Financial Stability Review – March 2005 2. Financial Intermediaries

Australian financial intermediaries remain in sound condition, an outcome that partly reflects the generally favourable economic conditions over the past decade or so. Profitability remains strong, credit losses are low and the main institutions are well capitalised. This is not to say that the current environment is without its challenges. In particular, the slowdown in the pace of household credit growth appears to have intensified competition in a range of markets, with some financial intermediaries taking on more risk at lower margins than has been the case for some time. To the extent that this is associated with some underpricing of risk it could ultimately presage a deterioration in the very good conditions experienced over recent years.

2.1 Deposit-taking Institutions


Banks, the largest deposit-taking institutions, have been highly profitable over the past decade. The pre-tax return on shareholders' funds has averaged 21 per cent per year over this period, and there has been relatively little volatility. While the rate of return on shareholders' funds has slipped a couple of percentage points over the past few years, largely reflecting a compression of interest margins, the banking industry is still generating returns that are high in comparison with most other industries. Over the past year, the five largest banks recorded an aggregate pre-tax return on equity of more than 18 per cent (Graph 28). Returns were held down by the lower profits of the National Australia Bank, following problems with its foreign currency options trading and other writedowns.

This overall strong performance reflects a combination of factors, including exceptionally low bad-debts expense and sustained efforts to reduce costs. Banks are also reaping the benefits from their substantial investments in wealth management, which are helping to boost non-interest income. This form of income, including fees and commissions, grew by 11 per cent last year and now accounts for around 45 per cent of total net income of the five largest banks (Table 5). In comparison, net interest income rose by 7½ per cent, with the effect of strong growth in loans and advances partly offset by declining interest margins.

The decline in margins, which has been going on for more than a decade, has seen the ratio of net interest income to interest-earning assets fall to 2.45 per cent (Graph 29). The reasons behind this trend decline were discussed at some length in the previous Review. In summary, on the funding side, they include a fall in the share of low-cost retail deposits, as banks have needed to access wholesale funds to finance lending and households have invested a larger share of their savings in non-deposit products. More recently, competition spurred by the introduction of high-yielding internet deposit accounts, notably by a number of foreign-owned banks, has put upward pressure on deposit rates. On the lending side, margins on a variety of loan products, particularly mortgages, have declined as a result of greater competition, often initiated by new providers of finance.

The effect of competition in housing loan markets is clearly evident in the spread between banks' standard variable mortgage rate and the cash rate, which has fallen by nearly 2½ percentage points since 1993, to around 1.8 per cent. Most of the decline occurred by 1997, with the spread being stable over recent years as standard variable mortgage rates have generally moved in lock-step with the cash rate. Notwithstanding this, the actual spread that banks earn on home loans has fallen recently, reflecting widespread discounting and broader product offerings (Box B).

Over the past year, margins have also been compressed due to the short end of the yield curve being more upward sloping than in 2003. This has compressed margins since banks' funding costs are determined, in part, by the 90-day bank bill rate, while their loan rates are often linked to the cash rate. In 2004, the spread between these two rates averaged around 25 basis points, up from 9 basis points in 2003.

Despite the ongoing pressure on margins and the slowdown in credit growth, financial market participants have generally revised up their expectations of future profitability for banks and, more so, for other financial institutions (Graph 30). In response, bank share prices have risen by 13 per cent since the previous Review, reversing the declines during the preceding half year. Nevertheless, since the slowdown in credit growth has become widely apparent, banks' share prices have underperformed the rest of the share market and those of other segments of the financial system (Graph 31).

Capital Adequacy

The regulatory capital ratio for the Australian banking system has been relatively constant over the past six to seven years, with capital fluctuating in a narrow range of around 10 to 10½ per cent of risk-weighted assets. By international standards, aggregate regulatory capital ratios in Australia are not particularly high, notwithstanding the largest Australian banks enjoying relatively high credit ratings. In part, this reflects the large share of relatively low-risk housing loans on banks' balance sheets.

The split between Tier 1 and Tier 2 capital has also been fairly stable over recent years, although there has been a slight substitution of shareholders' funds (Tier 1) for other forms of regulatory capital (Tier 2) (Graph 32). Within Tier 1, most banks have not needed to issue new equity in recent years, despite rapid growth in their assets, instead relying heavily on retained profits to boost their regulatory capital levels. Banks have tended to supplement these retained earnings with issues of hybrid capital instruments, while at the same time returning ordinary capital to shareholders through share buybacks. Within Tier 2 capital, general provisions for bad and doubtful debts have decreased relative to banks' assets, with this being offset by new issues of subordinated debt.

Over the six months to December 2004, the level of banks' regulatory capital rose by around 3 per cent. Retained profits, which account for one third of total capital, contributed around half of this growth, with the remainder largely reflecting issuance of hybrid instruments by two banks. In comparison, risk-weighted assets grew by 4 per cent over this period, resulting in a slight fall in the regulatory capital ratio to 10½ per cent as at December 2004. The capital ratios of credit unions and building societies remain around the highs of recent years (Graph 33).

Looking ahead, the implementation of the International Financial Reporting Standards (IFRS) has the potential to reduce the capital adequacy ratios of some banks. In particular, banks will need to remove any excess of market value over net assets in their life insurance subsidiaries from Tier 1 capital, and similarly, any deficits in defined-benefit superannuation schemes will need to be deducted from regulatory capital. APRA has, however, indicated that it will provide a transitional period for those banks significantly affected by IFRS adjustments.

Credit Risk

As noted above, Australian banks have benefited from very low bad-debts expense over recent years. As at end 2004, only 0.3 per cent of banks' on-balance sheet assets were classified as ‘impaired’ – that is, loans that are not well covered by collateral and where either payments are 90 days or more in arrears, or there are other reasons to doubt the ability of the borrower to repay the loan. Including those assets that are in arrears, but are well secured (‘past due’ items), the ratio of ‘distressed’ assets to total assets is still only 0.5 per cent (Graph 34). These are exceptionally low ratios both by our own historical experience and by standards overseas.

One reason for these very low ratios is the relatively high share of housing loans in most banks' portfolios. Residential housing loans now account for over half of total bank credit – which is high by international standards – compared to less than one third in the early 1990s. As at end December 2004, only 0.2 per cent of outstanding housing loans were past due by 90 days or more (Graph 35). This ratio has ticked up recently, though this increase primarily reflects a revision in the methodology used by one major bank to measure its housing loan delinquencies. There has not been a similar pick-up in arrears rates for other personal lending.

Another measure of the performance of housing loans is provided from data on loans that banks and other lenders have securitised. Over the past year, the arrears rate on these loans has also picked up, although, in this case, the increase is not explained by a change in reporting methodology. This rise may partly reflect an increase in the share of low-doc loans in the pool of securitised mortgages, with these loans having higher average default rates than standard housing loans.

With the overall rate of problem loans so low, there seems little prospect of further material declines. Indeed, it is more likely that, over time, the ratio of problem loans will increase, rather than fall. Such an outcome would be consistent with the intense competition in mortgage markets, which has seen banks supplement their ‘tried-and-tested’ lending practices with a variety of new approaches. These include:

  • the increased reliance on brokers to originate loans

    Broker-originated loans are estimated to account for around 30 per cent of new housing loans, although for some lenders, notably smaller regional institutions with limited branch networks, the figure is considerably higher. The use of brokers is promoting a higher rate of refinancing of mortgages than in the past, as brokers ‘shop around’ to find their clients replacement loans on better terms and conditions than their existing ones. To the extent that this process reduces overall debt-servicing burdens, it should help strengthen household balance sheets, but in practice many borrowers take the opportunity when refinancing to increase the size of their loan. So far, there is little evidence that broker-originated loans perform worse, on average, than loans originated directly by banks, but brokers' incentives are aligned more closely with volume than quality. Brokers are typically paid an upfront commission equal to about 0.6 per cent of the loan amount and a trailing commission of about 0.25 per cent annually.

  • the granting of low-doc loans

    Low-doc loans involve a large element of self-verification in the application process, often including verification of income. These loans are designed mainly for the self-employed with limited records of their income, but may also be sought by borrowers who have understated their income for tax purposes but wish to declare the correct, higher amount, to their lender, or those who are overstating their income for borrowing purposes. From a financial stability perspective, this latter category of borrower is the main source of concern, given that their capacity to service loans may be poor. While the major banks have only recently entered the low-doc market, a number of regional banks have been more active in undertaking low-doc lending, and have significant market shares. In the case of one regional bank, low-doc loans account for nearly 30 per cent of its outstanding housing loans. Though available data are incomplete, the share of low-doc loans for non-bank intermediaries also tends to be considerably higher than for the four largest banks, with low-doc loans comprising 22 per cent of housing loans securitised by non-bank lenders in the past two years.

    Although banks offer certain low-doc loans, they still typically do not lend to borrowers with impaired credit histories. However, this segment of the market, which is dominated by specialist ‘non-conforming’ lenders, has also grown rapidly in recent years (Box C).

  • an increase in permissible debt-servicing burdens

    A traditional rule of thumb for lenders was that interest and principal payments could not exceed 30 per cent of a borrower's gross income. This constraint has now been relaxed significantly. Banks' online calculators suggest that they routinely consider loan applications with debt-servicing ratios of over 45 per cent (Box D). In addition, the fall in nominal interest rates has allowed households to take on a larger debt relative to their income, for any given debt-servicing burden. The combined effect of these changes is that many households are likely to be more vulnerable to a change in their circumstances than was previously the case. However, lenders note that improvements in risk management techniques mean that they know more about, and better understand, the risks posed by their mortgage portfolios.

  • the use of alternative property valuation methods

    Over recent years, there has been a trend away from valuations that involve full external and internal inspections of properties. A recent APRA survey of approximately 100 lenders found that, while around two thirds of the valuations requested by lenders were performed in this way, there was also extensive use of alternative methods based on only external inspections, or conducted solely off site. These valuation techniques are typically based on information drawn from sources such as the contract of sale, Valuer General records, or desk-based electronic methods. Such techniques tend to be used by larger lenders for fully documented, low-LVR mortgages, but have not been tested in a downturn. APRA has requested that authorised deposit-taking institutions conduct formal and periodic reviews of valuation methods, including comparisons with results obtained using full on-site valuations.

Taken together, these changes are helping to provide borrowers with easier and cheaper access to finance. From an efficiency perspective, this is a welcome development, provided that both borrowers and lenders understand the risks involved and lenders are pricing the risks appropriately. It does mean, however, that the past performance of housing loan portfolios may not be a good guide as to how default rates play out in the future.

This is particularly true for investor housing loans, which have been such a prominent feature of the Australian housing market in recent years. The growth rate of lending for investor housing has significantly outstripped that of lending for owner-occupied dwellings over most of the past decade, although recently it has slowed to around the same rate as that for owner-occupier lending (Graph 36). This decline in growth has, however, not been uniform across banks, with some regional banks still experiencing rapid growth in investor housing lending. Much of this is ultimately securitised, with banks other than the four largest accounting for around 80 per cent of loans securitised by banks since the beginning of 2004 (Graph 37). Over the past year, these smaller banks have also increased the value of investor housing loans held on their balance sheets more rapidly than the four largest banks. So far, loan quality has not differed markedly between investor and owner-occupier housing lending, although the expanded investor market has yet to be tested through a more difficult economic climate.

In contrast to mortgage portfolios, the risks inherent in banks' business loan portfolios do not appear to have increased over recent years. As discussed in the previous chapter, corporate profitability is high, gearing and interest burdens are low, and there are few signs of the imbalances in commercial property markets that caused problems in the 1980s and early 1990s. Indeed, the arrears rate on banks' commercial property portfolios is currently very low, with only 0.2 per cent of outstanding commercial property loans impaired as at the September quarter 2004 (Table 6). Exposures in this area have, however, been growing relatively briskly, fuelled by 16 per cent growth in commercial lending relating to residential property, including development, over the year to September 2004. Prospects in this segment of the portfolio will ride in tandem with those for the residential property market more generally.

An important part of controlling credit risk is limiting the concentration of exposures to particular sectors, countries, or individual clients. Relative to total capital, Australian banks, in aggregate, have significantly reduced their overall ‘large exposures’ since the early 1990s, with large exposures to non-bank private sector entities having fallen to 5 per cent of the total value of capital in the banking system (Graph 38). While large inter-bank exposures have risen a little in recent years, these exposures typically raise fewer concerns from a credit risk management perspective, as banks tend to be highly rated counterparties.

In terms of country exposures, Australian banks' largest exposures are to New Zealand and the United Kingdom, predominantly through lending to residents by branches and subsidiaries located in those countries, rather than from cross-border lending by their Australian-based operations (Table 7). A significant amount of this lending is for housing in both countries, raising some familiar issues from an overall risk management perspective. As in Australia, house prices have grown strongly in New Zealand and the United Kingdom in recent times, household debt-to-income ratios are high by historical standards, and there are signs that momentum in housing markets has slowed.

Market Risk

By international standards, Australian banks continue to have relatively small unhedged positions in financial markets. This is evident in the major banks' exposure to market risk through their trading operations, as measured by the average value at risk (VaR).[2] Over 2004, this measure of risk was equivalent to 0.06 per cent of shareholders' funds, much lower than that for most international banks (Table 8). This figure was unchanged from 2003, despite a decline in financial market volatility, suggesting that the level of trading book exposures may have increased a little over the past year.

The single largest component of traded market risk is interest-rate risk, although this risk has declined, relative to shareholders' funds, since 2003. Interest-rate risk also arises in the banking book, due to mismatch in the maturity and repricing of assets and liabilities. However, for Australian banks, this risk too appears relatively low. For example, results reported in the four largest banks' financial statements indicate that a 1 percentage point movement in interest rates across the yield curve would have only a small impact on expected net interest earnings. This is consistent with the high proportion of Australian bank lending that is contracted at variable interest rates. For the four largest banks, around 60 per cent of total loans, and 80 per cent of housing loans, are based on variable interest rates.

Liquidity and Funding

The funding patterns of Australian banks over the past decade have been heavily influenced by developments in household balance sheets. Lending to the household sector has grown rapidly, while growth in retail deposits has been relatively slow, with the household saving rate declining and households investing a larger share of their savings in non-deposit products. By September last year, the cumulative differential between the increase in bank lending and the increase in bank deposits since the early 1990s had reached around $250 billion (Graph 39). The banks have funded this ‘gap’ by raising funds in wholesale markets, with offshore funding exceeding that raised in the domestic market (Graph 40). Reflecting these trends, the banking system now obtains more funding from offshore than it does through retail deposits in Australia. Around one third of these foreign liabilities are denominated in Australian dollars, while the remainder are denominated in a range of foreign currencies, with the exchange-rate risk typically being fully hedged.

Over the past year, banks have taken advantage of the historically low yields in global capital markets to lengthen the average maturity of their foreign borrowings. At the end of 2004, around 75 per cent of banks' foreign (non-intermediated) debt had a maturity of more than one year, up from 70 per cent at end 2003 (Graph 41). One positive consequence of these longer-term borrowings is that they reduce the likelihood of liquidity problems arising from difficulties in rolling over the liabilities.

On the other side of the balance sheet, the holding of assets that can be readily sold in difficult market conditions is also important in managing liquidity risk. The most liquid assets are those that the Reserve Bank will accept as collateral in its daily open market operations. Currently, such assets account for around 8 per cent of on-balance sheet assets, up from around 2 per cent in early 2004. This follows a decision by the Reserve Bank last year to widen its definition of acceptable collateral to include certain bank bills and certificates of deposit (Graph 42).

More broadly, total liquid assets have stabilised at around 12 per cent of on-balance sheet assets since late 2003, after this ratio fell for much of the previous decade. As noted in the previous Review, this decline partly reflects banks holding fewer government bonds in the face of a diminishing stock of Commonwealth Government bonds outstanding. Banks have partly compensated for this by increasing their holdings of bonds issued by domestic and overseas corporates (Graph 43). Despite this, bond holdings of Australian banks are still lower, as a share of total assets, than those of banks in the United States and United Kingdom.

Financial Markets' Assessment

Financial markets continue to view the Australian banking system favourably. The spread between yields on bank and government debt has remained steady at around 50 basis points over the past six months, and the credit default swap premium for the four largest banks has fallen to around its lowest level since these instruments became commonly traded in Australian markets (Graph 44). The expected future volatility of banks' share prices implied by options markets is also around historically low levels, suggesting few concerns about banks' earnings prospects (Graph 45). To some extent, these developments are unsurprising, given the global attitudes to risk discussed in Chapter 1.

Ratings actions in the banking sector have been positive over the past six months (Table 9). In late 2004, both Standard & Poor's and Moody's upgraded Adelaide Bank's long-term credit rating by one notch, to BBB+ and Baa1 respectively. In the past six months, Standard & Poor's has also upgraded BankWest from A to A+, Bendigo Bank from BBB to BBB+, and moved Bank of Queensland and ING Bank (Australia) from a stable to a positive outlook. Moody's financial strength rating of Australian banks, which unlike long-term credit ratings does not take account of likely external support, remains relatively high by international standards (Table 10).

2.2 Insurers

General Insurance

The general insurance industry continued to perform strongly in 2004, with major underwriters reporting robust profits. In addition to solid investment results, which were supported by buoyant equity markets, general insurers benefited from higher premium income, and claim levels that remained low by historical standards (Graph 46). Another factor supporting aggregate profitability has been the release of funds from claim reserves, as realised losses have been lower than the provisions placed in those reserves.

There are signs, however, that the strong increases in profitability may be beginning to moderate. Claims increased in the latter part of 2004, and competition is again placing downward pressure on premiums in some business lines, such as in the corporate property and public liability markets. That said, the outlook for the domestic general insurance industry remains generally benign, partly reflecting the stronger operational management practices and enhanced risk management processes introduced following the collapse of HIH. These improvements have been supported by the changes to prudential requirements introduced by APRA since 2001.

The health of global insurers – particularly reinsurers – is of interest because they underwrite some of the business of domestic insurers. Compared to the domestic industry, global insurers suffered substantial claims from the spate of natural catastrophes in 2004. While the tsunami in Southern Asia is estimated to have caused around US$5 billion in insured claims, its relatively muted impact on insurers reflects the low take-up of insurance cover in the region. In contrast, other natural disasters, including weather-related events in the US, Japan and Caribbean are estimated to have caused more than US$44 billion in total insured claims last year, making 2004 the costliest year for such events on record (Graph 47).

Despite the claims caused by natural catastrophes, profitability in the global reinsurance industry remained fairly strong in 2004, supported by robust investment returns and relatively high premiums. It was also helped by the fact that the direct insurers worst affected by the weather-related events in the US had retained most of the risk on their own books. Reflecting the overall profit outcome and efforts to strengthen balance sheets in recent years, credit rating agencies removed their negative outlook for the global reinsurance industry in 2004.

Life Insurance

Life insurers' assets increased by 2½ per cent over the past year, and profitability in the industry improved, mainly reflecting life insurers' exposure to the strong equity market. However, the effect of strong investment returns on profitability was partly offset by policy payments which, for the second year running, exceeded premium revenue (Graph 48). Credit ratings in the sector stabilised in 2004, after a number of years of decline.

Notwithstanding very good investment results over the past year, the life insurance industry has been under pressure for some time, partly reflecting the marked decrease in the share of superannuation assets held in life offices – around 25 per cent, compared to nearly 45 per cent in 1992 (Graph 49). The sector is expected to come under further pressure when the transitional tax relief, granted to life insurers following the federal government's overhaul of the industry's taxation rules, expires later this year.

2.3 Superannuation

Like insurers, superannuation funds have benefited from strong investment returns. Over the past year, the average growth of these funds was 18 per cent, the highest since 1999 (Graph 50). At end September 2004, total superannuation assets stood at $649 billion, equivalent to around 80 per cent of annual GDP. Equities and units in trusts accounted for nearly 50 per cent of superannuation assets, a share that has increased over the past five years, while the share of interest-bearing securities has fallen (Graph 51).

Over recent years, there has been a marked decline in the share of superannuation assets managed by defined-benefit funds (Graph 52). In the mid 1990s, these funds accounted for around 20 per cent of total assets, compared with their current share of around 4 per cent. One consequence of this decline is that households now tend to bear more market risk, relative to their income, while employers tend to bear less, since poor performance in asset markets no longer requires defined-benefit superannuation schemes to be replenished to the same extent as in the past.


Value-at-Risk (VaR) models use the distribution of historical price changes to estimate the potential for future losses, relative to a confidence level. A confidence level of 99 per cent, for example, indicates a 99 per cent probability that losses will not exceed the VaR estimate on any given day, based on historical performance. [2]