Reserve Bank confirms resilient financial system

Financial Stability Review

• Reserve Bank Financial Stability Review: The Reserve Bank has handed down the latest review of the financial system. “The Australian financial system remains resilient and its ability to withstand adverse shocks continues to be strengthened.”
• Household borrowing risks ease: “Concerns about riskier types of new housing borrowing have eased… A key contributor to the abatement of new risks in mortgage and housing markets has been the regulatory measures to improve the quality of new lending.”
• The Financial Stability Review has implications for finance providers, the broader sharemarket and interest rate settings.

What does it all mean?

• While the Aussie financial system is considered in strong shape, the Reserve Bank has provided a detailed assessment of current risks in its semi-annual update.
• Concerns about riskier types of new household borrowing appear to have eased. However, policymakers have warned against complacency. The Bank emphasised that “the high level of household indebtedness increases the risk of a rise in household financial stress amplifying a shock to the economy.”
• Much focus was devoted to rising risks in the global financial system. In particular, the Reserve Bank cited elevated Chinese corporate sector debt and the “complex and opaque nature of some parts” (shadow banks) of the Chinese financial system. The Bank also highlighted that rising short-term debt spreads in the US had spilled over into Australia. Aussie banks have shifted some of their funding from the US back to domestic debt markets.
• The Financial Stability Review has identified a host of risks, but, if anything, the latest metrics suggests the risks haven’t intensified in the past six months.

What do the figures show?

Reserve Bank Financial Stability Review

• Overall, the RBA noted: “The Australian financial system remains resilient and its ability to withstand adverse shocks continues to be strengthened…On the domestic front, concerns about riskier types of new housing borrowing have eased.”
• Global risks: “Current asset pricing suggests that investors see little chance of adverse outcomes, and consequently a detrimental shock could lead to a disruptive and lasting correction in a broad range of markets. This could be triggered by a sharp rise in interest rates in the absence of stronger economic growth arising from, for instance, a jump in realised or expected inflation or a change in investors’ risk appetite.”
• China risks: “The Chinese financial system remains a focus. Addressing risks in the financial system has been a priority for the Chinese authorities with regulatory reforms backed by strong political support. Debt levels are high, especially in the corporate sector, and a sizeable share of debt has been provided through less regulated ‘shadow banking’ channels. This has exposed the financial system to considerable credit, liquidity and contagion risks.”
• Short-term debt market risks: “Spreads on short-term debt have recently spiked to their highest level since 2009. In the past, this has typically been an indicator of market stress or a perception that the near-term credit risk of banks had risen. However, in this instance it appears instead to be due to changes in the demand for and supply of US money market instruments, given that spreads on long-term funding remain very narrow.”
• Key domestic risks: “The high level of household indebtedness increases the risk of a rise in household financial stress amplifying a shock to the economy.”
• Housing and mortgage debt: “The step-up in mortgage payments when the interest only period ends can be in the range of 30 to 40 per cent, even after factoring in the typically lower interest rates charged on principal and interest loans….However, number of factors suggest that any resulting increase in financial stress should not be widespread…. about one-third of mortgages have less than one month’s prepayments.”
• Household financial stress: “Some banks have reported that payment arrears have increased for some borrowers transitioning to principal-and-interest repayments at the end of an interest-only period. This partly reflects borrowers taking some time to adjust, though for a small share of borrowers this has reflected difficulty in making the higher repayments.”
• Residential building: “The potential risks posed by the large pipeline of apartment construction in Sydney and pockets of inner-city Melbourne and Brisbane have not materialised in a significant manner, at least to date. In Melbourne and Brisbane, the flow of new additions has peaked and, so far, been absorbed with little disruption to apartment markets, with vacancy rates steady or declining, rents steady or rising, and apartment prices generally only falling modestly.”
• On tighter lending standards: “The regulatory measures and broader strengthening of lending standards have contributed to an improvement in the risk profile of new housing lending and the resilience of household balance sheets. They have also contributed to the recent moderation in housing market conditions.”
• Commercial property: “Conditions in commercial property remain an area to watch….Non-residential commercial property prices in Sydney and Melbourne have risen further, with yields falling, in part reflecting ongoing ‘search for yield’ activity. In contrast, in the resource-intensive states conditions in office property markets remain challenging with elevated vacancy rates. More broadly, Australian-owned banks have slowed the growth in their commercial property exposures following a review by the Australian Prudential Regulation Authority (APRA) in 2016, though growth in lending by some foreign banks has remained strong.”
• On banks: “The resilience and overall financial performance of Australian banks has continued to improve. Profits in the second half of 2017 grew from an already high level, in part because of the increase in lending rates implemented by banks following the regulatory measures. Conditions in local and offshore long-term funding markets have also been generally favourable for banks, although there has been a recent rise in bank bill rates.”
• Retail sector: “Despite an overall improvement in business conditions, the discretionary retail sector (including clothing, apparel and footwear and department stores) is facing challenges. These businesses are experiencing strong competition from online and international retailers and liaison indicates that retailers are investing in technology to increase efficiency. Although there have been some recent high-profile failures, the retail sector’s corporate insolvency rate remains low.”

What is the importance of the economic data?

• The Financial Stability Review is published by the Reserve Bank every six months. The report is basically a health check on the financial sector but it also assesses the state of household and business balance sheets.

What are the implications for interest rates and investors?

• The Reserve Bank continues to closely monitor the Aussie housing market and the debt levels of households.
• There are no implications for interest rates from the latest Financial Stability Review.