in June 2009, from 7.9 per cent in December 2008, reflecting increases in all loan categories (Graph 23). A particular concern for lenders is that falls in house prices have pushed many borrowers into ‘negative equity’, where the value of the loan exceeds the value of the property. Private sector estimates suggest that around one third of mortgaged homes are in negative equity – with one eighth owing more than 125 per cent of their property’s value. In contrast, in the United Kingdom, the Bank of England estimates that between 7 and 11 per cent of owner-occupier mortgages are in (mostly marginal) negative equity.

Businesses are also experiencing tighter credit conditions, lower cashflow and weakened balance sheets, and measures of financial difficulty have generally increased. For example, Moody’s global speculative-grade default rate has increased by 9 percentage points over the 12 months to August 2009 to 11.5 per cent, the highest rate since the early 1990s (Graph 24). This rate is, however, forecast by Moody’s to decline over 2010. As with households, debt-servicing burdens have been alleviated by sharp reductions in policy rates, even though risk margins have widened. Concerns about businesses’ ability to refinance maturing debt have lessened in recent months, along with the easing in extreme risk aversion, though lenders and investors remain cautious. Asset exposures remain problematic for a number of firms given earlier price falls, particularly those that are highly geared. In this environment, as discussed above in the section on credit and wholesale funding markets, many firms are looking to reduce leverage, and equity raisings have picked up while business credit growth continues to fall.

A particular area of weakness has been companies with commercial property exposure. Commercial property prices in most markets have been pressured recently by rising vacancy rates, increased risk aversion and tough financing conditions in both intermediated and non-intermediated markets. In the United States and United Kingdom, prices have fallen even further than house prices (Graph 25). Prices of other commercial property-related assets, such as share prices of listed property companies, have shown improvement in recent months, but have generally not risen by as much as broader indices.

The effects of the poorly performing global commercial property market are being felt on banks’ balance sheets. In the United States, reflecting a delinquency rate of almost 8 per cent, banks’ commercial property charge-offs reached 2.1 per cent in the June quarter 2009 – only marginally lower than the levels experienced during the early 1990s. The experience of the 1990s, where the cycle in total returns was less pronounced, was that charge-offs continued at a high rate for a considerable period after the peak (Graph 26).