# Bulletin – March 2023 Financial Stability Non-bank Lending in Australia and the Implications for Financial Stability

## Abstract

Non-bank lenders help to finance some forms of economic activity that might otherwise go unfinanced by traditional banks. However, as the global financial crisis demonstrated, non-bank lending activities have the potential to undermine financial stability, in part because they are less constrained by regulation. Risks to financial stability can include the amplification of credit and asset price cycles, increased competition for borrowers that prompts banks to weaken their own lending standards, and the potential of stress spilling over into the prudentially regulated financial system. Unlike in some other economies, non-bank lending accounts for a small share of total credit in the Australian economy and banks have relatively limited exposure to non-bank lenders. Non-bank lending therefore poses little systemic risk to financial stability in Australia at present. However, it has grown strongly in recent years, particularly for housing. Regulators and policymakers therefore need to continue monitoring developments in this space. This article provides a primer on non-bank lending in Australia, focusing on lending for housing and the potential risks to financial stability.

## Introduction

Lending by non-banks can play an important role in financing some forms of economic activity that might not otherwise be financed by the traditional banking system, without putting customer deposits at risk. However, as much of the lending activity of non-banks occurs outside of the prudential regulatory perimeter, policymakers and regulators need to monitor developments in the sector for risks posed to financial stability.[1] As events leading up to and during the global financial crisis (GFC) showed, such risks can include:

• the potential for non-bank lending to be more concentrated, riskier and more pro-cyclical than bank lending as a result of lighter regulation, which can amplify credit and asset price cycles
• competition from non-banks that might encourage banks to weaken their lending standards in order to protect or grow market share
• linkages between non-banks and banks that could result in stress in the non-bank sector spreading to banks.

As non-bank lenders operate with fewer regulatory constraints than banks, market discipline acts as a key mechanism that helps to limit how far non-bank lenders can ease lending standards and how far along the risk spectrum they can operate. This is particularly the case for non-bank lenders that securitise loans, especially for housing, as visibility of these lenders’ activities has improved with increased reporting requirements following the GFC (Debelle 2012; Aylmer 2016); by contrast, other segments of non-bank lending remain more opaque. Regardless of these improvements, non-bank lending can still lead to a build-up of systemic risk because non-banks’ business models tend to involve liquidity and maturity mismatches and the use of leverage.

Internationally, non-banks are viewed as a key vulnerability in the global financial system. For example, during the GFC, the early stages of the COVID-19 pandemic and the periods of asset price volatility in 2022, the non-bank sector amplified financial market stress. Some of these events resulted in central banks and/or governments, including in Australia, intervening to restore orderly functioning of financial markets – the disruptions in the UK pension fund sector in late 2022 being the most recent example. Given the inherent vulnerabilities and the growing size of the global non-bank sector, international bodies – such as the Financial Stability Board (FSB), the Bank for International Settlements and national regulators – are working to improve their visibility and understanding of non-banks so as to increase the resilience of the sector (Carstens 2021; FSB 2022).

The small size of Australia’s non-bank sector, and in some respects its different structure, mitigates some of the vulnerabilities posed by non-banks internationally – but these vulnerabilities are still present. Australian superannuation funds, although not a focus of this article because their investment focus is more on equities and they do not lend much outside of holding bonds, provide a helpful example of differences in structure. Compared with the UK pension sector, Australian superannuation funds are mostly defined contribution rather than defined benefit, have larger cash holdings and have more limited use of leverage. This leaves Australian superannuation funds well placed to manage liquidity shocks, as was demonstrated in the early stages of the pandemic (RBA 2021).[2] In order to examine the role of non-bank lending in Australia and its implications for financial stability, this article focuses on credit intermediation by non-banks that are not regulated by the Australian Prudential Regulation Authority (APRA).

## A variety of non-bank lenders operate in Australia, accounting for around 5 per cent of the financial system

Non-bank lenders account for a small share of the financial system in Australia, at around 5 per cent of total financial system assets (Graph 1). Non-bank lending is undertaken by registered financial corporations (RFCs) and some types of managed investment funds, including hedge funds. RFCs utilise a business structure that is similar to banks, in that they obtain short-term debt funding and extend longer term credit to households and businesses. RFCs predominantly provide credit for residential housing and automobiles (autos), although lending to businesses and commercial property developers also features in their portfolios. The business model of managed investment funds differs to banks and RFCs; they are mostly delegated asset managers that act as pass-through vehicles for other investors, such as superannuation funds.

RFCs account for about half of non-bank lenders’ assets in Australia. RFCs can be split into two broad groups – securitisers and non-securitisers. Securitisers originate loans and then package these loans into asset-backed securities (ABS). Residential mortgage and auto lending account for the largest share of the non-bank securitisation market. By contrast, non-securitisers retain loans on their balance sheets. These lenders focus mostly on non-housing credit, such as lending for construction, non-auto personal finance and some business loans.

Managed investment funds, including hedge funds, account for the other half of non-bank lenders’ assets. Managed funds’ debt instruments as a share of the financial system has declined since 2016, as funds switched more of their portfolios to equities (and equity-like exposure) in search of higher returns in a low-interest rate environment. The size of the Australian-domiciled hedge fund sector cannot be deduced from existing data sources.

There are limited data covering non-bank credit intermediation more broadly, particularly outside of housing lending. In part, this is because non-bank lenders have less extensive reporting requirements than prudentially regulated banks.

## Endnotes

The authors are from Financial Stability Department. [*]

For a comprehensive discussion of non-bank activity, see Adrian and Jones (2018). [1]

The resilience of Australian superannuation funds will be further strengthened by APRA’s enhanced requirements for investment stress tests, liquidity management (including liquidity stress tests) and asset valuations (APRA 2022). [2]

For further detail on data limitations for non-bank activity, particularly for property development, see Gishkariany, Norman and Rosewall (2017); RBA (2019). [3]

For a discussion of the dataset and coverage of the RMBS market, see Fernandes and Jones (2018). [4]

Liaison with non-banks during the pandemic indicated that most non-banks offered payment deferrals to borrowers in need. However, unlike some banks that offered blanket deferrals, non-banks had stricter criteria and assessed each referral request on a case-by-case basis. [5]

For example, Claessens et al (2021) found in a sample of 24 countries (including Australia) that a tightening of macroprudential policy can lead to an increase in non-bank activities and a reduction in bank assets. [6]

Part IIB of the Banking Act 1959 gives APRA the power to extend macroprudential policy to non-bank lenders where the provision of non-bank finance is materially contributing to instability in the financial system. [7]

APRA (2023) assessed that the combination of rising interest rates and the higher serviceability buffer coincided with a decline in high debt-to-income lending over 2022. [8]

In other words, banks are now required to assess a borrowers’ capacity to service a mortgage at an interest rate that is at least 3 percentage points above the product loan rate compared with the 2.5 percentage points that was commonly applied by banks at the time of this policy announcement. [9]

APRA expected banks to limit new IO lending to 30 per cent of total new residential mortgage lending and within that place strict limits on IO lending taking place at LVRs above 80 per cent. In addition, banks were expected to manage lending to investors to remain within the previously announced investor limits. Finally, banks needed to ensure serviceability metrics were appropriate for the given conditions and limit loans to high-risk segments of the portfolio. See APRA (2017). Garvin, Alex and Rosé (2021) analysed the effects of APRA’s 2014 and 2017 policies on the banking system and found that banks increased advertised rates by around 10–30 basis points and that lending growth in targeted mortgages declined by around 20–40 percentage points within a year of the policy announcements. [10]

The new capital framework is more risk sensitive, whereby riskier lending (e.g. investor and IO loans) is subject to higher risk weights under the new framework. [11]

For further discussion, see Johnson, Lane and McClure (2022); Kearns (2022). [12]

## References

Adrian T and B Jones (2018), ‘Shadow Banking and Market-based Finance’, IMF Departmental Paper No 2018/013.

APRA (Australian Prudential Regulation Authority) (2017), ‘APRA Announces Further Measures to Reinforce Sound Residential Mortgage Lending Practices’, Media Release, 31 March.

APRA (2018), ‘Revisions to the Capital Framework for Authorised Deposit-taking Institutions’, Discussion Paper.

APRA (2021), ‘An Unquestionably Strong Framework for Bank Capital’, Information Paper, 21 November.

APRA (2022), ‘Prudential Standard SPS530 Investment Governance in Superannuation’, 17 November.

APRA (2023), ‘Update on APRA’s Macroprudential Policy Settings’, Information Paper, 27 Feburary.

Arsov I, IS Kim and K Stacey (2015), ‘Structural Features of Australian Residential Mortgage-backed Securities’, RBA Bulletin, June, pp 43–58.

Aylmer C (2016), ‘Towards a More Transparent Securitisation Market’, Speech to the Australian Securitisation Conference, Sydney, 22 November.

Carse V, A Faferko and R Fitzpatrick (2023), ‘Developments in Banks’ Funding Costs and Lending Rates’, RBA Bulletin, March.

Carstens A (2021), ‘Non-bank Financial Sector: Systemic Regulation Needed’, BIS Quarterly Review, December.

Claessens S, G Cornelli, L Gambacorta, F Manaresi and Y Shiina (2021), ‘Do Macroprudential Policies Affect Non-bank Financial Intermediation?’, BIS Working Paper No 927.

Debelle G (2012), ‘Enhancing Information on Securitisation’, Address to Australian Securitisation Forum, Sydney, 22 October.

Dwyer J, K McLoughlin and A Walker (2022), ‘The Reserve Bank’s Liaison Program Turns 21’, RBA Bulletin, September.

Fernandes K and D Jones (2018), ‘The Reserve Banks’ Securitisation Dataset’, RBA Bulletin, December.

FSB (Financial Stability Board) (2022), ‘Global Monitoring Report on Non-Bank Financial Intermediation 2022’, 20 December.

Garvin N, K Alex and C Rosé (2021), ‘Macroprudential Limits on Mortgage Products: The Australian Experience’, RBA Research Discussion Paper No 2021-07.

Gishkariany M, D Norman and T Rosewall (2017), ‘Shadow Bank Lending to the Residential Property Market’, RBA Bulletin, September, pp 45–52.

Johnson C, K Lane and N McClure (2022), ‘Australian Securities Markets through the COVID-19 Pandemic’, RBA Bulletin, March.

Kearns J (2022), ‘Securitisation: Past, Present and Future’, Speech to the Australian Securitisation Converence, Sydney, 30 November.

Moody’s (2022), ‘Moody’s – Australian Non-bank Lenders’ Improved Loan Quality Tempers Risks of Rising Inflation and Interest Rates’, Research Announcement, 20 July.

RBA (Reserve Bank of Australia) (2021), ‘Box C: What Did 2020 Reveal About Liquidity Challenges Facing Superannuation Funds?’, Financial Stability Review, April.