Financial Stability Review – March 2007 Financial Intermediaries
The ongoing expansion of the Australian economy continues to be reflected in the strong performance of financial intermediaries. Banks and general insurers have, in aggregate, been highly profitable in recent years and the wealth management industry has benefited from strong growth in assets under management. In the banking sector, a notable feature of the current environment is the robust competition that is evident for both household and business lending opportunities, as well as for deposits. The arrears rate on housing loans has also increased from the very low levels of a few years ago, reflecting the general lowering of credit standards that has taken place since the mid 1990s. Notwithstanding this, the level of banks' overall non-performing loans remains very low.
Deposit-taking Institutions
Profitability
The Australian banking system continues to be highly profitable, with the aggregate pre-tax profits of the five largest banks increasing by 14 per cent in the 2006 financial year, to around $24½ billion (Table 3). This represents an aggregate pre-tax return on equity of 27 per cent, which, abstracting from changes associated with the move to the new International Financial Reporting Standards (IFRS), is broadly similar to the average of recent years (Graph 32).[1] The pre-tax return on assets has been less affected by the accounting changes and is largely unchanged from the previous year, to stand at slightly above the average of the past decade.
Strong profitability continues to be associated with a robust expansion of balance sheets, with total assets (excluding intra-group activities) on banks' domestic books increasing by 17 per cent over the year to January 2007. While this figure is slightly boosted by accounting changes, it largely reflects ongoing strong growth in domestic lending – which accounts for around 65 per cent of total assets – as well as increased holdings of trading and investment securities. Lately, foreign-owned banks' assets have grown particularly strongly, increasing by 20 per cent over the year to January (Graph 33).
Banks' interest margins continue to decline, with the ratio of net interest income to average interest-earning assets falling to 2.3 per cent in the latest financial year (compared to 3.7 per cent a decade ago) (Graph 34). This ongoing narrowing of margins reflects competitive pressures in both lending and deposit markets – in Australia and abroad – and the fact that the banking sector is sourcing a higher share of funding from wholesale markets than in the past.
At the same time, the banking sector is earning a higher share of its income from wealth management activities. While accounting changes contributed to banks reporting relatively modest growth in income from wealth management operations over the past year, this form of income now accounts for about 13 per cent of total income for the five largest banks, compared to 9 per cent five years ago. Moreover, funds under management at these banks increased by 16 per cent in the latest financial year.
A key driver of banks' strong performance over the past decade or so has been the moderate growth of operating expenses, relative to that of income. In the latest year, aggregate expenses for the five largest banks fell slightly, due mainly to lower restructuring costs at one bank. As a result, the aggregate cost-to-income ratio for these banks fell to 48 per cent in 2006, around 13 percentage points lower than it was in the mid 1990s (Graph 35).
Lending and Competition
As noted in previous Reviews, strong competition in lending markets is a prominent feature of the current banking environment. Over recent years, this competition has been particularly pronounced in the housing loan market and has been associated with a contraction in margins and significant changes in lending practices. More recently, competition has also intensified around lending to businesses as banks have refocused their attention on this segment to help offset the moderation in the demand for housing credit.
Bank business credit grew by 17 per cent over the year to January, up slightly from 16 per cent over the preceding year, and faster than the 11 per cent growth in banks' on-balance sheet housing credit. Growth has been particularly strong in large loans, including syndicated facilities where a number of lenders each finance a portion of the total amount. Nearly $100 billion of such facilities were approved last year, 38 per cent higher than in 2005, with around one quarter of these used to finance mergers and acquisitions, compared to an average of 15 per cent over the period since the early 1990s (Graph 36).
As discussed in The Macroeconomic and Financial Environment chapter, the strong growth in leveraged buyouts in the past year is an issue that has attracted considerable attention. While some of the largest Australian banks are active participants in this market, arranging and underwriting debt issued in these transactions, they typically retain only a portion of the credit risk in their own lending portfolios, while distributing the majority to other institutional investors. A recent survey by APRA showed that, at end December 2006, the gross private equity exposures (including short-term underwriting commitments) of the larger Australian-owned banks totalled approximately $15 billion, although amounts actually funded are considerably smaller.
A number of factors have prompted the strengthening of competition in business lending, including the activities of newer entrants into the market. Foreign-owned banks operating in Australia have expanded their business lending at a rapid rate recently, and have been particularly active in the market for large loans (see Box C). In addition, domestic banks face competition from banks located overseas, with the value of cross-border loans outstanding to Australian businesses increasing strongly in the past two years, to stand at around $45 billion at end 2006, compared to an average of around $20 billion over the preceding decade (Graph 37). Much of this increase has been associated with the activities of banks located in the United States and the United Kingdom.
Another factor prompting greater competition has been the rising prominence of brokers in the business banking market, particularly in asset‑backed finance (including commercial property) and loans to small- to medium-sized enterprises (SMEs) backed by residential property. It appears that broker-originated business lending has grown strongly (albeit from a low base) in recent times and, although precise data are unavailable, it has been estimated that as much as one third of small- to medium-sized borrowers currently access finance through brokers.
Competitive pressures have manifested themselves in an ongoing contraction in business loan margins, with the spread between the weighted-average variable interest rate on business loans and the cash rate falling by around 35 basis points over the past year, with recent margin compression most evident in large loans (Graph 38). Business surveys also indicate continued pressure on lending margins, with the JPMorgan and East & Partners Survey of Business Borrowers showing that the number of businesses that have experienced a reduction in their borrowing spread over the past year significantly exceeds the number that have experienced an increase. Moreover, lenders appear more willing to compete on the non-interest features of business loans, with the same survey showing that the number of businesses that have had a reduction in their lending fees has exceeded the number that have experienced an increase over recent years (Graph 39). Reflecting this competitive environment, banks have sought to bolster the number of business banking staff, as well as to streamline the processing of business loans. Part of this process has been to make greater use of automated approval systems for certain types of loans.
Competition also remains intense in the housing loan market, which, over recent years, has been associated with some notable changes in lending practices. As discussed at some length in previous Reviews, these include: an increase in permissible debt-servicing and loan-to-valuation ratios; the use of alternative property valuation techniques; an increased reliance on brokers to originate loans; and the wider availability of ‘low doc’ loans. More recently, it appears that many lenders have attempted to maintain strong growth in their mortgage portfolios at the same time as the demand for housing finance has moderated from its peaks in 2003.
This competition is evident in the contraction of margins on variable-rate housing loans, with the vast majority of new borrowers now paying an interest rate less than the major banks' standard variable home loan indicator rate. The average interest rate paid by new borrowers was around 60 basis points below the standard variable rate as of mid 2006, compared to an average discount of around 45 basis points two years earlier, and around 20 basis points in the mid 1990s (Graph 40). Consistent with a large proportion of housing loans having been taken out in recent years, the average discount on outstanding loans has increased to around 40 basis points. With refinancing accounting for over one quarter of new housing loan approvals over the past two years, it seems likely that average housing loan margins will continue to contract, even if the size of the discount on new loans stabilises.
It appears that competition has also picked up around fixed-rate housing lending, as some lenders have responded to increased demand for these products. In late 2006, fixed-rate loans accounted for around 20 per cent of owner-occupier loan approvals, well above the average of around 10 per cent since 2000. At the same time, the margin on fixed-rate loans has narrowed slightly, with the 3-year fixed indicator rate increasing by less than the 3-year swap rate over the past year.
The narrowing of housing loan margins has been particularly pronounced in the low-doc segment of the mortgage market. These loans involve a large element of self-verification in the application process and are designed mainly for the self-employed or those with irregular incomes who do not have the documentation required to obtain a conventional mortgage. The interest rate paid on new low-doc loans was, on average, around 20 basis points below the major banks' standard variable indicator rate in mid 2006, compared to 50 basis points higher than the standard variable rate two years earlier. This is equivalent to 45 basis points above the actual rate paid on new full-doc loans. In general, however, banks entered the low-doc market later than some more specialised non-bank lenders.
Heightened competition has also seen the increased availability of housing loans that require little or no deposit. While such products have been available from certain lenders for some time, no-deposit loans are now available from a wider range of lenders and tend to feature more prominently in product advertising. Margins on no-deposit loans have narrowed recently, with many lenders advertising these products at rates below the major banks' standard variable indicator rate, whereas a premium was typically charged a few years ago – the average advertised interest rate on no-deposit loans is currently around 45 basis points below the standard variable rate. While the high loan-to-valuation ratios on these loans may result in a borrower being more susceptible to a change in their financial circumstances, lenders' mortgage insurance is typically required on these loans.
The ability of banks and non-bank lenders to access funding through the residential mortgage-backed securities (RMBS) market at attractive spreads has been one of the factors that has sustained the competition in the housing loan market. Investors currently require spreads of around 22 and 16 basis points over the bank bill swap rate to hold AA-rated and AAA-rated RMBS, respectively (Graph 41). This compares to spreads of around 70 and 35 basis points a few years ago.
Strong competition is also evident in the personal lending market, especially in credit cards. Most issuers, including the five largest banks, now offer low-rate cards with interest rates in the range of 9 to 14 per cent, compared with 17½ per cent on traditional cards. Like other segments of the loan market, competition has been spurred by smaller players and newer entrants – foreign-owned banks, for example, have increased their share of total bank credit card balances outstanding from 8 per cent in early 2002, to 12 per cent as at January 2007. As discussed in The Macroeconomic and Financial Environment chapter, margin lending is another component of personal credit that has recently grown quickly.
Credit Risk and Capital Adequacy
Credit Risk
The ratio of banks' non-performing assets to on-balance sheet assets remains at a very low level, both by historical and international standards. As at December 2006, this ratio stood at 0.4 per cent and has been largely unchanged over the past year or so, after falling for a number of years (Graph 42). Of these non-performing assets, just under half are classified as ‘impaired’ – that is, payments are in arrears (or otherwise doubtful) and the amount owed is not well covered by collateral. The remainder are considered to be well covered by collateral, though payments are in arrears by 90 days or more.
Within these aggregate figures, the arrears rate on domestic business loans has fallen consistently over the past few years and, while it ticked up in the December quarter to 0.9 per cent, it remains low (Graph 43). In contrast, both the domestic personal and housing loan arrears rates increased between 2003 and early 2006, but have shown little change since.
Notwithstanding the overall low levels of problem assets, there have been slightly divergent trends in non-performing assets ratios across different types of banks, with the ratio for the foreign-owned and four largest Australian-owned banks continuing to fall over the past two years, while it has risen slightly for other Australian-owned banks (Graph 44). For foreign-owned banks, part of this fall reflects the recent strong growth in their assets noted above, although the level of problem assets has also declined over recent years. This divergence across bank types is consistent with developments in banks' mortgage portfolios, where the mild increase in housing loan arrears from the lows of two years ago has been less pronounced at the four largest banks compared to other Australian-owned banks. This is likely to partly reflect a higher aggregate share of low-doc loans on regional banks' balance sheets, with such loans accounting for as much as one quarter of some regional banks' outstanding mortgages. More generally, as discussed in The Macroeconomic and Financial Environment chapter, it is unsurprising that housing loan arrears are higher than they were a few years ago given the changes in the housing finance market that have seen credit become more widely available, and on more accommodating terms, than in the past.
Although housing and personal loan arrears are higher than they were a few years ago, so far, this has not translated into increased write-offs, with total write-offs for the four largest banks equivalent to 0.20 per cent of domestic loans outstanding in 2006 (down from 0.26 per cent in 2004). Personal loans, which are often unsecured, tend to have higher loss rates than other forms of lending and accounted for around 70 per cent of these write-offs. Notwithstanding this, the personal write-off rate, at around 1.5 per cent, is lower than it was four years ago (Graph 45).
Australian banks are also exposed to credit risk through their overseas operations. Over the past six months, Australian‑owned banks' foreign exposures increased by around 7 per cent, to stand at around 29 per cent of total assets as at December 2006 (Table 4). These exposures remain concentrated in New Zealand and the United Kingdom and are largely due to the activities of branches and subsidiaries located in these countries. Although Australian‑owned banks have built a stronger presence in the Asia-Pacific region in recent years, claims on these countries remain a small share (6 per cent) of banks' total foreign exposures.
Capital Adequacy
Australian banks remain well capitalised, with an aggregate regulatory capital ratio of 10.4 per cent as at December 2006, around the same as a year ago and the average of the past decade (Graph 46). The aggregate capital ratio of the credit union sector has steadily increased to 16 per cent over recent years, while the aggregate ratio for the building society sector has fallen a little, to around 14 per cent.
For banks, the Tier 1 capital (primarily paid-up equity and retained earnings) ratio has fallen slightly over the past year but, at 7.4 per cent, it remains well above international minimum requirements. Strong profitability has allowed banks to increase retained earnings at around the same rate as risk-weighted assets over recent years while, at the same time, paying out around two thirds of their after-tax profits to shareholders in the form of dividends (Graph 47).
The Tier 2 capital (primarily term subordinated debt) ratio increased slightly over the past year as issuance of term subordinated debt has outpaced growth in risk-weighted assets. Over the past decade or so, there has been a considerable change in the composition of Tier 2 capital. Banks have increased their use of lower Tier 2 capital – mainly term subordinated debt – while their use of perpetual subordinated debt has declined. Lower Tier 2 capital has increased to around 75 per cent of total Tier 2 capital, up from around 60 per cent in the mid 1990s.
Market Risk
Australian banks have traditionally had only small unhedged positions in financial markets. This is illustrated by the fact that, in 2006, the value-at-risk – which measures the potential loss, at a given confidence level, over a specified time horizon – for the four largest banks was equivalent to 0.04 per cent of shareholders' funds, which was unchanged from the previous two years (Table 5). Consistent with this low exposure to market risk, Australian banks do not rely heavily on trading income for profitability, with this form of income accounting for around 5 per cent of total operating income of the four largest Australian banks in the latest year, compared to as much as one third for some of the large globally active banks.
The use of derivatives is an important element of banks' trading activities, with the banking sector as a whole increasing its trading in such instruments in recent years, mainly reflecting the activities of foreign-owned banks in interest-rate and foreign-exchange markets. Nearly one quarter of the banking sector's total trading income was earned through derivative trading activities in 2006, up from around 10 per cent three years ago.
Funding and Liquidity
As discussed at some length in previous Reviews, the way in which the banking sector funds its balance sheet growth has changed considerably over the past decade or so. This is mainly due to the fact that bank credit growth, particularly that extended to the household sector, has consistently outpaced the growth in retail deposits over much of this period. Reflecting this, retail deposits accounted for 21 per cent of banks' total liabilities as at January 2007, down from 37 per cent a decade ago (Graph 48).
At the same time, vigorous competition in the deposit market over recent years has led many deposit-takers to offer high-yield online savings accounts. The average rate on these accounts is 5.7 per cent, only slightly lower than the cash rate of 6.25 per cent, and well above the rates available on transaction accounts. While this competition has meant that banks have to pay more for traditionally low-cost retail funding, and has hence added to the pressure on margins, it has also increased the attractiveness of bank deposits as a financial asset for the household sector. The higher returns available on these accounts has contributed to a strengthening in bank deposit growth over the past five or so years, and it may also be one reason why the Westpac and Melbourne Institute Survey of Consumer Sentiment shows that the share of households that view bank deposits as the ‘wisest place for savings’ has increased to around 20 per cent, up from 15 per cent at the end of the 1990s (Graph 49).
Notwithstanding the recent stronger growth in deposits, banks continue to rely more heavily than in the past on wholesale markets, including those offshore, to fund their balance sheet growth. Over the year to January 2007, banks' foreign liabilities increased by over 25 per cent and accounted for about 28 per cent of total liabilities, compared to around 15 per cent in the mid 1990s. Around two thirds of this offshore borrowing has been through the issuance of debt securities, primarily by the four largest banks and denominated in US dollars. The foreign-currency risk is, however, almost fully hedged using derivative instruments.
Of these offshore debt securities, around 80 per cent had been issued into the US and UK markets, though Australian banks have expanded the number of markets in which they issue securities over recent years. In 2006, the weighted-average term to maturity of offshore bonds issued by the four largest banks was around five years.
While the four largest banks continue to tap offshore debt markets, other Australian-owned banks rely relatively more on securitisation to bridge the gap between retail deposit growth and lending growth. For these banks, the value of assets that have been securitised is equivalent to 28 per cent of the value of assets retained on their balance sheets, compared to less than 2 per cent for the four largest banks.
On the other side of the balance sheet, liquidity risks in the banking sector are managed, in part, through holding assets that can be readily sold in adverse market conditions. Such ‘liquid’ assets include government securities and securities issued by other authorised deposit-taking institutions, as well as cash and deposits. On a domestic books basis, liquid assets accounted for around 11 per cent of total assets in 2006, a share that has remained relatively stable in recent years after falling for much of the 1990s (Graph 50). The proportion of these assets that can be used in repurchase agreements with the Reserve Bank has also been broadly steady since the eligibility criteria were expanded in March 2004.
While Australian banks tend to hold a lower share of their assets in traditionally liquid form than they did a decade ago, financial innovation has increased the liquidity of other parts of the portfolio. In particular, the growth of securitisation markets means that banks' loan portfolios, particularly residential mortgages, may be more readily used to meet the redemption of liabilities than in the past. The ability of banks to tap securitisation markets as a source of liquidity depends, in part, on having the appropriate systems in place to arrange an issue, potentially at short notice. Reflecting changes in liquidity management practices, APRA also allows banks that have sufficiently sophisticated liquidity management systems to use a scenario-based approach to show that they would be able to meet their payments for five days under adverse conditions.
Financial Markets' Assessment
Financial markets and rating agencies continue to take a positive view of Australian banks and the financial sector more generally. In February, Standard & Poor's (S&P) upgraded the four largest Australian banks' long-term credit ratings to AA from AA-, the first upgrade for any of these banks since 1996 (Table 6). Of the world's 100 largest banks (ranked by Tier 1 capital), only three have higher S&P credit ratings. Suncorp-Metway was also upgraded, to A+, in March.
Banks' share prices have increased by around 14 per cent over the past six months, slightly underperforming the broader market (Graph 51). Market-based measures of credit risk also remain benign, with bank bond spreads remaining low by the standards of recent years, and the premia on credit default swaps – both senior and subordinated – falling further over the past six months (Graph 52).
General Insurance
The Australian general insurance sector, in aggregate, continued its recent run of strong results in the latest financial year. In 2006, pre-tax return on equity was 28 per cent, with aggregate pre-tax profits increasing by 6.5 per cent from the previous year (Graph 53). Return on equity was around the same as in the past two years, but around 9 percentage points above the average return of just under 20 per cent recorded over the previous five years.
Within this aggregate result, investment revenue accounted for around 60 per cent of total profits, though the level of investment revenue was down slightly from the previous year. The insurance sector also continued to benefit from a favourable claims environment, with the ‘combined ratio’ – claims and underwriting expenses relative to net premium revenue – remaining low by recent standards, at around 85 per cent. Losses from Cyclone Larry, which hit northern Queensland in March 2006, are currently estimated at between $350 million and $500 million, which is within the provisions insurers hold against such events.
Consistent with developments elsewhere in the financial system, heightened competition is placing pressure on premiums in the general insurance industry. This pressure has been most pronounced in commercial business lines – including public and product liability, and professional indemnity insurance – in which gross premium revenue has generally contracted over the past year or so. At the same time, however, the claims experience in many of these lines has been relatively subdued, influenced in part by previous tort law reforms, which have limited insurers' cost of claims.
In personal insurance lines – which account for half of insurers' premium revenue – growth in net premium revenue was slower than the growth in net claims over the year to June 2006.
In aggregate, general insurers continue to hold capital well in excess of minimum regulatory requirements. As at June 2006, their aggregate capital holdings amounted to twice the regulatory minimum, although this coverage ratio has fallen from 2.3 times the minimum requirement a year earlier.
Financial market participants and rating agencies continue to hold a positive view of the general insurance sector. All of the five largest general insurance companies are rated A+ or higher by Standard & Poor's (Table 7). General insurers' share prices outperformed the broader market over the past six months, partly reflecting the favourable reaction to merger and acquisition activity, both in Australia and overseas. The merger of Suncorp-Metway and Promina continues the trend of consolidation in the insurance sector that has been evident for a number of years, with the number of general insurers in Australia having declined by around 20 per cent over the past decade or so. As a result of this trend, the five largest direct insurance groups accounted for just under three quarters of gross premium revenue in the year to June 2006, up from around 60 per cent in 2000. This ratio will increase further following the integration of Suncorp-Metway's and Promina's businesses.
Global reinsurers – including their Australian branches – appear to be well placed to absorb some of the risk from domestic insurers. Following two years of historically high natural catastrophe claims – around half of which were covered by the reinsurance industry – total insured catastrophe losses declined to one of the lowest levels seen in the past 20 years in 2006 (Graph 54).
Wealth Management
The wealth management industry continues to expand rapidly in Australia, with total (consolidated) assets under management increasing by around 15 per cent over the year to December 2006, to stand at nearly $1.1 trillion (Table 8). Superannuation funds recorded the strongest growth in assets over the period, continuing the trend of much of the past decade, and account for nearly 55 per cent of total assets under management.
As noted above, banks in Australia are among the financial institutions that have sought to benefit from the strong growth in the wealth management industry, with Australian-owned banking groups' share of total retail funds under management currently standing at around 40 per cent (Graph 55). While banks' market share remains well above its level of around 20 per cent in the 1990s, it has fallen somewhat since the large-scale acquisitions around the turn of the decade. This decline, in part, reflects competition in the wealth management sector, including the entry of a significant number of new fund managers over recent years.
Superannuation
Superannuation funds' assets increased by $100 billion, or around 20 per cent, over the year to December 2006, to stand at nearly $600 billion. This rate of increase was around the same as that over the preceding year, notwithstanding a slight moderation in the buoyant investment returns recorded over recent years. At the same time, households invested around $53 billion directly with superannuation funds over the year to September 2006, which is around the record levels for new contributions seen over the past few years (Graph 56).
One of the factors contributing to the strong growth of assets in superannuation funds has been the changes to retirement savings arrangements in Australia over the past 20 or so years, particularly the introduction of compulsory employer contributions in 1992. Looking ahead, the recently announced changes to the taxation treatment of superannuation are likely to increase the incentives for households to invest in superannuation, relative to other assets, and hence may provide a further fillip to the industry. Most notably, tax on payouts from pre-taxed funds has been abolished, and reasonable-benefit limits that capped the amount of superannuation that could be taken on a tax-advantaged basis have been removed. Other changes include the introduction of a $50,000 limit on tax-advantaged contributions that is irrespective of age, as well as a limit on post-tax contributions of $450,000 over three years; as a transitional measure, one-off post-tax contributions of up to $1 million are permitted prior to 1 July 2007.
Life Insurers
Assets of life insurers increased by 6 per cent in 2006, to stand at $210 billion (Graph 57). While premiums and new contributions marginally exceeded policy payments in 2006, the vast majority of life insurers' asset growth in recent years has been due to investment returns. As noted in previous Reviews, this dependency on investment returns rather than policy premiums reflects the long-running challenge faced by the life insurance industry associated with households shifting a greater share of their retirement savings into superannuation funds, rather than life offices. Indeed, it seems likely that the performance of life insurers will remain closely linked to equity markets, with these institutions increasing the share of their assets invested in domestic and overseas equities to around 62 per cent of financial assets, up from around 45 per cent a decade ago.
Other Managed Funds
The combined (consolidated) assets of public unit trusts, cash management trusts, friendly societies and common funds increased by around 12 per cent over the year to December 2006 and accounted for just over one quarter of funds under management (Graph 58). Unit trusts, which account for over 80 per cent of these assets, recorded growth of 14 per cent over the period, compared to 22 per cent over the preceding year. In contrast, rising commercial property prices continue to underpin strong growth in property trusts, with assets of these funds increasing by 18 per cent over the past year.
Footnote
For further details see Reserve Bank of Australia (2006), ‘Box A: International Financial Reporting Standards’, Financial Stability Review, September. [1]