Financial Stability Review – March 20244.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates

Since 2022, many households and businesses have experienced significant pressure on their finances, but most have managed to adjust to continue servicing their debts. These pressures are expected to ease over the next couple of years based on the economic outlook presented in the February Statement on Monetary Policy. However, a key risk to this outlook is that inflation and interest rates remain higher for longer than currently anticipated. This Focus Topic investigates the ability of mortgagors and larger businesses to service their debts under both scenarios. The key findings are:

  • Most mortgagors and larger businesses would be able to service their debts even if pressure on their finances remained elevated for a more extended period. Accordingly, the risks to financial stability under the higher-for-longer scenario remain limited.
  • However, under both scenarios, conditions will remain challenging throughout this year for the mortgagors already facing acute budget pressures. More persistent budget pressures are expected to result in a slight increase to the (small) share of borrowers most at risk of becoming unable to service their debts.
  • Ongoing high interest rates would have a moderate effect on the ability of indebted listed companies to service their debts. However, the firms assessed in this exercise are larger companies that tend to be less exposed to interest rate risk. Smaller businesses would be more vulnerable to such a scenario, but data limitations precluded their coverage in this analysis. Even still, related risks to the financial system would be restricted by the relatively small share of banks’ lending to smaller firms.

The Scenarios

We used scenario analysis to help us understand how different economic conditions might affect the ability of mortgagors and large businesses to service their debts. Such analysis shows how changes in inflation and interest rates can impact indebted households and firms in order to identify potential vulnerabilities. Ultimately, the insights gained from this analysis help us better understand some of the interactions between monetary policy and financial stability.

The two scenarios considered are:

  • The February Statement scenario – As per the outlook presented in the February Statement, inflation returns to the target range in 2025, the cash rate is assumed to decline in line with market expectations (at the time of the Statement) and real wages growth is positive over the next few years.
  • The Higher-for-Longer scenario – Inflation proves more persistent than expected in the February Statement, which leads to a model-based assumption for the cash rate path that is 50 basis points higher than the path assumed in the February Statement scenario.[1] (This is an illustrative scenario only; the actual policy response in the event would depend on the specific circumstances.) Inflation then returns to the target range slightly later and real wages growth is lower than forecast in the February Statement scenario.

Most mortgagors are expected to remain able to continue servicing their debts under both scenarios.

Methodology

We assess mortgagor resilience in two steps. First, we use the RBA’s Securitisation System loan-level data to estimate how many borrowers with variable-rate owner-occupier loans would experience a cash flow shortfall − that is, their minimum mortgage payments and essential expenses exceed their income. Then, we estimate how many of these borrowers with a cash flow shortfall might run out of savings buffers by 2025.

To complete these steps, we use a mix of observed and estimated information. We observe borrowers’ minimum mortgage payments and the prepayments they have made into their offset or redraw accounts. Then we estimate their current incomes and essential spending needs. We proxy borrowers’ essential expenses using the Melbourne Institute’s Household Expenditure Measure (HEM). We estimate their current income by growing their income reported at loan origination in line with the Wage Price Index (WPI). This estimate is conservative as it does not allow for increases in borrowers’ incomes that arise from promotions and job switching over time or for incomplete income disclosure by some borrowers when applying for a loan.[2]

It is important to note that our measure of cash flow shortfall is unlikely to directly translate into mortgage default, as there are other adjustments households can make to adapt to financial pressures.

Most borrowers are projected to have sufficient income to meet their debt-servicing obligations and other essential spending needs out to 2025 even if interest rates were to increase by another 50 basis points. The Higher-for-Longer scenario raises the share of borrowers estimated to have a cash flow shortfall by around 1 percentage point compared with the February Statement scenario for 2024 and 2025. The share in the Higher-for-Longer scenario is estimated to peak above 6 per cent in mid-2024, before declining below the December 2023 estimate by the start of 2025 (Graph 4.1.1).[3]

Graph 4.1.1
Graph 4.1.1: Line chart showing estimated share of variable-rate owner-occupier borrowers with a cash flow shortfall. The chart includes projections using February Statement assumptions (blue dots) and projections under the Higher-for-Longer scenario (pink dots). The projected share falls over the next two years under both scenarios.

Despite greater budget pressures under the Higher-for-Longer scenario, we estimate that less than 3 per cent of variable-rate owner-occupier borrowers would be at risk of depleting their liquid savings buffers by the end of 2025. This is around ½ a percentage point more than under the February Statement scenario (Graph 4.1.2). In addition, the estimated shares under either scenario are unlikely to translate fully into increases in mortgage defaults: many of these borrowers could still make other – often difficult – adjustments. These could include increasing their hours of work, temporarily reducing some expenses or – as a last resort – selling their property. These adjustments may not be available for some borrowers, including those with lower incomes and greater leverage. However, this does not affect our current overall assessment that financial stability risks from housing lending remain contained (see Chapter 2: Resilience of Australian Households and Businesses).

Graph 4.1.2
Graph 4.1.2: Bar chart showing the share of borrowers estimated to be at risk of depleting buffers by the end of 2025 under assumptions from the February Statement scenario on the left and the Higher-for-Longer scenario on the right. The share is over 2 per cent in the February Statement scenario and a little higher for the Higher-for-Longer scenario.

Most listed companies are expected to remain well placed to continue servicing their debts under both scenarios.

Methodology

We assess the resilience of indebted listed companies by evaluating their ability to service their debts under the different scenarios. To do so, we use business-level data covering non-financial listed companies – which tend to be larger businesses – to estimate the (debt-weighted) share of businesses with earnings less than double their interest expenses.[4] This is equivalent to an interest coverage ratio (ICR) less than 2, which is indicative of weaker debt-servicing capacity and, historically, has been associated with an increased risk of insolvency.

In contrast to the exercise conducted for mortgagors, we do not allow for full pass-through of changes in interest rates to businesses’ interest expenses. The rate of pass-through is determined by how quickly businesses’ debt and hedges mature and thus need to be refinanced at potentially higher interest rates. Businesses can take actions to reduce pass-through – by, for example, reducing the duration of new debt issuance (as interest rates on fixed-rate debt usually increase with maturity) or deleveraging. We apply a pass-through rate of 40 per cent after around two years, based on historical experience.[5] For simplicity, we apply the same interest rate increase to all businesses and hold earnings constant.

Across both scenarios, the share of companies more at risk of debt-servicing challenges is little changed over the next couple of years (Graph 4.1.3). The share of listed companies projected to have an ICR less than 2 is only moderately higher under the Higher-for-Longer scenario than under the February Statement scenario and, under both scenarios, it remains well below its peak during the global financial crisis (GFC). While our analysis assumes firms’ earnings (the other component of a firm’s ICR) to be constant under both scenarios, the findings are little changed when allowing for some decline in earnings.[6]

Graph 4.1.3
Graph 4.1.3: A line graph showing the historical estimates of the debt-weighted share of listed companies with ICR < 2. A shaded panel shows scenario projections of the estimated debt-weighted share of listed companies with ICR < 2 under the February Statement scenario and the higher-for-longer scenario. Under both scenarios, the projected debt-weighted share of listed companies with ICR < 2 over the horizon is only slightly higher than in December 2023, and declines over the horizon.

Additionally, strong balance sheets limit the risk that these firms will experience severe financial stress in either of these scenarios. Cash buffers (relative to expenses) are double the pre-pandemic level, and indebtedness has been relatively stable among those firms currently or projected to have an ICR less than 2 under both scenarios. Cash buffers have declined from pandemic peaks but are still well above pre-pandemic levels (Graph 4.1.4, left panel).[7] The decline was driven by strong growth in expenses; cash holdings in dollar terms have remained at pandemic peaks for most firms. Information from the Bank’s liaison program suggests cost pressures have eased for some companies and many are stepping up their focus on cost-cutting measures. Gearing – which measures debt over equity – has declined since the GFC (Graph 4.1.4, right panel). Furthermore, firms with a projected ICR less than 2 in our scenarios typically have lower gearing than other listed companies with higher ICRs. Consistent with relatively low indebtedness, half of those firms projected to have an ICR less than 2 can fully pay off their short-term debt with their liquid assets.

Graph 4.1.4
Graph 4.1.4: A two panel graph showing the median ratio of cash holdings to monthly operating expenses of the sample of firms with ICR < 2; and then median gearing ratio of the sample of firms with ICR < 2. The median scaled cash holdings is higher than pre-pandemic, and the median level of gearing remains low.

We do not have timely balance sheet data to allow for a similar analysis of indebted smaller businesses, but banks’ small exposures to these businesses limits risks to the financial system. Small businesses are more vulnerable to an increase in interest rates than larger ones as they have higher earnings volatility and lower cash buffers. Effective interest rates have already risen considerably among small businesses. Since 2022, the outstanding small business lending rate has increased by nearly 300 basis points, more than double the increase for listed companies and close to two-thirds of the increase in the cash rate (Graph 4.1.5). As a result, these businesses have already been facing higher interest expenses. Consistent with this, liaison with banks suggests there is relatively more stress among smaller businesses, although loan arrears remain low. Smaller businesses have also accounted for the bulk of the increase in business insolvencies since 2022. Loans to small businesses account for only around 6 per cent of bank loans, and, as a result, risks to the financial system from this lending activity remain low. Some businesses, particularly smaller ones, also obtain credit from non-banks, whose share of business credit has continued to increase. However, risks to the financial system from this lending activity remain low as non-banks’ share of lending remains small and banks have limited exposures to non-bank lenders (see Chapter 3: Resilience of the Australian Financial System).

Graph 4.1.5
Graph 4.1.5: A line graph showing the effective business rates for listed companies and the outstanding small business lending rate. Since June 2022, the actual outstanding small business lending rate has increased by more than the increase in the effective interest rate for listed companies.

Endnotes

This scenario was calibrated using the RBA’s main macroeconomic model (MARTIN). [1]

We also make assumptions about borrowers’ savings behaviour to project buffers over the scenario horizon. To estimate the share of borrowers who are likely to deplete their buffers (offset and redraw balances), we assume borrowers estimated to be in cash flow shortfall draw down their buffers by the size of the cash flow shortfall each month. For more details on the scenario analysis methodology, see RBA (2023), ‘Box B: Scenario Analysis on Indebted Households’ Spare Cash Flows and Prepayment Buffers’, Financial Stability Review, April. For more details on how we assess household financial stress, see RBA (2023), Financial Stability Review, October; Brischetto A (2023), ‘Financial Stability and the Financial Health of Australian Mortgagors’, Speech to the Sydney Banking and Financial Stability Conference, University of Sydney, 8 December. [2]

For a discussion of why the share of borrowers with cash flow shortfall declines gradually in the February Statement scenario, see Box: How are budget pressures expected to evolve from here? in Chapter 2: Resilience of Australian Households and Businesses. [3]

This analysis uses detailed financial statement information for Australian publicly listed companies provided by Morningstar. The sample for analysis is limited to non-financial companies with debt and excludes companies with a ratio of debt to assets less than 10 per cent. [4]

We have estimated this pass-through rate of interest rates to listed companies’ interest expenses based on historical relationships over a sample of companies from 2006–2022. This pass-through rate appears to be stable over time, including a more recent three-year horizon. [5]

A decline of 10 per cent in profits across all the listed firms does not materially impact the share of businesses with an ICR less than 2 across all scenarios and horizons. [6]

Most firms that are projected to have an ICR of less than 2 under our scenario have a cash buffer equivalent to at least one month of expenses; the median has nearly two months. Scaling by current expenses underestimates how long these buffers could support a firm. Businesses are typically able to quickly cut costs in response to falling demand, although this flexibility does vary by industry (see RBA (2023), Financial Stability Review, April). [7]