Financial Stability Review – March 2009 The Australian Financial System

The Australian financial system has weathered the current challenges better than many other financial systems. Unlike in a number of other countries, the Australian banking sector continues to report solid profits, has little exposure to high-risk securities, and the largest banks have maintained their high credit ratings. The system is soundly capitalised and the banks have been able to raise additional equity from the private sector at only modest discounts to prevailing prices. The introduction of the Australian Government Guarantee Scheme for Wholesale Funding and Large Deposits has also helped shore up banks' access to funding, and banks have recently taken the opportunity to lengthen the maturity profile of their liabilities.

Notwithstanding this positive assessment, the banking system is facing a more difficult environment than it has for some years. While the overall level of profitability is high, it has declined recently and problem loans have increased from the very low levels of recent years. Banks' lending growth has also slowed recently, although banks generally continue to make credit available to good quality borrowers, albeit on less accommodating terms than in the recent past.

Profits, Capital and Liquidity of the Banking System


In contrast to the banking systems of many other countries, the Australian banking system continues to earn solid profits. In aggregate, the five largest banks recorded headline profits after tax and minority interests of around $8 billion over the latest half year (to September for four of these banks and to December for the other), which represents an annualised post-tax return on equity of 15 per cent (Graph 26 and Table 1). Although this was a strong outcome, profits were around 13 per cent lower than over the same period a year earlier.

There are a number of interrelated factors that have contributed to the relatively strong performance of the Australian banking system. One is that Australian banks typically have only limited direct exposures to the types of securities – such as CDOs and US sub-prime residential mortgage-backed securities – that have led to significant losses for many banks abroad. A corollary of this is that Australian banks' balance sheets remain heavily weighted towards domestic loans, particularly to the historically low-risk household sector. With strong growth in domestic lending over the past decade or so outpacing growth in domestic savings, Australian banks have experienced solid profit growth and, unlike many banks around the world, have not been in the position of having to invest surplus domestic savings outside the home market, where experience suggests that it is often hard to earn the same risk-adjusted return as on domestic assets. As discussed below, while the arrears rate on the banks' loan portfolios has risen recently, it remains lower than in many other countries, particularly on housing loans. This reflects several factors, including:

  • Lending standards were not eased to the same extent as elsewhere. For example, the non-conforming housing loan market in Australia (the closest equivalent to the sub‑prime market in the United States) accounted for only around 1 per cent of the mortgage market in mid 2007, compared to around 13 per cent in the United States. Moreover, ‘negative amortisation’ loans, where the balance could rise at first, became common in the United States but have not been part of the Australian mortgage market.
  • The level of interest rates in Australia did not reach the very low levels experienced in some other countries where low rates made it possible for many borrowers with limited repayment ability to obtain loans. Moreover, the period of particularly rapid continual increases in Australian house prices had come to an end by late 2003, with some households having subsequently already been through a period of balance-sheet adjustment.
  • All Australian mortgages are ‘full recourse’ following a court repossession action, and households generally understand that they cannot just hand in the keys to the lender to extinguish the debt. This reduces their incentive to take out loans that cannot be repaid unless housing prices increase substantially, as well as lenders' incentives to offer such loans. In contrast, in many US states, lenders can foreclose quite quickly and without court action, so they have not tended to incur the expense of suing for any shortfall, even where this is legally possible.
  • The legal environment in Australia places a stronger obligation on lenders to make responsible lending decisions than is the case in the United States. In particular, the Australian Uniform Consumer Credit Code (which has been in operation since 1996) means that courts can set aside mortgage agreements where the lender could reasonably have known that the borrower would not be able to repay the loan without causing substantial hardship.

Another factor that has contributed to the resilience of the Australian banking sector is that the domestic regulatory framework has performed well. By international standards, the Australian Prudential Regulation Authority (APRA) has been relatively proactive in its approach to prudential regulation, conducting several stress tests of authorised deposit-taking institutions' (ADIs') housing loan portfolios and strengthening the capital requirements for higher-risk housing loans. As an example, in 2004, APRA introduced higher risk weights on non-standard loans such as those with low documentation.

Reflecting the Australian banks' focus on domestic lending, the sector's relatively strong performance continues to be underpinned by growth in net interest income. For the five largest banks, net interest income increased by 15 per cent over the past year as a result of the ongoing expansion of banks' balance sheets (see below). After a decade of sustained downward pressure, the interest rate margin that the five largest banks earned on their domestic lending was broadly unchanged over the past year, at around 2.2 per cent (Graph 27).

In contrast to the increase in aggregate net interest income, the five largest banks' headline income from their wealth management operations declined markedly over the past year, largely reflecting the downturn in the local and global equity markets. More than two thirds of the fall was accounted for by net losses on investment assets held in one bank's life insurance business, though these losses are ultimately borne by policy holders rather than shareholders of the bank. When this bank is excluded, wealth management income was around 25 per cent lower in the latest half year than for the same period one year previously.

Notwithstanding weaker wealth management income, the recent decline in bank profits has been mainly due to a rise in provisioning charges. The five largest banks reported charges for bad and doubtful debts of $5.3 billion over the latest half year, compared to $1.4 billion in the same period a year earlier. Banks' trading updates and analysts' expectations suggest that the charges for bad and doubtful debts are likely to rise further, to be equivalent to around 0.5 per cent of their assets for the 2009 financial year (Graph 28). This is up from the unusually low charges over recent years – when both specific and general provisions fell to very low levels – but well below the expense for bad and doubtful debts incurred in the early 1990s. This recent rise in the bad debts expense partly reflects an increase in the provisions that banks hold against a general deterioration in their loan portfolios, such as that arising from the downturn in economic conditions, both in Australia and overseas. It also reflects higher individual provisions, including against exposures to highly leveraged companies that have experienced difficulties in the current environment. Provisioning expenses have also increased at the regional banks, with these banks reporting a $360 million rise in provisioning charges over the past year.

These higher charges are likely to see the banking system's aggregate post-tax profits decline in the near term, with analysts generally anticipating that aggregate profits for the largest banks will be around 10 per cent lower in the 2009 financial year than in 2008. If this were to occur, the post-tax return on equity would be around 14 per cent which, while lower than the average return over the past decade, would still be higher than that being earned in many other banking systems around the world.

The higher provisioning charges reflect a rise in banks' non-performing assets, with the ratio of non-performing assets to total on-balance sheet assets standing at around 1 per cent as at December 2008, compared to 0.4 per cent a year earlier (Graph 29). This ratio is now marginally higher than that recorded in the 2001 downturn, but well below the early 1990s peak of over 6 per cent. Of these non-performing assets, around one third are classified as ‘past due’ but not impaired, meaning that the outstanding amount is well covered by the value of collateral, though repayments are overdue by at least 90 days.

The rise in non-performing loans has been evident across each of the main segments of the domestic loan portfolio, though it has been most pronounced in lending to businesses, with the non-performing business loan ratio increasing from 0.6 per cent to 2.1 per cent over the year to December 2008 (Graph 30). This increase partly reflects the general downturn in economic conditions, but it is also due to a small number of exposures to highly geared companies with complicated financial structures and/or exposures to the commercial property sector.

In banks' commercial property loan portfolios, the impaired assets ratio stood at 3.3 per cent as at December 2008, compared to around 1½ per cent in early 2008 (Graph 31). This ratio is now higher than it has been for around a decade or so, but is much lower than the levels reached in the early 1990s. Much of the recent rise is accounted for by loans for retail property and, to a lesser extent, residential development, with only a small rise in the arrears rate on loans for office property.

In the mortgage and personal loan portfolios – which together account for over half of on-balance sheet loans – non-performing loan ratios have also risen, but remain low by the standards of many other countries. As at December 2008, non-performing housing loans accounted for 0.48 per cent of Australian banks' outstanding on-balance sheet housing loans, compared to 0.32 per cent a year earlier. Housing loan arrears rates for Australian credit unions and building societies are lower than for banks and are around the same levels as in 2005 (Graph 32).

Looking ahead, the main downside risk to the performance of banks' housing portfolios is from a rise in unemployment as the economy slows, with the recent declines in interest rates having helped to alleviate debt-servicing pressures. Notwithstanding this, in previous credit cycles it has typically been business and commercial property loans that have posed the greater risk to asset quality.

An issue that has also drawn some attention recently is the Australian banks' exposures arising from their overseas assets, particularly in New Zealand and the United Kingdom, where economic conditions have weakened significantly. As at December 2008, the Australian banks' overseas exposures accounted for around 30 per cent of their total assets, with New Zealand and the United Kingdom together accounting for about two thirds of these foreign exposures (Graph 33). The recent deterioration in conditions in these two countries, including falls in house prices, has been associated with a sharp decline in lending growth, and an increase in non-performing loans and provisions.

As noted above, one of the other factors that has held Australian banks in good stead during the market turmoil is that they have not typically relied on income from trading activities or securities holdings to support their profitability. For the five largest banks, this form of income accounted for only around 5 per cent of total income in the years immediately preceding the onset of the market turmoil, with this share falling to around 2 per cent in the latest half year. In contrast, large global banks were earning as much as one third of their income from market-related activities prior to mid 2007. Consistent with the Australian banks' low exposure to market risk, the value-at-risk – an estimate of the potential loss, at a given confidence level, over a specified time horizon – for the five largest banks was equivalent to only 0.05 per cent of shareholders' funds in the latest year.

Capital and Liquidity

The Australian banking system remains soundly capitalised, with the aggregate capital ratio increasing by nearly 80 basis points, to 11.4 per cent, over the six months to December 2008 (Graph 34). This increase was largely accounted for by issuance of common equity, with the Tier 1 capital ratio increasing from 7.3 per cent to 8.2 per cent. The same general pattern is evident in the ratio of common equity to assets – a more straightforward measure of leverage – which has increased from 3½ per cent to 4 per cent over the past six months. The credit union and building society sectors are also well capitalised, with aggregate capital ratios of 16¼ and 14½ per cent. The recent increases in banks' capital ratios reflect market-wide pressures to increase capital, rather than any change in APRA's prudential requirements.[1]

Unlike many of their international peers, the largest Australian banks have been able to raise the additional Tier 1 capital from private shareholders, rather than the Government, and have done so at only a modest discount to prevailing market prices. In the second half of 2008, the four largest banks issued a combined $18 billion of equity capital, with most of the recent raisings having taken the form of new issues of ordinary shares. This is in contrast to previous years when the major banks tended to rely more heavily on dividend reinvestment plans (Graph 35). The regional banks have also issued capital recently, raising a combined $1.3 billon of equity since mid 2008. These raisings have seen the share of banking system capital accounted for by common equity rise to around 40 per cent over 2008, after this share had generally fallen over recent years (Graph 36).

It is also worth noting that APRA has adopted a conservative approach to the implementation of the Basel II Capital Adequacy Framework, especially regarding the risk weights that apply to residential mortgages and equity investments. For example, industry estimates suggest that the Tier 1 capital ratios of the four largest banks would be between 1½ and 3 percentage points higher if they were calculated under the UK Financial Services Authority's capital framework.

Another notable development since mid 2007 has been a marked rise in the banking system's holdings of liquid assets. Since the onset of the market turmoil, banks' holdings of liquid assets (including cash, deposits and highly rated securities) have increased by around 75 per cent, reflecting a more cautious approach to liquidity management in the challenging environment. This has seen the ratio of liquid assets to total domestic assets increase from around 13 per cent in mid 2007, to around 17 per cent as at January 2009, the highest share in over a decade (Graph 37). Given the very limited supply of liquid assets other than those issued by banks themselves, the higher holdings of liquid assets have largely taken the form of short-term paper issued by other banks. In addition to higher holdings of traditionally liquid assets, the banks have ‘self securitised’ around $135 billion of residential mortgages, with these eligible for repurchase agreements with the RBA.

Financial Markets' Assessment

Reflecting their relatively strong performance and solid capital positions, the largest Australian banks continue to be viewed favourably by rating agencies. Each of the four largest Australian banks is rated AA by Standard & Poor's (S&P), with these ratings having been unchanged since they were upgraded in early 2007 (Table 2). Given that many international banks have been downgraded recently, only seven of the other top 100 global banking groups have an equivalent or higher rating from S&P (Graph 38).

While S&P and Fitch maintain the major banks on a stable outlook, Moody's recently placed these banks on a negative outlook, but indicated that “…even in a severe downside scenario we would expect Australia's major banks to remain solidly positioned within the Aa rating band.” The only Australian-owned bank to have had its rating downgraded since mid 2008 is Suncorp-Metway, with S&P reassessing the bank to be of ‘strategic’ rather than ‘core’ importance to the overall group. Recent takeovers have seen the ratings of both St George and BankWest raised to match their acquirers, Westpac and Commonwealth Bank.

Notwithstanding this generally favourable assessment, the index of Australian banks' share prices has fallen by 46 per cent from its November 2007 peak (Graph 39). Similarly, CDS premiums – the price paid by investors to insure debt – for Australian banks remain elevated. The cost of insuring the senior debt of the four largest Australian banks is currently around $200 per $10,000, compared to $5–$10 in the years preceding the financial turmoil.

The fall in banks' share prices is similar to that in the broader market, but considerably less than the falls in the banking share price indices in many other countries; the banking sectors in the United States, United Kingdom and Europe have all recorded declines of around 75 per cent from their peaks. Reflecting this, Australia's four largest banks are all currently ranked in the largest 30 banks in the industrialised countries when measured by market capitalisation, with the largest currently ranked ninth.

Despite the falls in share prices, volatility has declined recently for both banks and the market as a whole, though it remains above pre-crisis levels (Graph 40). The daily movement in the Australian share market since July 2007 has averaged just under 2 per cent, compared to an average of 0.8 per cent over the previous 10 years. The volatility of banks' share prices is also lower than it was late last year, but remains above that for the market as a whole.

The movements in banks' share prices over the past year or so has seen significant changes in market-based valuation measures, with the price/earnings ratio for the banking sector falling to around 8 as at end February, less than half the 2006 peak (Graph 41). Similarly, dividend yields for Australian banks are around 9.4 per cent, compared to a 10-year average of 4.9 per cent, consistent with recent indications that dividends are likely to be lower in the period ahead.

Guarantee Arrangements

As discussed in The Global Financial Environment chapter, the bout of heightened risk aversion that swept through global capital markets in the latter part of 2008 led to pressure on the availability and cost of funding for banks around the world. The collapse of Lehman Brothers in September precipitated a period of extreme uncertainty about the health of the global financial system, and the increase in risk aversion led to the virtual closure of global capital markets. Despite their ongoing good performance, the Australian banks were not immune from these developments, with investors becoming reluctant to buy long-term bank debt and some depositors also showing signs of nervousness. In response to this extraordinary environment, and following moves by the Irish Government in late September, many governments announced that they would strengthen their deposit protection arrangements and provide guarantees of banks' wholesale debt. In line with these developments, the Australian Government also moved to reassure depositors and investors in October by announcing guarantee arrangements for deposits and wholesale funding. These arrangements have been successful in sustaining depositor confidence and in ensuring that Australian banks have continued access to capital market funding.

The guarantee arrangements for wholesale funding became fully operational on 28 November 2008, with the Government announcing that the arrangements would remain in place until ‘market conditions normalise.’ Access to the scheme is on a voluntary basis, with institutions able to apply to have each line of securities guaranteed for a fee (see Box A: Government Guarantees on Deposits and Wholesale Funding). Since these arrangements have been in place, Australian banks have issued $85 billion of long-term debt, with $81 billion of this having been issued under the guarantee scheme (Graph 42 and Table 3). This compares with just $3½ billion of term debt that was issued over the three months to November 2008. Around two thirds of the guaranteed bonds have been issued offshore, mainly in the US private placement market and, more recently, in the Japanese ‘Samurai’ market. In total, nine banks have issued long-term debt under the guarantee program.

Banks have also issued guaranteed short-term paper, but the volumes have been much lower than for term debt. Currently, the value of guaranteed short-term debt outstanding is estimated to be around $19 billion, which is equivalent to 5½ per cent of total short-term bank debt outstanding (Graph 43). After strong issuance in the early stages of the guarantee arrangements, the value of outstanding short-term debt has drifted down over the past couple of months. In contrast to long-term debt, most guaranteed short-term paper has been issued in the domestic market.

In setting the premiums on the guarantee, the Government considered a range of factors, including the international experience and the need to ensure that the guarantee arrangements did not continue indefinitely. In particular, the premiums were set at a level that was between the then current market price – which was viewed as the product of very stressed conditions – and the price that is likely to prevail when more normal market conditions return. Institutions pay the guarantee fees on the average daily value of guaranteed liabilities over the preceding month and, on this basis, have paid total fees of $147 million since the scheme was introduced.

The recent pattern of capital market issuance has seen the banking system reduce its reliance on short-term capital market funding, after a number of banks had shortened the maturity of their liabilities in the early stages of the market turmoil. Over the year to December 2008 (the latest available aggregate data), the value of banks' outstanding securities with an original maturity less than one year that are held outside of the domestic banking sector fell by around $95 billion, with their share of total outstandings declining by over 20 percentage points, to just under 20 per cent (Graph 44). Since the guarantee was announced, banks have issued the vast majority of their debt at terms of 3 to 5 years, with the average maturity of outstanding bonds increasing slightly over recent months.

The other aspect of the guarantee arrangements is the guarantee on deposits. For amounts of up to $1 million there is no fee for the guarantee, and for amounts above $1 million the guarantee only applies if the ADI pays the relevant fee. For large deposits, institutions are typically offering the guarantee on an ‘opt in’ basis to customers, though there has been relatively little demand for this guarantee, with the guarantee fee being paid on around $19 billion of deposits in February 2009.

The deposit guarantee has been important in helping reassure depositors, after there were signs of nervousness following the collapse of Lehman Brothers. This nervousness was evident in the increased demand for banknotes late last year, as well as in changes in deposit flows within the ADI sector, with the largest banks gaining market share in the period preceding the guarantee announcement and some smaller institutions losing market share.

With the safety of deposits no longer a notable concern for the public, the period since the introduction of the guarantee has seen continued strong deposit growth for the ADI sector as a whole, and a number of the smaller institutions have regained some of the market share that they had ceded to the major banks. Over the six months to January 2009, total deposits in ADIs increased at an annualised rate of more than 20 per cent, around the fastest rate for many years (Graph 45). Both household and business deposit flows have been above average, with growth in term deposits particularly strong. This reflects both supply and demand factors. As discussed below, banks have been competing more vigorously for deposit funding, and increased risk aversion on the part of investors has increased demand. The latest Westpac and Melbourne Institute Survey of Consumer Sentiment, for instance, showed that around one third of surveyed households viewed bank deposits as the ‘wisest place for savings’, which is around the highest share in over 15 years.

Funding Conditions

While the guarantee arrangements have facilitated access to capital markets, spreads on wholesale funding remain well above pre-crisis levels, although lower than in late 2008. In the domestic money market, the spread between the yield on three-month bank bills and the overnight index swap rate for the same maturity reached a peak of around 90 basis points in October, after averaging around 45 basis points over the preceding couple of months, and around 10 basis points prior to the onset of the market turmoil (Graph 46). More recently, this spread has narrowed significantly to currently be around 30 basis points.

Spreads on term debt also widened further towards the end of last year, with the spread between five-year domestically issued bonds and Commonwealth Goverment Securities (CGS) increasing to over 250 basis points, compared with around 200 basis points in mid 2008 and around 60 basis points prior to the onset of the market turmoil. Despite the higher spreads, declines in long-term interest rates have meant that bank bond yields are currently around 300 basis points lower than in mid 2008. The spreads on offshore funding also widened markedly, with the effective Australian dollar spread widening by around the same amount as domestic spreads (after taking into account the cost of swapping the debt back into Australian dollars). So far this year, spreads have narrowed a little, with domestic unguaranteed bonds currently trading in secondary markets at a weighted-average spread to CGS of around 215 basis points, and guaranteed bonds trading at spreads of 190 basis points (including the guarantee fee; Graph 47).

Recent developments have also had an effect on competition in the deposit market, as banks have been seeking to increase their share of funding sourced from deposits. This overall strong competition for deposits has seen a significant increase in deposit rates relative to short-term money market rates (Graph 48).

While banks have been able to tap capital markets and attract strong inflows of new deposits, conditions in the asset-backed commercial paper (ABCP) and residential mortgage-backed securities (RMBS) markets remain difficult. As discussed in detail in previous Reviews, ABCP markets around the world were the first to be affected by the repricing of risk, and these markets have remained strained. As at December 2008, the outstanding value of ABCP issued by Australian entities (on and offshore) was around $40 billion, 45 per cent lower than its peak in mid 2007. It is estimated that the spread on domestic ABCP over the bank bill rate is currently around 65 basis points, whereas it had been possible to issue ABCP at spreads of around 5 basis points prior to mid 2007. Conditions in the RMBS market also continue to be very difficult, with spreads remaining uneconomic for most issuers. RMBS issuance had averaged just $2½ billion per quarter since mid 2007, compared to a quarterly average of $15 billion over the previous two years. Of the issuance that has taken place since end October, the bulk has been purchased by the Australian Office of Financial Management (AOFM) (see Developments in the Financial System Architecture chapter).

To assist in the smooth functioning of markets, the RBA has adopted various measures in response to the difficult conditions over the past year. One of these was to significantly increase the supply of Exchange Settlement balances, with these balances peaking in December, partly in response to increased demand for settlement balances around year end (Graph 49). In addition, the RBA has enhanced the flexibility of its domestic liquidity operations by accepting a wider range of securities for repurchase agreements, and conducting repurchase agreements for longer terms.

Lending Growth and Credit Conditions

Domestic credit growth has moderated over the past six months, reflecting a combination of demand and supply factors. As discussed in more detail in the Household and Business Balance Sheets chapter, businesses and households are taking a more cautious approach to gearing in the current environment and have reduced their demand for new borrowing. At the same time, there has been some tightening in the terms and conditions on which credit is available, although this is not an unexpected development at this stage of the credit cycle.

Bank business credit increased at an annualised rate of 9½ per cent over the six months to January 2009, although growth has slowed more recently as new lending has been offset by loan repayments (Graph 50). These outcomes follow the very strong growth in business credit over the second half of 2007 when capital markets dried up and companies increasingly turned to banks for funding.

As financial conditions have tightened, there has been an easing of the very strong competition that was evident in some areas of the business loan market in the middle years of this decade. Industry liaison suggests that banks have sought to restore credit standards somewhat, including by increasing their risk margins and strengthening non-price conditions such as collateral requirements and loan covenants. Indications are that this has been more pronounced for larger-value loans than for smaller business loans. By industry, conditions have tightened appreciably for commercial property, reflecting the high degree of uncertainty about asset quality and valuations.

The strong competition in the middle years of the decade had been underpinned by the activities of some newer entrants into the market, including foreign-owned banks. These banks had, as a group, been expanding their business lending at an above-average pace for several years and made notable gains in their share of the large-value segment of the market. While, in aggregate, foreign-owned banks continued to extend credit to domestic borrowers over the past six months, the pace of expansion is noticeably slower than had previously been the case. At the same time, credit extended by the five largest banks has increased at a slightly faster pace than total business credit over the past six months (Graph 51).

The available evidence also suggests that, despite the tightening in conditions, banks have continued to lend to the commercial property sector. According to APRA data, banks' outstanding exposures to Australian commercial property increased by nearly $9 billion, or 5 per cent, over the December quarter. Information from the syndicated loan market also suggests that most property companies that had large refinancing requirements during 2008 were generally able to rollover their debt, albeit on less accommodating terms than in the recent past (Graph 52).

Not unexpectedly, the growth of banks' lending to households has also moderated recently, with household credit (including loans no longer held on banks' balance sheets because they have been securitised) growing at an annualised rate of around 8 per cent over the six months to January 2009, compared to 10 per cent over the previous six months. This is a faster rate than the overall growth in household borrowing, reflecting the fact that banks have increased their market share in home loan originations since the turmoil began.

On the demand side, households are taking a more conservative approach to their finances and, in aggregate, have increased savings and reduced their appetite for new borrowing. On the supply side, lenders have recently unwound some of the easing in lending standards that occurred in previous years, particularly for higher-risk borrowers. Many lenders have reduced their maximum loan-to-valuation ratios (LVRs), with most of the largest lenders reportedly no longer offering 100 per cent LVR loans. Most lenders are also applying tighter criteria for low-doc loans, including increased documentation requirements and risk margins. There are also signs that banks are paying closer attention to the pricing of full-doc home loans, with at least one major bank reducing the typical ‘discount’ that it offers below the advertised standard variable rate on average-sized full-doc loans to 50 basis points, from 70 basis points.

These developments have occurred against a backdrop of significant changes in market shares and the nature of competition in the mortgage market. Most notably, lenders that had previously relied heavily on securitisation for funding have been significantly affected by the strains in the RMBS market. The share of owner-occupier loan approvals accounted for by wholesale lenders fell to around 3 per cent in January 2009, from around 12 per cent in mid 2007. The smaller Australian-owned banks, foreign banks, as well as credit unions and building societies have also lost some market share over the past year or so. In contrast, the five largest Australian banks have increased their share of new owner-occupier loans to 82 per cent in January 2009, a 20 percentage point increase from mid 2007 (Graph 53).

General Insurers

The Australian general insurance industry reported aggregate post-tax profits of $2.2 billion in 2008, which translated into an aggregate post-tax return on equity of around 8½ per cent (Graph 54). While this was lower than the returns recorded during the previous few years, it continued the run of solid industry profits since the turn of the decade.

The downward pressure on insurers' profits over the past year largely reflects more difficult underwriting conditions. Aggregate claims (net of reinsurance and other recoveries) paid by Australian insurers increased by 33 per cent over 2008, compared with an average annual rise of 3 per cent over the previous three years. The factors that contributed to this outcome included a number of significant weather-related events as well as an increase in the size and frequency of smaller claim events in a number of classes of business. At the same time, industry net premium revenue – gross premium revenue less reinsurance expenses – increased by around 4 per cent in 2008. This compares to an annual average rise of around 2 per cent over the past few years, with the pick-up in growth reflecting premium rate rises for both commercial and personal lines of insurance. Nonetheless, the industry's underwriting result was the weakest for a number of years, with the aggregate combined ratio – claims and underwriting expenses relative to net premium revenue – increasing by 17 percentage points, to 105 per cent. This is the highest level since 2002 and indicates that, in aggregate, insurers recorded a loss on their underwriting business over the past year.

With underwriting results weaker than for some time, Australian insurers' profits in 2008 were mainly from returns on invested premiums. Unlike many of their international peers, Australian insurers have been relatively insulated from the decline in the equity market over the past year, with only around 7½ per cent of their financial assets held directly in equities at the beginning of the year. Around three quarters of their financial assets are held in fixed-income securities, so insurers have generally benefited from price gains on these holdings. Consistent with this conservative investment mix, Australian insurers have not reported any direct exposure to US sub-prime mortgage assets and associated structured investments.

Despite having faced more difficult operating conditions in 2008, the aggregate capital position of the general insurance industry remains sound, with insurers holding capital of around twice the regulatory minimum as at mid 2008 (the latest available aggregate data). Several of the large insurers have also raised capital, including IAG and QBE which have raised around $2.5 billion in recent months.

Rating agencies continue to hold a generally favourable view of the Australian insurance industry. The four largest general insurers are all rated A+ or higher by S&P, with Suncorp's general insurance division retaining its A+ rating despite the downgrade of its banking operations (Table 4). In addition, the rating agencies' outlooks on these four insurers are stable, in contrast to the negative outlooks assigned to many of their international peers. Share prices of the largest listed Australian insurers are, however, around 40 per cent lower than at the beginning of 2008, and had until recently fallen sharply in 2009, partly reflecting the expected impact on profits of the Victorian bushfires, and some profit results having been lower than the market expected (Graph 55). Notwithstanding this, the share price performance of Australian insurers compares favourably with other international markets; for example, the US insurance index has fallen by around 70 per cent over the past year, and the European insurance index has fallen by more than 60 per cent.

Over the past year, Australian general insurers ceded around one quarter of gross premium revenue to reinsurers, and several of the larger Australian insurers have recently sought to strengthen their reinsurance arrangements for 2009. This has generally involved the lowering of retention limits – the maximum amount that an insurer is liable to pay for a single event before the rest is passed on to reinsurers. For some insurers, it has also involved the purchasing of aggregate cover, which protects them against large losses from the accumulation of smaller individual events.

The majority of this reinsurance cover is placed with the large global reinsurers. The global reinsurance industry had experienced several years of strong profitability in the middle years of this decade, though more recently several reinsurers have reported large investment losses as the market turmoil spread from structured finance-related assets, where reinsurers had relatively low exposures, to bonds and equity securities. On the underwriting side, reinsurers have also had to absorb large claims, including those associated with hurricanes Ike and Gustav in the United States. This has placed some pressure on reinsurers' balance sheets, though evidence from the 2009 reinsurance renewal period suggests that premium rates have risen. Notwithstanding some high-profile downgrades, the majority of large reinsurance companies are rated A or higher by S&P.

As discussed in the previous Review, developments in global housing markets have focused attention on the lenders' mortgage insurance (LMI) sector. Mortgage insurance provides protection for lenders against borrower default, and is also a form of credit enhancement in the RMBS market. In Australia, the largest non-captive LMIs are QBE and Genworth, and these insurers have continued to report solid profits during 2008, though claims have recently risen a little. In contrast, US mortgage insurers have reported large losses over the past year or so, as house prices there have fallen and defaults have risen significantly. Despite the relatively good performance of the Australian housing market, the poor outcomes in the United States have had implications for the Australian LMI industry, as until recently the largest insurers were both owned by US mortgage insurers. While the sale of PMI's Australian division to QBE in September last year distanced part of the Australian LMI industry from the difficulties experienced by US mortgage insurers, large losses at the US parent of Genworth saw its credit rating downgraded, which has affected the credit rating of Genworth's local operations.

Not surprisingly, the largest Australian mortgage insurers have recently tightened their underwriting standards. This has occurred against the backdrop of tightened lending standards at banks, and has generally involved increased documentation requirements on low-doc loans and a reduction in the maximum LVRs on loans that insurers are willing to cover.

Managed Funds

The turbulence in financial markets over the past year or so has had a marked impact on the performance of the funds management industry. On a consolidated basis, the industry's assets under management fell by around 14 per cent over the year to December 2008, to stand at $1.2 trillion (Table 5). The recent falls have been broadly based across all fund types.

Superannuation Funds

According to ABS data, superannuation funds' (consolidated) assets under management fell by 14 per cent over the year to December 2008, compared with a decade-average annual growth rate of around 16 per cent. This fall primarily reflects lower valuations on investment assets during 2008, with APRA data showing that superannuation funds recorded aggregate losses on their investment portfolios of around $100 billion in the first nine months of 2008 (Graph 56). While aggregate APRA data on returns for the December quarter are not yet available, industry data show that superannuation funds have recorded further losses since the end of the September reporting period. Inflows of new funds have also been significantly lower than in recent years, as market-linked assets have become less attractive to many investors. In the September quarter, net inflows into superannuation funds were $6.9 billion, compared with a quarterly average of around $9 billion between 2002 and mid 2007.

With around half of superannuation funds' assets held in domestic equities and units in trusts as at June 2007, the downturn in equity markets has had a significant effect on the superannuation industry. Since the onset of the market turmoil, allocations to domestic equities and units in trusts have fallen to around 42 per cent of assets under management, while holdings of cash and deposits have increased to around 18 per cent of assets, their highest share in at least 20 years (Table 6).

Life Insurers

According to ABS data, life insurers' (consolidated) assets declined by 20 per cent over 2008, after having increased at an average annual rate of around 4 per cent over the previous decade. Superannuation assets continue to account for around 90 per cent of life insurers' total assets, and investment returns on these funds have typically accounted for a significant share of life insurers' asset growth. In previous years, this reflected the strong growth of the equity market, as around three quarters of life insurers' assets are held in equities and units in trusts. However, over the year to September 2008 (the latest available aggregate data), the exposure to declining equity markets contributed to the industry recording around $30 billion in investment losses, with further losses likely to be reported in more recent quarters (Graph 57). While income derived from ordinary ‘risk’ business remained positive in 2008, the majority of life insurers' revenue is sourced from superannuation, meaning that the overall performance of the industry will remain closely tied to developments in this sector. Notwithstanding large investment losses, the aggregate capital position of the life insurance industry remained sound as at end September, with insurers holding capital of around 1½ times the minimum requirement.

Public Unit Trusts and Other Managed Funds

Outside of superannuation funds and life offices, the majority of funds under management are invested in public unit trusts. On a consolidated basis, assets of public unit trusts declined by around 16 per cent in 2008 (Table 7). The declines in asset values have been broadly based across the various types of public unit trusts, with most asset classes having experienced price falls since the onset of the market turmoil. The fall has been largest for unlisted equity trusts, whose assets under management declined by 38 per cent over the year to December 2008.

One sector that has been particularly affected by recent developments is the mortgage trust industry. While many of these funds had been experiencing outflows over the first three quarters of 2008, redemptions accelerated in September and October in the wake of the general retreat from risk taking and the guarantee arrangements on deposits. Given the illiquidity of the trusts' underlying assets, most responded by suspending redemptions. Following these redemption freezes, ASIC introduced provisions allowing members to apply to withdraw funds on hardship grounds, including if they would be unable to meet immediate living or medical expenses. As at late December, around 500 applications had been received. Some of the suspended trusts have also begun to offer withdrawals, with funds generally being made available on a pro-rata basis.

Market Infrastructure

A noteworthy feature of the recent difficult environment is that the infrastructure supporting Australia's financial markets has continued to function effectively. Australian equity market trading volumes rose to record levels in late 2008, reaching a peak of around 500,000 trades per day in October, though volumes have declined somewhat since then (Graph 58). Turnover on the Sydney Futures Exchange (SFE) has also declined recently, to around 180,000 trades per day, compared to a peak of 400,000 in late 2007. The default of Lehman Brothers was handled without significant disruption, high-value settlements have continued to operate efficiently, and the central counterparties servicing the equity and exchange‑traded derivatives markets have increased margin requirements and undertaken closer monitoring of participants.

In RITS, the real-time high-value payments system operated by the Reserve Bank, there has been an observed improvement in the timeliness of settlement, notwithstanding an increased focus by market participants on counterparty risk. As an illustration of the improvement, since mid September 2008 half of the daily payments (by value) have typically been completed by 2:00 pm, whereas in the year to mid September 2008 it typically took until 2:30 pm to complete half the payments (Table 8). The improvement is also evident in average queue times in RITS which have declined significantly for many banks (Graph 59). An important factor in explaining the continued smooth operation of Australia's high-value payment system is the increase in Exchange Settlement balances at the Reserve Bank. With additional balances in the system, banks have been able to make payments earlier in the day without fear that there would be a shortage of liquidity later in the day.

Foreign exchange-related settlements through the Continuous Linked Settlement Bank (CLS) have also proceeded smoothly over recent months, despite some operational challenges associated with the failure of Lehman Brothers. An increased focus on counterparty credit risk has underscored the rationale for having introduced a payment-versus-payment (PvP) settlement system for the foreign exchange market. In offering PvP settlement, CLS is specifically designed to manage the risk that one party might pay away the currency it is selling and, due to the failure of its counterparty, not receive in return the currency it is purchasing.

Two key components of the financial infrastructure are the central counterparties operated by the Australian Securities Exchange (ASX): the Australian Clearing House (ACH) which clears trades for the equity market, including ASX options; and the Sydney Futures Exchange Clearing Corporation (SFECC), which clears futures trades. Although Lehman Brothers was not a direct participant in the Australian central counterparties operated by the ASX, a number of participants had provided it with clearing services, and the central counterparties assisted in the close out or transfer of these firms' Lehman Brothers-related open derivatives positions, avoiding significant disruption to the market. In the cash equities market, Lehman Brothers' third party clearers honoured any unsettled trades, although there was a brief period of increased settlement fails reflecting a delay in the release of Lehman's securities owing to legal uncertainties. Overall, the rate of fails on equities settlements in Australia remains very low, although failure rates did increase temporarily after the ban on short selling was introduced, as some securities lenders became reluctant to lend securities.

Finally, in response to the increased volatility, Australia's two central counterparties have increased margin requirements, as well as increasing their surveillance of participants. In several cases, the changes in initial margins have been sizeable, leading to a large increase in margin funds held by the central counterparties. For instance, on 15 October the initial margin rate for the 90-day bank bill futures was increased from $1,020 to $2,600 and the rate on 30-day interbank cash rate futures contracts from $810 to $2,800 (Graph 60). This added $760 million to the pool of initial margin held by SFECC. The combination of significant initial margin adjustments during the period and an increase in participants' open positions led to a more than doubling in the amount of collateral held by SFECC between June and December 2008 (from $3 billion to $6.8 billion). Moreover, the increased volatility has meant that it has not been uncommon for participants' initial margins on derivatives to be eroded rapidly and, as a result, intraday margins have been called more regularly, for both SFECC and ACH.


Laker, JF (2009), ‘APRA: The Year Ahead’, speech to the Australian British Chamber of Commerce, Sydney, 26 February. [1]