Financial Stability Review – March 20242. Resilience of Australian Households and Businesses

2.1 Households

High inflation and interest rates have put pressure on household budgets over the past two years, but nearly all borrowers continue to service their debts on schedule.

Many households continue to experience pressure on their budgets from high inflation and tighter monetary policy. Since the start of 2022, real disposable income (income after tax and interest payments and adjusted for inflation) has declined by around 7 per cent to be near its pre-pandemic level in per capita terms (Graph 2.1). Households with lower incomes, including many renters, have felt these budget pressures acutely. Most mortgagors have experienced an increase in their minimum scheduled payments of 30–60 per cent since the first increase in the cash rate in May 2022. Sharply higher housing costs (for borrowers and renters) and broad-based cost-of-living pressures have weighed heavily on the budgets of many households and contributed to very weak consumer sentiment. Information received through the RBA’s liaison program indicates that more people than usual, and including wage earners and mortgagors, are seeking support from community organisations.

Despite pressures on households’ budgets, almost all borrowers have been able to continue to service their debts. While housing and personal loan arrears have increased since late 2022, they remain below their pre-pandemic peak (Graph 2.2). At the same time, a small but increasing share of borrowers have requested and received temporary hardship arrangements from their lenders, which has contributed to arrears rates remaining a little lower than would have otherwise been the case. Based on their latest assessment of the economic outlook, banks expect arrears rates to increase a bit further from here but remain low relative to history.

Households’ ability to manage their finances during this period of rising interest rates and high inflation is due to several factors, including:

1. The strong labour market has supported household incomes over recent years. Low unemployment – and, in turn, the ability of workers to retain or find more work (including extra hours) – has supported households’ incomes and their ability to service their debts over this period. Labour market conditions have eased, and both the unemployment and underemployment rate have increased from their troughs in late 2022. Still, the share of Australians with a job remains around its highest level ever.
2. Many households have adjusted their spending, particularly spending in areas such as retail and hospitality (discussed below).
3. Most households entered this period in a relatively strong financial position, with material spare cash flows and larger savings buffers than before the pandemic (Graph 2.3).^[1] This has provided room for households to adjust to higher inflation and mortgage costs, including by saving less and, in some cases, drawing on their existing savings buffers (discussed below).

   

Mortgagors with low buffers and high leverage have been more likely to fall behind on their loan payments.

Overall, loan arrears are low, though they are higher among borrowers with high leverage as these borrowers tend to have lower buffers.^[2] Borrowers usually draw down on their savings buffers before falling behind on their loan payments. Those who start with low buffers or find it difficult to build up buffers are therefore more likely to fall behind on their loan payments. As a result, arrears rates are highest among highly leveraged borrowers (relative to their income or the value of their property) (Graph 2.4, red bars).^[3]

By contrast, other borrower groups often considered more at risk have fallen into arrears at a rate similar to the aggregate. This includes owner-occupier borrowers who have rolled off a low fixed rate onto a higher variable rate. This resilience partly reflects that these borrowers were able to build up savings buffers over a longer period of unusually low interest rates.^[4] Arrears rates are slightly lower than the aggregate among recent first home buyers, who borrowed within the past three years, including when interest rates were at their lowest; this is another group often considered more at risk.^[5] Arrears rates are similar across states and territories, consistent with solid employment conditions across the country.

Overall, less than 1 per cent of all housing loans are 90 or more days in arrears, and less than 2 per cent of highly leveraged borrowers – the group of households most at risk – are in arrears.

Mortgagors’ cash flow and savings buffers have declined over the past two years, but most borrowers appear able to service their debts.

Savings buffers remain above pre-pandemic levels for many borrowers. The increase in interest rates since May 2022 has reduced the size of variable-rate owner-occupier borrowers’ savings in offset or redraw accounts relative to their minimum scheduled payments (Graph 2.5).^[6] This has been particularly pronounced for borrowers in the highest mortgagor income quartile; these borrowers tend to have larger loans and so their scheduled mortgage payments change by more when interest rates change. High-income borrowers are also the only group that, in aggregate, has drawn down notably on their offset and redraw balances over 2023. Nonetheless, high-income borrowers still hold the largest prepayment buffers, and some of this decline in offset and redraw balances likely reflected withdrawals to support discretionary consumption. Households in the bottom three mortgagor income quartiles tend to have smaller buffers, but many continued to add to their balances in dollar terms over 2023.

Most borrowers remain able to service their debts and cover essential costs out of their income, despite their budgets being squeezed by higher interest rates and inflation.^[7] However, around 5 per cent of variable-rate owner-occupier borrowers are estimated to have had expenses exceed their income as interest rates and prices have risen over recent years, leading to an estimated cash flow shortfall (Graph 2.6). In addition to cutting back their spending to mostly essential items and trading down in quality for some goods and services, these households have had to make other adjustments to continue servicing their mortgages. These include drawing down on liquid savings, selling assets and working additional hours. Lower income borrowers are more likely to be in this group.

Many households with an estimated cash flow shortfall still have substantial savings buffers to draw on to cover their expenses. The share of borrowers more at risk of falling behind on their loan – that is, those estimated to have a cash flow shortfall and low buffers – has increased over the past two years but still represents less than 2 per cent of variable-rate owner-occupier borrowers.^[8]

Looking ahead, nearly all borrowers are expected to be able to continue servicing their debts even if budget pressures remain elevated for an extended period.

Whether budget pressures gradually ease, as implied by the forecasts in the February Statement, or inflation is more persistent and interest rates remain higher for longer than currently expected, the vast majority of borrowers are expected to remain able to service their debts on schedule. Under both scenarios, however, 2024 will remain a challenging year for the cohort of borrowers already experiencing acute budget pressures (see 4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates). If budget pressures ease in line with the February Statement forecasts, the share of households with an estimated cash flow shortfall will decline later in 2024 (see Box: How are budget pressures expected to evolve from here?). Should inflation remain high for longer than forecast, the small number of borrowers who are close to or in cash flow shortfall would have to make further difficult adjustments to their finances in order to meet their obligations.

In a severe but plausible downturn, a larger-than-expected increase in the unemployment rate would increase financial stress among affected borrowers; still, risks to the financial system would likely remain contained. Even though an increase in unemployment is highly disruptive for affected households, it is unlikely to lead to a one-for-one increase in loan defaults. This is because several factors mitigate the risk of default for borrowers. Historically, mortgagors have been less likely to lose their jobs during a period of rising unemployment compared with other households. Additionally, some mortgagor households have multiple incomes, which makes it less likely they will lose their entire household income. Moreover, around half of all borrowers have enough buffers to service their debts and essential expenses for at least six months; this share is slightly higher than before the pandemic (Graph 2.8). Lastly, lenders can provide temporary support to those who have lost work by offering hardship arrangements in some circumstances.

Further supporting financial system resilience, most borrowers have strong equity positions, which protects them from default and limits lenders’ losses. Sound lending standards and the general increase in housing prices over recent years continue to support borrowers’ resilience. The share of new loans originated at high loan-to-value ratios has fallen since 2021 and is around historical lows. The share of loans (by number or balances) estimated to be in negative equity at current housing prices remains very low.^[11] While usually a last resort and very disruptive for owner-occupier borrowers, this would allow almost all borrowers to sell their properties and repay their loans in full before defaulting. The share of loans in negative equity is estimated to increase to around 11 per cent under a severe downside scenario where housing prices fall by 30 per cent from their January 2024 levels (all else equal), but greater losses for lenders would only be realised if more borrowers became unable to service their loans.

As a result, losses incurred by lenders are likely to remain manageable in most plausible adverse circumstances. As such, banks – supported by their strong profits and capital positions – are well placed to withstand such losses while continuing to lend to households and businesses (see Chapter 3: Resilience of the Australian Financial System). This conclusion is supported by the results of previous stress tests run by banks, the Australian Prudential Regulation Authority and the RBA.

2.2 Businesses

Most businesses’ profitability is around pre-pandemic levels, but some firms are experiencing challenging conditions.

Slowing demand, continued domestic input cost pressures and higher interest expenses are weighing on some businesses’ profitability. Most businesses’ operating profit margins (which exclude interest expenses) have remained around pre-pandemic levels based on the latest available data (Graph 2.9).^[12] However, there is a low but increasing share of firms experiencing challenging conditions. This is particularly the case in discretionary sectors as households have pulled back on consumption, which has led to more significant declines in profitability in the retail and hospitality industries. More broadly, domestic cost pressures for labour and non-labour inputs remain elevated, and some firms are finding it difficult to pass higher costs through to the prices paid by consumers given weaker demand. At the same time, interest expenses continue to increase. The impact of higher interest rates tends to be larger for smaller businesses; the use of interest rate hedges and issuance of longer term fixed-rate debt slow the pass through of higher interest rates to larger businesses (see 4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates).

Financial stress among businesses has increased but from below-average levels …

Some indicators of financial stress among businesses have picked up. However, this follows a period where these indicators were very low, and many are still below or around historical averages. More specifically:

• Company insolvencies have risen to more normal levels. This reflects a few factors: the removal of significant support measures that were put in place during the pandemic; more challenging trading conditions as the economy has slowed in the face of high inflation and tighter monetary policy; and the Australian Tax Office resuming enforcement activities on unpaid taxes. However, insolvencies remain below the pre-pandemic trend on a cumulative basis (Graph 2.10, left panel). Additionally, businesses entering insolvency generally continue to be small and have little debt, limiting the impact on lenders. While the construction sector still accounts for the largest share of insolvencies, conditions in parts of the industry are beginning to stabilise (Graph 2.10, right panel). Some residential builders have been able to rebuild margins, following a challenging period where profit margins on fixed-price contracts were severely affected by input costs that were sharply rising as well as costly delays.^[13] Sectors more exposed to consumer discretionary spending, such as hospitality, have accounted for an increasing share of insolvencies of late.
• Business-related personal insolvencies remain near historical lows. This includes construction-related personal insolvencies, suggesting that recent stress among larger construction businesses has not spilled over in a material way to households that own and operate small construction businesses.
• The share of business loans extended by banks that are non-performing has remained steady at low levels. This is consistent with most firms remaining profitable and that it is mostly small businesses with little debt that are entering insolvency (Graph 3.3). However, some businesses also secure credit from non-banks, whose share of business credit has continued to increase (see Chapter 3: Resilience of the Australian Financial System). Some market reports have suggested that non-performing business loans have been increasing at some of these non-bank lenders, but system-wide business loan arrears data are not available across the non-bank sector.
• The share of businesses with severely overdue trade credit has increased but remains below its pre-pandemic average (Graph 2.11). Trade credit is a particularly important source of financing for small businesses.
• Larger companies remain able to service their debts. Among listed companies, the (debt-weighted) share with earnings less than double their interest expenses – equivalent to an interest coverage ratio (ICR) less than 2 – is around its 10-year average (see 4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates).

… but strong financial positions limit the risk of widespread financial stress in the business sector …

Challenging economic conditions will continue to affect businesses’ finances over the coming period. Growth in demand is expected to remain subdued and growth in costs, including of labour and other domestic inputs, is expected to moderate only gradually. Interest expenses will continue to increase for many firms, including larger businesses as interest rate hedges and fixed-rate debt mature.

However, this is unlikely to translate into broad-based stress across the corporate sector. While growth in demand has slowed, the level of demand is still relatively high.^[14] In addition, business balance sheets remain strong, as most businesses benefited from the policy measures introduced during the pandemic and the rapid economic recovery that followed. As a result, most larger listed companies still hold cash buffers slightly higher than pre-pandemic levels (Graph 2.12). For smaller businesses, aggregate cash buffers remain above historical average levels, but these have declined and information from the RBA’s liaison program suggests liquidity buffers are unevenly distributed. In aggregate, leverage of non-financial businesses is relatively low at just over 20 per cent, relative to the 2007–2019 average of nearly 30 per cent.

Scenario analysis suggests most listed firms could withstand a prolonged period of high inflation and interest rates. Financial stress among larger listed companies remains limited and around pre-pandemic levels for the two scenarios considered − the economic outlook as presented in the February Statement, and a more persistent-than-expected inflation scenario (see 4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates). Consistent with this, liaison suggests that banks continue to have appetite to lend with some caution to businesses more exposed to discretionary spending; market pricing of default risk among larger companies also remains low.^[15]

… and risks to the financial system from the business sector remain low.

Banks have limited exposure to businesses that have entered insolvency and are well placed to manage a further worsening in credit quality from business loans. Non-banks tend to be more exposed to riskier business loans, such as those extended to smaller businesses. However, these lenders account for a small share of total credit in the Australian economy (and around 10 per cent of business credit) and, unlike in some countries, banks have limited exposures to non-bank lenders (see Chapter 3: Resilience of the Australian Financial System).

2.3 Commercial real estate

Conditions remain challenging in CRE markets globally, including in Australia. Weak leasing demand − reflected in higher vacancy rates and weak rental growth − and higher interest rates are weighing on many CRE (in particular, office) owners’ profitability. The same factors are weighing on asset valuations, with aggregate valuation measures down by around 14 per cent since mid-2022. These pressures have been felt unevenly across sectors and are particularly acute for lower grade office properties. Further falls in valuations are expected by some industry participants, though the pace and magnitude of declines are uncertain as low transaction volumes have made price discovery difficult.

Despite continued challenging market conditions, there is little evidence of financial stress among owners of Australian CRE and risks to the domestic banking system remain contained.

Domestically, available information suggests that the financial positions and funding arrangements of CRE owners reduce the immediate risk of forced asset sales at potentially steep (‘fire sale’) discounts. More specifically:

• Australian Real Estate Investment Trusts (A-REITs) continue to maintain strong financial positions. They have modest leverage, despite write-downs of the value of their assets, and earnings equivalent to around three times their interest payments (Graph 2.13).
• Unlisted trusts appear to have managed liquidity pressures from redemption requests to date. In aggregate, unlisted trusts have lower levels of leverage than listed A-REITs and redemptions have not resulted in disorderly asset sales. However, information from the RBA’s liaison program provides a more nuanced picture, highlighting that some unlisted trusts have much higher levels of leverage than others and are therefore more exposed to a worsening in market conditions. Data gaps make it difficult to form definitive assessments of the risks in these vehicles, though a worsening in market conditions would be passed through to trust investors in the form of lower (or negative) returns.^[16]
• The share of non-performing CRE loans from banks has increased slightly but remains negligible, in part reflecting conservative lending practices among banks operating in Australia. While some loans no longer meet the banks’ interest coverage ratio (ICR) requirements, information from the liaison program suggests that banks are supporting existing borrowers who can demonstrate a path back to meeting minimum requirements. More broadly, Australian banks have relatively small exposures to CRE and to non-banks that operate in the Australian CRE market, thus limiting the scope of wider financial system stress.

However, a key risk to the domestic CRE market stems from international lenders and investors withdrawing funding.

Deteriorating conditions in overseas CRE markets could spill over to the Australian CRE market through common funding sources and ownership (see Chapter 1: The Global and Macro-financial Environment). These linkages have increased over the past decade as foreign participation in Australia’s CRE market has risen.^[17] However, to date there has been limited evidence of a withdrawal of foreign funding:

• A-REITs’ access to funding has not tightened significantly. A-REITs appear to continue to have access to foreign debt markets at favourable terms and interest rates.
• Foreign banks’ appetite for Australian CRE lending remains robust. Foreign banks’ exposures to Australian CRE continue to increase, although at a slower pace than a couple of years ago (Graph 2.14, left panel). These banks account for around 20 per cent of bank lending to CRE in Australia.
• Foreign investors’ interest in Australian CRE remains stable. Foreign owners’ portfolios of established Australian CRE are little changed on net over the past couple of years (Graph 2.14, right panel). We have less visibility over direct investment in new CRE development; however, while there have been reports of the withdrawal of some foreign investors from the residential development market, liaison with domestic market participants suggests this has been limited.

Endnotes

Household financial buffers shown in Graph 2.3 are from Wave 22 of the Household, Income and Labour Dynamics in Australia (HILDA) Survey, released in December 2023. Most survey responses for 2022 were collected in the second half of that year. Housing expenses and estimated essential expenses reported by many households are likely to capture some increase in inflation and interest rates since the beginning of 2022. Data on households’ assets are only available every four years. [1]

This is based on analysis using loan-level data from the RBA’s Securitisation System dataset. Arrears rates from these data can differ from arrears rates reported by lenders to the Australian Prudential Regulation Authority as some lenders tend to remove loans in arrears from their self-securitised pools of loans. The differences appear to be minor over the last five years. For more details, see Fernandes K and D Jones (2018), ‘The Reserve Bank’s Securitisation Dataset’, RBA Bulletin, December. [2]

Borrowers with a higher loan balance relative to the value of their property are more likely to have lower savings buffers, lower incomes and lower total wealth than other borrowers. In addition, they have seen larger increases to their scheduled minimum payments compared with other borrowers. See RBA (2023), ‘5.3 Focus Topic: Indicators of Household Financial Stress’, Financial Stability Review, October. However, as many of these borrowers have originated their loans at a loan-to-value ratio (LVR) above 80, they would have been required to obtain lenders’ mortgage insurance. This protects the lender from losses if the borrower defaults on the loan. [3]

See RBA (2023), ‘5.2 Focus Topic: An Update on Fixed-rate Borrowers’, Financial Stability Review, October. [4]

In part, this also reflects that arrears rates tend to increase with the age (‘seasoning’) of a loan. This is because the cumulative chance of a borrower to experience a shock to their income (such as job loss) or another personal misfortune (such as ill health or a relationship breakdown) increases over time. Arrears rates are only moderately elevated among all first home buyers (not just those who bought within the past three years), reflecting the higher average age of these loans. See Kearns J (2019), ‘Understanding Rising Housing Loan Arrears’, Speech to the 2019 Property Leaders’ Summit, Canberra, 18 June. [5]

Prepayment buffers are shown for variable-rate owner-occupier borrowers only, as these borrowers have the largest scope for and strongest incentives to save via prepayments in their offset or redraw accounts. Borrowers on fixed rates typically have no or limited access to such accounts. Previous analysis suggest that fixed-rate borrowers appear to have nonetheless built similarly sized buffers to variable-rate borrowers (see RBA (2023), ‘5.2 Focus Topic: An Update on Fixed-rate Borrowers’, Financial Stability Review, October). Investors’ savings are unobservable in the Securitisation System data, but investors tend to have higher incomes and higher wealth, including their investment properties, which supports their resilience. [6]

These estimates use the RBA’s loan-level data from the Securitisation System dataset. Essential expenses are proxied by the Melbourne Institute’s Household Expenditure Measure (HEM). For further assumptions underlying the spare cash flow estimate, including why they could over- or underestimate the share of borrowers in cash flow shortfall, see RBA (2023), ‘Box B: Scenario Analysis on Indebted Households’ Spare Cash Flows and Prepayment Buffers’, Financial Stability Review, April. [7]

Borrowers already in arrears are not included in this measure. [8]

This path is a little higher in the first half of 2024 than in the December quarter of 2023 because the latest increase in the cash rate was part way through the quarter (November), leading to a small initial increase in the estimated share of borrowers with a cash flow shortfall. [9]

We also assume that the underemployment rate increases by the same amount as the unemployment rate. The assumed loss in working hours also pushes some affected borrowers into cash flow shortfall. [10]

Estimates from the RBA’s Securitisation System dataset suggest that the share of loans in negative equity, defined as a current LVR greater than 100 per cent, is around 0.1 per cent. Current loan balances are net of offset and redraw account balances, and current property values are estimated by growing forward values at loan origination using house price indices at the SA3 level. The median LVR for loans in the RBA’s Securitisation System dataset is lower than in the population as counterparties are incentivised to securitise prime loans (typically with LVRs below 80 per cent) to reduce the haircut applied when posting collateral. Profit reports from banks suggest that the share of loans in negative equity on their books remains very low at around 1 per cent on average. [11]

For more detail on business profits, see RBA (2023), ‘Box B: Have Business Profits Contributed to Inflation’, Statement on Monetary Policy, May. [12]

See RBA (2022), ‘Box C: Financial Stress and Contagion Risks in the Residential Construction Industry’, Financial Stability Review, October; RBA (2023), ‘Box: Risks in the residential construction industry’, Financial Stability Review, October. [13]

See RBA (2024), Statement on Monetary Policy, February. [14]

For more detail on small business access to finance, see Chan P, A Chinnery and P Wallis (2023), ‘Recent Developments in Small Business Finance and Economic Conditions’, RBA Bulletin, September. The risk of default is measured by a distance-to-default model, which uses information on liabilities from financial statements together with a company’s market capitalisation to assess credit risk. A company is at risk of default if its market value of assets falls below the book value of its liabilities. For more detail, see Robson M (2015), ‘Default Risk Among Australian Listed Corporations’, RBA Bulletin, September. [15]

For a discussion on potential financial stability risks from non-bank financial institution activity in Australian CRE markets and related data gaps, see Robinson M and S Tornielli di Crestvolant (2024), ‘Financial Stability Risks from Non-bank Financial Intermediation in Australia’, RBA Bulletin, April. [16]

See Lim J, M McCormick, S Roche and E Smith (2023), ‘Financial Stability Risks from Commercial Real Estate’, RBA Bulletin, September. [17]