Financial Stability Review – September 2006 Overview

From a financial stability perspective, the past six months have been broadly reassuring. A year or so ago, there was anxiety in some quarters that the shift to less accommodating monetary policies in major financial centres – and, by extension, the withdrawal of cheap funding from investors – might be the trigger for abrupt and disorderly price adjustments in global financial markets. This has not occurred. Monetary policy has been tightened in the major economies and, while there has been an increase in volatility in a range of financial prices, financial markets have continued to function in an orderly manner. There have also been modest declines over the past couple of months in the prices of some relatively high-risk assets, including emerging market equities and sub-investment grade debt, as investors have shown a greater tendency to discriminate between assets than they had over recent years. These are favourable developments.

Notwithstanding the recent movements, valuations in many markets continue to be based on expectations of ongoing favourable economic outcomes, both in terms of growth and inflation. While it is entirely possible that these views will prove to be well founded, valuations remain susceptible to disappointing news. Earlier in the year, for example, concerns about nascent inflationary pressures – and hence, greater uncertainty about the extent and duration of the monetary policy tightening in the major financial centres – contributed to the sell-off in some financial markets. Further disappointing news on inflation or economic growth would be expected to have a similar effect.

One notable development over the recent past has been a strong pick-up in business credit growth in a number of countries. This pick-up has been underpinned by above-average growth in the world economy and still below-average interest rates. More generally, the appetite for leverage and historically relatively risky assets remains strong. There have been large inflows into both hedge funds and private equity funds and there is ongoing strength in demand for structured finance products. While these developments can be seen in a generally favourable light, the increased leverage embedded in many of these investments could pose significant challenges in less favourable economic conditions.

Domestically, the household sector continues to take a more cautious approach to its finances than was the case a few years ago, although household credit growth remains strong. Over the past two years, consumption has increased broadly in line with household income, after having grown more quickly than income over the past decade. Recently, there has been a modest increase in mortgage arrears, largely reflecting the general lowering of credit standards that has occurred over the past decade. Notwithstanding this increase, the aggregate arrears rate remains low by both historical and international standards. Overall, household balance sheets appear to be in reasonable shape and have benefited from historically low levels of unemployment and significant gains in the value of financial assets over the past few years. Nevertheless, developments in household balance sheets, both at the aggregate and the disaggregated level continue to warrant close attention.

In the domestic financial system, banks remain highly profitable and well capitalised, benefiting from very low levels of bad debts which, in turn, are a by-product of the long-running economic expansion. Bank balance sheets continue to expand at a relatively fast pace, with business credit growing at around the highest rate since the late 1980s. This strong growth is being accompanied by a significant increase in competition for business loans, with margins declining and a number of lenders taking steps to expand their business lending capabilities. Competition in the housing loan market also remains very intense, with ongoing margin compression. The challenge for banks and other lenders is to avoid an undue erosion of credit standards following 15 consecutive years of economic expansion. As has been noted in previous Reviews, it is important that both borrowers and lenders recognise that the experience of recent years may not be the best guide as to how the future unfolds.