Financial Stability Review – March 20243. Resilience of the Australian Financial System

3.1 Banks

High capital levels mean banks are well placed to absorb losses on their loan portfolios …

The resilience of the Australian banking system is enhanced by the quantity and quality of capital held by banks. Common Equity Tier 1 – the highest quality capital – as a share of risk-weighted assets increased by a further 0.9 percentage points in the 12 months to December 2023. All banks exceed their minimum regulatory capital requirements by a considerable margin, which should ensure they can absorb losses without interrupting the provision of credit and other financial services (Graph 3.1).

The increase in banks’ capital ratios partly reflects recent changes to capital requirements. These include implementation of the new bank capital framework in January 2023 and loss-absorbing capacity requirements for domestic systemically important banks (currently the four largest banks in Australia) in January 2024.^[1] Requirements on Australian banks to manage interest rate risk changed in December 2023 following industry consultation the year prior. These changes were informed by lessons from the collapse of several US banks in March 2023, in part due to their failure in managing interest rate risk.^[2]

… with profits and provisions supporting the resilience of banks.

Banking system profitability declined slightly over 2023 due to slower loan growth and greater competition for mortgage lending and term deposits (Graph 3.2). This followed an increase in profitability in 2022 as rising interest rates helped boost earnings on interest rate hedges and liquid asset holdings. Pressures on profitability are expected to remain in the coming year. Profits strengthen banks by enhancing their ability to absorb losses.

The level of provisions − profits that banks put aside to absorb future losses − has declined recently, owing in part to a reduction in banks’ uncertainty about the economic outlook. Some banks have reduced their collective provisions, which are determined by models of expected loss and the judgement of risks, with market analysts expecting further reductions this year.

Bank losses due to loan defaults are expected to increase slightly …

The share of bank loans that are in default ticked up slightly over 2023 as more borrowers were unable to service their debts. The share of loans in default − non-performing loans – remains relatively low, reflecting the resilience of the Australian economy and banks’ prudent lending standards over recent years (Graph 3.3). The strong labour market and ongoing profitability among most businesses have helped households and firms to service their debts despite cost-of-living pressures and higher interest rates.

The increase in loan defaults over 2023 was mainly driven by owner-occupier housing loans. The share of owner-occupier housing loans in default has increased from its low levels in late-2022 but remains below levels seen during the pandemic. The share of non-financial business loans that are in default increased modestly in 2023 but also remains low, consistent with the resilient economic conditions and banks’ conservative lending practices.

Banks expect defaults to increase slightly in the coming year. Loans with payments overdue for less than 90 days – a leading indicator of defaults – have continued to tick up gradually. Information from the RBA’s liaison program suggests that defaults in business lending are expected to increase (and by more than in housing lending) as weak household consumption growth, due to budget pressures, will weigh on business income. Loan defaults could increase by more if economic conditions are weaker than currently forecast or if inflation turns out to be higher than expected, resulting in tighter monetary policy than otherwise (see 4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates).

… and banks would remain resilient even in a severe but plausible economic downturn.

Stress tests suggest that large banks could continue to lend in a severe but plausible economic downturn. The Australian Prudential Regulation Authority (APRA) recently conducted a stress test of banks based on a domestic economic downturn scenario featuring high inflation, unemployment rising to 10 per cent and housing prices falling by more than one-third. The stress test was applied to the 11 largest banks in Australia, which account for 85 per cent of banking system assets. The capital ratios of each bank remained above its prudential requirements and banks were able to continue providing credit to households and businesses in the scenario.^[3]

The high capital ratios of smaller banks not included in the APRA stress test will support their ability to weather unexpected financial shocks. The average CET1 ratio of these banks is around 16 per cent, well above their minimum capital requirements including regulatory buffers. All banks are required by regulators to ensure they hold capital resources commensurate with their risk profiles and to use stress testing or scenario analysis to help assess their capital settings.^[4]

Banks are managing their liquidity and funding risks.

Banks hold liquid assets above their regulatory requirements (Graph 3.4).^[5] This supports their ability to make payments in a short period of liquidity stress. APRA is currently consulting on changes to strengthen the Minimum Liquidity Holdings (MLH) regime following lessons from the March 2023 turmoil in parts of the global banking system, including smaller regional banks in the United States.^[6] The proposed changes are aimed at ensuring banks subject to the MLH regime (typically smaller banks) can prudently value their liquid asset holdings in times of stress, reduce contagion risk by strengthening the composition of their liquid asset holdings, and have robust operational processes in place for accessing exceptional liquidity support from the RBA.

Banks have been managing the impact of Term Funding Facility (TFF) repayments smoothly. The RBA established the TFF in 2020. The program offered low-cost three-year funding to banks to lower interest rates for borrowers and support business lending. By the end of February 2024, around $90 billion of the $188 billion borrowed under the TFF had been repaid. TFF repayments cause banks’ liquidity ratios to decline. To date, banks have comfortably managed this impact by pre-emptively raising term deposits, issuing wholesale debt and buying high-quality liquid assets; as a result, banks’ liquidity ratios remain high.

In the June quarter of 2024, $93 billion is due to be repaid. This funding task has its risks – bank liquidity ratios could decline by more than anticipated, financial markets could be disrupted if banks rapidly increase their demand for liquid assets to protect their liquidity ratios, or bank funding markets could be impacted by external shocks that make it challenging to replace funding. However, these risks will be mitigated if banks continue to actively manage their liquidity positions.

Large banks continue to comfortably meet their Net Stable Funding Ratio (NSFR) requirements. The NSFR requirement aims to ensure sufficient use of long-term funding, such as stable deposits and long-term debt. This limits banks’ reliance on short-term debt and volatile funding sources that could dry up in stress periods and thereby increase the risk of failure. Strong domestic investor demand has made it easier for banks to raise stable wholesale funding; despite record issuance of bank bonds in 2022 and 2023, the spread of major bank bond yields to the three-year swap rate – a key pricing benchmark for bond issuance – has remained broadly in line with its decade average, indicating that demand for bank bonds has been firm.

3.2 Non-bank Financial Intermediaries (NBFIs) and Financial Market Infrastructures (FMIs)

NBFIs and FMIs play important roles in the Australian financial system.

NBFIs account for around 45 per cent of financial system assets in Australia, a somewhat smaller share than in other advanced economies (Graph 3.5). NBFIs include a broad range of firms that provide important financial services but do not hold a banking licence, including superannuation funds and non-bank lenders such as registered financial corporations.^[7] FMIs, such as payment systems and central counterparties, provide services that are critical to the operational efficiency and stability of Australia’s financial system.

NBFIs play an important role in the Australian financial system but are less tightly regulated than banks because they do not accept deposits. As recent events have demonstrated, in some circumstances disruptions among NBFIs globally can threaten financial stability, with the potential to transmit stress to Australia through financial markets.

Risks to the Australian financial system posed by the NBFI sector are relatively contained but remain an area of focus for regulators. A particular feature of the Australian NBFI sector is the size of prudentially regulated superannuation funds (discussed below). Work has been underway by CFR agencies for some time to assess risks to the Australian financial system from the superannuation sector. CFR agencies also continue to work on addressing data gaps to improve visibility of less-regulated NBFIs’ activities in Australia. The sector’s exposure to commercial real estate and growing use of over-the-counter derivatives have been recent areas of focus.

In many overseas economies, the larger size and different structure of NBFI sectors have left those financial systems vulnerable to disruption. There have been a number of episodes of stress originating from NBFIs in global financial centres in recent years, including from the mismanagement of liquidity risk. Furthermore, these episodes have shown how disorderly market functioning abroad can transmit to financial market conditions in Australia. International initiatives are underway to better identify and manage risks from NBFIs, including those aimed at addressing liquidity risks in open-ended investment funds, strengthening margining practices and increasing the monitoring of leverage in NBFIs.

Financial stability risks from NBFIs in Australia are limited by the operation and structure of superannuation funds.

The superannuation fund sector in Australia poses fewer financial stability risks than large pension funds and other NBFIs in some advanced economies. Superannuation funds are prudentially regulated and account for over half of all NBFI assets in Australia; by contrast, the advanced economy average is around one-fifth. Leverage in the domestic superannuation fund sector is relatively low, in part due to restrictions on funds’ ability to borrow. In addition, defined benefit funds are less prevalent in Australia than in some other countries, including the United Kingdom where leverage in defined benefit pension funds was a key driver of stress in the government bond market in September 2022.^[8] Australian superannuation funds also have higher cash holdings than pension funds in some other advanced economies, making them more resilient to liquidity stress. Compared with other large (non-pension) NBFIs in key financial centres, including open-ended investment funds, they are also less exposed to the risk of asset fire sales that can result from a surge in redemption requests from investors.

Nevertheless, the rapid growth in assets managed by the Australian superannuation sector has seen it become more interconnected with the banking system over the past two decades. Around 8 per cent of banks’ debt funding and over one-quarter of banks’ listed equity is now held by superannuation funds (Graph 3.6). This means that the collective investment decisions of superannuation funds, including their liquidity risk management practices, could materially influence domestic asset prices and bank funding conditions. It is important, therefore, that the approach of superannuation funds to liquidity risk management continues to strengthen in line with APRA’s revised guidance.^[9]

Competition has caused Australian non-bank lenders to seek alternative sources of credit growth …

Housing lending from non-bank lenders declined sharply over 2023 (Graph 3.7). This was largely due to competition from banks, which unlike non-bank lenders benefit from low-cost deposit funding, and so attracted mortgage customers away from non-bank lenders.

The loan composition in the non-bank lender sector has adjusted towards non-prime mortgage and business lending to support their profits. Some new lending by non-bank lenders may be higher risk, such as lending to business sectors that have historically been vulnerable to economic downturns (e.g. property and construction lending) and lending to self-managed superannuation funds that tend to have concentrated portfolios. Auto and equipment lending has increased in recent months and accounts for most of the growth in non-bank business lending. Non-bank lenders that specialise in auto and equipment loans source most of their debt funding from asset-backed security issuances. Liaison suggests that some non-bank lenders have relaxed their mortgage underwriting and serviceability assessment standards, including the serviceability rate used in loan assessments, in part to support lending growth.

A few non-bank lenders also recently started offering new personal lending products in the form of ‘deposit gap’ financing that borrowers can use as a mortgage deposit – resulting in an effective loan-to-valuation ratio of 100 per cent. However, the market for these products is very small and is being monitored by CFR agencies.

… and there are emerging signs of a deterioration in asset quality.

The share of housing loans in arrears increased by more for non-bank lenders than for banks over 2023 (Graph 3.8). This reflects the loss of some high-quality mortgage customers to banks and that interest rate rises were passed on to non-bank mortgages somewhat quicker than bank mortgages, given that non-banks originated fewer fixed-rate mortgages at low rates during the pandemic. Housing loan arrears at non-bank lenders have historically tended to be higher than at banks, reflecting differences in the composition of borrowers. Non-bank lenders’ customers include potentially riskier borrowers who do not have the documentation typically required by banks (e.g. the self-employed) or do not fulfil the usual lending criteria of banks (e.g. borrowers with irregular incomes).

Financial stability risks from the Australian non-bank lending sector are contained.

Risks from non-bank lenders to the Australian financial system are mitigated by the sector’s limited size and modest links to other financial institutions. Compared with other advanced economies, a small share of financial system assets in Australia is held by ‘Other Financial Intermediaries’ (OFIs), a segment of NBFIs that includes non-bank lenders.^[10] OFIs’ direct financial links to banks and the overall financial system are also around historical lows and have declined over the past 15 years.

FMIs’ adoption of new technologies creates benefits and risks.

Technological development can improve the resilience, workflows and security of FMIs, but can also present some risks. The RBA has been closely monitoring technological developments domestically and internationally, including the adoption of cloud services, distributed ledger technology (DLT) and artificial intelligence (AI).^[11]

Increasingly, FMIs are exploring how public cloud technology could support their critical services. Cloud technology can provide potential benefits over traditional technologies, including greater security, resilience and flexibility. However, migrating to and operating in the cloud also poses a range of risks due to the nature of the technology and an increased reliance on third-party suppliers. FMIs will need to identify and carefully manage these risks to ensure their critical services remain resilient and secure to support the stability of the financial markets they serve.

FMIs operating in Australia are also exploring the adoption of DLT technology and AI. FMIs are interested in understanding whether the use of DLT can generate efficiencies to clearing and settlement processes, such as faster settlement, reduced credit risk and margin requirements, and simplified operational processes. However, there are potential challenges, such as greater liquidity requirements because of shorter settlement periods (compared with traditional infrastructures) and potentially less netting of transactions. FMIs overseen by the RBA are investigating the use of AI in areas such as workflow and data management improvements. However, they currently have no plans to use AI in core clearing and settlement processes.

Endnotes

See APRA (2021), ‘APRA Finalises New Bank Capital Framework Designed to Strengthen Financial System Resilience’, Media Release, 29 November; APRA (2021), ‘Finalising Loss-absorbing Capacity Requirements for Domestic Systemically Important Banks’, Media Release, 2 December. [1]

See APRA (2023), ‘APRA Moves to Reinforce Requirements for Banks to Manage Interest Rate Risk’, Media Release, 12 December. [2]

See Lonsdale J (2023), ‘Speech to Citi Australia and New Zealand Investment Conference’, 12 October. [3]

See APRA (2023), ‘Prudential Practice Guide CPG: 110 Internal Capital Adequacy Assessment Process and Supervisory Review’, November. [4]

Large banks are required to keep their Liquidity Coverage Ratio – the ratio of a bank’s high-quality liquid assets to its expected cash outflow over a 30-day stress period – above 100 per cent. Similarly, smaller banks are required to keep their Minimum Liquidity Holdings ratio – the ratio of a bank’s liquid assets to its total liabilities – above 9 per cent. [5]

See APRA (2023), ‘Targeted Changes to ADI Liquidity and Capital Standards’, Letter, 15 November. [6]

Services offered by the NBFI sector include: investment management services offered by superannuation funds, investment funds and insurers; credit intermediation offered by non-bank lenders; financial market trading services offered by market-makers and prime brokers; and payment and financial market services offered by FMIs. [7]

See Choudhary R, S Mathur and P Wallis (2023), ‘Leverage, Liquidity and Non-bank Financial Institutions: Key Lessons from Recent Market Events’, RBA Bulletin, June. [8]

See APRA (2023), ‘Prudential Practice Guide: SPG 530 Investment Governance’, July. [9]

See Robinson M and S Tornielli di Crestvolant (2024), ‘Financial Stability Risks from Non-Bank Financial Intermediation in Australia’, RBA Bulletin, April. [10]

AI is a fast-evolving group of technologies designed to emulate human cognitive functions. It encompasses tools such as machine learning (looking for patterns and improving predictability over time) and generative AI (e.g. ChatGPT). For more detail on operational risks from digital technologies, see RBA, ‘5.5 Focus Topic: Operational Risk in a Digital World’, Financial Stability Review, October. [11]