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The global financial crisis (GFC) occupied only a quarter of the decade of the 2000s but, because of its severity and implications for future financial sector development, dominates the decade. The Australian financial system coped relatively well with the GFC, raising the question of whether there was something special about its structure and prior evolution which explains that experience. This paper reviews Australian financial sector performance and development over the decade, then provides a more detailed overview of the Australian GFC experience and its implications, and considers explanations for the Australian financial sector resilience.

The Australian (and global) financial system entered the first decade of the millennium preparing for a systems crisis, in the form of the Y2K computer scare, which on 1 January 2000 passed without event. But towards the end of the decade, the financial sector was faced with, arguably, its most serious systemic crisis ever, which the Australian financial system and economy weathered relatively well compared with advanced nations in the northern hemisphere.1 While the GFC occupied only one-quarter of the past decade (from mid 2007), it prompts the questions which this review must seek to answer. Was there something about the structure and evolution of the Australian financial system which explained its resilience in the face of the crisis; and was that resilience due to lower risk-taking by the banking sector in the lead up to the crisis? Did the distribution of risk within the financial system facilitate adjustment to the shocks encountered? What role can be attributed to government and regulatory responses following the onset of the crisis?

In order to place the developments of the 2000s in context, this paper is structured as follows. First, overall macroeconomic and flow of funds trends are reviewed. Second, the overall picture of financial sector growth and structure in the 2000s is briefly reviewed in Section 3.2 Then, because of the important role of regulation in financial sector evolution, Section 4 examines the major regulatory developments and influences on the financial sector prior to the GFC. Section 5 examines important developments in the financial sector in more detail. Section 6 outlines how the GFC

1 The World Economic Forum Development Report increased Australia’s financial system ranking from 11th internationally in 2008 to 2nd in 2009, partly in response to Australia’s experience during the financial crisis. See Roubini and Bilodeau (2010).

2 See Ryan and Thompson (2007) and Donovan and Gorajek (2011) for comprehensive reviews.

KEVIN DAVIS

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RESERVE BANK OF AUSTRALIA

affected Australian financial markets and regulatory responses to that. Section 7 discusses the fallout from the GFC in terms of financial regulation and Section 8 draws on the prior discussion to address the questions posed above regarding Australian financial sector resilience. Section 9 focuses upon end of decade issues and Section 10 concludes.

The 1990s, reviewed by Gizycki and Lowe (2000), were marked by serious financial dislocation and substantial banking sector losses at the start of the decade, from which a gradual recovery occurred throughout the decade. In contrast, the 2000s were relatively tranquil until the severe dislocation of the GFC, although the start of the 2000s was marked by two disruptive events. One was the global ‘tech stock’ boom and bust which, apart from adverse stock market consequences and failures of a number of new ‘tech’ stocks, had limited implications for Australia. The other was the collapse of the major insurance company HIH in 2001, which created significant economic disruption and led to government compensation of policyholders. Otherwise, a generally tranquil financial environment (in a period sometimes referred to globally as the ‘great moderation’) persisted for some time into the 2000s, reflected in declining unemployment, good output growth, and low stock market volatility as shown in Figure 1.

01234567 0612 18 24 30 36 42 % pa Real GDP growth (LHS, year-ended) 2010 % Unemployment rate (LHS) ASX 200 volatility (RHS) 2008 2006 2004 2002 2000

THE AUSTRALIAN FINANCIAL SYSTEM IN THE 2000s: DODGING THE BULLET

However, that period sowed the seeds of excessive lending, leverage, underpricing of risk, and inadequate governance and regulation internationally, which contributed to the GFC. Similar trends in market risk premia and risk-taking were evident in Australia, and the monetary authorities exercised a degree of monetary restraint, reflected in the increases in the cash rate after 2002 as shown in Figure 2. As Figure 2 also demonstrates, longer-term rates did not respond to the hikes in the cash rate, while Figure 3 illustrates how risk premia in business and corporate funding rates declined, with the real expected cost of loan funds trending down somewhat from around 4 per cent, despite the increasing short-term cash rate.

234567 234567% 10-year bond rate 2010 % 2008 2006 2004 2002 2000 Cash rate

KEVIN DAVIS

RESERVE BANK OF AUSTRALIA

01234 01234% Business loan spread (LHS) 2010 2008 2006 2004 2002 2000 % pts AA spread (LHS) Real business loan rate (RHS)

That period of relative tranquillity was also accompanied by a boom in asset prices reflected in stock and house prices, and in strong credit growth as shown in Figure 4. While the GFC led to substantive declines in stock prices from the record high in November 2007, house prices continued to climb. There was ongoing commentary3 about a possible housing price bubble, but housing prices relative to wages had increased only modestly after 2003 (following a significant boom prior to that time). Substantial deleveraging by both businesses and households saw a marked decline in the rate of credit growth following the onset of the GFC.

THE AUSTRALIAN FINANCIAL SYSTEM IN THE 2000s: DODGING THE BULLET

75 100 125 150 175 75 100 125 150 175 % Housing price index(a) June 2004 = 100 -100 10 20 -10 010 20 Index Index 2010 2007 2004 2001 1998 Credit growth Twelve-month ended % Wage index(b) ASX 200 index Housing Business Total

KEVIN DAVIS

RESERVE BANK OF AUSTRALIA

Table 1 highlights some apparent differences. The first is relatively lower bank deposits and assets as a ratio to GDP for Australia, which may reflect a number of influences. One would be a higher proportion of household assets in pension funds (superannuation) – over 70 per cent of GDP at the start of the decade – and the resulting growth of the funds management sector (the fourth largest in the world). That could be expected to be reflected in a higher use of capital markets; however, this is not apparent in Table 1. Another could be a larger role for ‘shadow banking’ (non-prudentially regulated financial institutions engaged in fund raising, lending and other financial services), although, as will be shown later, this seems not to be the case.4 Alternatively, historically low household savings rates, coupled with high investment, may have led to this outcome, which is consistent with the heavy reliance of banks, through most of the decade, upon international wholesale market funding. This offshore financing has been an important component of net capital inflow reflecting a persistent current account deficit on the balance of payments, although subdued bank lending and increased deposit growth at the end of the decade saw offshore funding decline somewhat (Debelle 2011).

Second, while the private bond market appeared to be of average size by 2007, this primarily reflected growth in securitisation and the Kangaroo bond market (Australian dollar domestic issues by foreigners) rather than corporate issues. Third, reflecting the strong government fiscal position, the public sector bond market was relatively small by international standards.

Ratio to GDP