Financial Stability Review – October 2025Financial Stability Assessment
Global financial stability risks are elevated and an international shock could spill over to the Australian financial system.
In an environment of heightened risk in the international system, stress events have the potential to interact with – and amplify – existing vulnerabilities and generate disruptive shocks. While April’s sharp global spike in market volatility did not give rise to significant financial stability concerns in Australia, this was likely helped by its short duration. Volatility in international financial markets has subsided over recent months – to long-run average levels or below – as the prospect of the most severe form of retaliatory global trade war receded somewhat. However, the international outlook remains clouded in uncertainty, including in relation to fiscal sustainability concerns in some advanced economies and the possible lagged effects of tariff increases on prices and activity in the United States. The risk of regulatory fragmentation across the international financial system has also increased, as jurisdictions pursue diverging priorities, including in banking and digital assets regulation. These uncertainties add to the growing risks to the financial system stemming from cyber and operational incidents. Physical and transition risks associated with climate change, including rising uninsurability, also remain of concern. With such a wide range of risks, the possibility of a material shock to the international financial system is rising.
Three key vulnerabilities in the global financial system stand out as having the potential to significantly affect financial stability in Australia:
- Vulnerabilities in key international financial markets, including sovereign debt markets, interacting with persistent vulnerabilities in the global non-bank financial institution (NBFI) sector. Despite rising geopolitical tension, and fiscal sustainability challenges in a number of large advanced economies, risk premiums in global equity and credit markets remain low, and sovereign bond term premia are only around long-term averages. Forward-looking measures of financial market volatility are also generally subdued. A reassessment of the likelihood or consequences of key risks materialising would therefore make international financial markets vulnerable to sharp corrections. Highly leveraged trading strategies employed by hedge funds, liquidity mismatches among bond funds, concentration in equity markets, and interlinkages across the global financial system, have the potential to amplify an adverse shock.
- Operational vulnerabilities resulting from increasing digitalisation and interconnectedness, with increased potential for operational incidents to interact with other stress events. The rapid digital transformation of the financial system has the capacity to support efficiency and innovation. At the same time, it has heightened operational risks in an environment of rising cyber risk alongside elevated geopolitical tensions. The system has also become more interconnected, in part reflecting third-party concentration risk in critical services (including where these are provided offshore). The increased potential for operational incidents to occur alongside financial stress, such as a liquidity shock, increases the scope of coordination required across regulators, government and industries in responding to such events.
- Longstanding vulnerabilities in China’s financial and property sectors. Persistent weakness in the property sector, amid a structural rebalancing in the Chinese economy, remains a vulnerability for real estate companies, local government finances and the wider Chinese financial system. Chinese banks continue to experience pressure on margins and asset quality issues; liquidity concerns also emerged recently in pockets of the system. Authorities have intervened to recapitalise state-owned banks and encourage regional bank consolidation, and the ongoing local government debt swap program is helping to mitigate some of the pressures in the financial system. However, these challenges are unlikely to dissipate for some time. A material disruption to financial stability in China would affect the Australian financial system indirectly, via global risk sentiment and trade channels.
If risks were to materialise, these vulnerabilities could spill over to the Australian financial system through three channels:
- Via global financial markets. A significant increase in risk aversion in global markets could sharply increase financing costs, including in Australia, and restrict Australian firms’ and financial institutions’ access to funding and liquidity in global markets. A resulting tightening in financial conditions would intensify financial pressures on domestic borrowers and, if severe enough to strain financial institutions’ balance sheets, could limit credit availability in the Australian economy. It could also create liquidity strains for Australian banks and NBFIs, such as superannuation funds – although there is considerable scope for most borrowers and lenders to draw down on buffers in the event of a liquidity shock. Any depreciation of the exchange rate would also play a shock-absorbing role.
- Via the digital and physical infrastructure underpinning the Australian financial system. A direct and rapid impact on the Australian economy could arise from severe operational disruptions to key financial institutions, or to the financial or wider national infrastructure on which the financial system depends. The potential effects on public confidence from disruptions of this nature would be highly dependent on the surrounding context. Strengthening operational resilience in the Australian financial system has become a key regulatory priority.
- Via the real economy. A global economic downturn, particularly one that leads to a sharp slowdown in China (Australia’s most significant trading partner), could negatively affect Australia through trade channels – including commodity prices and investment – and spill over into weaker spending by Australian consumers and businesses. As discussed below, the Australian financial system is well placed to continue supporting the economy in an economic downturn.
The Australian financial system remains financially resilient overall.
The Australian financial system remains well placed to continue to provide vital services in the event of an economic downturn. If a significant economic downturn occurs, banks are well positioned to absorb large loan losses while continuing to support the economy through lending to households and businesses. Australian banks’ resilience has been supported by a long period of prudent lending standards, the high quality and quantity of capital, and significant holdings of liquid assets. Some borrowers continue to experience severe financial stress, but the overall share of such borrowers has remained small and losses to banks have been well contained by strong collateral values. Non-performing loans remain small relative to banks’ capacity to absorb losses.
The superannuation sector has tended to support financial stability in previous periods of financial stress, but building resilience to severe liquidity and operational shocks and managing a large and expanding market presence remain priorities. Superannuation funds now account for around 160 per cent of Australian GDP and in aggregate the value of assets held by superannuation funds are expected to continue to grow until at least 2050. The interconnections between superannuation funds and banks have the potential to transmit stress in a severe market-wide liquidity stress event. As the sector’s foreign asset holdings continue to build, there will be a growing need to hedge foreign exchange risk, which will require careful liquidity management. The April cyber-attacks on the sector have also highlighted the potential consequences of operational disruptions coinciding with stressed conditions in financial markets. In the months ahead, results from the first Australian Prudential Regulation Authority (APRA) system risk stress test will provide further insights into the interconnections between Australian banks and superannuation funds, and the interaction between financial and operational risks. Continued strengthening of superannuation funds’ governance, liquidity and operational risk management practices remain areas of ongoing focus for regulators.
General insurance firms remain well capitalised and profitable, but insurance affordability and availability may become increasingly challenging over time. Recent profitability in the sector has been supported by low claims, higher premiums and a moderation in the growth of reinsurance costs. Home insurance premiums remain at historically high levels, partly reflecting the increase in climate and weather events and related growth in reinsurance costs, and building cost inflation. These trends could continue as climate change intensifies weather-related risks to physical infrastructure over time. Decreasing affordability of insurance could increase underinsurance, lowering the credit quality of existing mortgage loans.
The strong financial positions of most Australian households and businesses would limit the risk of widespread financial stress in an economic downturn. Cash flow pressures have eased a little over the past year as inflation and interest rates have declined. Supported by ongoing strength in the labour market and a recent increase in real household disposable income, the share of mortgagors in severe financial stress – where mortgage payments and spending on essentials exceeds their income – remains small and has declined further. Most mortgagors have maintained large liquidity and equity buffers, which help insulate them and protect the banking system from loan losses in most plausible adverse circumstances. While the share of companies entering insolvency remains elevated in the retail, hospitality and construction industries – where the operating environment has been challenging, particularly for smaller firms – at an economy-wide level the insolvency rate is around its longer run average. Further, generally high cash buffers and stable leverage ratios mean firms can manage fluctuations in their cash flows more readily than otherwise, reducing the likelihood of not meeting loan obligations. The forecasts presented in the August Statement on Monetary Policy (based on the market-implied cash rate path at that time) suggest that most households and businesses would see some improvements in their cash flow positions over the next year or so, supported by an improvement in the economic environment and easing financial conditions. However, the most vulnerable borrowers will continue to face significant challenges and the outlook remains uncertain.
However, it is important that lending standards remain sound …
If heightened competition for business loans was associated with a material erosion in lending standards, it could lead to a build-up of vulnerabilities in the business sector and undermine future resilience. Heightened competition for business loans, including from non-bank lenders, has supported credit availability for some businesses and reduced refinancing risks over the past year. To date, other than a slight easing in commercial real estate (CRE) lending standards, there has been little evidence of a broad decline in lending standards. NBFI lenders, including private credit funds managing investor capital, are also emerging as an important source of financing for entities that cannot readily obtain bank financing, though these lenders are still not sufficiently large to be of systemic importance. Nevertheless, with strong growth in business credit and information on some non-bank lending more limited than for banks, the RBA and other Council of Financial Regulators (CFR) agencies are monitoring conditions in this segment of the market.
Macroprudential policy can play an important role in helping to contain housing-related vulnerabilities that could build over the monetary policy easing phase. While lending standards have remained prudent, a material increase in riskier forms of lending in response to lower interest rates could contribute to a build-up in vulnerabilities. This could occur in two distinct but related ways: by amplifying the housing price and credit cycle; and by increasing the risk that borrowers may struggle to service their loans in future. In turn, these can increase the risk, severity and macroeconomic implications of future shocks. In the context of declining interest rates, the RBA supports APRA’s recent position to keep macroprudential settings steady, given any loosening has the potential to amplify macro-financial vulnerabilities. The RBA also supports efforts by APRA to work with industry to ensure a range of macroprudential tools could be deployed in a timely manner if needed.
… and that financial institutions in Australia continue to enhance their resilience to geopolitical and operational risk.
Strengthening resilience to geopolitical and operational risk, including crisis recovery arrangements, is an increasing priority for regulators and industry. Geopolitical risk is impinging on the global economy and financial system in complex ways and is introducing novel financial stability challenges. This includes a greater risk of concurrent financial and operational stress events, which complicates the nature of crisis response and the scope of coordination required across regulators, government and industries. Advancing digitalisation of the financial system also increases the prospect that cyber-attacks and operational incidents could have systemic implications. In response, CFR agencies are actively working with industry to strengthen the resilience of individual institutions and the wider system. This work includes: wide-ranging scenario analysis; testing of crisis management plans, with a focus on coordination across regulators, government and industry stakeholders; strengthening of cyber defences; identifying and managing service provider concentration risks; and developing capabilities to ensure Australians can continue to make and receive payments in the event of a material disruption to the payments system.