Research Discussion Paper – RDP 2020-05 How Risky is Australian Household Debt?

Household indebtedness has increased substantially over several decades and across a range of countries. It is commonly cited as a major risk to numerous countries, including Australia. We consider how much risk this debt poses to Australia by asking three questions: (i) what accounts for the rise in household debt-to-income ratios and its level in Australia relative to other countries?; (ii) what losses might the Australian banking system suffer from these exposures in the event of a severe stress?; and (iii) how does household debt affect the sensitivity of consumption in Australia to severe economic shocks? Our results suggest that risks arising from Australian household indebtedness are more subtle than sometimes conveyed. In particular: fundamental factors (higher real incomes, a fall in nominal interest rates, financial liberalisation and household ownership of the rental stock) mostly account for the current level of household debt; banks appear resilient to a severe downturn thanks to moderate loan-to-valuation ratios on residential mortgages; and the distribution of debt does not appear to heighten wealth effects on consumption. However, there are risks. Our model cannot account for the increase in debt over the past four or five years. In addition, we demonstrate that a large but plausible fall in asset prices could lead to a substantial fall in consumption and that the increase in indebtedness over the past decade has slightly increased the potential loss of consumption during periods of financial stress.