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RESERVE BANK OF AUSTRALIA

Financial Stability Review – September 2009

Overview

Conditions in the global financial system have improved significantly since the time of the last Financial Stability Review in March. While markets remain under a degree of stress, the extreme risk aversion that broke out following the Lehman Brothers collapse last September has dissipated, and confidence has begun to recover. These developments have occurred alongside signs of improved prospects for recovery in the global economy.

The period of most intense stress in global markets extended over the six months from September 2008 to March 2009. This period was marked by steep declines in world equity prices, exceptionally large risk premiums in a range of markets and serious dysfunction in wholesale credit markets. It was during this period that governments around the world moved to support their financial systems by expanding depositor protection and offering guarantees for banks’ wholesale funding.

The improvement in financial conditions since March has been evident across a range of indicators. Equity prices in the major economies have reversed some of their earlier declines, rising by around 50 per cent from their trough. Credit spreads have narrowed and, in recent months, there has been a resumption of activity in unguaranteed credit markets that had previously been closed. Another encouraging sign is that most major banks in the United States and Europe have reported profits recently after the large losses incurred during 2008.

Notwithstanding these more positive developments, the situation in the global financial system remains challenging. In particular, loan losses associated with banks’ on-balance sheet lending still have some way to unfold, with commercial property an area of particular weakness in some countries. In addition, the transition away from emergency support measures and towards more normal macroeconomic policy settings still has to be managed.

The Australian financial system has, throughout the crisis period, remained resilient. In aggregate, the Australian banks have experienced only a modest decline in profitability. While there has been some diversity of performance across banks, increases in loan losses and impairments across the banking system to date have been lower than in many other countries. The banks are well capitalised and have strengthened their balance sheets further with significant new equity raisings during the past year.

The Australian banks and other authorised deposit-taking institutions (ADIs) were affected by the financial crisis primarily through its impact on the cost and availability of funding. Wholesale borrowing costs increased significantly relative to the cash rate, and in some cases funding markets were effectively closed. The introduction of the guarantee arrangements late last year played an important part in ensuring that Australian banks and other ADIs maintained access to funding during the most intense phase of the crisis, and that the system was therefore able to continue lending.

More recently, conditions in funding markets for Australian institutions have been improving. As has been occurring in global markets generally, risk spreads faced by Australian wholesale borrowers have declined over recent months. With investor risk appetite returning, the higher-rated banks have been increasingly willing to tap wholesale markets on their own credit standing, without the support of the Government guarantee. Spreads on residential mortgage-backed securities in the Australian market have also narrowed, and this has begun to support new issuance to private investors.

In the non-financial sectors, sentiment among Australian households and businesses has improved considerably over recent months, as it has in other countries. The household sector experienced a sharp decline in net worth during the period when equity prices were falling, but this has been partly reversed since March, and household disposable income has received a significant boost from interest rate reductions and fiscal transfers. Overall borrowing by households has continued to expand over the past couple of years, though the pace of growth has moderated. Margin lending to households has declined sharply, and there has been little growth in other forms of personal lending or in lending for investment housing. However, lending for owner-occupied housing has picked up noticeably since the start of the year in an environment of low interest rates, first-home owner incentives and improving confidence. The increase in borrowing has been associated with firmer conditions in the market for established housing.

In contrast to developments in the household sector, borrowing by businesses from financial institutions has been declining since late last year. This has reflected both reduced demand for credit in the current environment and, to some extent, tighter lending standards. While most businesses entered the crisis period with sound balance sheets after a long period of economic expansion, the climate of uncertainty over the past year has prompted many of them to strengthen their balance sheets, by taking advantage of the recovery in equity markets to raise additional equity.

In summary, global financial conditions remain challenging. But, while further setbacks cannot be ruled out, the severe downside risks that loomed six months ago have significantly abated. The resilience of the Australian financial system through the crisis period has reflected a combination of factors including the comparatively mild nature of the overall economic slowdown in Australia, the absence of large-scale exposures to structured securities, and relatively conservative lending practices, particularly for housing. While loan losses may rise further in the current environment, Australian banks remain better placed than their counterparts in many other advanced economies to weather any further adverse developments in the global financial system.

As foreshadowed in the March Review, substantial work is underway around the world to reconsider financial regulations in light of the lessons from the financial crisis. Much of this work is being co-ordinated through major international forums including the G-20, the Financial Stability Board and the Basel Committee on Banking Supervision. Key areas of focus include capital and liquidity standards, systemic risk, compensation and incentives, and accounting standards. Australia is an active participant in these discussions, and the Reserve Bank will be working closely with other domestic authorities to consider Australia’s response to these international regulatory developments.