The latest 62 page edition of the RBA Financial Stability Review has been released, and it continues their line “of some risks, but no worries”. International economic conditions, and business confidence are, they say, on the improve while Australian household balance sheets and the housing market remain a core area of interest. The potential impact of rising rates and flat income are discussed, once again, but little new is added into the mix.
From a financial stability perspective, banks hold more capital, have tightened lending standards, and shadow banking is under control.
The key domestic risks in the Australian financial system continue to stem from household borrowing. Household indebtedness, most of which is mortgage borrowing, is high and gradually rising against a backdrop of low interest rates and weak income growth. While some households have taken advantage of low interest rates to make excess mortgage payments, others have increased their borrowing. Higher interest rates, or falls in income, could see some highly indebted households struggle to service their debt and so curtail their spending.
Prepayments are an important dynamic in the Australian mortgage market as they allow households to build a financial buffer to cushion mortgage rate rises or income falls. Aggregate mortgage buffers – balances in offset accounts and redraw facilities – remain around 17 per cent of outstanding loan balances, or over 2½ years of scheduled repayments at current interest rates.
These aggregates, however, mask substantial variation; about one-third of mortgages have less than one months’ buffer Not all of these are vulnerable given some borrowers have fixed rate mortgages that restrict prepayments, and some are investor mortgages where there are incentives to not pay down tax deductible debt. This leaves a smaller share of potentially vulnerable borrowers with new mortgages who have yet to accumulate prepayments, and borrowers who may not be able to afford prepayments. Partial data suggest that the share of households with only small buffers has declined in recent years, in part due to declines in mortgage rates. Households with small buffers also tend to be lower-income or lower-wealth households, which could make them more vulnerable to financial stress.
Household indebtedness is high and, against a backdrop of low interest rates and weak income growth, debt levels relative to income have continued to edge higher. Steps taken by regulators in the past few years to strengthen the resilience of balance sheets, including limiting the pace of growth of investor lending, discouraging loans with high loan-to-valuation ratios (LVRs) and strengthening serviceability metrics, have seen the growth in riskier types of lending moderate. The most recent focus has been on limiting interest-only lending, and banks have responded by further reducing lending with high LVRs for interest-only loans, increasing interest rates for some types of mortgages and significantly reducing interest-only lending.
The tightening of banks’ lending standards for property loans is constraining some households and developers but, in doing so, making the balance sheets of both borrowers and lenders more resilient. Conditions are relatively weak in the Brisbane apartment market, with a large increase in supply reflected in declines in prices and rents. There are, however, few signs of significant settlement difficulties to date. More generally, while housing market conditions vary across the country, there are signs of easing of late, particularly in Sydney and Melbourne where conditions have been strongest.
With the tightening of lending standards, there is a potential that riskier lending migrates into the non-bank sector. To date, non-bank financial institutions’ residential mortgage lending has remained small though their lending for property development has picked up recently. While the banking system has minimal exposure to the non-bank financial sector, growth in finance outside the regulated sector is an area to watch.
Here are some of the other nuggets:
Very low interest rates have also contributed to strong growth in property prices internationally as investors search for yield. To the extent that prices have moved beyond what their underlying determinants suggest, this increases the risk of sharp price falls if interest rates were to rise suddenly or if risk sentiment were to deteriorate.
While household debt levels are high, and rising, to date the impact on households’ ability to service their debt has been muted by falls in interest rates to historically low levels. Nonetheless, highly indebted households are more likely to struggle to repay their debts, or substantially reduce their consumption, in response to a negative shock, such as a rise in unemployment, an unexpectedly large increase in interest rates or a sharp fall in housing prices.
The distribution of debt is also important in identifying where risks lie as typically it is not the ‘average’ household that gets into financial In Canada and Sweden, for example, the risks from high household debt may be heightened since the debt is concentrated among younger and low‑to-middle-income households, who are likely to be more vulnerable
to negative shocks.
Further, interest-only (IO) lending has been identified as increasing risks in some jurisdictions.4 Households with IO loans remain more indebted throughout the life of the loan than if they had been paying down the loan principal, making them more vulnerable to higher interest rates, reduced income, or lower housing prices. Such households are also more vulnerable to ‘payment shock’ due to the increase in repayments following the end of the interest-only period of the loan.
Global experience is that the culture within banks can have a major bearing on how a wide range of risks are identified and managed. There have been a number of examples where the absence of strong positive culture has given rise to a deterioration in asset performance, misconduct and loss of public trust. In Australia, there have also been examples of weak internal controls causing difficulties for some banks. These include in the areas of life insurance, wealth management and, more recently, retail banking. In August, AUSTRAC (the Australian Transaction Reports and Analysis Centre) initiated civil proceedings against the Commonwealth Bank of Australia for breaches of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006. In the current environment where investors still expect high rates of return, despite regulatory and other changes that have reduced bank ROE, banks need to be careful of taking on more risk to boost returns.
A central element to address this issue is to ensure that banks build strong risk cultures and governance frameworks. Regulators have therefore heightened their focus on culture and the industry is taking steps to improve in this area.