Transcript of Question & Answer Session Evolving Bank and Systemic Risk

Thank you, Jonathan. Excellent talk. So we do have a few questions here coming through the chat. And to everyone that is connected, please do take advantage of the live Q and A option, that's where you can be sending your questions through. So we're going to start off though with something that obviously the RBA is aware. There has been some criticism of banks restricting lending to those that are carbon intensive firms such as miners. But how much of this is valid and how much of this is kind of sensationalised around that topic?

This is a difficult area for banks. They need to be very forward looking in their decisions on lending. So they need to consider both the changing policy and changing attitudes. For example, asset prices can change very quickly in response to not only current policy changes but expected policy changes or expected behaviour. So for example, a bank might think about writing a three-year loan to a coal miner and they might anticipate there are not going to be any significant changes in policy over the next three years. But if they did expect that there was going to be a change in policy in say five years or 10 years' time, that in itself could actually mean that the value of the assets that they're lending against the value of the coal mine could fall significantly.

And so it could be that when that initial three-year loan comes up, that the coal miner struggles to be able to refinance that loan and so the bank, who made the initial loan, would be still left holding a loan that can't be repaid and so would face credit risk. It can be quite challenging for banks because they need to be anticipating what's going to be happening down the track and how that's going to affect the likelihood that the borrower will be able to repay. So that's the credit risk, the market risk that they're facing. They obviously also need to think about how this affects their reputation, which can flow through to their ability for funding. So funding risk, liquidity risk, and so forth. It is really a challenging area, and we can see why banks are taking this very seriously.

Excellent. Yes, thank you. I think that is an issue but one we kind of miscalculate when you're talking about you're trying to actually manage maturity, and mismanagement of maturity when it comes to some of these issues as well. So another question is kind of the elephant in the room wherever you are in Sydney or even Australia as a whole about the housing market and the affordability of the housing market. So specifically, here, the housing market has been in the media obviously with APRA's macroprudential measure increasing the serviceability around the ability for borrowers to actually be able to take out loans depending on if interest rates were to rise. In terms of the roles, do we see that there are macroprudential policies have in addressing bank and systemic risk? Is it able to effectively trickle down? Or is this something to say that we're kind of in this world where we'll always have borrowers on one hand and they're not always the stakeholders within the banks themselves?

As I noted, Australian banks have very similar portfolios, and that includes a very large share of their assets being housing loans. So housing lending is very important for understanding systemic risk. And macroprudential policy has gained a lot of prominence, most notably really globally following the GFC where we've had very low interest rates in a number of countries. And so macroprudential policies have typically, in most countries, been employed to address housing risks in an environment of low interest rates where housing risks have been building. So we've seen them used in quite a number of countries for that reason.

In Australia, similarly we have low interest rates, and given the high level of housing debt for the household sector both relative to history and to other countries, it's clearly a risk both for the financial system and for the economy more broadly. When we do stress testing of the banks, either the bottom-up stress testing that APRA does or APRA and ourselves also do top-down stress testing, those results indicate that the Australian banks are very resilient to any shocks to housing. And that comes because for most loans outstanding, they actually have a relatively low dynamic LVR. Meaning that you could experience a relatively large fall in prices, and the banks would not necessarily lose any money. But because of that large stock of debt, it can clearly be a risk to the economy more broadly and so to the macro financial system. So macroprudential policy is really important in addressing that potential for systemic risk.

The measure that APRA have implemented, a change in the serviceability assessment rate, is a really good way of getting at what is the potential risk in the system. It means that each borrower who ends up taking a loan is more resilient. They've got a bigger gap between their income and their housing and non-housing expenses. And so that gap can compensate for shocks to their income or expenses and makes it more likely that they can make their repayments on their loans but also that they're not going to curtail their consumption and so you wouldn't have the big macroeconomic effect.

And I think that is the major thing, the message that you're trying to make sure that everyone, every consumer, every bank, everyone understands, is that if you see a fall in consumption, regardless of if those borrowers are able to make their mortgage payments, you're going to see that has massive repercussions across the economy. So is there a role for financial literacy that it's hard when we are so apt to follow the movements of the cash rate and etc, but we maybe don't know what it means for interest rates to go up or down if you're a borrower or saver, so where does that fall? I mean, is it on us as academics? Is it on the popular press? Or is there a role that you could see even within the ability to educate a little bit with this process currently now and people are very, very keen to be understanding what happens now, the new world?

I think that's a really interesting point in that many people who are taking out a home loan now, their working life up until recently had never seen a recession. They'd had 30 years without a recession. Over their entire living experience, interest rates have been low. They've never experienced the high interest rates of the 1990s, etc. And they've always seen growing housing prices. So a lot of people can then think that: "Well, housing's a sure bet. I should just borrow as much as I can and gear up." And so I think it is really important that both the media, organisations like the Reserve Bank, academics, schools even, manage to educate people and communicate what the risks are, that there is the potential for people to lose their income, for interest rates to increase.

So if individuals are making prudent borrowing decisions, then that's really going to help to make the financial system more resilient also. So a lot of our work and communication are trying to ensure that the banks are making good decisions, and there's a lot of questions about who's responsible, whether it's the individual or the bank in making those decisions. The bank is obviously much better informed, but we want individuals to be able to make good decisions for themselves. And so I think that does involve ensuring that individuals are well informed and understand the risks that they're taking.

Yeah, I think that's a good thing. The more we do on those lines, better off they are. So I think we have one last question, it is a bit of a tricky one. But if in the case that global banks have learned that central banks will step in to resolve liquidity crisis, etc, doesn't that increase moral hazard?

So there's a very important distinction there between something that's an extreme, broad systemic liquidity crisis and something that's a liquidity crisis that affects a bank or an individual bank, so it's idiosyncratic. So we can think about liquidity as being a public good. And so in that situation, the central bank has effectively a mandate for ensuring that the broad financial system is sufficiently liquid. But an individual institution, if it faces a liquidity crisis from a name crisis because it has say, bad outcomes on its credit, it still needs to insure against that liquidity shock.

And so the reforms that we've had post GFC with the introduction of the liquidity coverage ratio, the net stable funding ratio, ensure that banks have a large amount of liquidity. I think what we're yet to see internationally is how usable that liquidity gets. And so it could well be that banks have all of this liquidity, but as soon as they try to use that, investors could become very nervous. So there is a challenge there in how the new framework really works. Because what we've seen even in the pandemic has not been in the end a very significant liquidity shock for the banks because of the amount of liquidity that central banks have provided. So I think it's still something that we have to watch carefully and learn a lot more about.