Financial Stability Review April 2021

The resilience of banks in Australia is a result of their high capital levels, their significant holdings of liquid assets and their ongoing profitability. Substantial policy support from governments, central banks and other regulators has also underpinned the resilience of the financial system over the past year. Banks in Australia do face some challenges in rising non-performing loans as a result of the economic downturn and refinancing their funding from the term funding facility in three years’ time, but both of these seem very manageable. Risks in other financial institutions appear contained. Notably, superannuation funds successfully managed some significant challenges for their management of liquidity last year.

Internationally, most banks are resilient. Capital ratios are higher than a year ago, and provisions have increased to account for higher losses on loans. However, some banks are more vulnerable and would be tested if there were to be a large increase in loan defaults. Another challenge for financial systems is the transition away from LIBOR as an interest rate benchmark.

GDP has almost returned to its pre-pandemic level in Australia, and the recovery continues to be a focus for financial regulators. But GDP remains below pre-pandemic levels in some other countries, adding to risks. If the economic recovery were to stall it would be challenging for vulnerable households and businesses and would lead to rising insolvencies. If some parts of the economy, such as the retail commercial property, continue to be constrained by the virus then lenders exposed to these sectors could face significant losses. Globally, slower growth would also impede the ability of banks that already had low profitability before the pandemic to generate new capital, and so weigh on their resilience to losses and willingness to lend. With rising long-term yields in major economies, slower growth in some emerging market economies could expose them to sharp capital outflows, exchange rate depreciations or unhelpful increases in their domestic interest rates.

Many asset prices, including housing in Australia and other countries, have been rising and/or are high. This is a consequence of very low interest rates and expectations of a strong recovery in the economy and income that assets earn. Rising asset prices are helping the economic recovery and reducing the risk that falling prices would result in losses on loans financing those assets.

However, risks from rising asset prices and debt could build, particularly if lending standards are weakened. Persistent increases in asset prices could lead to expectations rises will continue and so increase risk taking and borrowing, especially given low interest rates. This could push asset prices above their fundamental values which could lead to a correction in asset prices, which if borrowers’ income fell could expose lenders to large losses on higher debt.

Recent cyber-attacks have demonstrated the increased sophistication of perpetrators and the risks to financial institutions in Australia and other countries. Financial institutions globally typically rate cyber as one of the most substantial risks they face and it is a focus for regulators. Large financial institutions, which are more systemically important, have the scale for substantial investment on cyber security. However, with a very large number of attacks, there remains the likelihood that even large financial institutions or critical financial market infrastructure will at some point be impacted, possibly via third-party providers. Substantial cyber-attacks could risk financial stability if, for example, they corrupt significant data or if they affect large parts of the financial system or critical nodes. Given this, it is crucial that financial institutions and systems not only take preventative actions, but enhance resilience by planning recovery actions to cyber security breaches.