Financial Stability Review October 2022

Global financial conditions have tightened this year as persistently high inflation has prompted central banks in advanced economies to rapidly raise interest rates. In recent months, there have been material downgrades to the world economic outlook. Financial asset prices have declined and volatility has increased. Housing price growth has slowed or reversed in many economies in response to higher interest rates. Severe disruptions in energy markets have led to stress in some parts of the global financial system.

Global economic growth is expected to slow, although the risks facing different regions depend on existing vulnerabilities. In Europe, high and volatile energy prices are complicating the macroeconomic outlook and could exacerbate fragilities related to high sovereign debt and banking exposures in some euro area economies. Emerging market economies that are commodity-importers or are more reliant on foreign currency funding are particularly vulnerable to financial stress. And while Chinese authorities have provided further policy support to bolster the stressed property market, the country’s near and longer term policy challenges are complex and the outlook is increasingly uncertain.

Many households and businesses built up large saving buffers during the pandemic, which will assist them in facing the more challenging economic conditions. Banks remain well capitalised and loan arrears are low. However, global financial conditions could tighten further in the period ahead and test the resilience of some households and businesses.

Higher interest rates will increase borrowers’ debt payments. Despite a strong labour market, income growth has not kept up with inflation in Australia, leaving households with less capacity to service their debts. Many households will be able to manage this by reducing their spending and/or their rate of saving. However, a small share of borrowers with lower savings and high debt are vulnerable to payment difficulties. As a result, housing loan arrears rates are likely to increase in the period ahead from currently very low levels. Debt-servicing challenges will become more widespread if economic conditions, particularly the level of unemployment, turn out to be worse than expected and housing prices fall sharply.

Similar to households, most businesses have benefited from the strong economic recovery and have entered the interest rate tightening cycle in a healthy financial position. However, some businesses have been particularly affected by sharp rises in costs, labour shortages and supply disruptions. This is especially evident in the construction industry, where insolvencies have risen from low levels.

There have been further high-profile cyber incidents in recent months, including the recent Optus data breach. A significant cyber event could undermine confidence in the financial system and have systemic implications. Financial institutions, governments and financial regulators continue to work together to enhance the resilience of the financial system to cyber risks.

Climate change presents a systemic challenge to the financial system. Financial institutions are vulnerable to direct losses on assets from climate events and risks stemming from the transition to a lower emissions economy. Financial institutions have begun to take action to manage such risks – however, adjustments to lending and risk management practices will take time. Regulators are currently focused on improving the ability of businesses and institutions to disclose and manage financial risks associated with climate change.