Financial Stability Review – March 2008 The Australian Financial System

The Australian financial system is in sound shape and is weathering the turbulence in financial markets better than the financial systems in many other countries. The largest banks continue to report high levels of profitability, low non-performing loan ratios and strong

Against this favourable backdrop, recent developments in global financial markets have posed a number of challenges for the Australian financial system. In particular, while the demand for funding from banks has increased, the cost of financing this demand, in both domestic and offshore markets, has risen significantly. The banking system has been able to provide this additional financing, with deposits growing strongly and banks continuing to be able to raise a significant amount of funding in both domestic and international wholesale markets. The strains in credit markets are, however, having an effect on the nature of competition in the financial system. Most notably, difficulties in the RMBS markets are affecting the institutions that rely heavily on this source of funding to a greater extent than other lenders, and there has been some tightening of credit conditions in the mortgage market. There are also signs that the terms on which finance is available to some segments of the business loan market have tightened, with some foreign financial institutions looking to scale back their business lending in Australia.

Profits and Capital of the Banking System

Unlike banking systems in a number of other countries, the Australian banking system continues to be highly profitable. The five largest banks recorded an aggregate pre‑tax profit of $27 billion over the past year, an annual increase of 10½ per cent (Table 1). This represents a pre‑tax return on equity of 28 per cent, around the same as for the previous year (Graph 14). Profitability continued to be underpinned by low levels of problem loans, strong balance sheet growth, and rising income from wealth management operations.

Asset Quality

The ratio of banks' non-performing assets to total assets remains low both by historical and international standards. As at end December 2007, this ratio stood at 0.4 per cent of banks' total assets, down slightly on the figure six months earlier (Graph 15). Of these non-performing assets, just under half are classified as ‘impaired’, in that repayments are in arrears by more than 90 days (or are otherwise doubtful) and the debt is not well covered by the value of collateral. The remainder, while in arrears, are considered to be well covered by collateral. Despite the recent small decline in non-performing assets as a share of total assets, charges for bad and doubtful debts increased by one third over the past year, albeit from a very low base, to be the equivalent of 0.2 per cent of outstanding loans (Graph 16).

Australian banks have reported that they have only limited direct exposure to the sub-prime problems in the United States, primarily through small holdings of financial instruments backed by sub-prime debt. Some also, however, have indirect exposures through their links to institutions and businesses that have been directly affected by recent events. As discussed in Box A, one example is through the decline in the value of credit protection provided by US ‘monoline’ bond insurers. Another is through exposures to companies that had relied heavily on short-term debt for financing and have found this debt difficult to roll over in the current environment. Reflecting this, some of the larger banks have recently announced provisions against some of these exposures.

The recent decline in the aggregate non-performing loan ratio is evident across each of the main segments of banks' domestic loan portfolios (Graph 17). In the business portfolio, the ratio of non-performing loans to total loans stood at 0.9 per cent as at December 2007, compared with 1.3 per cent four years earlier. Within this aggregate figure, the share of banks' commercial property lending that is classified as impaired picked up slightly over the year to September 2007 (the latest available data), to 0.3 per cent, although this too remains low by previous standards (Graph 18). As noted above, some banks have recently announced higher provisions against business exposures, though the increase remains small compared with the size of the aggregate business loan portfolio. That said, any slowing in the domestic economy would likely be associated with some decline in the average quality of the business loan portfolio.

In the housing portfolio, 0.3 per cent of loans on banks' domestic balance sheets were non-performing as at December 2007, down from the figure in mid year and about the same as a year ago. Most non-performing housing loans are considered by banks to be well covered by the value of collateral. The ratio of non-performing personal loans to outstandings has also fallen slightly over the past six months and, at 0.9 per cent, is around the same level as a year ago. As noted in the Household and Business Balance Sheets chapter, this pattern has been broadly similar for credit cards and other personal loans.

The low arrears rate on household loans relative to many other countries – and particularly the United States – reflects the ongoing strength of the Australian economy, as well as a number of other inter-related factors. One of these is that the non-conforming housing loan market in Australia (the closest equivalent to the sub‑prime market in the United States) accounts for less than one per cent of outstanding mortgages, compared with about 13 per cent in the United States, and Australian banks have been very minor participants in this market. Another is that the level of interest rates has been quite different in the United States and Australia; in the United States, the Federal funds rate fell to 1 per cent in 2003/04 and then rose only slowly, making it possible for many borrowers with poor credit histories and limited repayment ability to obtain loans. A third factor is the legal environment. The Australian Uniform Consumer Credit Code (which has been in operation since 1996) means that courts can set aside mortgage agreements where the lender could reasonably have known that the borrower would not be able to repay the loan without substantial hardship. Further, Australian mortgages are ‘full recourse’, so that unlike in a number of states in the United States, a borrower in distress cannot just hand the keys to the lender, and effectively extinguish the debt. These legal requirements reduce both the incentive of lenders to provide loans to people that are likely to have difficulty repaying, and the incentive for borrowers to take out loans that cannot be repaid unless house prices increase substantially.

While these various factors have helped promote a more soundly based mortgage market in Australia, there nonetheless had been a general loosening of credit standards over recent years. For example, the share of low-doc loans among all housing loans extended in 2006 was 10  per cent, compared with 3 per cent in 2002. In addition, the debt-servicing criteria that lenders use in assessing loan applications had been eased, and lenders began making greater use of lower-cost electronic and off-site property valuation techniques. These changes mean that, looking forward, for any given state of the economy and interest rates, housing loan arrears are likely to be higher than in the past.

Balance Sheet Growth

The aggregate balance sheet of the banking system has continued to grow strongly over the past six months, reflecting robust demand for credit, particularly from businesses, and the provision of credit to some borrowers that in previous years would have obtained financing in the capital markets.

The assets held on banks' domestic balance sheets increased at an annualised rate of 31  per cent over the six months to January 2008, to stand at around $2,200 billion, following (annualised) growth of 20 per cent over the previous six months (Table 2). In the recent period, balance sheet growth has been inflated somewhat by banks issuing a significant amount of short-term paper to other banks as part of their liquidity management – banks' holdings of securities issued by other ADIs are currently around $84 billion, or 56  per cent, higher than they were in July 2007, with the vast bulk of this increase accounted for by securities with a maturity of less than one year (see below). Excluding these issues, as well as intra-group activities, total assets still increased at an annual rate of 22  per cent over the past six months. The increase in aggregate assets also partly reflects the bringing on-balance sheet of liquidity facilities to conduit vehicles that had previously been funded in the asset-backed commercial paper market, although the extent of this has been less than in some other banking systems.

Notwithstanding these factors, the recent expansion of the aggregate balance sheet of the banking system has been underpinned by strong growth of lending to the domestic business sector, with bank business credit outstanding increasing at an annualised rate of around 30  per cent over the six months to January 2008 (Graph 19). Loans with a value greater than $2 million, which comprise nearly 70 per cent of business credit outstanding, accounted for much of the pick‑up in growth over the second half of 2007. This is consistent with a reintermediation of business credit as corporates have found it more difficult to access non-intermediated debt markets since the onset of the current turmoil. In contrast, household credit growth (including loans no longer held on the balance sheet because they have been securitised) has moderated to an annualised rate of just under 12 per cent over the six months to January, compared to a peak of nearly 20 per cent in late 2003. The funding of this strong balance sheet growth is discussed below.

The assets of foreign-owned banks, as a group, had been growing at an above-average rate prior to the onset of the credit market turbulence, reflecting the strength of their business lending over the past couple of years and also attempts to gain a greater share of the retail market.^[1] In the early months of the current turmoil, the combined balance sheets of the foreign-owned banks grew even more strongly, with total assets (excluding intra-group transactions) around 20 per cent higher in September than in June (Graph 20). The pick‑up in growth over this period mainly reflected increased holdings of trading securities, which is consistent with reports that some foreign-owned banks had provided liquidity to conduits by purchasing the paper issued by these vehicles. In more recent months, the aggregate balance sheet of these banks has been broadly unchanged, though this has been due to reduced holdings of securities while, on average, lending growth has remained robust. Some foreign banks have, however, recently announced their intention to scale back their operations in Australia. In aggregate, the assets of Australian-owned banks have continued to expand strongly in recent months.

Compared with the growth in domestic balance sheets, growth in the global consolidated assets of Australian-owned banks has been somewhat slower, partly reflecting a moderation in the growth of banks' offshore assets. Over the six months to December 2007, total foreign claims increased at an annualised rate of around 5 per cent, to stand at $487  billion, which is equivalent to 27 per cent of banks' total assets (Table 3). A large share of these claims, around 46 per cent, is on entities in New Zealand and mainly arise through the activities of Australian banks' local subsidiaries. Like the Australian economy, the New Zealand economy has grown strongly for a number of years and household and business balance sheets generally remain in sound shape.

Uncertainty about the prospects for the US economy has focused attention on the size and credit quality of banks' exposures to the United States. In aggregate, Australian-owned banks have a relatively small direct exposure to the United States, amounting to $45  billion as at December 2007. This is equivalent to less than 10 per cent of their total foreign exposures and only 2½ per cent of their total assets. Moreover, these exposures typically do not arise through direct lending to the US household sector. Consistent with this, and as noted above, Australian banks' exposures to the US sub-prime mortgage market problems are small, and mainly indirect, through channels such as lines of credit to funding vehicles and lending to some companies that have been affected by credit market conditions.

Income

Over the past decade, the contribution of strong lending to growth in banks' net interest income has been partly offset by an ongoing decline in the interest rate margins that banks earn on this lending. Over the past year, the ratio of net interest income to average interest-earning assets of the five largest banks fell by a further 8 basis points, to stand at 2.2 per cent, compared to 3.4 per cent a decade ago (Graph 21). With most banks having only reported results for the year ended September 2007, the impact of the recent turbulence in credit markets is yet to be fully reflected in these figures. It is likely that margins have remained under downward pressure in more recent quarters as a result of higher funding costs, though this will be at least partly offset by recent increases in interest rates on both household and business loans.

Banks' income has also been supported by strong growth in wealth management income, which increased by 18 per cent over the past year, to account for 13 per cent of the five largest banks' total income. Unlike some of the large globally active banks, Australian banks have not traditionally relied heavily on income from trading activities. This form of income accounted for only around 5 per cent of the five largest banks' total income in 2007, with this share having been relatively stable over the past five years. Consistent with this, Australian banks have only small unhedged positions in financial markets.

Over the past year, the five largest banks' operating expenses increased by 4.2 per cent – considerably slower than growth in income and assets – and as a result the cost‑to‑income ratio (excluding significant items) fell by around 2  percentage points, to 46 per cent (Graph 22).

Capital Adequacy

Australian banks remain well capitalised, with an aggregate Tier 1 capital ratio of 7.2  per cent and a total capital ratio of 10.2 per cent as at December 2007 (Graph 23). The aggregate capital ratio has declined slightly over the past year, reflecting the strong growth in assets over the second half of 2007, although it remains around its average of the past decade. Credit unions and building societies also remain well capitalised, with aggregate capital ratios of around 16 per cent and 13 per cent, respectively.

Banks' strong profitability has meant that retained earnings have been an important source of Tier 1 capital over recent years, although a rising share of Tier 1 capital has been accounted for by ‘innovative capital instruments’, such as hybrid securities. Nonetheless, paid-up capital, which accounts for the majority of banks' Tier 1 capital, has continued to grow over the past six months due to acquisitions and the dividend reinvestment plans of the five largest banks.

As discussed in the Developments in the Financial System Infrastructure chapter, the Basel II Capital Framework was introduced by APRA on 1 January 2008. The introduction of Basel II is not expected to have a significant effect on the aggregate capital ratio, though some banks have indicated that it may result in a slight increase in their measured ratios.

Funding Conditions and Financial Markets

Funding Conditions

Notwithstanding their strong profitability, low non-performing loan ratios and sound capital positions, banks have faced more challenging conditions in credit markets over the past six months than they have for some time. Nevertheless, they have continued to be able to tap both domestic and international markets to finance the strong growth in their assets, although this has been at significantly higher spreads than has been the case over recent years. New fund raisings have also, on average, tended to be for shorter maturities than previously, with investors globally demanding very high premia for term funding.

Banks' domestic short-term funding costs have risen significantly since August, with the spread between the yield on three-month bank bills and the overnight index swap rate for the same maturity averaging 58 basis points over the past month, and currently standing at 45 basis points (Graph 24). This compares with an average spread of 10 basis points in recent years. Movements in this spread over the past six months have followed the same general pattern as similar spreads in a number of overseas markets, although the increases seen in September and December were somewhat smaller in Australia than elsewhere.

The cost of issuing in domestic term markets is also substantially higher than it was in the first half of 2007. For example, the two- and three-year bonds issued by some of the largest banks in recent months were at spreads of nearly 50 basis points above the bank bill swap rate (which itself has increased significantly), compared to around 30 basis points in September 2007, and an average of 10 basis points prior to the disturbances in credit markets. As discussed further below, offshore bond issuance has been very strong in the past few months, with spreads also widening considerably. Much of the activity has been in the US market, with the effective Australian dollar cost of issuing one- to two-year bonds being up to 40 basis points above the equivalent swap rate for ‘vanilla’ bonds, and slightly less than that for extendible bonds (Graph 25).

The funding demands of the banking system have been exacerbated by difficulties in both the asset-backed commercial paper (ABCP) market and the residential mortgage-backed securities (RMBS) market. The disruption to the offshore ABCP market has been particularly notable, with this market largely closed to new issues; as at January 2008, the outstanding value of offshore ABCP issued by Australian entities was 70 per cent below its peak in May 2007 (Graph 26). The domestic market has been able to fill some, but not all, of the shortfall, with onshore issuance of ABCP increasing significantly over the second half of 2007. Reflecting these developments, between July 2007 and January 2008, total outstanding ABCP fell by around $15 billion, or 20 per cent.

The spread on ABCP over the bank bill rate – which, as noted above, has itself increased – has risen significantly; prior to mid 2007, it had been possible to issue ABCP in Australia at a spread of less than 5 basis points over the bank bill rate, compared with current spreads of around 50 basis points. These difficulties in the ABCP market have seen the conduits that issue ABCP draw on their contracted liquidity facilities with banks. Some banks have also purchased the ABCP of the conduits that they sponsor as an alternative to providing a loan.

Conditions in the RMBS market have been more difficult still. Over recent months, issuance of RMBS has been extremely limited, after very strong growth in previous years. Since July last year, issuance has totalled less than $6 billion, compared with $45 billion in the first half of 2007 (Graph 27). The issues that did take place in late 2007 were at spreads of 40 to 60 basis points over the bank bill swap rate, compared to spreads of around 15 basis points earlier in 2007, with industry liaison suggesting that the required spreads have increased significantly further over recent months. With the bank bill spread itself having increased, the interest rate on a new AAA-rated RMBS would be likely to be over 150 to 200 basis points above the cash rate, compared with an average of 25 basis points over recent years.

These significantly higher spreads have meant that lenders that rely on the securitisation market have curtailed their lending and/or are continuing to rely on warehouse facilities provided by banks. While the cost of these facilities has also risen significantly, the increase has not been as large as the rise in RMBS spreads. Lenders are clearly reluctant to issue RMBS at current spreads, given that doing so would mean that their mortgage business would be unprofitable at existing mortgage rates.

Despite the disruptions to securitisation markets, banks, in aggregate, have been able to raise sufficient funds in domestic and offshore wholesale markets and through deposits from the household and business sectors (Table 4). Indeed, a number of banks have reported that they are ahead of their planned funding schedules for the current financial year.

When the strains in credit markets first emerged in August last year, banks significantly increased their issuance of short-term domestic securities, with available data showing that the outstanding value of banks' securities with a maturity of less than one year increased by $131 billion over the second half of 2007. Around $50 billion of this increase was accounted for by issuance to the non-bank sector, with investors having a strong preference for short-term bank debt, rather than RMBS and other instruments; the value of non-bank holdings of these securities doubled over the second half of 2007, to around $100  billion (Graph 28).

As noted above, banks also issued a significant volume of short-term securities to one another, with the value of banks' holdings of other banks' short-term securities increasing to $209 billion by the end of 2007, compared with $126 billion six months earlier. While this did not constitute financing for the banking system as a whole, it did increase the supply of eligible securities that can be used for repurchase agreements with the Reserve Bank, thereby adding to potential liquidity.

Banks have also benefited from strong growth in deposits from households and non-financial businesses, which together increased by $49 billion over the past six months. Household deposits grew at an annualised rate of around 20 per cent over the six months to January, the fastest pace for a number of years (Graph 29). This strong growth may well continue, given the recent volatility of alternative investments; the March 2008 Westpac and Melbourne Institute Survey of Consumer Sentiment showed that nearly one quarter of surveyed households viewed bank deposits as the ‘wisest place for savings’, up from about 11 per cent at the end of the 1990s and the highest share since 1992. Over recent times, the attractiveness of deposits has also been increased by the wide availability of high-yield internet-based accounts and the strong competition in deposit markets as banks seek deposit funding, rather than funding in the capital markets.

The large increase in short-term (domestic) funding has meant that the banking system as a whole is undertaking more maturity transformation than it had previously. While the banks have been prepared to do this, particularly given the significantly higher cost of term funding, they have seen a need to continue to issue in the term funding markets as it has become increasingly apparent that the current repricing of risk is likely to be both more sustained and pronounced than many had originally anticipated.

Reflecting this, the banks have issued record amounts of bonds in offshore markets in recent months. As at December 2007, the value of banks' offshore debt securities outstanding with a term-to-maturity greater than one year stood at $223 billion and, so far in 2008, the five largest banks have issued a further $35 billion of bonds in overseas markets (Graph 30). A significant share of this recent issuance has been in the form of extendible bonds issued in the United States through private placements, rather than public issues. These bonds typically give investors the option of extending the bond's maturity beyond an initial 13 months, until a final maturity date (usually in five to six years). Each of the four largest banks has also recently tapped the Japanese wholesale market by issuing yen-denominated ‘samurai’ bonds for the first time. These bonds have typically been at longer terms to maturity than those issued in the United States.

Reflecting the pattern of recent issuance, and assuming no extension, the average term-to-maturity of bank bonds issued so far this year has been around two years, compared with around 4½ years prior to the recent disturbances. However, the average maturity of total outstanding bonds has only declined slightly.

In the current environment, banks also appear to be taking a more cautious approach to their liquidity, with banks currently holding higher levels of liquid assets than they have in recent years. These assets include cash, deposits, and marketable securities such as Commonwealth Government Securities and securities issued by other ADIs (including bank paper issued by other banks). Banks' holdings of these assets have increased to around 17  per cent of total domestic assets in recent months, after this share averaged around 14  per cent over the preceding few years. In addition, a number of banks have recently securitised a portion of their home loan portfolios and kept the resulting securities on their balance sheets. These ‘self securitisations’ – which provide an additional source of liquidity, particularly when market conditions are difficult – follow the widening of the list of eligible securities for RBA repurchase agreements in September last year to include top-rated RMBS and ABCP backed by prime, domestic full-doc loans, as well as a broader range of securities issued by ADIs.

Financial Markets

Heightened volatility has been a feature of many financial markets since the previous Review. One example is that the daily movement in share prices has averaged around 2  per cent in 2008, compared with 0.9 per cent in the first half of 2007. Overall, the share market is down by around 25 per cent since its peak in November 2007, and by around 13  per cent on its level a year ago.

The share prices of Australian commercial banks have underperformed the broader market over this period, having fallen by around 30 per cent since their peak in November. Despite the strong position of the Australian banking system, this fall is broadly similar to the falls in share prices of US and European commercial banks since their peaks (Graph 31). The falls in the share prices of Australian ‘diversified financials’, some of which focus on investment banking activities, have been sharper still, with the relevant index having declined by around 47 per cent since November, underperforming similar indices in both the United States and Europe. Notwithstanding these recent movements, equity market analysts have maintained their positive outlook for Australian financials' earnings, forecasting an 8 per cent increase in earnings in 2008/09.

Credit default swap premia for Australian banks have also risen markedly during the current episode. The average price paid for insuring against a default by the largest banks has risen to around $120 per $10,000, from around $10 per $10,000 for much of the past few years (Graph 5 in The Global Financial Environment chapter). While this rise is likely to mainly reflect an increase in investor risk aversion rather than a significant reassessment of the likelihood of an Australian bank defaulting, it is nonetheless broadly in line with that for European banks. The overall impression created by the relatively strong correlation between movements in the various market prices in Australia and overseas is that investors are not being particularly discriminating among banks around the world.

Credit rating agencies continue to view the Australian banking sector favourably (Table 5). Unlike some of their US and European counterparts, rating agencies have not downgraded any of the Australian banks' ratings since the beginning of the market turmoil mid last year, although one small bank was recently placed on a negative credit watch by Standard & Poor's. The four largest banks all have AA ratings from Standard & Poor's, after being upgraded in early 2007.

Overall, Australia's financial market infrastructure has effectively handled the increased volatility and turnover of recent months. The equity market, in particular, has seen extremely large trading volumes on a number of days in recent months (Graph 32). There have also been periods of very high turnover in foreign exchange markets in recent months, and foreign exchange transaction settlements have roughly doubled over the past year, with the inter-bank payments system coping well with the increased volume.

Activity on the Sydney Futures Exchange (SFE) has also trended up over the past year, although not to the same extent as on the equity market. The total value of margins held for SFE derivatives peaked at around $4.5 billion in June 2007, but trading positions have since been wound back in response to increased market volatility (Graph 33). In August 2007 there were a number of days of particularly large market movements, which resulted in very large amounts of variation margins having to be paid. In more recent months, market participants' reduced risk appetite has meant that, despite further periods of sharp volatility, total variation margin amounts have been more contained. The increased market volatility has also resulted in SFE increasing margin parameters for SPI futures positions.

Although the market infrastructure has generally performed well, in late January the equities brokerage firm Tricom was unable to meet its ASX settlement obligations, leading to a 4½ hour delay in settlement. While the delay was disruptive to market participants, and dented market sentiment, the financial position of ASX's clearing house was not compromised, and settlement of participants' and clients' on-market trades (which comprise the bulk of share market activity) was not at risk. The Reserve Bank is satisfied that ASX and SFE clearing and settlement facilities operate in accordance with the Financial Stability Standards determined by the Payments System Board; its most recent assessment of these facilities' compliance with these Standards was published in January.^[2] Both the Reserve Bank and ASIC continue to discuss with ASX a number of issues arising from these difficulties.

Lending and Competition

Recent developments in credit markets are having different effects across institutions and, as a result, are having a noticeable impact on competition in the Australian financial system. In the housing loan market, those lenders that have relied relatively heavily on securitisation markets for funding (such as mortgage originators and some smaller ADIs) have lost market share, and in the business loan market there are signs that financing conditions have tightened in the high-value end of the market.

Over recent years, strong competition has been a feature of the Australian mortgage market and has led to a marked contraction of margins and, as noted above, a number of changes in lending practices. As discussed in previous Reviews, this competition has resulted in the majority of new borrowers paying an interest rate less than the major banks' standard variable indicator rate. In recent years, ‘discounts’ of at least 70 basis points have been common. The contraction in margins on low-doc loans had been even more pronounced prior to the recent turmoil, with many lenders ceasing to charge a premium on these loans, whereas earlier in the decade an interest rate premium was common. Reflecting this, the average rate paid on new low-doc loans was only around 30 basis points higher than that paid on new full-doc loans as at the end of 2006, compared with 110 basis points earlier in the decade.

The narrowing of spreads on RMBS over the four or so years prior to mid 2007 was an important factor underpinning competition in the mortgage market, as it allowed lenders that rely on this market for funding to offer lower interest rates to borrowers. As noted above, the RMBS market has been one of the most affected by the global repricing of risk and this has had a material effect on some lenders that had relied on this market, particularly non-ADI lenders. The difficulties have been compounded by a number of institutions that have traditionally provided warehouse facilities deciding to close, or scale back, these facilities. The largest banks, however, make relatively little use of securitisation, with their outstanding securitised loans accounting for only around 6 per cent of total housing loans outstanding. The reliance on these markets varies considerably across the other Australian-owned banks, with some of these banks financing more than half of their loans through securitisation prior to the recent turmoil.

Reflecting the differences in funding patterns, non-ADI lenders were among the first to raise their interest rates as funding costs rose, and have increased their advertised standard variable interest rates by an average of 40 basis points more than the increase in the cash rate since July 2007. While most other lenders have also increased their advertised rates by more than the cash rate, access to alternative sources of funding, including deposits, has meant that their funding costs have not risen by as much.

The effect of the changed competitive environment in the mortgage market is evident in recent changes in market shares, with data on housing loan approvals showing that the share of owner-occupier loan approvals by wholesale lenders (mainly mortgage originators) fell to around 6½ per cent in January 2008, compared with around 12 per cent for the previous few years (Graph 34). Conversely, the share of new loans approved by the five largest banks has risen in the past few months. In addition, with mortgage margins under downward pressure, many lenders have re-examined their use of brokers and the commissions that they pay to these brokers.

The changed financial environment is also having a significant effect on the pricing of home loans by a number of non-conforming lenders. The vast majority of non-conforming loans are provided by specialist non-ADI lenders, with the three largest of these accounting for an estimated 70 per cent of the market. Since late last year, it is estimated that these lenders have increased their advertised interest rates by around 110 basis points more than the increase in the cash rate. In addition, a number of non-conforming lenders have adjusted their lending practices, including by reducing maximum allowable loan-to-valuation ratios, reducing the range of products they offer, and scaling back growth targets.

A number of banks have also increased the interest rates charged on credit cards and personal loans by more than the increase in the cash rate, although indications are that these markets remain quite competitive overall.

The business lending environment has also been very competitive over recent years. As discussed above, the growth of banks' lending to the household sector has moderated from its peak in 2003/04, while business credit growth has picked up significantly. One of the factors that had spurred the strong competition was the activities of some of the newer entrants into the market, including foreign-owned banks. As a group, these banks, some of which focus on large corporates, expanded their business lending at an above-average rate in recent years, with annual growth of over 30 per cent since late 2006. Reflecting this, foreign-owned banks' share of the market for large-value loans increased to 27 per cent as at late 2007, from 23 per cent a couple of years earlier.

Notwithstanding this recent strong growth, there are signs that developments in credit markets are having an impact on competition and lending standards in the business loan market, particularly for large-value business loans. Industry liaison suggests that some lenders, particularly some foreign-owned banks, are taking a less vigorous approach to competition in this market after a number of years where lending standards had come under downward pressure. Consistent with this, some lenders appear to have scaled back their involvement in the syndicated loan market in the early part of 2008.

Competition in the market for smaller-value business loans appears to have remained firm, which may partly reflect some banks refocusing on this market as demand for housing finance moderated. One of the factors that has contributed to the strong competition in the SME market has been the increased prominence of brokers in this segment, with an estimated one fifth of SMEs now accessing finance through this channel. Banks have also focused attention on speeding up approval times for small business loans, and have increased the number of business banking staff in recent years.

General Insurers

The Australian general insurance industry remained highly profitable over the 2007 calendar year. Insurers recorded an aggregate pre‑tax return on equity of 22 per cent, which was lower than in 2006, but still well above its decade‑average of 14 per cent (Graph 35). As usual, the main contribution to earnings was income derived from the investment of insurance premiums. General insurers' investment mix has traditionally been relatively conservative, with fixed-interest securities accounting for around 70 per cent of total investment assets, and equities accounting for around 10 per cent in recent years. Australia's largest general insurers have not reported any direct exposures to US sub ‑prime risk through their investment portfolios. Consistent with this, aggregate earnings remained quite strong in the December quarter.

Over the past year, general insurers faced a slightly more challenging claims environment than they have in recent years. Aggregate claims (net of reinsurance and other recoveries) increased by around 13 per cent, largely reflecting a series of weather-related events, including severe storms and floods in Australia's eastern states in mid to late 2007. Insurers are estimated to have recorded around $2 billion of Australian ‘catastrophe’ losses over the year, compared with $0.6 billion in 2006.

Industry net premium revenue – gross premium revenue less reinsurance expenses – increased by 4 per cent, with a number of insurers citing competition in premium rates as a constraint on premium growth. This competition was most prominent in commercial business lines, where rates fell by an average of 8 per cent in 2007. In personal lines, premium rates were broadly stable on average, although there was a wide dispersion across individual business lines.

Reflecting the relatively large increase in net claims and small increase in net premium revenue, the underwriting result was weaker than in recent years. The combined ratio – claims and underwriting expenses relative to net premium revenue – increased slightly, to 89 per cent, indicating a modest deterioration in underwriting conditions.

In aggregate, Australian general insurers have a strong capital position and appear well placed to absorb any further rise in claims. As at December 2007, the industry held aggregate capital of around twice the regulatory minimum.

Notwithstanding this generally favourable picture, a form of insurance business that has attracted attention due to developments overseas is lenders' mortgage insurance. Mortgage insurance provides protection for lenders against borrower default, and is also a form of credit enhancement in the RMBS market. In Australia, the largest non-captive lenders' mortgage insurers (LMIs) are subsidiaries of US companies, and the US industry has recorded sharp falls in profitability since the onset of the recent turmoil. While the Australian LMIs have maintained their high credit ratings, the rating agencies have placed them on negative watch or outlook. The Australian LMI sector, however, appears to be in a sound position, holding capital equivalent to 1.2 times the regulatory minimum requirement, and it recorded solid profits in 2007. Moreover, the domestic household sector remains in good financial shape and, as a result, the value of claims in the Australian mortgage market remains low compared to the value of gross premium revenue. In addition, APRA has devoted considerable attention to strengthening the prudential framework for the LMI industry over recent years. In particular, APRA increased LMIs' minimum capital requirements, and made them more risk sensitive, in late 2005.

Nonetheless, any downgrades would affect Australian lenders to the extent that their on-balance sheet loans are covered by mortgage insurance or the cost of issuing RMBS rose further. In Australia, almost all outstanding prime RMBS are covered by mortgage insurance, although any downgrade of LMIs would most likely only affect the relatively smaller, lower-rated tranches of RMBS. Moreover, only a small proportion of banks' on-balance sheet loans have mortgage insurance from those LMIs that have been placed on negative credit watch.

More generally, rating agencies continue to hold a favourable view of the Australian general insurance industry, with each of the four largest general insurers being rated A+ or higher by Standard & Poor's (Table 6). These ratings are unchanged since the previous Review, though IAG was placed on negative watch in February. Share prices of the major Australian general insurers have, however, underperformed the broader market over the past year or so, reflecting a series of storm‑ related profit warnings and recent profit results generally coming in below market expectations (Graph 36).

Global reinsurers – which absorb much of the risk from domestic insurers – appear to have entered the recent credit market volatility in a solid financial position, with aggregate capital estimated to be around five times the regulatory minimum. Profitability of the major reinsurers has been very strong in recent years, partly reflecting higher property reinsurance rates, and global catastrophe losses having been far lower in the past two years than in the previous two (Graph 37). Reinsurers' investment portfolios have also generated favourable returns, and they appear to have limited exposure to assets which have come under the most stress in recent times – it is estimated that less than one per cent of total industry assets are investments directly bearing US sub-prime risk. In addition, global reinsurers also have relatively little exposure to the global financial guaranty industry; less than five per cent of net premium revenue is generated from these lines of business.

Rating agencies also maintain a positive industry rating profile for the reinsurance industry and a stable outlook. The majority of reinsurers are rated A or higher by Standard  & Poor's, and the largest are rated AA or higher. However, like other segments of the financial system, credit default swap premia for the largest global reinsurers have risen sharply since mid 2007.

Managed Funds

The funds management industry's consolidated assets under management increased by 14  per cent over the year to December 2007, to stand at nearly $1.4 trillion, with growth much weaker over the second half of the year than in the first half of the year (Table 7).

Superannuation Funds

Superannuation funds' assets under management increased by $122 billion, or 18  per cent, over the year to December 2007. This partly reflected strong inflows of new funds in the first half of the year, mainly associated with the changes to superannuation taxation arrangements that came into effect on 1 July 2007. In the June quarter alone, net contributions were $33 billion, compared to an average of $10 billion per quarter over the previous three years (Graph 38).

Notwithstanding the strong inflows in the first half of 2007, investment returns have comprised the bulk of superannuation funds' income in recent years. While aggregate data on returns for the December quarter are not yet available, many funds have reported significantly lower investment returns in the recent period, due to the downturn in global and Australian equity markets. Around half of superannuation funds' assets were held in equities and units in trusts as at December 2007, and growth in these assets moderated significantly over the second half of 2007 (Table 8). Australian superannuation funds appear to have minimal direct exposures to the problems in US sub-prime related debt markets, although several funds have modest holdings of CDOs backed by US sub-prime debt. This low exposure is consistent with aggregate data showing that only 4  per cent of superannuation funds' financial assets are invested in offshore bonds (including CDOs).

Life Insurers

Life insurers' assets grew by 7 per cent over the year to December 2007, and account for around 16 per cent of the funds management industry. With superannuation assets accounting for around 90 per cent of life insurers' total assets, the inflow of new business was particularly strong in the June quarter of 2007 (Graph 39). In contrast to the broader superannuation industry, inflows remained strong in the September quarter. Although a declining share of life insurers' income has come from traditional life business, the growth in income from this form of business has been stronger in the past two years than it has been for some time. This partly reflects increased volumes of group life business written via industry and other public offer superannuation funds.

As has been the case for superannuation funds, investment income has accounted for a significant share of life insurers' asset growth. Over recent years, this has reflected the strong growth of the equity market, with around 50 per cent of life insurers' statutory fund assets held in the form of Australian equities and units in trusts, up from 30 per cent in the mid 1990s. With the Australian equity market having fallen by around 25  per cent since its peak last year, the growth in investment returns is likely to have moderated in more recent quarters.

Looking ahead, with only 10 per cent of life office assets now related to writing risk insurance, the prospects for the life insurance sector are likely to remain closely tied to developments in superannuation. Notwithstanding this, some commentators have argued that households are ‘under insured’, which may give scope for risk business to increase in the future. Some life insurers have also streamlined their application processes, typically through the use of online applications.

Public Unit Trusts and other Managed Funds

Outside of superannuation funds and life offices, the majority of funds under management are invested in public unit trusts, which grew by 9 per cent over the year to December  2007, though growth was entirely confined to the first half (Table 9). The value of listed property and unlisted equity trusts (which together account for nearly 80 per cent of all unit trust assets) fell in the second half of 2007. As noted above, the performance of these, and other unit trusts, has been affected by the recent falls in share prices in Australia and overseas, as well as by the difficulties of several large property companies in recent months. However, while several Australian hedge funds collapsed in the early stages of the turmoil, there have been no announcements more recently of severe stresses in the sector.

Footnotes

See Reserve Bank of Australia (2007), ‘Box C: Foreign-owned Banks in Australia’, Financial Stability Review, March. [1]

See Reserve Bank of Australia (2008), 2006/07 Assessment of Clearing and Settlement Facilities in Australia, January. [2]