Financial Stability Review October 2021

At a Glance

Financial systems in Australia and internationally remain resilient despite some setbacks

Financial systems in Australia and internationally have been resilient to the effects of the COVID-19 pandemic. Banks have cushioned the economic impact of the pandemic and have supported the recovery through loan repayment deferrals and new lending.

In most advanced economies, improved economic conditions have seen increased earnings for businesses and households. This has strengthened their balance sheets and borrowers' abilities to repay debt. As a result, banks' loan losses have been much lower than was expected early in the pandemic. Banks in Australia, and many elsewhere, have therefore been able to reduce provisions for future loan losses. This has contributed to higher profits and improved capital positions, enabling regulators to remove restrictions on dividend payments.

Some emerging market economies, where the rollout of vaccines has been generally slower than in advanced economies, have experienced temporary setbacks given the spread of the highly infectious Delta variant.

In Australia, the spread of the Delta variant and extended lockdowns have interrupted the economic recovery. Policy measures have supported household and business balance sheets. A much smaller share of borrowers have taken up banks' offers of loan repayment deferrals than last year. The businesses and households most at risk of experiencing financial stress continue to be those working in highly impacted industries and living in areas under the most stringent lockdowns.

There is a risk of excessive borrowing due to low interest rates and rising house prices

Low interest rates have contributed to high prices for financial assets and housing. There has been some increased risk-taking and higher borrowing.

Most major equity markets are well above, and credit spreads below, pre-pandemic levels. With interest rates expected to remain low, investors have been taking on more risk to seek higher returns – for example, with greater purchases of debt issued by lower-rated companies. Some asset prices appear high given the pandemic still presents a risk to economic activity. Price falls could be widespread if interest rates were to increase sharply due to unexpected inflation or rising risk premiums, or if there are extended falls in output.

In Australia, and some other countries, there have been large increases in housing prices and an acceleration in borrowing. Vulnerabilities can increase if housing market strength turns to exuberance with borrowers taking on greater risk given expectations of further price rises and banks potentially easing lending standards. In response to these risks, the Australian Prudential Regulation Authority has increased the interest rate buffer used to assess loans, which will reduce the borrowing capacity for new borrowers.

Most borrowers' income has recovered, but others may struggle with loan repayments

Most borrowers' income has recovered from large falls resulting from the pandemic. But income remains lower for some in heavily impacted industries and particularly in some emerging market economies.

In Australia, most borrowers' income had recovered to exceed pre-pandemic levels before the latest lockdowns, except for some in industries such as tourism and hospitality. With rapid progress in vaccination rates and projected reopening of the economy in sight, incomes are expected to bounce back from lockdowns and so most borrowers should be able to make their debt repayments.

In some emerging market economies, financial stability risks are elevated because output has not yet fully recovered from the large falls seen earlier in the pandemic, and low vaccination rates increase the risk that further lockdowns are needed. These economies could experience further financial instability from capital outflows and exchange rate depreciations as advanced economies start to increase their interest rates.

In China, authorities remain focused on lowering elevated financial system vulnerabilities. Policymakers face the challenge of addressing those vulnerabilities without triggering widespread stress and sharply lowering economic growth. In general, the numerous policy changes occurring simultaneously raises the probability of unintended, and potentially problematic, consequences.

Cyber-attacks remain a growing risk for financial stability

The number and severity of cyber-attacks on financial institutions continues to increase. In Australia and internationally, financial institutions and regulators are focusing on strengthening the resilience of individual institutions and the financial system to a substantial cyber-attack.

Large financial institutions are able to devote significant resources to cyber defence, and so are generally regarded as having some of the best cyber defences available. However, given the large number of attacks, it seems almost inevitable that the defences of a significant financial institution will be breached at some point. Whether such an attack could result in systemic financial instability will depend on the part of the financial institution or system impacted and potential network effects, as well as the overall cyber resilience of the institution and financial system. Financial regulators remain committed to improving cyber resilience.