Financial Stability Review October 2020

After a period of heightened volatility and stress following the onset of the pandemic, financial systems have fared well. They have cushioned rather than amplified the shock. This reflected post-global financial crisis reforms that strengthened banks and unprecedented actions taken by policy makers. However, with economies experiencing large contractions in output the focus has shifted from liquidity to the solvency of borrowers as the expected defaults will result in credit losses for lenders. The global economic recovery is going to take time and its path will be uneven and dependent on the course of the virus. Some financial systems face pre-existing risks from weak bank profitability and high household, business or government debt. Risks to financial systems are therefore likely to remain elevated for some time to come.

Households' cash flow also benefited from loan repayment deferrals and the early release of funds from superannuation. Households have used this boost to cash flow to increase their saving buffers in response to higher economic uncertainty. This has included households making larger payments into mortgage offset and redraw accounts. However, with unemployment having increased and many employees working reduced hours, the share of households experiencing financial stress has increased and will increase further. While some households are struggling, the finances of most households are faring well to date and demand for housing has held up. There have been small falls in housing prices in Sydney and Melbourne, with these being larger in inner city areas.

Support measures, in conjunction with temporary insolvency relief, have seen increased cash buffers and lower rates of business failures this year. Continued availability of equity and debt funding has enabled large businesses to shore-up their balance sheets. However, business failures will rise substantially when loan repayment deferrals and income support come to an end. Business failures have flow-on effects to their creditors, both financial institutions and other businesses, and their employees. Some commercial real estate also poses significant risks for lenders and leveraged investors. Structural change had been driving rising retail property vacancy rates and falling valuations, and this has accelerated with the pandemic. Conditions in office markets had been tight prior to the crisis, but with the economic downturn and changing expectations of future office use, conditions have deteriorated.

Banks' capital has increased further this year, reflecting that they remained profitable, despite materially increasing provisions for future credit losses. The Bank and the other Council of Financial Regulators (CFR) agencies have intensified their collaboration to effectively support the financial system. While the Australian financial system is in a strong position, risks are elevated. These risks to the financial system would be exacerbated by a weaker-than-expected economic recovery, for example stemming from further setbacks on the health front or international political tensions. However, stress tests of the Australian banking system indicate that banks would remain above their minimum capital requirements even if the economic contraction is substantially more severe than expected. Given their strong balance sheets, banks will be well placed to continue lending, supporting the economic recovery and so in turn the Australian financial system.