Financial Stability Review April 2022

While financial asset prices have fallen in early 2022 due to an increase in interest rates, there have not been significant declines in residential or commercial property prices.

Financial markets expect interest rates to increase further – but rates may need to increase by more than currently expected by financial markets to contain inflationary pressures in some countries. Disruptions to supply chains due to the pandemic and the war in Ukraine, as well as sharp increases in energy and other commodity prices, will add to already high inflation. Together, these factors could depress economic growth.

In Australia, robust economic activity has strengthened businesses' and households' balance sheets. Most indebted households have further increased their substantial excess payment buffers. But the ratio of housing credit to income has edged up from an already high level – which has become a focus of regulators. Business insolvencies are rising from a very low level as some businesses face lower revenue and much higher costs. Overall, however, borrowers' strong financial positions have resulted in very low levels of non-performing loans. Banks have healthy profits, as well as high capital ratios and liquid asset holdings.

Financial institutions continue to face long-run challenges. The financial risks from climate change is currently a significant focus for regulators and banks around the world.

Higher interest rates will increase borrowers' debt payments. Higher inflation will reduce the funds households and businesses have to make those payments, particularly if incomes do not increase alongside higher interest rates. Loan performance could then deteriorate significantly. The current stress among highly indebted property developers in China highlights these risks.

In Australia, increases in businesses debt payments will be limited by their relatively low leverage. Household debt relative to income is high compared to other countries and to historical levels. Most households are well placed to meet higher debt payments because they have been making excess mortgage payments in recent years. However, high levels of household debt can lead to reduced spending should incomes fall or expenses rise. While banks have generally maintained strong lending standards, the recent increase in new high debt-to-income loans points to some risk – such borrowers are more likely than others to report repayment difficulties, but only if they have low liquidity buffers or low incomes.

Many financial asset prices remain at high levels, notwithstanding some recent declines. The prices of most types of commercial and residential property are also elevated.

Interest rates are used to value all assets and so a large increase could cause the prices of many different types of assets to fall. Rising risk aversion – possibly triggered by an escalation of the conflict in Ukraine – could lead to declines in asset prices, as could weak growth (or falls) in real income resulting from high inflation and increasing interest rates.

Where the assets are leveraged – which is common for residential and commercial property – large price falls could lead to significant losses for financial institutions if borrowers are unable to repay their loans or maintain loan covenants. Volatility in asset prices can also be disruptive to financial markets, particularly where leverage is high or there are liquidity mismatches. Increases in global interest rates have in the past triggered crises in emerging market economies with weaker economic fundamentals.

Cyber-attacks are a significant risk for banks and other financial institutions given the importance of technology in the financial system. Technology systems have become larger and more complex over time, and the frequency and sophistication of attacks has increased. As a result, it seems inevitable that an attack on a significant financial institution will eventually be successful. If an attack impacts a large or interconnected part of the financial system, or undermines confidence, it could interfere with broader functioning. To reduce the chance that a cyber-attack has a systemic effect it is critical that financial institutions and infrastructures have high resilience with the ability to quickly recover. Australia's financial regulators have been working with industry and government to achieve this.