Financial Stability Review – March 2004 2. Financial Intermediaries

The financial sector in Australia is in good shape, which is to be expected given the strong macroeconomic and financial conditions currently in place. Authorised deposit-taking institutions (ADIs) are experiencing strong demand for household credit, while other intermediaries such as insurance companies and superannuation funds have been able to rely on the stronger equity markets to boost their investment returns.

2.1 Deposit-taking Institutions

Current Conditions

Australian banks have enjoyed favourable conditions since the mid 1990s. In 2003, the five largest banks earned an aggregate pre-tax return on equity of 19 per cent, down slightly on recent years (Graph 24). The main driver of profit growth has been strong growth in the aggregate balance sheet, mainly due to the increase in household borrowing.

Net interest income rose solidly in 2003, but less quickly than the growth in the balance sheet, due primarily to the average interest margin falling as low-margin housing loans have come to account for an increasing share of the loan portfolio. Non-interest income has grown somewhat more quickly reflecting improvements in wealth management businesses (Table 3). Profitability has also been helped by some further improvements in asset quality, facilitating a further reduction in provisioning expenses. While operating costs have risen moderately, the strong increase in income pushed the cost-to-income ratio slightly lower to 53 per cent in 2003 (well down on the peak of 68 per cent in 1992).

Regulatory capital ratios have remained broadly unchanged over recent years. For locally incorporated banks, the weighted-average ratio is 10 per cent of risk-weighted assets, and for building societies and credit unions banks it is around 14 per cent (Graph 25). By international standards, Australian banks hold a relatively high share (around two-thirds) of their regulatory capital in high-quality ‘Tier 1’ capital, mainly equity.

Asset Quality

Reflecting the sustained expansion of the Australian economy, the banks' holdings of distressed assets (i.e. those where borrowers are more than 90 days late in meeting payments or where for other reasons lenders doubt they will be repaid) have continued to edge lower. At 0.6 per cent of on-balance-sheet assets, they are at the lowest level in over a decade and also very low by international standards (Graph 26, Table 4).[6]

As already noted, the ongoing improvement in asset quality over the past year has facilitated a reduction in provisioning levels, with both specific and general provisions falling (Graph 27). The decline in general provisions, to their lowest level since the 1980s, has occurred despite the use of dynamic provisioning by the major banks.

One factor behind the trend decline in impaired assets over the past decade has been the shift in the composition of bank credit away from business lending towards mortgage finance (Graph 28). Residential mortgages have much lower default rates than business loans, and mortgages in Australia have historically had low default rates by international standards. The rapid expansion in mortgage lending, however, raises the question of whether such low default rates will be sustained, particularly if the economic environment was to become less benign. As discussed in the chapter on The Macroeconomic Environment, the recent surge in mortgage lending has included a high share of lending to investors, the use of new mortgage products making it easier for marginal borrowers to obtain finance, and a significant increase in debt levels relative to income. Collectively, it is likely these factors have added to the overall riskiness of the banks' mortgage portfolios.

The strong growth in investor activity has meant that investment loans now account for around a third of total housing loans outstanding, up from around 15 per cent in the early 1990s (Table 5). Contrary to some industry views, Australian Prudential Regulation Authority (APRA) data confirm that, even in the benign environment of recent years, default rates on these loans have been somewhat higher than for owner-occupier loans. Partly in response to the strong growth in these loans, a number of lenders have recently tightened investment loan approval standards, particularly for inner-city apartments.

The introduction of new loan products, such as ‘low-doc’ and other types of non-conforming loans, has also had some effect on the overall riskiness of mortgage portfolios.[7] While, at this stage, there is no evidence to confirm that, in Australia, default rates on these loans are higher than on other loans, overseas experience suggests that this is likely to be the case. In particular, default rates for US sub-prime mortgage borrowers (i.e. those with blemished or non-existent credit records) have shown some tendency to be more sensitive to an economic slowdown than traditional mortgages. Moreover, in the UK it appears some borrowers have overstated their income when applying for ‘self-certified’ mortgages (akin to Australian low-doc loans). Whether or not this experience is replicated in Australia remains to be seen. Any impact on overall default rates, however, is likely to be relatively small, given non-conforming loans in Australia account for only a few percentage points of overall lending for housing.

Another loan product that may perform differently from the more traditional mortgage in harsher economic conditions is interest-only loans, which have become increasingly popular over recent years. With these loans, which are typically available with terms of between one and five years, borrowers make regular interest payments but no repayments of principal until the loan matures. Because the principal is not being reduced, any fall in the value of the property is more likely to result in the borrower having negative equity, which may increase the probability of default.

Although comprehensive data on interest-only loans in Australia are not available, liaison with a number of banks suggests approximately 14 per cent of outstanding home loans are on interest-only terms (Table 6). Interest-only loans account for a significantly higher proportion of new loans than they do of outstanding loans. Part of the difference is explained by the fact that many interest-only loans eventually convert to standard principal and interest loans. Interest-only loans are also a higher share of investment loans than owner-occupied loans, reflecting the tax advantages of maximising the proportion of loan repayments directed towards interest costs.

While the overall riskiness of mortgage portfolios has likely increased over recent years, the size of the change needs to be kept in perspective. Recent stress testing of ADIs' mortgage lending undertaken by APRA examined the possible impact of a 30 per cent fall in house prices.[8] APRA estimated that even if such a fall caused the aggregate default rate on residential mortgages to increase to 3.5 per cent (more than ten times the worst single-year default rate experienced in Australia over the past 20 years), the aggregate capital ratio for ADIs would fall by around only 70 basis points to 9.6 per cent, well above the required minimum of 8 per cent. Under this scenario, more than 90 per cent of ADIs would continue to meet regulatory capital adequacy requirements, and for the small number of institutions that fell below the minimum requirements the breach would be small.

The APRA stress testing highlights the importance of two interrelated risk mitigants that support the quality of ADIs' mortgage books: loan-to-valuation ratios (LVRs) and mortgage insurance. The median LVR on loans at origination is 70 per cent, which means house prices would need to fall substantially for banks to incur widespread losses on the security backing defaulted loans. This is supported by the tendency for households to repay their loans ahead of schedule, accelerating the LVRs' decline over the life of the loans. While ADIs offer some low-deposit loans, loans with an LVR above 95 per cent account for just 2 per cent of all mortgages. Moreover, most very high LVR loans are covered by mortgage insurance, although, surprisingly around a third of loans with an LVR greater than 80 per cent have no insurance.

Overall, around a fifth of all loans are covered by lenders' mortgage insurance. For such loans, the ADIs' recourse to mortgage insurance should cover any shortfall in the value of defaulted loans' underlying security. If ADIs were forced to make a large number of claims, however, insurers would more carefully review ADI's adherence to insurance policy terms and conditions, which could see some claims declined. In addition, a very large increase in defaults could, under some scenarios, cause difficulties for the mortgage insurance industry, which is highly concentrated. The risk of this, however, currently seems quite small.

Given the current capital position and low default rates, ADIs appear well-placed to withstand a slowing in the housing market. Of more concern would be the wider economic consequences of a housing downturn associated with a pull-back in household spending. Such an outcome has the potential to affect not only home loans but also business lending.

Notwithstanding this risk, business loan portfolios look to be in sound shape. The impaired loan ratio for commercial property lending – historically the main source of credit quality problems for ADIs – is currently very low, and there are few signs of overheating in the commercial property market (Table 7).

One notable development over the past year, however, has been the strong growth in banks' Australian commercial property exposures, which increased by 17 per cent over the 12 months to September 2003, and now amount to 40 per cent of loans to businesses in Australia. This growth has been due to an expansion in lending against office property and residential developments (Graph 29). One risk here is that a downturn in the residential property market could cause difficulties for some property developers, particularly if a large number of off-the-plan investors fail to settle, leaving developers to resell properties into a falling market. If this were to happen, the overall credit risk in banks' commercial loan portfolios would obviously increase.

Another aspect of credit risk is the concentration of lending to particular clients. One way of measuring this is to take account of all exposures, including both those that are on- and off-balance sheet, that are in excess of 10 per cent of a bank's capital. On this measure, in aggregate, the large exposures of the Australian banks have shown little change (as a share of capital) for some years, but are down considerably on the levels in the early 1990s (Graph 30).

Another determinant of credit risk is the mix between banks' domestic and foreign assets. Currently, slightly less than a quarter of Australian banks' assets are held offshore (Table 8). Over recent years, there has been considerable change in the composition of these assets, with exposures in Japan and the United States declining, and those in New Zealand increasing. While exposures to credit risk in New Zealand may offer less diversification to Australian banks than exposures elsewhere in the world due to the close links between the Australian and New Zealand economies, Australian banks are likely to have a better understanding of the New Zealand market than markets in some other countries. Australian banks have only relatively small exposures to emerging market economies.

Liquidity risk

Retail deposits grew strongly over the past year as households sought low-risk investments in the face of the earlier weakness in equity markets. This arrested the longer-term switch in the composition of banks' liabilities away from retail deposits in favour of wholesale funding. This switch has seen retail deposits fall from an average of 60 per cent of total bank liabilities between 1960 and 1980 to about 25 per cent currently (Graph 31). Since 1990, all of the growth in the share of wholesale funding has been accounted for by foreign borrowings. Foreign wholesale liabilities now account for 26 per cent of total liabilities.

This longer-term switch to wholesale funding has, in part, reflected increasing competition for household savings from other investment vehicles, particularly managed funds. In response, banks have found it cost-effective to tap the offshore markets. Australian banks have been able to diversify their borrowings across a wider range of investors, securities and currencies, which has aided day-to-day liability management. While borrowing takes place in a range of maturities, almost half of outstanding offshore borrowing matures within three months. The vast bulk of the banks' foreign currency borrowing is fully hedged and hence does not carry exchange rate risk.

Traditionally, banks have balanced their liquidity needs by holding a buffer of highly liquid assets. However, in line with the abolition of various liquidity conventions and the decline in the stock of government securities on issue, holdings of highly liquid assets (public sector securities, cash and deposits with the Reserve Bank) have declined substantially. Offsetting this trend, to some extent, is the fact that new financial techniques have increased the liquidity of other assets on the balance sheet. In particular, the rapid growth of the market for asset-backed securities is allowing banks to treat their residential mortgages as a potential source of liquidity.

Other risks

The banks' exposure to movements in interest rates, exchange rates and other financial prices arising from their trading activities has edged up over the past year. This risk exposure, however, remains small in comparison to their credit risk exposures. This is reflected in the fact that the total regulatory capital requirement for market risk is only around 1 per cent of the requirement for credit risk. This ratio is considerably higher in a number of banking systems overseas, where commercial and investment banking is relatively more important.

In addition to the broad risks relating to credit quality, liquidity and market price movements, ADIs are also exposed to operational risk – the risk of loss arising from weaknesses in banks' internal systems or from external events such as power outages. Operational-risk losses can be large. For example, it is estimated that National Australia Bank has lost $360 million as a result of unauthorised trading of foreign exchange options during 2003/04.

Market-based measures of bank risk

Overall, financial markets have a favourable assessment of the outlook for banks.

Buoyed by the overall strength of the economy, bank share prices have risen quite strongly so far in 2004. This has largely reversed the falls that occurred over the second half of last year as the market factored in the impact of acquisitions (in particular ANZ's takeover of National Bank of New Zealand and National Australia Bank's increased stake in AMP, which the National Australia Bank subsequently sold) and the prospect of some weakening in the demand for household credit (Graph 32).

Options market valuations suggest, relative to the experience of the past five years, that the market assigns a very low probability to substantial falls in the major banks' share prices in coming months (Graph 33). For example, the market attaches only a 1 per cent probability to a more than 10 per cent fall in the average share price of the banks over the next 60 days.

The spread between the yield on bank-issued bonds and that on government bonds provides a measure of debt market participants' expectations of the likelihood banks may default on their bond obligations. Bank bond spreads and comparable measures based on credit default swap prices have risen by around 14 basis points since end September.[9] However, at least some of the rise in bank bond spreads reflects consideration of factors other than banks' creditworthiness.[10] Despite these increases, the level of spreads suggests that debt market participants assign only a very low likelihood of bank default.

Most banks' credit ratings have remained stable over the past six months. The banks' weighted average rating is AA−/Aa3 (Table 9). In February, Fitch upgraded Bendigo Bank's rating to BBB+ from BBB in the light of its improved geographic diversity. Standard & Poor's downgraded National Australia Bank to AA− from AA in March following the bank's foreign exchange trading losses. Standard & Poor's has a negative outlook for AMP Bank. BankWest, Bendigo Bank and Adelaide Bank were assigned positive outlooks by Standard & Poor's, while Moody's put Arab Bank on positive outlook.

2.2 Insurers

The insurance sector has been a source of concern in many countries in recent years, mainly reflecting weak investment performance – a problem that has been somewhat alleviated by the recent recovery in equity prices. The general insurance sector has also benefited from a pick-up in premium income in Australia following the collapse of HIH Insurance and an improvement in premiums globally in the wake of the terrorist attacks in the US in 2001. The major exception to the good news story for Australian insurers has been AMP, which recorded one of the largest losses in Australian corporate history of $5.5 billion for 2003. This was attributable to AMP's troubled UK operations; there were no concerns about the viability of the Australian businesses.

General Insurers

Declines in premium and investment revenue reduced general insurers' profitability in 2001 and 2002 (Graph 34). For the first half of the 2004 financial year, however, profitability has strengthened due to growth in premium income, stronger underwriting standards, comparatively mild claims expenses and cost efficiencies.

The average solvency ratio for general insurers declined between 2000 and 2002, but has since improved as insurers raised capital to comply with APRA's new capital adequacy requirements, which became effective in July 2002 (Graph 35).[11] This provides an important buffer against the potential for any slowdown in premium growth and pick-up in claims.

Apart from their own capital, general insurers rely on reinsurance which allows them to lay off their risk exposures to specialist reinsurers. All major reinsurers active in the Australian market are foreign owned, hence developments in the global market are of direct relevance to Australian insurers. Increases in insurance premiums, resolution of prior-year claims and the stabilisation of capital markets have improved global reinsurers' standing. Nonetheless, global reinsurers are still digesting investment losses on their equity portfolios and a number of reinsurers' credit ratings were downgraded last year (Graph 36). The share of reinsurers that are not rated has also risen, in part due to a number of companies being placed into run-off (i.e. the reinsurers are not writing any new business). Rating agencies currently have a negative outlook on the reinsurance sector due to concerns about the adequacy of reinsurers' reserves.

Life Insurers

While Australian life offices' superannuation business has grown steadily in recent years, standard life insurance business has declined, with preliminary data suggesting that statutory fund assets backing ordinary life business fell by 4.5 per cent in the year to June 2003. Traditional life insurance products, such as whole-of-life insurance and annuities, are losing favour as customers move towards investment-linked funds management products, where life insurers face stiff competition from the broader funds management industry.

Life insurers in Australia are required to keep the assets that back their policies separate from other assets through the use of statutory funds. The return on assets held in the funds halved between end 2000 and mid 2003, primarily due to the weaker performance of international equity markets (Graph 37). The statutory funds are subject to both solvency requirements and capital adequacy requirements. Both the solvency and capital adequacy of life insurers have been relatively stable over the past five years, with the aggregate solvency coverage ratio currently standing at 1.8 and aggregate capital adequacy currently at 96 per cent (Graph 38).[12]

2.3 Superannuation

Like the insurance sector, superannuation fund performance has been strongly influenced by equity market developments. Total superannuation assets grew by 10 per cent to nearly $550 billion in the year to September 2003, compared to annual growth rates of almost 20 per cent in the late 1990s (Graph 39).

In contrast to the two previous years when investment returns were negative, in the year to September 2003 investment returns accounted for more than half the net growth in assets (Graph 40). The median return for large superannuation funds for the calendar year 2003 was around 7.6 per cent. This was the highest since 1999, and resulted from strong returns in all major asset classes in the second half of 2003, particularly equities. With most superannuation assets now held in accumulation (i.e. defined-contribution) funds rather than defined-benefit funds, households are directly affected by the funds' performance.

The allocation of superannuation funds' assets between the various asset classes strongly influences the year-to-year variability in the funds' investment returns. The proportion invested in Australian equities has risen from 40 per cent in the late 1990s to 45 per cent in 2003 (Graph 41). At the same time the share of funds invested in Australian interest-bearing securities has fallen. This suggests the potential variability of superannuation fund earnings has risen a little. Overseas assets comprised about 18 per cent of total assets in September 2003, a proportion that has been gradually falling since the end of 2001; of this, around 80 per cent is in equities. The proportion of superannuation assets held in land and buildings has been stable, at around 6 per cent.


Under Australian prudential requirements, impaired assets are defined to include assets where agreed payments of interest or principal are 90 days or more past due and where the current value of security against the asset is insufficient to cover full repayment, and other assets where there is reasonable doubt over the ultimate collectibility of principal or interest. Distressed assets include both impaired assets and other assets that are more than 90 days past due (that remain well secured). [6]

Non-conforming loans are loans provided to borrowers who do not meet the banks' standard lending criteria. Borrowers taking out low-doc loans are unable to gain approval for traditional lending products due to insufficient documentation – particularly regarding their income or employment record. [7]

J Laker, ‘The Resilience of Housing Loan Portfolios – APRA's “Stress Test” Results’, address to the Securities Institute of Australia, Sydney, 9 October 2003, and N Esho, ‘Stress Testing Housing Loan Portfolios’, APRA Insight, 3rd Quarter 2003, pp 6–19. [8]

For more detail on these risk measures see I Arsov and M Gizycki, ‘New Measures of Credit Risk’, Reserve Bank of Australia Bulletin, July 2003, pp 10–14. [9]

In particular, strong overseas demand for Commonwealth Government bonds has contributed to the rise in bond spreads. [10]

Although the calculation of the solvency ratio differs slightly between life insurers and general insurers, both ratios compare a measure of net assets to the relevant statutory solvency requirement. [11]

The solvency ratio measures the level of capital needed under a range of adverse economic conditions if the life insurer were closed to new business. The capital adequacy ratio concerns the level of capital that is required if a life insurer is to remain a viable ongoing operation. For further details see Life Insurance Actuarial Standards Board (2002), Actuarial Standard 2.03: Solvency Standard, March and Life Insurance Actuarial Standards Board (2002), Actuarial Standard 3.03: Capital Adequacy Standard, March. [12]