Overview 1

Box A: Effects of Low Yields on Life Insurers and Pension Funds 16

Box B: The Recent Growth in Banks’ Commercial

Property Exposures 30

Box C: The Regulatory Capital Framework for

Residential Mortgages 52

Copyright and Disclaimer Notices 65

It is available on the Reserve Bank’s website (www.rba.gov.au).

The graphs in this publication were generated using Mathematica.

Information Department

Telephone: +61 2 9551 9830

Facsimile: +61 2 9551 8033

Email: rbainfo@rba.gov.au

ISSN 1449-3896 (Print)

ISSN 1449-5260 (Online)

Risks in the global financial system have shifted in

the past six months. Advanced country banking

systems have recorded improving asset quality

and capital positions. The recent rise in premia in

some financial markets suggests that investors

are becoming more discerning about risk, but

search for yield behaviour is still evident in a range

of asset markets where prices remain elevated.

Although concerns about Greece came to a head

in the middle of the year during the protracted

negotiations with its creditors, there was little

spillover to other countries’ financial systems partly

because European bank exposures to Greece have

been wound back.

Attention has instead shifted to China and other

emerging market economies. The growth outlook

for a number of these economies has deteriorated

against a backdrop of higher debt; in addition,

lower commodity prices, fiscal pressure and political

instability are compounding the situation in some

cases.

These concerns have precipitated a pick-up

in financial market volatility in emerging and

advanced economies. There have been sizeable

fluctuations in some equity and currency markets,

with the large run-up in Chinese equity prices that

began in 2014 now substantially reversed. The price

movements in some financial markets, including

in advanced economies, have, on occasion, been

amplified by short periods of trading disruption,

underlining concerns that some investors might

be under-pricing liquidity risk. With the US Federal

Reserve’s first tightening since 2006 in prospect, the

risk is that this combination of factors could trigger

a sharp repricing in markets. However, while adding

volatility to some markets in Australia, to date these

global factors have not had a material impact on

Australia’s financial system.

The domestic risks to financial stability in Australia

continue to revolve mainly around developments in

some local property markets. The risks surrounding

housing and mortgage markets seem higher than

average at present. Housing markets have been

buoyant in Sydney and Melbourne over much of the

year, with very strong price growth and a historically

large role being played by investors. The recent

enhanced scrutiny of lending practices following

reviews by the Australian Prudential Regulation

Authority (APRA) and the Australian Securities

and Investments Commission (ASIC), along with

substantial data revisions by banks, has shown that

the level of investor activity was in fact higher over

recent years than had originally been thought.

For several years, overall mortgage lending

standards have been tighter than they were in

the lead-up to the global financial crisis: ‘low-doc’

loans are rare; genuine savings are expected

to fund at least part of the deposit; and it is now

common practice to apply a buffer to the interest

rate when calculating allowable loan sizes. However,

lending standards appear to have been somewhat

weaker around the turn of this year than had been

apparent at the time, or would be desirable in the

Risks have been growing in commercial lending

related to property, which historically has been

a common source of financial instability both

domestically and abroad. Building approvals for

new apartments have remained very strong over

2015, even though rental markets already look

soft in some areas and the projected growth of

net international student arrivals has been revised

down. The divergence between commercial

property valuations and rents has widened further,

with strong local and foreign investor interest for

new and existing office buildings in particular, even

though vacancy rates are quite high. At the same

time, falling commodity prices are weighing on the

profitability of many resource-related companies,

though the rest of the business sector looks to be in

fairly good shape. In this context, the deterioration

in New Zealand’s dairy sector in response to low

global milk prices will be an area to watch, given the

size of the Australian bank subsidiaries’ exposures to

that sector.

These risks appear to be comfortably manageable

at this stage, but they underscore the need

to maintain sound lending standards and the

resilience of the financial and non-financial sectors.

As noted, most banks have now strengthened

the serviceability metrics used in their mortgage

lending and taken steps to slow the pace of growth

in investor lending towards APRA’s expectations.

Banks also report that they are becoming

increasingly wary of lending to property developers

in markets that look oversupplied. The large banks

have enhanced their resilience recently by raising

substantial amounts of fresh capital in advance of

new prudential requirements. Many households

have likewise been bolstering their resilience in a

number of ways, including paying down their debt

faster than contractually required and increasing

their offset account balances.

Nonetheless, competition among lenders remains strong in the owner-occupier part of the mortgage market and in parts of the business lending market.

Looking ahead, a key challenge will be to ensure

that, in an environment of low interest rates, lending

standards at both Australian and foreign-owned

banks do not weaken materially from here. Over the

medium term, it will also be important to monitor

how banks respond to the wide range of ongoing

international and domestic regulatory changes.

The responses of banks to the housing-related

prudential measures announced last December

have evolved over the course of the year, and

the effects of some of the most recent actions

undertaken by the banks, such as increasing pricing

on some types of housing loans, will not yet be

fully apparent in published data. Nonetheless,

some indicators of housing demand, including the

growth of investor credit, have moderated of late;

in particular, there are a few tentative signs that

sentiment may be turning in the housing markets

of the two largest cities. Assuming that these early

signs of a better risk profile in the housing market

are borne out in future data, this would imply that

the household and banking sectors are becoming

better placed to manage the risk environment than

The focus of global financial stability risks has been

shifting to emerging market economies and their

potential to contribute to destabilising adjustments

in financial markets. Volatility has picked up in

global financial markets, following a lengthy period

of very low volatility and compressed risk premia

(Graph 1.1). Concerns about the prospects for

economic growth in China, against the backdrop of

a significant run-up in debt in recent years, helped

trigger the downward revaluation of global equity

prices and higher financial market volatility. These

concerns weighed on investors’ expectations for

growth in a number of emerging market economies,

particularly commodity exporters given lower

commodity prices. Higher debt, fiscal pressure and

political instability have been compounding factors

for some emerging markets. With the first US Federal

Reserve policy interest rate increase since 2006

in prospect in the period ahead, the risk remains

that this combination of factors could trigger a

sharp repricing in markets where for several years

investors have been searching for yield. Recent price

movements in some financial markets, including

in advanced economies, have, on occasion, been

amplified by short periods of market dislocation,

underlining concerns that liquidity risk might be

underpriced by some investors.

The global banking sector has continued to improve

its resilience, which should help mitigate the risks to

broader financial system stability arising from these

developments. In the major advanced economies,

bank profitability has been supported by further

improvements in asset quality, particularly in the

United States. In the euro area, near-term concerns

about Greece have abated following the rescue

package agreement reached in August. Gradual

improvements in economic conditions in most

euro area economies have supported bank profits,

although there continues to be slow progress in

reducing the large stock of non-performing loans.

Key banking indicators in emerging markets have

generally remained sound to date, including in more

vulnerable markets; however, some banking systems

face very challenging operating environments,

which could entail a future weakening of asset

performance.

Median rolling 50-day standard deviations of daily percentage changes

Exchange rates, bilateral to USD*

0.5

1.0

1.5

ppt

0.5

1.0

1.5

ppt

Advanced**

Emerging***

Equity prices

2007 2009 2011 2013 2015

0.0

1.5

3.0

4.5

ppt

0.0

1.5

3.0

4.5

ppt

* Exchange rate data for China from August 2010

** Australia, Canada, euro area, Japan, New Zealand, Switzerland,

United Kingdom and United States

*** Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hong Kong,

Hungary, India, Indonesia, Malaysia, Mexico, Philippines, Poland,

Russia, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand and

Turkey

Sources: Bloomberg; RBA

banking sector could be another channel for risks to

emerge and amplify a macroeconomic downturn.

Policy challenges from the heavily controlled

financial system in China have become more

evident, highlighting the difficulty the authorities

face in promoting financial liberalisation while

supporting financial stability and economic

growth. Recent developments in the Chinese stock

market associated with leveraged investors, and

the measures adopted to address them, provide

an example of such challenges. Chinese equity

prices have fallen by around 35 per cent from their

June 2015 peak, after rising by 150 per cent over

the previous year (Graph 1.3).1 Initial price falls

were contained by a range of policy actions by the

Chinese authorities, which included direct purchases

of shares. Price falls continued as policymakers

reportedly stepped back from these efforts, though

prices have been more stable in recent weeks.

The policy challenges facing the Chinese authorities

were further underscored by the volatility in

international financial markets that followed the

People’s Bank of China’s announcement of reforms

to make the renminbi (RMB) exchange rate more

market determined. While this policy is likely to be

1 See RBA (2015), ‘Box A: The Recent Decline in Chinese Equity Prices’,

China has been an engine of growth for Australia

and the world in the post-crisis period, yet financial

stability risks have been building. Credit grew rapidly

alongside strong asset price growth and there was

apparent over-investment in some sectors of the

Chinese economy such as real estate and heavy

industry (Graph 1.2). Debt provision spilled beyond

the heavily regulated banking system to the more

opaque shadow banking sector. If economic growth

continues to slow from the very strong pace in

recent years, any past excesses may be exposed.

2005 2007 2009 2011 2013 2015

0

50

100

150

%

0

50

100

150

%

Selected economies, per cent to GDP at market exchange rates

China

Emerging Latin America****

(excl China and Japan)

Asia**

Selected other emerging markets***

* Loans and other debt funding provided by domestic and non-resident

sources

** Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore,

South Korea, Taiwan and Thailand

*** Czech Republic, Hungary, Poland, Russia, Saudi Arabia, South Africa

and Turkey

**** Argentina, Brazil and Mexico

Sources: BIS; CEIC Data; RBA; Thomson Reuters

2003 2007 2011 2015

0

50

100

150

200

250

index

0

50

100

150

200

250

index

Shanghai A shares, 2 January 2014 = 100

Source: Bloomberg

Risks in China are particularly prominent for highly

leveraged firms, including some firms in the oil

and gas industries that are exposed to a decline

in energy prices and construction firms that have

raised significant foreign currency denominated

bond funding in recent years. Similarly, many local

governments have large debts, and land sales

account for a sizeable share of their revenues. Links

between the formal banking sector and the shadow

beneficial for macroeconomic stability, the reform’s

announcement prompted widespread concern

about the potential for further depreciation of

the RMB and added to near-term pessimism over

Chinese economic conditions and private capital

outflows.

have continued to implement a range of measures

to ameliorate financial risks and reduce some market

restrictions. For example, a debt swap program has

allowed local governments to use lower-yield bonds

to refinance existing borrowings raised off-balance

sheet via financing vehicles. A range of measures

have also been implemented to address other

distortions that have encouraged growth of the

shadow banking sector. Official data suggest that

these measures – which include restricting banks’

interbank investments, further liberalising interest

rates and insuring bank deposits – have helped

slow growth in off-balance sheet lending in China

(Graph 1.4).

account controls limit the potential for pressure to

arise from foreign creditors, and foreign exchange

reserves are large, despite falls in recent months. The

measured central government fiscal position is also

very strong, though the overall public sector fiscal

position is considerably less so given the build-up

in debt among local governments and state-owned

enterprises.

The main financial risks to the rest of the world from

an economic downturn in China are likely to be

indirect, through the implications for world trade

volumes, commodity markets and the associated

effect on sentiment in financial markets. Direct

financial links are much less significant because

China’s capital account is still relatively closed. That

said, there are growing direct financial linkages

with the rest of the world that could reverberate in

particular jurisdictions in the event of difficulties in

China: these include large exposures to China by

banks located in Hong Kong and Chinese banks’

lending overseas, particularly if overseas lending by

other Asian banks were to slow as well.

Banking system in China

The profitability of Chinese banks continued

to decline in the first half of 2015, though the

banks reportedly remain highly profitable overall

(Graph 1.5). State-owned and joint stock commercial

banks, which account for 60 per cent of banking

system assets, continued to be more profitable

than many smaller Chinese commercial banks. The

moderate decline in aggregate profitability reflected

lower growth in both net interest income and

Though Chinese banks continue to report low

non-performing loan (NPL) ratios, these ratios

and associated loan-loss expenses have risen as

2005 2007 2009 2011 2013 2015

0

25

50

75

%

0

25

50

75

%

Year-ended growth in stock

Bank loans

Non-intermediated

finance**

Off-balance sheet lending*

* Entrusted loans, trust loans and bank accepted bills

** Corporate bond and non-financial corporate equity issuance

Sources: CEIC Data; PBC; RBA

Despite ongoing policy challenges, the Chinese

authorities have supported growth and financial

stability to date, and in many ways remain well placed

to continue to do so. They have many levers given

the ongoing large role of the state in the economy

and the heavily regulated financial system. Capital

economic growth has slowed. Loans to the

manufacturing and the wholesale & retail trade

sectors have primarily driven these increases; loans

to these sectors appear to be less well collateralised

than other categories of lending.

Several factors have raised concerns that Chinese

banks’ asset quality could deteriorate more

markedly: existing corporate leverage is high and

there are signs that economic activity has slowed

further recently. In addition, the share of loans

classified as ‘special mention’ – where there are some

doubts surrounding repayment but loss is not yet

expected – has picked up. A sizeable share of bank

lending is to the construction industry. Relevant to

collateral values in this segment, national property

prices in the residential property market have risen

in recent months, primarily in the largest cities, which

has partly unwound earlier declines. The pace of

annual growth in land prices slowed through 2014,

but has shown signs of improvement over 2015.

Large Chinese banks’ capital ratios increased

marginally during the six months to June 2015,

supported by preference share offerings by two

of the large banks. Large Chinese banks’ Common

Equity Tier 1 (CET1) capital ratios also increased over

the half year and currently range between 9.2 and

12.2 per cent of risk-weighted assets, compared to

the end-2015 transitional CET1 regulatory minimum

of 7.3 per cent and global systemically important

bank (G-SIB) surcharge of 1 per cent (where

applicable). The aggregate CET1 capital ratio for the

broader banking system was stable at 10.5 per cent

over the half year. As of June 2015, each of the five

largest Chinese banks was reported to be compliant

with the Liquidity Coverage Ratio on a fully phased-in

basis.

For emerging markets more broadly, capital inflows

have been strong in the years following the global

financial crisis, supported by low interest rates in the

advanced economies, relatively strong economic

growth and high commodity prices (Graph 1.6).2

However, portfolio capital inflows have slowed

significantly and appear to have reversed for

some economies more recently. This has occurred

alongside interrelated concerns about economic

growth prospects in China, weaker domestic growth

outlooks, commodity price falls and expectations

2 There are various definitions of emerging markets. The definition

used in Graph 1.6 and elsewhere is based on the fairly broad group

of economies in the MSCI Emerging Markets Index (which includes

countries such as Korea that are excluded from narrower definitions,

such as that used by the International Monetary Fund). Hong Kong is

also added to this group given its close financial linkages with China.

Selected performance indicators

Return on equity

2007 2011 2015

0

5

10

15

20

25

%

Joint stock

City

Non-performing loan ratio*

2011 2015

0

2

4

6

8

10

%

Rural

State owned**

* Share of loans

** Decline in non-performing loan ratio in 2008 due to removal of

policy-related loans from Agricultural Bank of China

Sources: CEIC Data; RBA; SNL Financial

2005 2007 2009 2011 2013 2015

-200

-100

0

100

US$b

-200

-100

0

100

US$b

* Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hong Kong,

Hungary, India, Indonesia, Malaysia, Mexico, Philippines, Poland,

Russia, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand

and Turkey

Sources: CEIC Data; IMF; National Sources; RBA; Thomson Reuters

that the US Federal Reserve would soon increase its

policy interest rate for the first time since 2006.

These developments have been reflected in

sharp depreciations of several emerging market

currencies, especially for economies that are reliant

on commodity exports and/or where there is

political instability, such as Brazil, Russia and Turkey

(Graph 1.7). Equity prices have generally fallen in

these economies, and for some corporate bond

spreads have widened significantly.

risks – which have been associated with past

financial crises – may be low in aggregate. While

bond issuance by emerging market corporations has

increased – especially in Asia – the ratio of foreign

currency bond issuance to nominal GDP has been

broadly stable (Graph 1.8). In addition, an increasing

share of debt funding has been raised via long-term

bond issuance, which may have lengthened

aggregate maturity profiles and reduced rollover risk.

Against the US dollar, 2007 average = 100

2007 2011 2015

20

40

60

80

100

120

index

India

Indonesia

South Korea

Thailand

Malaysia

2011 2015

20

40

60

80

100

120

index

Brazil

Russia

South Africa

Turkey

Source: Bloomberg

Quarterly issuance, per cent to quarterly GDP*

Asia**

(excl China and Japan)

2

4

6

% China

3

6

9

%

Local currency

Latin America***

2007 2011

0

2

4

6

%

Foreign currency

Other****

2007 2011 2015

0

2

4

6

%

* Includes financials and non-financials; September 2015 GDP based

on IMF forecasts

** Hong Kong, Indonesia, India, Malaysia, Philippines, South Korea,

Taiwan and Thailand

*** Argentina, Brazil, Chile, Colombia and Mexico

**** Czech Republic, Hungary, Poland, Russia, Saudi Arabia, South Africa

and Turkey

Sources: Dealogic; RBA

The shift in capital flows and lower economic

growth expectations have raised concerns about

vulnerabilities associated with emerging market

corporate sector leverage, which has increased

significantly in some economies since the financial

crisis. While most emerging market corporate

debt has continued to be intermediated by banks,

corporations have increasingly sourced funding

directly from markets, partly because financing

conditions in global markets have been so favourable

in recent years. This pattern reversed in the

September quarter, when corporate bond issuance

dropped sharply across most emerging markets.

Some of the increase in emerging market

corporate borrowing in recent years reflects

financial deepening in these economies and

available evidence suggests currency and rollover

Nevertheless, corporations in some sectors

– such as construction and energy – and in some

countries – such as Brazil, India, Indonesia and

Turkey – have increased their foreign currency

borrowings in recent years. Depending on

whether and how they hedged, the profits of

some corporations might come under pressure

because of domestic currency depreciations and

slower economic growth. More generally, increased

exposures of advanced economy investors to

emerging market corporations and sovereigns

in recent years may be a channel through which

financial stresses in emerging markets spill over to

advanced economies.

In the low-yield environment, residential property

prices have appreciated considerably over recent

years in a number of economies, including Brazil,

Malaysia and Taiwan. More recently, however,

price growth has moderated in these economies

(Graph 1.9). Housing prices in Hong Kong have

risen especially quickly, partly as a result of the

accommodative monetary policy setting associated

with its fixed exchange rate system. In response to a

further increase in prices – particularly for residential

apartments – and a historically high household

debt-to-GDP ratio, the Hong Kong Monetary

Authority tightened macroprudential policies

in February. While growth in loan approvals has

decelerated somewhat since these measures were

implemented, housing price growth remains rapid.

vulnerable emerging markets, such as Brazil and

Turkey. Russian banks continue to be pressured by

a combination of rouble depreciation, contracting

economic activity, economic sanctions and rising

NPLs.

Key banking indicators in east Asian economies

generally remained sound in the first half of

2015. Most large banks in the region remained

highly profitable, despite some moderation in

the profitability of banks in Indonesia, Malaysia

and Thailand associated with increased loan-loss

expenses and slower growth in net interest income

(Graph 1.10). Korean banking system profitability

continued to recover in the six months to June

2015 following significant losses for some banks in

2013, but remains pressured by lower non-interest

income and higher provisioning expenses than

east Asian peers. All banking systems in Asia

continue to report low aggregate NPL ratios, and

aggregate capital ratios are well above regulatory

minimums (Graph 1.11).

2010 average = 100

2007 2011 2015

25

50

75

100

125

150

index

Hong Kong

Taiwan

2007 2011 2015

25

50

75

100

125

150

index

Brazil

Russia

Turkey

South Africa

* Deflated using consumer price indices

** Average of new residential property prices

Sources: BIS; CEIC Data; RBA

After tax and minority interests

0

10

20

%

Singapore

Taiwan

South Korea

Hong Kong

0

10

20

%

Russia

Turkey

2011 2015

0

10

20

30

%

Malaysia

India

Indonesia

Thailand

2011 2015

0

10

20

30

%

* Number of banks: Brazil (11), Hong Kong (19), India (39), Indonesia (37),

Malaysia (34), Russia (22), Singapore (3), South Africa (7), South Korea (16),

Taiwan (29), Thailand (22) and Turkey (25); adjusted for significant mergers

and acquisitions

Sources: Bloomberg; RBA; SNL Financial

Banking systems in other emerging and

non-Japan Asia markets

Weaker economic growth and the build-up in debt

imply that banking systems in emerging markets

face a more challenging near-term operating

environment, but key banking indicators remained

sound in the first half of 2015 even across the more

about growth in China and other emerging market

economies has led to a broad reassessment of risk

in financial markets, causing a moderate tightening

in financial conditions in the advanced economies.

In advanced economy equity markets, where

valuations had been relatively high by historical

standards, prices are around 10–15 per cent lower

than their recent peaks. Similarly, corporate bond

spreads have widened to be around historical

averages, with spreads widening further for

lower-rated bonds.

Monetary conditions in the major advanced

economies are expected to be very accommodative

for some time, even though economic conditions

in these economies have generally improved and

the US Federal Reserve is expected to start raising

its policy interest rate in the period ahead. For

example, sovereign bond yields remain around

historically low levels, though they have increased

investors appear to have become more discerning

about risk, search for yield behaviour continues to

be supported by accommodative monetary policy

and is evident in a range of asset markets where

prices remain elevated.

Low interest rates support economic growth and

economic risk taking but, if persistent, can encourage

investors to increase financial risks in an attempt to

maintain expected nominal returns. For example,

term premia in US Treasury securities are estimated

to have fallen to be around zero, indicating that

investors are receiving minimal compensation for

bearing the risk that interest rates do not evolve

as expected – which is larger for a given maturity

when yields are low (Graph 1.12). Low yields can

be particularly challenging for insurance firms and

defined benefit pension plans, which typically rely

on financial asset returns to meet their long-term

liabilities (see ‘Box A: Effects of Low Yields on Life

Insurers and Pension Funds’).

Share of loans

20

40

%

India

Thailand

Malaysia

Indonesia

20

40

%

Turkey

South Africa

Russia

2003 2009 2015

0

5

10

%

Taiwan

Singapore

Hong Kong

South Korea

2003 2009 2015

0

5

10

%

Mexico

Brazil

* Definitions of non-performing loans differ across jurisdictions

Sources: CEIC Data; National Banking Regulators; RBA; SNL Financial;

World Bank

1965 1975 1985 1995 2005 2015

-200

0

200

400

bps

-200

0

200

400

bps

Monthly

10-year

3-year

Source: Federal Reserve Bank of New York

The low-yield environment has been reflected in

buoyant activity in a range of markets. Commercial

real estate prices have increased in a number

of countries in recent years to be near or above

pre-crisis peaks, and credit standards appear to

have eased for commercial property lending in the

United States. Residential real estate prices have

also increased in many advanced economies over

recent years, such as Germany, Sweden and the

United Kingdom. Corporate bond issuance in major

advanced economies has also remained solid in

sub-investment grade issuers. A significant share

of proceeds appears to have been used to fund

mergers and acquisitions and share buybacks, rather

than new investments.

The strong pace of bond issuance reflects the

growing importance of financial intermediation

through markets and asset managers, rather than

banks, in the post-crisis period as banks’ business

models and the regulatory environment in which

they operate have changed (Graph 1.13). This has

focused attention on the potential for a sell-off in

bond markets to have disruptive effects on the

broader economy, possibly exacerbated by rapid

redemptions by bond fund investors and a structural

decline in bond market liquidity in recent years.

Per cent to nominal GDP

United States

2003–08 2009–14

-4

0

4

8

% Euro area**

2003–08 2009–14

United Kingdom

2003–08 2009–14

-4

0

4

8

%

Total

Net equity issuance

Net bond issuance***

Change in business credit

* Definitions differ across jurisdictions

** Includes unincorporated non-financial enterprises

*** Includes commercial paper in the United States and United Kingdom;

includes all debt securities in the euro area

Sources: BOE; ECB; RBA; US Federal Reserve

June 2010** December 2012 June 2015

United

States

Euro area Other

Europe

United

Kingdom

Japan

0

10

20

30

40

%

0

10

20

30

40

%

Per cent of total assets

* Includes banks classified by the Financial Stability Board as G-SIBs

as of November 2014; excludes ING and Standard Chartered

** December 2010 for the euro area and June 2011 for Japan

Sources: RBA; SNL Financial

The structural decline in bond market liquidity is

mostly attributable to reduced market-making

activities by banks, and is reflected in a range

of indicators including the declining share of

trading assets on the balance sheets of the G-SIBs

(Graph 1.14).3 The decline in market making by banks

reflects regulations that were designed to shift some

risks from banks to end investors, as well as changes

March, pp 63–73.

in financial institutions’ own risk preferences. Both of

these factors are expected to add to overall financial

system resilience.

While equity market volatility picked up in recent

months, bond markets were relatively stable, even

as outflows accelerated from some bond funds.

However, concerns persist about broader market

resilience to large shocks. Challenges in equity

markets on 24 August, and prior episodes of

bond market turbulence, such as the ‘flash rally’ in

US Treasuries on 15 October 2014, have shown that

the implications of developments such as growth in

exchange-traded funds and algorithmic trading may

not be fully understood.

In the euro area, immediate concerns associated

with Greece were allayed when agreement over

a third bail-out package was reached. In contrast

to the situation in 2011, market reactions to

uncertainty prior to the agreement were muted. For

example, Greek sovereign bond spreads rose but

widening in other peripheral European sovereign

bond spreads was limited relative to what was

observed during previous episodes (Graph 1.15).

This reflected a number of factors that have reduced

channels for contagion including significantly lower

private‑sector exposures to Greece, increased

and risk in financial markets reassessed more broadly.

More generally, the euro area remains susceptible

to financial stress because the gradual economic

recovery and low inflation continue to weigh on

bank profits and the debt-servicing capacity of

highly indebted sovereigns.

Bank profitability

Profitability of the major banking systems increased

somewhat in the six months to June, primarily in

the United States and the euro area where profits

were supported by improving asset quality and

stronger credit growth; profitability was generally

stable in other banking systems. Returns on equity

remain below pre-crisis levels in most countries,

however, because equity funding has increased

and returns on assets are lower (Graph 1.16).

Returns on assets have been weighed down by

factors including compressed net interest margins

associated with low interest rates and flat yield

curves, litigation expenses and, mainly for some euro

area banks, stubbornly high levels of NPLs. These

factors continue to dampen the outlook for bank

profitability, which is reflected in low share price

to book value ratios (Graph 1.17). Bank share prices

have fallen in the major advanced economies since

than, broader equity price falls.

2009 2010 2011 2012 2013 2014 2015

0

1 000

2 000

3 000

bps

0

1 000

2 000

3 000

bps

To German Bunds

Portugal

Spain

Italy

Ireland

Greece*

* Break on 12 March 2012 due to the first private sector debt swap

Sources: Bloomberg; RBA

2003 2006 2009 2012 2015

-20

-10

0

10

20

%

-20

-10

0

10

20

%

After tax and minority interests

Canada

Australia

UK

Euro area

US

Japan

* Number of banks: Australia (4), Canada (6), euro area (41), Japan (4),

United Kingdom (4) and United States (18); adjusted for significant mergers

and acquisitions; reporting periods vary across jurisdictions

Sources: Banks’ Annual and Interim Reports; Bloomberg; RBA; SNL Financial

support from the European Central Bank (ECB), and

further advances in the European framework for

financial regulation.

Nevertheless, longer-term challenges to the Greek

Government and banking system remain, and

deposit withdrawals and international transfers

continue to be restricted. It is unclear if Greece can

implement all of the extensive commitments in the

agreement or what their economic impacts might

be; a slow recovery would exacerbate vulnerabilities

in the banking system and reduce the Greek

Government’s ability to reduce its debt to a more

sustainable level. Greek banks remain burdened

by a large volume of NPLs, are undercapitalised

and continue to be reliant on Emergency Liquidity

Assistance funding from the ECB. Up to €25 billion of

the €86 billion rescue package has been earmarked

for Greek bank resolution and recapitalisation, which

will include the bail-in of senior bondholders. The

recapitalisation of Greek banks is likely to occur

before year-end, after the conclusion of asset quality

reviews and stress tests in October, but before

the Single Resolution Mechanism becomes fully

operational on 1 January 2016.

Although broader euro area financial market

contagion from recent developments in Greece

was limited, if difficulties were to again arise,

confidence in the euro area could be undermined

to Asia, most notably to China and Hong Kong.

Japanese banks also have large exposures to this

region and have been actively expanding their

overseas activities recently. Exposures to emerging

markets outside of Asia are generally smaller.

the advanced economies do not appear to have

large direct exposures to the energy sector and

commodity producers, so their profitability seems

unlikely to be adversely affected by the falls in

commodity prices. Nonetheless, lower commodity

prices could indirectly reduce bank profitability

in commodity-exporting economies if economic

growth were to slow in these countries. Some

banks in the United States and Canada are reported

to have undertaken actions to mitigate the risk

of losses associated with loans to oil and natural

gas producers, including reducing credit lines,

tightening credit standards and restructuring

existing loans.

Capital

The majority of large banks in the advanced

economies increased their CET1 ratios over the

first half of 2015 (Graph 1.19). This was mainly

achieved through an increase in retained earnings,

2005 2007 2009 2011 2013 2015

0

1

2

3

ratio

0

1

2

3

ratio

Monthly*

US

Euro area

UK

Canada

Australia

Japan

* End of month; October 2015 observation is based on latest available data

Sources: Bloomberg; RBA

2005 2007 2009 2011 2013 2015

0

2

4

6

8

%

0

2

4

6

8

%

Share of loans

Other Europe

US

Australia

UK

Canada

Euro area

Japan

* Definitions of ‘non-performing loans’ differ across jurisdictions; number

of banks: Australia (4), Canada (6), euro area (41), Japan (5), other

Europe (10), United Kingdom (4) and United States (18)

Sources: APRA; Banks’ Annual and Interim Reports; Bloomberg; FSA;

NPLs continue to vary widely across jurisdictions and

are a factor explaining some of the variation in bank

profitability and valuations. For most jurisdictions

outside the euro area, loan-loss provisions amongst

large banks have returned to be around pre-crisis

levels. The decline in provisions has been associated

with improving asset performance, with NPL ratios

continuing to decline over the first half of 2015.

However, these ratios remain above pre-crisis levels

in most jurisdictions (Graph 1.18).

In the United States, further declines in NPL ratios for

residential real estate loans continued to underpin

asset quality improvements, which have been

supported by better economic conditions and a

small pick-up in credit growth. NPL ratios continued

to fall in the euro area – most notably in Ireland and

Spain – but remain high in most euro area countries

compared with both pre-crisis levels and relative to

other banking systems. The aggregate NPL ratio in

the United Kingdom has declined to be at its lowest

level since 2008, though the pace of improvement

has slowed more recently.

Some international banks have significant exposures

to emerging markets (Table 1.1). As a proportion of

global consolidated assets, banks headquartered

in the United Kingdom have the largest exposures

though a modest increase in CET1 issuance and a

fall in risk-weighted assets in the United Kingdom

also contributed. All of the G-SIBs that report fully

phased-in Basel III CET1 ratios continued to exceed

the minimum Basel III targets including the capital

conservation buffer and G-SIB surcharge, even

though full phase-in does not occur until 2019.

Issuance of Additional Tier 1 (AT1) and Tier 2 capital

declined somewhat over the first half of 2015,

although this followed very strong issuance in the

second half of 2014; under Basel III, banks have been

required to report non-risk weighted leverage ratios

since 1 January 2015, which can be met with CET1

or AT1 capital. Most G-SIBs in the major advanced

economies report leverage ratios that are either

close to meeting, or exceed, the fully phased-in

Basel III and supplementary requirements.

Claims by BIS reporting banks, ultimate risk basis, March 2015

Share of global consolidated assets (per cent)

Euro area(b) Japan

United

Kingdom(b) United States

Emerging Asia and Pacific 1.1 3.5 4.8 2.3

China 0.4 0.8 1.8 0.6

India 0.2 0.3 0.7 0.5

Indonesia 0.0 0.3 0.2 0.1

Malaysia 0.0 0.2 0.5 0.1

South Korea 0.2 0.6 0.7 0.6

Thailand 0.0 0.8 0.1 0.1

Asian Offshore Financial Centres 0.5 1.3 4.3 0.8

Hong Kong 0.2 0.7 3.3 0.4

Singapore 0.3 0.5 0.9 0.4

Emerging Europe 2.9 0.3 0.5 0.5

Russia 0.3 0.1 0.1 0.1

Turkey 0.5 0.1 0.3 0.1

Latin America and Caribbean 1.8 0.8 1.2 1.5

Brazil 0.7 0.4 0.6 0.5

Mexico 0.6 0.2 0.4 0.7

Africa and Middle East 0.6 0.4 1.9 0.5

(a) Regional totals for emerging markets are equivalent to the BIS totals for ‘developing’ economies; selected individual economy

exposures do not sum to regional totals

(b) Global consolidated assets are as at 30 June 2014

Sources: BIS; BoJ; ECB; FDIC

December 2013 June 2014 December 2014 June 2015

United

States

Euro area Other

Europe

United

Kingdom

Japan**

0

5

10

%

0

5

10

%

Fully phased-in Basel III, asset-weighted average

* Includes banks classified by the Financial Stability Board as G-SIBs as

of November 2014; excludes Standard Chartered

** Japanese banks’ CET1 ratios are based on transitional Basel III

requirements

Sources: Banks’ Annual and Interim Reports; Bloomberg; RBA; SNL Financial

Funding and liquidity

Bank funding conditions generally remained favourable in the first half of 2015, despite a modest widening in bond spreads and increased deposit competition in the euro area (Graph 1.20). The volume of bank bond issuance has slowed somewhat, with maturities continuing to exceed issuance in the euro area; in the major banking systems, balance sheets continue to be increasingly funded with deposits and, to a lesser extent, equity.

Though growth in domestic bank lending has

recently picked up in Japan, overseas lending

continues to be the key driver of the expansion of

the large Japanese banks’ loan portfolios. The Bank

of Japan has continued to highlight foreign currency

liquidity risk arising from Japanese banks’ overseas

operations – a significant proportion of foreign

currency lending is funded via short-term money

markets – as well as increased interest rate risk mainly

associated with Japanese banks’ accumulation of

euro-denominated bonds with long maturities.

US spreads

350

700

bps

AA

A

Euro area spreads

350

700

bps

US issuance

2007 2011 2015

0

75

150

US$b Euro area issuance

2011 2015

0

150

300

US$b

* Spread to equivalent government bonds

US**

2005 2010

-35

0

35

70

%

Housing

Euro area

2005 2010 2015

-35

0

35

70

%

Tighter standards

Business

* Net percentage of respondents reporting tighter standards

** US housing is total housing before 2007, a simple average of prime and

non-traditional mortgage loans from June 2007 to December 2014, and

an average of government-sponsored enterprise eligible, qualified and

non-qualified mortgage loans from January 2015; business series

represents large and medium respondents only

Sources: ECB; RBA; Thomson Reuters

The phase-in of the Liquidity Coverage Ratio (LCR)

commenced in most of the major banking systems

during 2015. The LCR requires banks to hold a

sufficient amount of high-quality liquid assets to

cover expected net cash outflows over a 30-day

stress period. Banks have generally been active

in positioning their balance sheets to meet the

new liquidity requirements ahead of regulatory

deadlines; most G-SIBs in the major advanced

economies already report LCRs that exceed the

fully phased-in Basel III requirements. As discussed

in part, by reducing deposits of large institutional

customers, which are treated less favourably under

the new liquidity requirements.

In the United Kingdom, buy-to-let (investor)

mortgage lending has continued to grow more

rapidly than lending to owner-occupiers. With little

available evidence that underwriting standards of

major UK lenders have fallen, the Bank of England’s

Financial Policy Committee (FPC) has judged that

there is no immediate case for additional prudential

measures specifically for the buy-to-let mortgage

market. However, the FPC has said that it remains

alert to the potential risks that the sector could

pose to broader UK financial stability, both through

credit risk to banks and the potential amplification

of movements in housing prices, especially given

already high levels of household debt. The FPC

was granted Powers of Direction over mortgage

lending for owner-occupied properties earlier in

2015 and HM Treasury is expected to consult on

FPC Powers of Direction for buy-to-let lending later

in 2015.

New Zealand

Australia’s major banks have significant operations

in New Zealand, making its banking system of

particular interest. The housing and dairy sectors

continue to be key areas of focus for New Zealand

financial stability.

For some time, the Reserve Bank of New Zealand

(RBNZ) has been concerned about rapid housing

price inflation given already elevated levels of

mortgage debt relative to household income.

While housing price inflation slowed significantly

following the implementation of restrictions on

high loan-to-value ratio (LVR) lending in late 2013

and increases in the official cash rate in 2014, house

price growth in Auckland has subsequently picked

up sharply (Graph 1.22). The RBNZ attributes this

to ongoing supply constraints, increased demand

driven by high net immigration, stronger investor

participation and low mortgage interest rates; the

RBNZ has cut interest rates by a cumulative 75 basis

In May, the RBNZ announced that most mortgages

on investment properties in the Auckland Council

area will soon be required to have maximum LVRs

of 70 per cent. Banks will also be expected to hold

additional capital against all investor housing loans

in New Zealand. The stated aims of these policies are

to moderate the cyclical role of residential investors

in the Auckland housing market and to strengthen

the resilience of banks against any future housing

market downturn.

The RBNZ has also raised concerns about the fall in

dairy incomes associated with lower international

milk prices. The dairy sector is both important to

the New Zealand economy and highly indebted.

Lending to the dairy sector accounts for around

10 per cent of New Zealand bank lending, with

around half of all dairy sector debt held by one-tenth

of dairy farmers. International milk prices have fallen

by around 50 per cent since their 2013 peak and are

below the estimated industry average break-even

point. The RBNZ estimates that one quarter of

New Zealand dairy farmers had negative cash flow in

the 2014–15 season. To date, dairy land prices have

held up, but a scenario where both agricultural land

prices and income are falling would place highly

2007 2009 2011 2013 2015

-20

-10

0

10

20

%

-20

-10

0

10

20

%

Year-ended, three-month moving average

Auckland

Rest of New Zealand

Sources: RBA; REINZ; Statistics New Zealand

Box A

Effects of Low Yields on Life Insurers

and Pension Funds

Life insurance firms and defined benefit pension

funds are important participants in the global

financial system. They provide insurance against

mortality risks and help fund retirements, as well as

channelling significant funding to banks, corporates

and governments. Their combined assets of

around US$23 trillion in Organisation for Economic

Co- operation and Development (OECD) economies

as at 2013 represented around 8 per cent of total

financial assets of financial firms in these countries.

This box outlines the effects of the low-yield

environment that has prevailed since the financial

crisis on the life insurance and defined benefit

pension fund industries and the measures that some

firms have taken in response. Australia is less affected

than some other countries because these sectors are

small here (Graph A1).

Defined benefit

Life insurance

0 50 100 150 %

Germany

Australia

France

United States

Canada

Switzerland

United

Kingdom

Netherlands

Per cent to GDP, 2013

Sources: APRA; BIS; OECD; RBA

European life insurers

Return guarantees

2010 2014

1

2

3

4

%

90th percentile

10th percentile

Median

Investment yields*

2010 2014

1

2

3

4

%

* Based on a sample of 43 European life insurance companies

Sources: European Insurance and Occupational Pensions Authority;

SNL Financial

Low interest rates can present challenges for life

insurance firms and defined benefit pension funds

if they had previously offered to pay guaranteed

benefits to policyholders based on the higher

interest rates, and hence asset yields, prevailing

at the time. Recent data suggest there are some

European life insurers whose return guarantees to

policyholders now exceed their own investment

returns (Graph A2).

These promised benefits – which represent

liabilities on pension funds’ and life insurers’ balance

sheets – are typically expected to become payable

long into the future, with maturities that are much

longer than those of many financial assets. The

resulting maturity gap has meant that the decline

in interest rates following the financial crisis often

increased the present value of these firms’ liabilities

by more than the present value of their assets;

In other jurisdictions where data are available,

funding ratios for defined benefit pension funds

remain lower than before the crisis but have

generally remained above 100 per cent, in some

cases because regulation requires this.2 That said,

aggregate funding ratios can disguise funding

challenges at individual funds and in many cases are

not directly comparable across countries.

In response to the persistent low-yield environment

and the associated pressures on their funding ratios

and cash flows, life insurance firms and defined

benefit pension funds have altered their business

models significantly. Sponsors of some defined

benefit pension plans are reported to have increased

age and contribution requirements for current and

future employees, reduced benefit promises for new

employees (including closing defined benefit plans)

and, in some cases, sold pension liabilities to third

parties. Insurance firms have made efforts to improve

operating efficiency, increased offshore investments

and expanded offerings of flexible return guarantee

products and protection policies that do not entail

interest rate risks.

Firms in both industries have also adjusted their asset

allocations in response to the low-yield environment.

Aggregate data indicate that investment in fixed

income assets has increased, equity allocations have

fallen and bond durations have been lengthened to

reduce duration gaps.3 There has also been evidence

of ‘search for yield’, with some institutions increasing

allocations to lower-rated securities (Graph A4) and

alternative investments, such as private equity and real

estate. These shifts in asset allocation may have increased

expected returns at the cost of greater exposure to

credit risk, liquidity risk and asset price volatility.

2 For example, in the Netherlands the minimum funding ratio is

105 per cent.

3 Japan is a notable exception to this trend, with government policy

resulting in increasing equity allocations in public pension funds.

the ratio of the two, termed the ‘funding ratio’,

has therefore tended to decline. Other factors

have probably exacerbated this effect, including

increased longevity and reduced policy ‘surrenders’

(cancellations) that have lengthened the duration of

liabilities, and regulatory changes that have required

greater use of market interest rates when calculating

assets and liabilities.1

Funding ratios for defined benefit pension funds in

the United States and the United Kingdom illustrate

some of these concerns. With the onset of the

financial crisis, these ratios fell sharply (Graph A3),

driven by falls in equity prices. Since then, funding

ratios in these countries have generally remained

below 100 per cent, weighed down by declining

interest rates. Funding ratios below 100 per cent

typically indicate underfunding and, if persistent,

can signal that business models need to change to

ensure that liabilities can be met when they fall due.

1 In addition, existing maturity gaps tend to widen as yields fall because

of ‘negative convexity’ effects. For more details, see Domanski D,

Shin H S and Sushko V (2015), ‘The Hunt for Duration: Not Waving But

Drowning?’, BIS Working Paper No. 519.

United States

2009 2013

60

80

100

120

ratio

(RHS)

10-year government

bond yield

United Kingdom

2009 2013

0.0

1.5

3.0

4.5

%

(LHS)

Funding ratio*

* Ratio of the present value of assets to liabilities. US data includes

private and publicly funded occupational pensions; UK data includes

privately managed occupational pensions

Sources: European Insurance and Occupational Pensions Authority;

Federal Reserve Board; RBA

Insurance firms and pension funds promote financial

stability because they have long investment horizons

and fund themselves with premium contributions,

which are less susceptible to bank-style runs and

associated asset ‘fire sales’.4 Nonetheless, their large

size, concentration and interconnectedness within

the broader financial system mean that problems

with these institutions could still pose risks to

financial system stability.

Funding problems with defined-benefit pension

funds can be transferred onto sponsors, such

as corporate entities and governments. For

corporations, this risk potentially creates a

heightened level of uncertainty about funding their

regular business operations, distracts management

from their core responsibilities and can raise firms’

costs of capital. For governments, which can include

state and municipal authorities, defined benefit

pension funding shortfalls could place additional

pressure on budgets. If this was to occur during a

4 Life insurance products can be subject to liquidity risk through

policyholders exercising their surrender option. Historically, largescale

policy surrenders have not occurred when interest rates have

increased, but have occurred in some situations in which the parent

entity was near failure.

2006 2008 2010 2012 2014

0

10

20

30

40

%

0

10

20

30

40

%

Share of total assets bearing credit risk, median*

AAA-rated

AA-rated

A-rated

B-rated

* Based on a sample of 42 European life insurance companies

Source: SNL Financial

for counter-cyclical fiscal policies.

More generally, problems at insurance firms and

pension funds could harm confidence if a significant

share of the population became concerned about

the security of their wealth held in these institutions.

That said, such risks are mitigated in some

jurisdictions by insurance mechanisms that protect

policyholders if a life insurance firm or defined

benefit pension plan should fail.5 For example, seven

small and mid-sized Japanese life insurance firms

failed between 1997 and 2008 because low interest

rates, combined with declines in equity and real

estate prices, rendered them unable to meet return

promises. However, these failures had little effect on

broader financial stability. These firms were resolved

in an orderly manner with support from policyholder

protection schemes, although return promises had

to be lowered and policy surrenders were suspended

for a time.

Life insurance firms and defined benefit pension

funds have adjusted their business models in recent

years, increasing their resilience to low yields. And

life insurers have generally remained profitable, in

part because capital gains on existing asset holdings

partly offset lower interest income. Nevertheless,

pressure from the low interest rate environment and

other structural forces, such as increasing longevity,

remain. Firm managers and regulators need to

ensure that funding positions are resilient to a range

5 In Australia, the Financial Claims Scheme provides a form of insurance

cover for general insurance policyholders in the event of an insurance

firm insolvency. However, there is no formal scheme in place to

protect life insurance policyholders.

the risk of oversupply is rising in some apartment

markets. While housing lending standards have

been better in recent years than in the years leading

up to the financial crisis, recent investigations

by regulators have revealed that standards were

somewhat weaker than had originally been thought.

As a result, some borrowers have had less of a safety

margin against unexpected falls in income, increases

in expenses or increases in interest rates.

However, in response to the supervisory actions

undertaken by the Australian Prudential Regulation

Authority (APRA) and the Australian Securities

and Investments Commission (ASIC) in 2015 to

date, many lenders have changed their price

and non-price lending terms and conditions.

Lending practices and standards have therefore

strengthened and there are now tentative signs

of a slowdown in the pace of growth in investor

credit. Furthermore, although the gross household

debt-to-income ratio has risen to new highs,

households continue to build up mortgage buffers

and indicators suggest that financial stress in the

household sector remains low.

Risks are rising in the commercial property sector.

Yields have fallen to low levels, due to continued

strength in offshore and local investor demand,

despite generally soft leasing conditions. Oversupply

is also evident in the Perth and Brisbane office

markets. The risk that prices might fall in the future

has therefore increased, particularly if global interest

rates were to rise or foreign investor demand was

to weaken. The possibility of a downturn in some

apartment markets has also increased risks for

residential property developers. Any such fall in

prices would reduce developers’ equity in projects

underway and increase the likelihood of settlement

failures on pre-sold apartments in these areas.

Nonetheless, the risks to the domestic financial

system have been lessened by the significant

decline since the financial crisis in banks’ exposures

to the commercial property sector, as a proportion

of their assets, although growth in such lending has

started to pick up again in recent years.

Other parts of the business sector continue to

pose little near-term risk to the financial system.

While the sustained falls in commodity prices have

weighed on resource-related companies’ ability to

service their debts, particularly for smaller resource

producers and mining-services companies, the

domestic banks’ exposure to this sector is fairly

limited. In the non-mining sector, business finances

generally remain in good shape and indicators of

financial stress are low.

Six-month-ended annualised growth

Sydney

2010 2015

-16

-8

0

8

16

24

%

Houses

Melbourne

2010 2015

Other capitals*

2010 2015

-16

-8

0

8

16

24

%

Apartments

* Weighted average of Adelaide, Brisbane, Canberra, Darwin, Hobart

and Perth

Sources: ABS; CoreLogic RP Data; RBA

Housing price growth has picked up to a very

rapid pace in Sydney and Melbourne over the

past six months, particularly for detached houses

(Graph 2.1). Growth in apartment prices has been

slower, as strong demand from investors has in part

been met by a large increase in new apartment

supply in these cities. Outside of Sydney and

Melbourne, investor demand has remained more

modest and housing price growth has been much

slower and generally more similar across houses

and apartments. Recently there have been tentative

signs of some slowing in the Sydney and Melbourne

housing markets: auction clearance rates have fallen

and price growth has eased in Sydney of late.

loan approvals data suggest that the overall level

of investor demand has remained strong, especially

in New South Wales and Victoria (Graph 2.2). Loan

approvals for owner-occupiers have reportedly

increased sharply in the past month or so. Large data

resubmissions by several banks also indicate that

the level of investor lending over recent years has

been higher than had initially been reported. Over

recent months, lenders have announced changes

to a range of price and non-price lending terms

and conditions to strengthen lending practices and

respond to supervisory expectations (for details,

see ‘The Australian Financial System’ chapter). Since

then, there have been tentative signs that investor

demand has started to cool.

had recently announced a range of measures in

response to risks relating to lending for housing.

These included guidance from APRA that it may take

supervisory action where an individual authorised

deposit-taking institution’s (ADI’s) investor housing

loan portfolio grows by materially more than 10 per

cent a year. While annual growth in investor housing

credit nationwide has since stabilised at slightly

above 10 per cent, after picking up through 2014,

Includes construction and refinancing

Owner-occupiers

2007 2011 2015

0

2

4

6

$b

Qld

Other

Investors

2011 2015

0

2

4

6

$b

Vic

NSW

Sources: ABS; RBA

high level of investor activity arises from its potential

impact on housing prices and its interaction with

leverage. Specifically, this activity can amplify the

run-up in housing prices and hence increase the risk

of prices falling significantly later on. Investors are

more likely to contribute to the run-up in prices than

owner-occupiers because the rationales for their

purchases differ: capital gains are likely a greater

motivating factor for investors, and rising prices can

induce even more investor demand by increasing

expectations for future price rises. Investors also

tend to face fewer barriers to exit when the market

turns down. Because most home buyers, whether

owner-occupiers or investors, purchase with

leverage, a sizeable price fall could induce financial

distress for some households. More generally, it

could affect financial stability indirectly, by weighing

on wealth and spending across the household sector

and thereby dampening the broader economy and

labour market. Furthermore, the risk to the stability

of financial institutions increases the longer the

elevated rates of investor lending and housing price

growth persist.

Another risk arising from robust investor activity is

that speculative demand could lead to an excessive

increase in construction activity and future supply

overhang. While the housing market remains a long

way from oversupply nationwide, some geographic

areas appear to be reaching that point, particularly

the inner-city areas of Melbourne and Brisbane.

Apartment approvals remain at very high levels

in these areas, even though these rental markets

already look soft; apartment prices have been little

changed in the past year, rental vacancy rates are

relatively high and growth in rents is subdued

(Graph 2.3 and Graph 2.4). If prices were to fall

significantly in these areas due to oversupply, the

main risk to financial stability would be through

negative effects on the financial health of residential

developers (see the ‘Commercial Property’ section

below).

Per cent to existing dwelling stock**

CBD

6

12

%

6

12

%

Brisbane

Melbourne

Inner city (excl CBD)

2003 2006 2009 2012 2015

0

3

6

%

0

3

6

%

Sydney

* Four-quarter rolling sum

** Dwelling stocks estimated by RBA

Sources: ABS; CoreLogic RP Data; RBA

Annual growth**

Prices

0

15

%

0

15

%

Sydney

Brisbane

Rents

2007 2009 2011 2013 2015

-10

0

10

%

-10

0

10

%

Melbourne

* SA4 regions: Sydney – City and Inner South, Melbourne – Inner and

Brisbane – Inner City

** Rolling 12-month average growth rate

Sources: CoreLogic RP Data; RBA

Investment in residential property by self-managed

superannuation funds (SMSFs) continues to grow

quickly. According to Australian Taxation Office

data, borrowing for such investment also continues

to increase, with the level of borrowing recently

revised significantly higher, although it still amounts

to less than 3 per cent of SMSFs’ total assets. As

property investment could, at the margin, introduce

new vulnerabilities in the financial system, because

it provides a vehicle for potentially speculative

property demand that did not exist in the past. This is

one reason why the Reserve Bank, in its submissions

to the Financial System Inquiry, recommended that

borrowing by superannuation funds be restricted.1

Recent investigations by regulators have revealed

that housing lending standards in recent years have

been somewhat weaker than had originally been

thought (though still better than in the years leading

up to the global financial crisis). In some cases,

practices have not met prudential expectations,

potentially placing lenders at risk of breaching their

responsible lending obligations under consumer

protection laws.2 In particular, poor documentation

and verification by lenders in many instances

suggests that some borrowers may have been given

interest-only loans that were not suitable for them.

Serviceability assessments also seem to have been

especially problematic: the common (and prudent)

practice of applying a buffer to the interest rate used

when calculating the allowable new loan size had in

some cases been undermined by overly aggressive

assumptions in other parts of the serviceability

calculations (for details, see ‘The Australian Financial

System’ chapter). As a result, some borrowers have

had less of a safety margin against unexpected falls in

income, increases in expenses or increases in interest

rates than it had appeared.

Banks have tightened lending standards across the residential mortgage market over recent months in response to this regulatory scrutiny, including through stricter loan serviceability assessment criteria, lower maximum loan-to-valuation ratios (LVRs) for investor loans and shorter interest-only periods for owner-occupiers. These changes will increase the resilience of the household sector, as new borrowers will be somewhat better placed to withstand possible negative shocks such as lower income or a fall in housing prices. This is particularly important at a time when risks in the housing market are already heightened, interest rates remain at historic lows, and competition in the owner-occupier lending market remains strong (especially as lenders focus less on investor loans).

Because many of these changes took effect within the past few months, they had little impact on the June quarter data on the characteristics of new housing loans. Recent data revisions have revealed that loans with LVRs above 80 per cent and interest-only loans to owner-occupiers were somewhat less common than previously reported. These revised data show that the share of lending with LVRs above 90 per cent edged down over the first half of 2015, while the share of interest-only lending to owner-occupiers drifted up further (Graph 2.5).

2 See Byres W (2015), ‘Sound Lending Standards and Adequate Capital: Preconditions for Long-term Success’, Speech to the COBA CEO & Director Forum, Sydney, 13 May; and ASIC (2015), ‘Review of Interest-only Home Loans’, Report No. 445, August.

Share of new loan approvals

Owner-occupiers

10

20

% Investors

10

20

%

80 < LVR 90

LVR > 90

2009 2012

0

25

50

%

Interest only

2009 2012 2015

0

25

50

%

Other

Low doc

* Series are break-adjusted for reporting changes; ‘Other’ includes loans

approved outside normal debt-serviceability policies and other

non-standard loans

Sources: APRA; RBA

The increased prevalence of interest-only lending

has been a concern for regulators; these loans can

involve greater risk than principal and interest loans

because borrowers need not pay down any principal

during the interest-only period. For example, ASIC

noted in their recent review of interest-only lending

that, in the first five years of a principal and interest

loan, a borrower making scheduled repayments

at current interest rates would typically pay down

about 10 per cent of the principal, establishing

a sizeable cushion against any fall in housing

prices. Anecdotal information also suggests that

some owner-occupier borrowers may be using

interest-only loans as a means of affording a larger

loan. Nonetheless, ASIC found that interest-only

loans made in recent years have been less risky in

some other respects: they have tended to be taken

out by higher-income borrowers, have lower LVRs at

origination, and on average have been paid down

more quickly than a typical principal and interest

loan when balances in offset accounts are taken into

account. Looking ahead, the challenge for lenders

will be to ensure that the risk profile of these loans

does not deteriorate.

Household credit growth overall has remained

moderate, because new lending for purposes other

than investor housing has been fairly subdued,

although it looks to be picking up. Many existing

borrowers also continue to take advantage of lower

interest rates to effectively pay down their mortgages

faster than required. This includes building up

balances in offset accounts, which continue to grow

rapidly.3 Aggregate mortgage buffers – as measured

by balances in offset and redraw facilities – remain

around 16 per cent of outstanding loan balances,

equivalent to more than two years of scheduled

repayments at current interest rates (Graph 2.6).

An increased willingness by some households

to take on more debt, coupled with slow wage

growth, has resulted in a further pick-up in the gross

debt-to-income ratio, which has now reached new

highs. Net of balances in offset accounts, though,

the increase has been quite moderate (Graph 2.7).

While still at high levels, the debt-to-assets ratio

has declined over the past few years as the value of

household assets has grown faster than household

debt. Households with higher debt-to-assets or

3 For further details on the impact of offset account balances on net

housing debt, see RBA (2015), ‘Box E: Offset Account Balances and

2009 2011 2013 2015

0

5

10

15

%

0

10

20

30

mths

Share of housing loans outstanding

(LHS)

Number of months

(RHS)

* Data are adjusted for reporting changes; darker lines are seasonally

adjusted

Sources: APRA; RBA

Debt-to-assets ratio*

15

30

%

Household

Housing

Debt-to-income ratio*

60

120

%

Interest payments-to-income

ratio**

1995 2005 2015

0

6

12

% Household saving ratio***

1995 2005 2015

-10

0

10

%

* Debt to the financial sector; dashed line is net of offset account balances

** Excludes unincorporated enterprises

*** Net of depreciation

Sources: ABS; APRA; RBA

debt-to-income ratios also tend to have higher

incomes, suggesting that leverage is concentrated

among households that are more able to service it.

The current low level of interest rates is also aiding

households’ ability to service their debts, and as the

latest reductions in the cash rate flowed through to

mortgage rates, the proportion of income required

to meet interest payments has fallen further over

the year to date. Households also continue to save a

greater share of their income than in the decade or

so prior to the financial crisis, though the saving ratio

has fallen a little in the past couple of years.

Indicators suggest that household financial

stress remains fairly benign, despite measures

of unemployment being somewhat elevated.

While the share of banks’ housing loans that are

non-performing has edged higher recently, it

remains low. As a share of the dwelling stock,

applications for property possessions have declined

in the four largest states since 2011. Similarly,

non-business related personal administrations as

a share of the adult population continue to trend

lower, and nationally are around the lowest level

in more than a decade. Labour market conditions,

which strongly influence the extent of household

financial stress, have improved so far this year.

However, forward-looking indicators are more mixed.

In a global environment of low interest rates and

ample liquidity, investor demand for commercial

property has been strong, particularly from foreign

investors, which has pushed prices sharply higher.

However, leasing conditions have generally been

soft, creating a growing divergence between

prices and rents (Graph 2.8). As a result, commercial

property yields have fallen to low levels (Graph 2.9).

The spread of these yields to that for long-term

government bonds remains relatively wide,

suggesting that the decline in commercial property

yields might not be excessive. Current prices could

seem less justifiable, however, were global interest

rates to increase. Prices could also fall if foreign

demand were to weaken significantly. Given that

commercial property lending has historically been a

key source of financial sector losses during episodes

of financial instability, both in Australia and overseas,

it is important that lenders and regulators remain

alert to the risks in this market.

The strength in investor demand has been broad

based across property types and most pronounced

in the eastern seaboard capitals. The total value of

office, retail and industrial property transactions

has increased considerably over recent years, to be

50 per cent higher in the year to June 2015 than its

pre-crisis peak (Graph 2.10). Foreign buyers have

become more prominent, directly accounting for

around one-third of purchases during the past

two years. Investors from Asia, especially China,

have driven much of this increase. Foreign capital

has also been flowing into the residential property

development sector across the eastern seaboard

capitals, particularly inner-city Melbourne.

In the office property market, the risk of a fall in

prices appears most pronounced in Brisbane and

Perth, where signs of oversupply are most clearly

visible. Lower tenant demand from resource-related

companies and, in Brisbane, the public sector, has put

downward pressure on rents and pushed vacancy

rates to high levels (Graph 2.11). The large amount

of space under construction in both cities is likely

to see vacancy rates rise even further as projects are

completed, though relatively few developments in

earlier stages of planning are expected to proceed

in coming years.

Conditions are noticeably firmer in the Sydney and

Melbourne office leasing markets. Vacancy rates have

remained lower than in other capital cities and have

recently fallen due to a pick-up in tenant demand.

Effective rents have also risen of late, after being

stagnant for a number of years. While significant

2009 = 100

CBD Office

1995 2005

25

50

75

100

125

index

Rents**

Industrial

1995 2005

Prices

Retail

1995 2005 2015

25

50

75

100

125

index

* CBD office and industrial are prime property, retail is regional

(non-CBD) centres

** CBD office is effective rents, industrial and retail are face rents

Sources: ABS; JLL Research; RBA

Office

2000 2015

0.0

2.5

5.0

7.5

10.0

12.5

%

10-year

AGS yield*

Industrial

2000 2015

Discount rate**

Spread to AGS*

Retail

2000 2015

0.0

2.5

5.0

7.5

10.0

12.5

%

* Australian Government securities; spread to AGS in percentage points

** The rate applied to estimate the net present value of property assets

from their projected future cash flows

Sources: IPD; RBA

construction is either underway or mooted in both

cities, this new supply is likely to be more easily

absorbed than in other cities. Consistent with these

more positive leasing conditions, investor demand

has been strongest in Sydney and Melbourne, and

prices there have grown rapidly. The recent sale of

a large portfolio of office properties in these cities at

low yields points to further strong price growth and

yield compression.

Reflecting these differences in risk across cities,

banks have expressed caution about lending into

Year to June

Industrial By property type

Retail

Office

10

20

$b

10

20

$b

Unknown By purchaser

Foreign

Australian

2003 2007 2011 2015

0

10

20

$b

0

10

20

$b

* Only includes transactions greater than $5 million

Sources: JLL Research; RBA; Savills

Capital city CBD markets

10

20

30

%

National*

10

20

30

%

Perth

Brisbane

1995 2005 2015

0

10

20

30

%

Sydney

Melbourne

1995 2005 2015

0

10

20

30

%

Adelaide

Canberra

* Excluding Darwin and Hobart

Source: JLL Research

the Brisbane and Perth office markets. Similarly,

liaison suggests that developers would require much

higher precommitment rates before commencing

office projects in Brisbane and Perth (reportedly

around 80 per cent) than in Sydney and Melbourne

(around 50–60 per cent).

Yields have also fallen in industrial and retail

property markets, as prices and rents have diverged.

Tenant demand for industrial space has been weak,

although supply-side factors – namely limited

construction and the significant withdrawal of

space for redevelopment into apartments – have

moderated the impact on leasing conditions. This

has resulted in a modest decline in rents over recent

years. At the same time, prices have risen sharply

on the back of strong growth in investor demand,

including from foreign investors. Similarly, subdued

leasing conditions contrast with robust investor

demand in the retail property market. While price

growth has been more modest than for office and

industrial property, it has recently picked up, in part

due to increased interest from offshore.

As noted, risks to residential property developers

appear to have increased over the past six months.

The large volume of apartment construction

currently underway and planned has continued

to grow, and the price of development sites has

increased rapidly due to strong developer demand.

Foreign developers have contributed to this

dynamic, and are reportedly willing to pay more for

development sites than many local developers.

The risk of a downturn in apartment markets is

greatest in the inner-city regions of Melbourne

and Brisbane, which look susceptible to potential

oversupply. While investor demand appears

strong at present, including from foreign investors,

apartment markets in these areas already look

soft, and future tenant demand, including from

international students, is uncertain. Highlighting this

uncertainty, recent international student net arrivals

were less than the Department of Immigration and

Border Protection’s forecasts, and the Department’s

forecasts for coming years have been revised down

significantly. More generally, population growth has

slowed noticeably of late.

Any downturn in apartment market conditions

would weigh directly on the developers’ equity in

projects underway, and would increase the risk of

off-the-plan sales falling through. In liaison, some

banks have expressed concern about this settlement

risk on pre-sold apartments, particularly in light of

the recent regulatory measures aimed at moderating

investor demand, though they have also noted

that pre-sale defaults have been very limited so far.

A number of banks have responded to this, and the

risk of oversupply more generally, by tightening

lending standards to apartment developers in the

more at-risk areas.

So far, the near-term risks to the domestic financial

system from the commercial property sector

appear modest, but they are rising. Although

banks’ commercial property exposures declined as

a share of their total assets after the financial crisis,

growth in this type of lending has picked up in

recent years, driven by the major Australian banks

and by Asian-owned banks (see ‘Box B: The Recent

Growth in Banks’ Commercial Property Exposures’).

Competition among lenders is strong, putting

considerable pressure on lenders’ margins, so the

commercial property sector will require continued

close monitoring for some time yet.

Outside the property sector, risks to the financial

system from non-financial businesses remain

low and the sector’s finances are generally in

good shape. Business failure rates have fallen

significantly across most industries and states over

recent years and, in aggregate, are close to decade

lows, although business failures have picked up

a little in recent months (Graph 2.12). The share of

banks’ business loans that are non-performing has

also continued to decline across most industries.

1990 1995 2000 2005 2010 2015

0.0

0.3

0.6

%

0.0

0.3

0.6

%

Share of businesses in each sector, six-month annualised

Unincorporated**

Incorporated*

* Corporations entering external administration

** Business-related personal administrations and other administrations

Sources: ABS; AFSA; ASIC; RBA

The sizeable deleveraging of the business sector

following the financial crisis has contributed to these

trends, as has the low level of interest rates. Further,

the large depreciation of the Australian dollar over

the past year or so will have benefited businesses

in a number of industries, although the increased

volatility in currency markets could expose any

instances of poorly designed hedging practice (or lack of hedging altogether).

Business demand for new intermediated credit has been fairly soft over much of 2015, despite the low level of interest rates, consistent with subdued non-mining investment (Graph 2.13). At the same time, implied repayment rates on existing loans are high, as some businesses use surplus cash to deleverage. The current environment of low demand for intermediated business debt creates a risk that banks may further relax lending standards in order to attract customers. As discussed in ‘The Australian Financial System’ chapter below, price competition for business lending has continued to strengthen over the past six months, and loan covenants have also been relaxed in some instances.

Overall, the business sector appears well placed to service its debt. The aggregate gearing ratio of listed corporations increased recently, but remains

2003 2006 2009 2012 2015

-15

0

15

%

-15

0

15

%

Six-month-ended, annualised

Net external non-intermediated

funding*

Unincorporated

business credit**

Incorporated

business credit**

* Excludes equity raisings by unlisted businesses

** Excludes securitised loans

Sources: ABS; APRA; ASX; Austraclear; Morningstar; RBA

Book value of debt-to-equity

Aggregate

2001 2008

0

20

40

60

80

100

% Distribution

2001 2008 2015

0

75

150

225

300

375

%

Median

75th percentile

95th percentile

90th

percentile

* Excludes financial and foreign-domiciled corporations

Sources: Bloomberg; Morningstar; RBA

1985 1991 1997 2003 2009 2015

0

10

20

30

%

0

10

20

30

%

Non-financial businesses’ interest payments as a per cent to profits

All businesses*

Listed corporations**

Unincorporated

businesses*

* Gross interest paid on intermediated debt from Australian-located

financial institutions

** Net interest paid on all debt; excludes foreign-domiciled corporations

Sources: ABS; APRA; Bloomberg; Morningstar; RBA

In contrast to the benign overall conditions in much

of the business sector, risks appear to have increased

further in the resource-related sector over the past

six months. The sustained falls in coal, iron ore and oil

prices are weighing heavily on the earnings and cash

flow of producers of these commodities, particularly

those higher up the cost curve. Most smaller

producers are struggling to cover costs at current

prices, with many already reporting losses. Where

producers have been cutting costs to preserve profit

margins, further cuts could prove progressively

harder. The dwindling investment pipeline and

ongoing cost-cutting by resource producers

have in turn reduced the output and earnings of

mining services companies. Overall, the earnings of

businesses in the resource-related sector have fallen

sharply over the past two years, although consensus

analyst forecasts point to some recovery in earnings

over the coming years (Graph 2.16).

Bank lending to the resource sector has increased

rapidly in recent years, and large resource producers

have increased their issuance of debt into financial

markets, especially offshore, even as they cut

investment spending. Higher debt and the steep

fall in profits have resulted in a significant rise in the

debt-servicing ratios of smaller resource producers;

within the range seen since the crisis, as do gearing

ratios in the more vulnerable tail of the distribution

(Graph 2.14). The sector’s aggregate debt-servicing

ratio also increased recently, but remains fairly

low (Graph 2.15). In addition, the share of debt

owed by businesses in the more vulnerable tail of

the distribution has declined over recent years.

The aggregate debt-servicing ratios for unlisted

corporations as well as unincorporated businesses

have fallen steadily since 2008 as interest rates have

declined.

estimated for the more vulnerable (and usually

smaller) resource producers and mining

services companies have fallen to their lowest

levels since the financial crisis (Graph 2.18).4

4 Distance-to-default measures the expected difference between the

market value of firms’ assets and the book value of their liabilities at

some horizon, in this case one year, expressed in terms of the asset

return volatility. For further details on this measure, see Robson

M (2015), ‘Default Risk Among Australian Listed Corporations’,

Annual

2001 2008

-5

0

5

10

$b

Oil & gas**

Iron

ore**

Coal**

Mining services

2001 2008 2015

0

20

40

60

$b

BHP Billiton

& Rio Tinto

* Listed corporations’ EBITDA; excludes foreign-domiciled corporations

** Excludes BHP Billiton & Rio Tinto

Sources: Bloomberg; Morningstar; RBA

Debt-to-equity ratio

2001 2008

0

30

60

90

%

Mining

services

BHP Billiton

& Rio Tinto

Net interest

expense-to-earnings ratio

2001 2008 2015

0

10

20

30

%

Other resource

producers**

* Excludes foreign-domiciled corporations; book value

** Includes listed junior explorers

Sources: Bloomberg; Morningstar; RBA

Debt-weighted, three-month centred moving average

Resource-related

2005 2010

0

3

6

9

12

std

dev

25th

percentile

10th

percentile

Other

2005 2010 2015

0

3

6

9

12

std

dev

Median

* Excludes financial and foreign-domiciled corporations

Sources: Bloomberg; Morningstar; RBA

the aggregate debt-servicing ratio of listed mining

services companies has also risen (Graph 2.17).

Although the debt-servicing capacity of many of

the smaller resource producers has been supported

by strong liquidity positions to date, continued low

commodity prices would erode these positions

in time. Indeed, some smaller resource producers

have come close to breaching debt covenants

and a range of firms have had their credit ratings

downgraded. Putting further pressure on their

debt-servicing ability, resource-related companies

may face difficulty rolling over their debt, with the

bonds of some companies currently trading at very

high yields. Despite the low business failure rate,

banks indicated in liaison that the performance

of their resource-related loans had deteriorated

somewhat. They also noted that the low level of

interest rates could be masking underlying stress in

this sector.

In line with these developments, a market-based

measure of default risk for listed corporations

– derived from equity prices and reported

liabilities – suggests that the financial health of

some parts of the resource-related sector has

deteriorated noticeably as commodity prices have

fallen. Over the past year, the distance-to-default

In contrast, the continued financial strength of the

largest resource producers has limited the decline

in the median distance-to-default. As a result, the

sector’s implied debt-at-risk – measuring the stock

of debt expected to be defaulted on – has been

fairly stable over recent years at very low levels.

Consistent with the low levels of debt-at-risk, risks

to the domestic banks arising from the resourcerelated

sector are limited because their exposure

to the sector is fairly low, though it has increased in

recent years. Most of the sector’s debt outstanding

is sourced from corporate debt markets rather

than domestic banks; foreign banks are also an

important source of funding. RBA staff estimate that

only around 2 per cent of the Australian banking

system’s consolidated group exposures are to

resource-related businesses, and this is reportedly

skewed towards the more highly rated or lower-cost

Box B

The Recent Growth in Banks’ Commercial

Property Exposures

Growth in commercial property lending has picked

up in recent years, while demand for business credit

outside of the property sector has remained more

moderate (Graph B1). Indeed, commercial property

exposures, which constitute around one-quarter

business credit over the past two years.1 Commercial

property lending comprises loans provided to

businesses for the development, acquisition or

improvement of property, where repayment is

dependent on the subsequent proceeds from

sale or the rental income generated from these, or

other, properties. Because downturns in commercial

property markets have triggered a number of past

episodes of financial instability (both domestically

and overseas), growth in banks’ commercial property

exposures warrants particular attention.

The growth in commercial property lending over

recent years has been driven by the major banks

and by a strong increase in lending from local

Asian-owned banks (Graph B2). The major banks

pulled back from commercial property lending

after the market turned down during the financial

crisis, but since 2012 they have steadily grown

their commercial property exposures by more than

5 per cent a year. The local Asian-owned banks have

increased their exposures particularly quickly over

this period, albeit from a low base, growing by a bit

less than 20 per cent a year. This has accompanied

an increase in residential development activity

1 These figures are broad estimates given the compositional differences

between the business credit and commercial property exposures

series. Business credit data include the on-balance sheet claims on

banks’ and non-bank financial institutions’ domestic books, whereas

commercial property exposures include both the on-balance

sheet and credit-equivalent off-balance sheet exposures of banks’

consolidated Australian operations.

Six-month-ended, annualised, non-seasonally adjusted

Contribution by component

2005 2010 2015

-20

-10

0

10

20

30

%

-20

-10

0

10

20

30

%

Total

Other business

credit

Growth by component

2005 2010 2015

-20

-10

0

10

20

30

%

Commercial

property exposures

Sources: APRA; RBA

Banks’ consolidated operations

2005 2010 2015

0

50

100

150

200

$b

All banks*

Major banks*

Non-major banks by

ownership

2005 2010 2015

0

10

20

30

40

$b

Australian

European

Asian**

Other

foreign

* Excludes overseas exposures

** Includes HSBC

Sources: APRA; RBA

in Australia, by both domestic and foreign firms,

particularly in the inner-city apartment markets of

Melbourne, Sydney and Brisbane. Liaison suggests

that local Asian-owned banks have a prominent

role in funding many foreign developers. Asian

investment in existing commercial property assets in

Australia has also increased strongly in recent years.

The increase in lending by local Asian-owned banks

has not, however, been confined to the commercial

property sector; they have increased their Australian

activities more broadly over recent years, consistent

with growing trade and financial linkages between

Australia and the Asian region.

In contrast, the commercial property lending of the

non-major Australian and European-owned banks

has remained relatively subdued in recent years,

after these banks reduced their exposures sharply

after the 2009 property market downturn. This pullback

followed a very sharp run-up in their exposures

prior to the financial crisis, and was likely a reaction

to the high impairment rates experienced on their

commercial loan portfolios and, in the case of some

European banks, to difficulties in home markets

(Graph B3). This experience highlights that banks’

commercial property lending can be very procyclical,

contributing to the build-up of risks during

property market upswings and aggravating the

fallout during subsequent downswings.

Although commercial property exposures increased

significantly across all loan categories in the leadup

to the financial crisis, before levelling out or

declining, the timing of the post-crisis recovery has

varied (Graph B4). Exposures for many segments

have been rising steadily for a number of years,

and office and retail exposures have now surpassed

their pre-crisis peaks. The growth in office property

lending has been driven by strong investor demand

for these properties as well as a pick-up in office

building construction.

The post-crisis decline in residential and land

development exposures was larger and more

prolonged than for other categories, as banks

tightened lending standards for property

development after recording significant loan losses

during the crisis. As a result, the pick-up in lending

for residential and land development has been more

recent, and sharper, than for other categories, driven

Banks’ consolidated Australian operations

2005 2010 2015

0

10

20

30

40

50

$b

Office

Retail

Industrial

Other

2005 2010 2015

0

5

10

15

20

25

$b

Residential

Land

development

Tourism & leisure

Sources: APRA; RBA

Banks’ consolidated Australian operations

By bank

2005 2010 2015

0

6

12

18

%

Major

banks

Other

Australianowned

banks*

Foreignowned

banks*

By category

2005 2010 2015

0

6

12

18

%

Residential

Land

development

Retail

Office

Industrial

* Includes overseas exposures

Sources: APRA; RBA

by increased housing development activity across

the major east coast cities. Among the banks, Asianowned

banks have expanded their residential and

land development lending rapidly over the past five

years or so, while strong growth in the major banks’

exposures began much more recently. While the

recent growth in residential and land development

extended to borrowers – have been even more

the difference between exposure limits and actual

exposures, largely reflecting construction loans that

will be drawn down over the life of the construction

project – points to further increases in exposures in

the near term (Graph B5). Given the current risks of

oversupply in some inner-city markets – discussed

in the ‘Household and Business Finances’ chapter

– banks will need to remain vigilant in assessing

the risks surrounding property development

loans to ensure that this lending is prudent and

appropriately covered by both capital and

Banks’ consolidated Australian operations

Residential

2007 2011 2015

0

10

20

30

$b

0

10

20

30

$b

Exposure

limits

Undrawn facility

Land development

2007 2011 2015

0

10

20

30

$b

0

10

20

30

$b

Actual

exposures

Sources: APRA; RBA

The Australian banking system continues to benefit

from strong overall asset performance. Bad and

doubtful debt charges are at historically low levels

relative to assets, with losses on business lending

having declined steadily over recent years and

those for housing lending remaining very low.

Nonetheless, as outlined in the previous chapters,

banks are facing an environment of heightened, but

manageable, risk in a number of key sectors.

Specifically, strongly rising housing prices in some

cities and high levels of investor activity have raised

some concerns about the banks’ housing loan

portfolios. Housing lending is particularly important

to banking stability because it represents a large and

rising share of Australian banks’ credit portfolios. With

this in mind, the Australian Prudential Regulation

Authority (APRA) and the Australian Securities and

Investments Commission (ASIC), in conjunction

with other agencies on the Council of Financial

Regulators (CFR), have implemented a number

of initiatives over the past couple of years to help

guard against housing market risks and reinforce

sound housing lending practices. Since the previous

risk-taking in their housing lending. Tighter lending

practices will, over time, leave the industry better

placed to cope with any future deterioration in the

housing market and the broader economy. Even so,

it is necessary and prudent for banks to continue

to review their lending standards and ensure they

remain appropriate for their risk appetite and the

prevailing external environment.

APRA also recently announced an increase in

capital requirements for most Australian residential

mortgages. The change, which comes into effect

from 1 July 2016, applies to large banks that use the

internal ratings-based approach to credit risk. ‘Box C:

The Regulatory Capital Framework for Residential

the capital framework for residential mortgages

in Australia. More broadly, APRA has endorsed the

Financial System Inquiry (FSI) recommendation

that Australian bank capital positions be further

strengthened to ensure that they are ‘unquestionably

strong’. The major banks have raised a significant

amount of common equity over recent months,

bolstering their resilience to possible future adverse

shocks.

Risks to the Australian banking system have

increased somewhat over the past six months from

banks’ lending to other sectors. The outlook for some

commercial property markets has deteriorated

further, and banks will need to be especially vigilant

in their commercial property risk appetite and the

maintenance of sound lending practices in the

period ahead. Another area to watch is the four

major banks’ international exposures, especially

housing and agricultural lending in New Zealand

where the risks have continued to grow.

Profitability in the general insurance industry has fallen in recent quarters due to above-average weather-related claims, and the recent tightening in bank lending standards has reduced premium revenue for lenders mortgage insurers. With strong competition weighing on premium rates for general insurance, the adequacy of insurers’ commercial product pricing warrants continued monitoring.

Asset performance is a key, albeit lagging, indicator

of banks’ stability. The asset performance of

Australian banks has improved steadily over recent

years and this trend continued over the first half of

2015. In banks’ domestic loan portfolio, the overall

ratio of non-performing assets to total loans was

0.9 per cent at June 2015, down from a peak of

1.9 per cent in mid 2010 (Graph 3.1).

Domestic books

Share of all loans

2005 2010 2015

0

1

2

3

4

%

Total

Share of loans by type*

2005 2010 2015

0

1

2

3

4

%

(36%)

Personal

(5%)

Housing

(59%)

Business**

* Each category’s share of total domestic lending at June 2015 is shown

in parentheses

** Includes lending to financial businesses, bills, debt securities and other

non-household loans

Source: APRA

Maintaining sound housing lending is important for

Australian banks’ total asset performance because

it accounts for about 60 per cent of their domestic

lending. The banks’ housing non-performing loan

(NPL) ratio edged higher over the six months to June

2015, to just over 0.6 per cent, but it remains below

the peak of 0.9 per cent in mid 2011. According to

disclosures by several major banks, housing loan

arrears rates have risen in those states most exposed

to weaker commodity prices.

However, historically only a small fraction of the

stock of non-performing housing loans have

resulted in actual losses for banks, because the value

of the debt on most non-performing housing loans

has been more than covered by the realisable value

of the property. In recent years, the write-off rate

for the major banks’ housing lending has therefore

been comfortably below 0.1 per cent (Graph 3.2).

In contrast, at around 2–3 per cent over recent years, write-offs on credit card debt and other personal lending have been higher, consistent with some portion of this lending being extended to borrowers with a relatively weak credit profile and on an unsecured basis. Although credit card and personal lending is riskier, it represents only a small share of banks’ total domestic loans.

2009 2011 2013 2015

0

1

2

3

4

%

0

1

2

3

4

%

Consolidated data for three major banks, annual

Credit cards

Other personal lending

Residential mortgage lending**

* Write-offs net of recoveries, as a share of on-balance sheet exposures

** After the effect of lenders mortgage insurance (LMI). LMI covers

mortgage losses that account for an even smaller share of the major

banks’ exposures

Source: Banks’ Pillar 3 Reports

While the overall stress in banks’ housing loan

portfolios remains low, banks are currently facing

an environment of heightened risk in their housing

lending (as discussed in the ‘Household and

Business Finances’ chapter). In view of this, APRA has

intensified its supervision of banks’ housing lending

practices over the past couple of years. As outlined

announced a number of additional supervisory

measures to reinforce sound housing lending

standards at authorised deposit-taking institutions

(ADIs). These measures include expectations

that: ADIs should not be increasing their share

of higher-risk housing lending; annual growth

in ADIs’ investor housing lending should not be

materially above 10 per cent; and ADIs’ serviceability

assessments should include an interest rate ‘buffer’

of at least 2 percentage points above the loan rate,

with a minimum ‘floor’ assessment rate of at least

7 per cent.

APRA also undertook a ‘hypothetical borrower

exercise’ in early 2015 to investigate the range of

housing lending standards. The survey required

a number of lenders to provide serviceability

assessments for four hypothetical borrowers – two

owner-occupiers and two investors. The results

revealed large variations in serviceability practices

across the industry and some cases where practices

were less prudent than is desirable.1 Specifically,

some lenders’ serviceability assessments were

based on: a lower level of living expenses than

declared by the borrower; optimistic judgements of

the reliability of borrowers’ income; and/or implicit

assumptions that interest rates on a borrower’s

existing debts would not rise. ASIC’s recently

released review of lenders’ interest-only housing

lending included similar findings, and also noted

instances where the lender did not make reasonable

enquiries that the interest-only loan was suitable for

the borrowers’ circumstances and their capacity to

repay.2 Overall, the findings of these reviews suggest

that banks’ lending practices, at least those relating

to serviceability assessments, were somewhat looser

than had been previously understood (although

lending standards overall were still better than in the

years leading up to the financial crisis).

Over recent months many banks have taken steps

to strengthen their housing lending practices and

respond to regulatory expectations.

been tightened. In particular, many banks have

increased the interest rate buffer used to test

that borrowers could continue to service the

loan if interest rates were to rise. It is now typical

for banks to have an interest rate buffer of at

1 For a more detailed discussion of the results, see Byres W (2015),

‘Sound Lending Standards and Adequate Capital: Preconditions

for Long-Term Success’, Speech to the COBA CEO & Director Forum,

Sydney, 13 May.

2 For further detail, see ASIC (2015), ‘Review of Interest-only Home

Loans’, Report No. 445, August.

least 2.25 percentage points above the actual

loan rate, together with a floor assessment rate

of at least 7.25 per cent. Some banks have also

corrected their processes for collecting and

recognising a borrower’s declared minimum

living expenses, while most are altering their

minimum living expense assumptions so that

they increase with borrower income.

housing loans have been tightened. The prudent

practice of applying an interest rate buffer to

the prospective borrower’s existing mortgage

debt has been implemented by those banks

that were not doing so, although practices still

vary on how these buffers are applied. Negative

gearing benefits are no longer being considered

in some cases.

(LVRs) have been lowered for investors by

some banks. In addition, several banks have

reduced LVR caps for higher-risk loans, such as

those to certain locations, including miningexposed

regional towns and some metropolitan

postcodes.

adjusted. Some lenders have reduced the

maximum term of the interest-only period for

owner-occupiers, while others have tightened

their serviceability assessment by considering

a borrower’s capacity to make principal and

interest payments over the residual term (i.e. the

period after the interest-only loan expires) rather

than the full life of the loan.

In addition to the adjustments to non-price loan

terms, most banks have increased interest rates

on their investor housing loans over the past few

months. For new investor loans, fixed rates have

been raised and discounts to advertised variable

rates wound back. Interest rates on existing

variable-rate investor housing loans have been

lifted by between 20 and 50 basis points (although

one major bank instead increased pricing for

interest-only loans). There is now a differential

between the indicator rates for owner-occupier and

investor housing loans for the first time since 1996.3

Consequently, borrowers now have an incentive to seek reclassification of their loans as owner-occupier rather than investor lending where there has been a change to their living arrangements. Moreover, price competition for new and lower-risk owner-occupier borrowers remains strong, despite the forthcoming increase in the indicator rate announced by Westpac.

It remains too early to tell how much these changes

will affect growth in investor housing lending.

Annualised growth at the end of August 2015

remained above APRA’s 10 per cent benchmark

across the banking industry, including at some

major banks (Graph 3.3). Ongoing revisions to banks’

investor and owner-occupier lending data are

adding volatility to these credit aggregates. Looking

through this volatility, growth in aggregate investor

housing credit slowed over the two months to

August, and investor loan approvals have declined

moderately recently. It is possible that some banks

may need to further adjust their lending practices

for growth to slow below 10 per cent, although,

for an individual lender, any changes to headline

pricing could have less of an effect than desired

if competitors also move their pricing to avoid

attracting a higher share of investors.

More generally, as lending practices tighten, banks’

housing loan portfolios should, over time, become

better placed to cope in the event of weaker

economic and property market conditions. The

serviceability measures also provide more assurance

against the risk that new borrowers would be unable

to service the loan at interest rates well above

current levels. Even so, it is necessary and prudent for

banks to continue to review their lending practices

and ensure they remain appropriate for their risk

appetite and the prevailing external environment.

This includes segments of owner-occupier lending where competition among banks remains strong.

3 Lenders typically charged a 1 percentage point higher interest rate

for investors until 1996. For a discussion of historical developments,

see RBA (2002), ‘Innovations in the Provision of Finance for Investor

Six-month-ended, annualised

2007 2011 2015

-10

0

10

20

%

Total

Household

Business

Housing

2007 2011 2015

-10

0

10

20

%

Investor

Owner-occupier

Sources: APRA; RBA

After deteriorating during the economic slowdown

of 2008–09, the performance of banks’ domestic

business lending has improved steadily over

recent years. This has partly reflected the strong

recovery in commercial property prices, where

exposures previously accounted for a large (and

disproportionate) share of impaired business loans

(Graph 3.4). The tightening in business lending

standards around 2008–09 has also probably

strengthened the underlying quality of banks’

business loan portfolios. However, in recent periods

some banks have reported slightly higher ‘collective

provisions’ because credit quality has deteriorated in

Impaired assets outstanding

2005 2010 2015

0

5

10

15

20

$b

Business*

Share of loans by type

2005 2010 2015

0

2

4

6

8

%

Commercial property**

* Domestic books; includes lending to financial businesses, bills, debt

securities and other non-household loans

** Consolidated Australian operations

Source: APRA

2003 2006 2009 2012 2015

0.0

0.2

0.4

0.6

0.8

%

0.0

0.2

0.4

0.6

0.8

%

Domestic books, share of total resident assets

Total

Collective

Specific*

* Excludes portion of collective provision treated as specific provision

for regulatory purposes

Source: APRA

their agricultural and mining-related loan portfolios,

reflecting declines in global commodity prices

(Graph 3.5).

By region

Asia*

2007 2011 2015

0

20

40

60

$b Non-Asia

2007 2011 2015

0

20

40

60

$b

Europe

North America

* Includes HSBC

Sources: APRA; RBA

also increased because of the stricter criteria that

banks are now applying to investor housing loans.

Despite the recent targeted adjustments, banks

will need to remain vigilant in ensuring that their

risk appetite and lending practices are appropriate:

risks in residential property development and other

commercial property markets continue to build, and

this area of their lending has been a key source of

bank loan losses in the past (see the ‘Household and

Business Finances’ chapter).

Australian-owned banks’ international exposures

arise from their direct cross-border activities, as

well as the operations of their overseas branches

and subsidiaries. International exposures account

for around one quarter of Australian-owned banks’

consolidated assets (Table 3.1).

Australian-owned banks’ largest international

exposure is to New Zealand, where all four major

banks have sizeable banking operations. As is the

case in their Australian businesses, housing lending

represents a substantial share (a little under half ) of

the major banks’ credit exposures in New Zealand

(Graph 3.7). The performance of their housing lending

has been strong recently – the NPL ratio was 0.4 per

cent in early 2015, down from a peak of 1.3 per cent

Competition among lenders appears especially

acute in the commercial property loan market,

where price and non-price lending conditions

are generally under significant pressure. However,

liaison contacts report a rise in bank margins and

tightening of lending criteria for residential property

development over recent months. These changes

are a response to strong growth in banks’ exposures

to this segment and concerns about an oversupply

of apartments in some locations; settlement risk

on apartments purchased ‘off-the-plan’ may have

Ultimate risk basis, June 2015

Value

$ billion

Share of international

exposures

Per cent

Share of global

consolidated assets

Per cent

New Zealand 330 35 9

Asia(a) 183 19 5

United Kingdom 176 19 5

United States 140 15 4

Europe 58 6 1

Other 59 6 2

Total 945 100 24

(a) Asia includes offshore centres Hong Kong and Singapore

Sources: APRA; RBA

Non-agricultural lending

Agricultural lending

Residential

mortgages

Business

lending

Investment

and insurance

Other

0

10

20

30

40

%

0

10

20

30

40

%

Share of subsidiaries’ on-balance sheet exposures, March 2015*

* Data for CBA are end-June 2015 and data for Westpac are

end-September 2014

Sources: New Zealand Subsidiaries’ Annual Reports; RBA

in mid 2010. However, rapid housing price growth

in Auckland, along with strong investor activity, has

heightened the risk of a future fall in housing prices

and associated bank loan losses. Housing lending in

New Zealand is quite geographically concentrated,

with about half of the stock of debt secured against

properties in Auckland. The Reserve Bank of New

Zealand recently announced further measures

to curb investor housing lending at high LVRs in

Auckland, but relaxed LVR restrictions a little in other

regions of New Zealand (see ‘The Global Financial

Environment’ chapter).

The major banks also have substantial exposures

to the agriculture sector in New Zealand, reflecting

the economic importance of the dairy industry

there. Specifically, the major banks’ exposures to the

agriculture sector are around 13 per cent of their

credit exposures in New Zealand, around two-thirds

of which (roughly $30 billion) are to the dairy

industry. Although a much smaller share of assets

than housing lending, dairy exposures are riskier in

terms of both their probability of default and likely

losses in that event, and the risk of loss is currently

higher than usual given the low level of global milk

prices. There is also a risk that stress in the dairy sector

might exacerbate the rural property price cycle.

Australian-owned banks continue to expand their

exposure to several jurisdictions in Asia, including

China (Graph 3.8). Financial market volatility in

the Asian region has increased markedly over

recent months in association with concerns about

economic growth in China. At this point, the direct

risk to the Australian banking system from a possible

deterioration in economic and financial conditions

in China appears limited. Exposures to China and

the broader Asian region are only a small share of

Australian-owned banks’ assets, and many of these

are shorter-term and trade-related, factors which

should lessen credit and funding risks. That said,

operational and legal risks could be relatively high,

2009

2014

2015

0 10 20 30 40 $b

Other*

Indonesia

South Korea

India

Taiwan

Hong Kong

Japan

Singapore

China

Consolidated global operations, ultimate risk basis, as at June

* Cambodia, Laos, Malaysia, Philippines, Thailand and Vietnam

Sources: APRA; RBA

as some operations in Asia are new or dissimilar

to those in Australia. Any material impact on the

Australian banking system from developments

in Asia is more likely to be due to indirect effects,

such as those stemming from a sustained period of

turbulence in global funding markets and/or softer

economic growth across the Asia-Pacific region.

Global bank wholesale funding markets have been

less affected by recent international volatility than

equity markets. Australian banks generally retained

good access to a range of foreign currency bond

markets, and were able to issue bonds offshore

in June and July, around the time of heightened

concerns about Greece exiting the euro area.

Spreads on the major banks’ bonds have widened

since early 2015 but remain well below those seen

over 2008–12 (Graph 3.9).

The direct effect of higher wholesale funding costs

banks is less than five years ago because wholesale

funding is now a smaller share of their balance

sheets. Over recent years banks’ share of domestic

deposit funding has increased, while their bond

issuance has only been in line with their maturities

(Graph 3.10). Australian banks have issued about

$85 billion in bonds since the start of 2015; around

3–5 year residual maturity, A$ bonds

Yields

2007 2011 2015

1

4

7

%

Australian

Government

Securities

(AGS)

Spread to AGS

2011 2015

0

100

200

bps

Covered*

Unsecured

* Covered bond pricing interpolated to a target tenor of 4 years using

bonds with a residual maturity between 2 and 10 years

Sources: Bloomberg; UBS AG, Australia Branch

Unsecured (unguaranteed)

Unsecured (guaranteed**)

Covered

Maturities

Buybacks

Net issuance

2003 2007 2011 2015

-200

-100

0

100

200

$b

-200

-100

0

100

200

$b

A$ equivalent

* 2015 issuance is year-to-date

** Guaranteed by the Commonwealth of Australia

Source: RBA

70 per cent was issued in offshore markets, similar

to the share in the preceding few years. The recent

depreciation of the Australian dollar against the

major currencies should moderately reduce the

need for Australian banks to use global wholesale

funding markets, as less foreign currency issuance

is required to fund the same amount of Australiandollar-

denominated lending. Depreciation of the

Australian dollar also tends to add to banks’ liquidity

because they then receive collateral inflows from

counterparties to their derivative transactions for

hedging foreign-currency-denominated debt.

2007

2010

2014

0–3m 3–12m 1–5y >5y

0

20

40

%

0

20

40

%

Consolidated global operations, by remaining contractual maturity**

* Short-and long-term debt securities, including bonds, notes, commercial

paper, loan capital and bill acceptances

** As at end of financial year – 30 June for CBA and 30 September for

ANZ, NAB and WBC

Sources: Banks’ Annual Reports; RBA

Despite these changes, further lengthening of banks’

funding maturity profiles is likely to be necessary for

them to meet the Basel III Net Stable Funding Ratio

requirement scheduled for introduction in 2018.

The cost of banks’ domestic deposit funding has declined as competition for deposits has eased.

Since the start of this year, the major banks’ average

outstanding deposit rate has fallen by around

60 basis points, compared with a 50 basis point

decline in the cash rate over this period. Banks report

that they continue to refine their deposit offerings

and pricing to better reflect liquidity risk and adjust

to the Liquidity Coverage Ratio (LCR) requirement

that was introduced at the start of this year.4 A focus

for banks in this regard has been wholesale deposits,

such as those by financial institutions and large

corporations, because of the large balances involved

and their less favourable treatment under the LCR.

As at 30 June 2015, all locally incorporated banks

subject to the LCR exceeded the 100 per cent

minimum requirement. Banks’ aggregate LCR was

119 per cent, with projected net cash outflows

outweighed by holdings of high-quality liquid

assets (HQLA) and collateral eligible for use with the

Reserve Bank’s Committed Liquidity Facility (CLF)

(Table 3.2). Banks’ HQLA was split roughly evenly

between assets denominated in Australian dollars

4 The LCR is a global prudential requirement for banks to hold high-quality

liquid assets that at least cover their expected net cash outflows within

a 30-day stress period. See RBA (2015), ‘Box A: The Basel III Liquidity

All currencies; June 2015

Value

$ billion

Share of consolidated assets

Per cent

Net cash outflows 529 14

– Cash outflows 650 17

– Cash inflows 121 3

High-quality liquid assets 376 10

Committed Liquidity Facility(b) 251 6

(a) LCR equals the sum of HQLA and CLF divided by net cash outflows. Only locally incorporated banks that are subject to the 100 per

cent LCR requirement are included

(b) Amount of collateral eligible for use with the CLF

Sources: APRA; RBA

Banks can also lessen the impact of any deterioration

in wholesale funding conditions by ensuring that the

portion of their funding maturing in the near term is

small. Since 2007 the major banks have significantly

reduced the share of their wholesale debt with

maturities of less than three months (Graph 3.11).

Covered bonds have also enabled the major banks

to issue at longer tenors, as well as attract new

investors that have AAA mandates; liaison with

the major banks indicates that their unsecured

bond investor base has also become more diverse.

and foreign currency. Most Australian dollar HQLA

holdings were state government securities (‘semis’)

rather than Australian government securities, the

other debt securities that are allowed to be included

as Australian dollar HQLA.

Australian banks have increased their resilience to

adverse shocks over recent years by strengthening

their capital positions. In late 2014, the Final Report

of the FSI recommended that Australian bank

capital ratios be further strengthened to ensure

they are ‘unquestionably strong’ by international

standards. This view considered the importance of

a well-functioning banking sector to the Australian

economy and the trend towards higher regulatory

capital settings in a number of other countries.

Assessing the capital strength of banks across

jurisdictions is made difficult by, among other things,

differences in national regulatory definitions and

capital settings. To help inform the assessment in the

Australian context, APRA recently released a study

that provided internationally comparable capital

ratios for the major banks and a large number of

international peers as at June 2014.5 The study found

that the major banks’ aggregate Common Equity

Tier 1 (CET1) capital ratio was around 300 basis points

higher when reported on a comparable basis. This

result highlighted APRA’s conservative application

of the Basel international capital framework, both

for the definition of capital and the measurement of

risk-weighted assets. The major banks’ CET1 capital

ratio sat a little above the median of international

peers, while their total capital ratio was around

the median; these rankings were below the ‘top

quartile’ of the distribution that the FSI considered

appropriate. APRA will use the results of the relative

international bank comparisons to inform, but

not determine, the appropriate capital settings in

5 Data limitations mean that the calculation of internationally

comparable bank capital ratios is imprecise. For further details, see

APRA (2015), ‘International Capital Comparison Study’, Information

Paper, 13 July.

Australia over the medium term. Directly linking

domestic capital settings to a moving international

benchmark could require frequent, and perhaps

unnecessary, adjustment.

Within the Australian banking sector, the need for

unquestioned capital strength is particularly relevant

for the major banks. All four major banks have been

designated domestic systemically important banks

(D-SIBs) by APRA, because their dominant share of

banking activity in Australia means that their distress

could harm the real economy. Furthermore, they are

internationally active on both sides of their balance

sheets and are therefore subject to global market

conditions and scrutiny. It is vital that the major

banks are able to not only withstand severe external

shocks, but also support the economy during such

episodes by being able to secure new funding and

extend new lending.

In July, APRA announced an increase in capital

requirements for Australian residential mortgages

of banks using the internal ratings-based (IRB)

approach to credit risk – that is, the four major banks

and Macquarie Bank. The change, which comes into

effect from 1 July 2016, will increase the average risk

weight of these exposures from about 17 per cent

to at least 25 per cent (see ‘Box C: The Regulatory

Capital Framework for Residential Mortgages’). The

announcement addressed a recommendation of

the FSI to narrow the difference between banks’

capital requirements when calculated under the IRB

approach versus the standardised approach used

by smaller ADIs. This will also increase the resilience

of the banking system, given that housing lending

represents a large share of credit portfolios and the

IRB banks account for the bulk of Australian housing

lending. Moreover, the additional capital is timely

because banks are currently facing an environment

of heightened risk in their housing loan portfolios.

The major banks have taken a number of actions

capital positions. Around $18 billion in common

equity has been issued through a combination

of discounted rights issues, share purchase plans,

regulatory requirements at this juncture, in large part

because, as noted earlier, capital requirements for

their Australian mortgages are scheduled to increase

from mid 2016 (which could subtract around

80 basis points from the major banks’ aggregate

CET1 ratio). A number of other potential capital

policies on the international reform agenda might

require Australian banks to further increase their

capital positions.

Australian banks have also increased their issuance

of non-common equity capital (Additional Tier 1

and Tier 2 instruments, sometimes called ‘hybrids’)

in recent quarters (Graph 3.14). Issuance of around

$10½ billion in 2015 to date has been well above

the level of maturities in the period, and thus has

contributed to a rise in banks’ total capital ratio.

To help diversify their investor base, some of the

major banks have issued Tier 2 foreign currency

instruments in 2015, such as renminbi-denominated

instruments in Hong Kong.

Spreads on banks’ new Additional Tier 1 issuance

drifted higher in the first half of 2015, and recent

issues by the major banks have traded in the

0 2 4 6 8 10 %

Westpac

NAB

CBA

ANZ

Majors

Regulatory

minimum*

APRA Basel III basis, June 2015

CET1 minimum

Capital conservation buffer

D-SIB add-on

Pro forma September 2015**

December 2014

* The capital conservation buffer and D-SIB add-on will take effect on

1 January 2016

** Additional change to capital ratio from capital actions in the September quarter,

all else equal

Sources: APRA; Banks’ Financial Disclosures; RBA

plans (DRPs) (Graph 3.12). In mid October, Westpac

announced plans to issue a further $3.5 billion in

common equity. At this point the major banks have

not cut their dividend payments, which would

by definition accelerate the pace of their internal

capital accumulation. Major bank capital positions

have also been bolstered by asset divestment:

ANZ sold its Esanda dealer finance business; NAB

its commercial banking subsidiary in the United

States; and Westpac part of its asset management

business. NAB is also in the process of divesting

its UK subsidiary, for which it was required to raise

more than $3 billion in capital to provision for legacy

conduct issues.

DRP

Other

New issuance**

Buyback

Conversions***

2007 2009 2011 2013 2015

-3

0

3

6

9

12

$b

-3

0

3

6

9

12

$b

Raisings and buybacks*

* Excludes capital raised as part of an acquisition

** Includes new placements, rights issues, share purchase plans and

employee share schemes

*** Conversions of banks’ non-common equity capital instruments

Sources: ASX; Banks’ Annual Reports

The sizeable capital issuance drove a significant

increase in the major banks’ aggregate CET1 capital

ratio over the six months to June 2015 to 9.2 per

cent. Additional capital initiatives undertaken in the

September quarter add a further 80 basis points

of CET1 capital (Graph 3.13). Consequently, the

major banks’ capital ratios are now all well above

the required regulatory CET1 ratio of 8 per cent

(including the capital conservation buffer and D-SIB

surcharge). Nonetheless, it is prudent for the major

banks to maintain a larger-than-usual buffer above

Net* Tier 1 Tier 2 Maturities

2007 2009 2011 2013 2015

-4

-2

0

2

4

$b

-4

-2

0

2

4

$b

* 7-period Henderson trend; net change in capital can exceed net

issuance if maturing instruments are not fully Basel III compliant

Source: RBA

secondary market at a substantial discount to their

listing prices. These developments appear to have

partly reflected a combination of market volatility

and increased supply of hybrid instruments. Another

factor could be that investors might be substituting

into conventional common equity that has been

offered at a discount to market prices.

Under the Basel III international capital framework,

banks will be required to meet a non-risk-weighted

ratio, or ‘leverage ratio’, from 2018. The Basel III

leverage ratio is intended to be a backstop to the

risk-based capital requirements. The ratio measures

the size of a bank’s Tier 1 capital base relative to its

total on- and off-balance-sheet exposures, with

a low ratio indicating greater use of non-equity

funding. The largest Australian banks must begin

disclosing their leverage ratio from their first

reporting date after 1 July 2015. APRA expects to

consult on the implementation of the leverage ratio

in Australia after the calibration of the minimum

international leverage ratio is finalised by the Basel

Committee. The recent APRA study indicated that

the major banks’ aggregate ratio was about 4½ per

cent at June 2014, well above the draft 3 per cent

international leverage ratio requirement.

Disclosures of large global banks suggest that some

have further work to do to comfortably meet their

leverage ratio. There are indications that some

global banks are pulling back from financial market

activities to help ensure that they meet the leverage

ratio. Such balance sheet adjustments could have

implications for the Australian financial system

because global banks are major players in financial

markets here, such as those for certain derivatives

and securities financing. Because of the specialised

and complex nature of these activities, it might be

hard for other players to replace this activity, at least

at short notice. Liquidity in some Australian financial

markets could therefore be reduced; if so, market

participants will need to adjust their behaviour

accordingly.

Strong profitability in recent years, driven by improving loan performance and solid income growth, has supported Australian banks’ capital positions. In the six months to June 2015, banks’ aggregate profit was $20.2 billion, $2.7 billion (15½ per cent) higher than in the previous half year (Table 3.3). Headline profit growth was supported by one-off items, as well as increasing revenues from market-based activities, such as trading and investment income. Net interest income was little changed despite solid asset growth, as the net interest margin narrowed due to strong competition in lending markets. As expected, the bad and doubtful debt charge rose from its historically low level as a share of total assets, with some banks disclosing higher collective provisions.

At the time of writing, equity market analysts

expected the major banks’ profitability to decline

modestly in the near term (Graph 3.15). The major

banks’ return on equity was forecast to be around

14 per cent for the 2016 financial year, a little below

the average of around 15 per cent over recent years.

This reduction may reflect analysts’ expectations

of a small increase in bad and doubtful debts from

their current low levels and/or that rises in average

funding costs from higher capital levels will not be

fully passed on to borrowers. Even so, a subsequent

fall in the major banks’ return on equity might be

accommodated by investors if they were to adjust

their required returns to account for any decline in

risk arising from stronger capital positions. If, on the

other hand, banks continue to maintain their return

on equity targets, it will be important that they

do not pursue these through reducing resources

devoted to risk management and operational

capabilities.

Similarly, equity market investors appear to have

revised their view of the major banks’ earnings and

dividend prospects downwards, with their share

prices declining by 18 per cent since their peak in

March 2015 (Graph 3.16). This fall in share prices

partly reflects the change in risk sentiment among

financial market participants globally. The major

banks’ recent capital raisings have also been a

factor, as their share prices have fallen further than

the regionals and the broader market over recent

months. As a result, the major banks’ equity valuation

– as measured by their price-to-book ratio – is now

a little below its long-run historical average level,

although it remains well above those of the major

advanced-economy banking systems.

Consolidated global operations; $ billion

Dec 2014 June 2015 Change Average change

since 2010(b)

Income

Net interest income 34.6 34.5 –0.2 0.8

Non-interest income 17.8 19.1 1.3 0.0

Expenses

Operating expenses 25.4 24.3 –1.1 –0.1

Bad and doubtful debts 1.9 2.6 0.6 –0.3

Profit

Net profit before tax 25.5 27.2 1.7 1.1

Net profit after tax and minority interests 17.5 20.2 2.7 0.9

(a) Includes all Australian-owned banks, as well as foreign subsidiaries and branches of foreign banks operating in Australia

(b) Average half-yearly change

Sources: APRA; RBA

2007 2009 2011 2013 2015

25

50

75

100

125

index

25

50

75

100

125

index

1 January 2007 = 100

ASX 200

Major banks

Regional banks

Sources: Bloomberg; RBA

Return on shareholders’ equity

After tax and minority interests

0

10

20

%

0

10

20

%

Charge for bad and doubtful debts

Ratio to average assets

1987 1992 1997 2002 2007 2012 2017

0.0

0.5

1.0

1.5

%

0.0

0.5

1.0

1.5

%

Forecasts

* From 2006 data are on an IFRS basis; prior years are on an AGAAP

basis; includes St. George and, from 2009, Bankwest; analysts’ forecasts

are for the 2014/15, 2015/16 and 2016/17 financial years

Sources: Banks’ Annual and Interim Reports; Credit Suisse; Deutsche Bank;

Morgan Stanley; RBA; UBS Securities Australia

Addressing risks in shadow banking – defined as

credit intermediation involving entities and activities

outside the ‘regular’ banking system – has been a

core area of international regulatory reform since

the financial crisis. This has included assessing

the potential risks that might arise from bank-like

activities migrating to the shadow banking sector

in response to the tighter post-crisis prudential

framework for banks.

The shadow banking sector represents only around

5 per cent of financial system assets in Australia. This

share is down from over 10 per cent in 2007 and

well below that for a number of large economies.

These estimates are based on the Financial Stability

Board’s (FSB’s) ‘narrow definition’ of shadow banking,

which in Australia includes securitisation vehicles,

registered financial corporations that are not part

of a banking group, and managed funds that invest

in a range of short- and long-term credit products

(Graph 3.17).6 Because of its small size and minimal

credit and funding links to the regulated banking

system, the shadow banking sector in Australia is

judged to pose limited systemic risk. Nonetheless,

the Reserve Bank and other Australian financial

regulators continue to monitor shadow banking

activity for signs of risk. As part of these efforts,

the Reserve Bank provides regular updates to the

CFR and participates in the FSB’s annual global

assessment of shadow banking activity.

Non-bank securitisation activity is an area of

shadow banking that warrants particular attention

given the heightened risk environment in the

domestic mortgage market. Issuance of residential

mortgage-backed securities (RMBS) has picked

up since 2013, including for non-ADI mortgage

originators that fall outside the prudential regulatory

6 Other non-prudentially regulated financial entities account for a

further 10 per cent of financial system assets in Australia, but are

either not involved in credit intermediation or their parent institution

is subject to consolidated prudential regulation. For further discussion

of Australia’s shadow banking sector, see Manalo J, K McLoughlin and

C Schwartz (2015), ‘Shadow Banking – International and Domestic

perimeter. Mortgage originators tend to have

riskier loan pools than banks: they are the only

suppliers of non-conforming residential mortgages

(which are those that do not meet the standard

underwriting criteria of banks), and their RMBS

have a higher average LVR and a larger share of

low documentation loans and interest-only loans

(Table 3.4). Given the riskier nature of the underlying

collateral, mortgage originators usually provide

more credit enhancement to senior notes to achieve

AAA-ratings, such as by allocating a larger share of

the RMBS to junior sub-AAA tranches or through the

use of lenders mortgage insurance (LMI).

regulators remain alert to the possibility that activity

by non-bank issuers might pick up in response to

the recent tightening in banks’ housing lending

standards and higher pricing for banks’ investor

housing loans. The potential for this to occur will

depend on market demand for additional mortgage

Financial assets*

Value

2005 2010

0

150

300

450

$b Share of financial system**

2005 2010 2015

0

4

8

12

%

Registered financial corporations not part of a banking group

Managed funds investing in credit products

Securitisation vehicles (excluding self-securitisation)

* Total assets for some entity types where financial assets data

are unavailable

** Excluding RBA

Sources: ABS; APRA; RBA

originators’ RMBS, as well as mortgage originators’

access to the necessary warehouse funding from

banks (the provision of which regulators are

monitoring) along with their operational capability

to process greater lending volumes.

Superannuation funds are a large part of the

financial sector, accounting for three-quarters of

managed funds’ total assets, and in total are over

half the size of the banking sector in terms of assets.

Superannuation funds’ assets grew at an annualised

rate of around 9 per cent over the six months to

June 2015, to $2.02 trillion. The recent pace of

growth in total assets has been affected by the

volatility in Australian equity markets; for example,

APRA-regulated superannuation funds recorded

a net investment loss of 1.7 per cent over the June

quarter.

Superannuation funds are required to set an

investment return objective for the assets invested

on behalf of their members (by investment option).

This is typically defined as a fixed percentage in

excess of CPI inflation or relevant benchmark index.

Over recent years, the prolonged period of low

global interest rates and subdued economic growth

has lowered the returns available across various

investment classes, which has made it more difficult

for some superannuation funds to achieve their

return objectives (Graph 3.18). While superannuation

fund trustees have a legal obligation to act in the

best interests of their members, in this environment

there is a risk of superannuation funds choosing

higher portfolio allocations to riskier assets than

otherwise in order to try to boost returns. In

addition to exposing fund members to greater

risk, this behaviour could possibly contribute to

financial instability by amplifying asset price cycles,

though funds would typically aim to hold such

assets for a long time. While there has been no

significant shift in aggregate in superannuation

funds’ portfolio allocations in recent years, anecdotal

evidence suggests that low returns have prompted

some funds to switch into riskier assets such as

commercial property that are expected to generate

higher returns. However, it appears more common

-2 0 2 4 6 %

Cash

Australian

fixed income

International

fixed income

Australian

equities

International

equities

Commercial

property

Average real yield**

Past 5 years

Past 10 years

Current

* Does not account for investment fees or taxes; commercial property: IPD Australia

All Property Index discount rate; international equities: MSCI World Index forward

earnings yield; Australian equities: ASX 200 Index forward earnings yield;

international fixed income: Barclays Global Aggregate Bond Index yield; Australian

fixed income: Bloomberg AusBond Composite Index yield; cash: 1-year swap rate

** Assumes 2½ per cent inflation

Sources: Bloomberg; IPD; RBA; Thomson Reuters

At date of issuance; 2012/13–2014/15(a)

Major banks Other ADIs Non-ADIs

Average LVR 58 59 69

Per cent of loans with full documentation 100 100 83

Per cent of interest-only loans 19 21 33

Per cent of loans covered by LMI 22 97 89

Per cent of sub-AAA tranches 7 3 13

(a) For all marketed RMBS issuances with available data; weighted by loan values except per cent of sub-AAA tranches, which is based

on tranche face values

Source: RBA

Semiannual

Contributions to return on equity*

2003 2006 2009 2012 2015

-15

0

15

30

%

-15

0

15

30

%

Net loss ratio**

2003 2006 2009 2012 2015

40

60

80

%

40

60

80

%

Return on equity

Investment income

Underwriting result

Tax and other

* Ratio of net profit after tax to equity; annualised

** Ratio of net incurred claims to net premium; change in reporting

basis after June 2010

Sources: APRA; RBA

Brisbane hailstorm

Cyclone Marcia

Sydney & surrounding region storms**

Cyclone Yasi

Queensland floods

Other

00/01 02/03 04/05 06/07 08/09 10/11 12/13 14/15

0

1

2

3

4

$b

0

1

2

3

4

$b

* Losses from catastrophe events before 2011 have been indexed to

2011 prices; events from 2011 are the actual cost; the cost of recent

events may not have been finalised

** Includes low storm and hailstorm events that occurred in late April

Source: Insurance Council of Australia

for funds to have reduced their return targets or

communicated to members that returns may be

lower in coming years (or both).

Over the longer term, the ageing of the

population means that an increasing proportion of

superannuation funds’ members are moving from

the accumulation phase into the drawdown phase.

This demographic change may result in an increase

in allocation towards more conservative assets,

such as cash and deposits, potentially increasing

the interconnectedness between banks and the

superannuation industry. Also, as benefit payments

increase relative to contributions with the ageing of

the population and maturing of the superannuation

system, superannuation funds will need to carefully

manage the associated liquidity implications.

The general insurance industry remains well

capitalised, with capital equivalent to 1.7 times

APRA’s prescribed amount. Following several years

of strong outcomes, general insurers’ underwriting

result has declined sharply in recent periods

(Graph 3.19). Net claims expenses have risen

substantially, to be equivalent to around 70 per cent

of premium revenue, compared with lows of 60 per

cent recorded during 2012–13. Natural catastrophe

claims were historically high in the 2014/15 financial

year at around $3½ billion, with these mainly arising

from events in Queensland and New South Wales

(Graph 3.20). Insurers’ profit in the six months to June

2015 was also weighed down by lower investment income.

protection to banks and other lenders against

losses on defaulted mortgages. Australian LMIs

have benefited from a below-average level of

claims over recent years in a climate of rising

housing prices. However, the industry’s premium

revenue declined in the first half of 2015, with LMIs

reporting a reduction in new high-LVR policies as

banks tightened their mortgage lending practices.

In addition, claims from the mining-exposed states

of Queensland and Western Australia have increased

recently.

The concentration of Australian LMIs’ customer

base in the four major banks means that they are

vulnerable to a significant decline in demand.

In the first half of 2015, Westpac stopped using

Genworth and QBE (the two major Australian LMIs)

as its external LMI providers and shifted its risk to an

offshore reinsurer. While NAB renewed its contract

with Genworth in June, it is possible that banks might

actively reduce their business with Australian LMIs in

the future, either by switching to offshore providers

or by ‘self-insuring’ mortgages (that is, charging the

borrower a low-equity fee and retaining the risk

themselves).

Life insurers’ profits increased noticeably in the six

months to June 2015, driven by an improvement in

individual disability income insurance (commonly

known as ‘income protection insurance’), a line of

insurance business that had been generating losses

since mid 2013 (Graph 3.22). As discussed in previous

a number of structural weaknesses that have

contributed to low profitability over recent years.

These include poor definitions of product benefits,

pricing not being adjusted for enhanced benefits,

a lack of data on insurance risk and a shortage of

skills for claims management. APRA has recently

observed a number of improvements in these areas,

particularly in pricing and data analysis on ‘group’

polices (that is, policies sold through superannuation

funds).7 Despite the recent challenges, the life

insurance industry is well capitalised, at 1.8 times

APRA’s prescribed capital amount.

The Australian Government recently endorsed a

package of reforms that were proposed by industry

participants in response to ASIC’s concerns about

the quality of retail life insurance advice.8 Key

components of the reforms, which could become

fully effective in 2018, include a reduction of up-front

commissions paid to advisers and a lengthened

period during which commissions may be clawed

7 See Khoo B (2015), ‘Letter to LI Entities on Group Insurance’, 18 May.

8 For further details, see Frydenberg J (2015), ‘Industry Reform Proposal

on Retail Life Insurance Welcomed’, media release, 25 June.

Commercial

Personal

Mixed/other

-20 -15 -10 -5 0 5 10 15 %

Travel

Consumer credit

Marine & aviation

CTP

Commercial motor

Home & contents

Domestic motor

Commercial liability

LMI

Commercial property**

Professional indemnity

Employers’ liability

Year to June half 2015

* Gross written premium divided by number of policies written

** Fire and industrial special risks insurance

Sources: APRA; RBA

Net profit after tax*

700

1 400

$m

700

1 400

$m

Selected business lines

2009 2010 2011 2012 2013 2014 2015

-600

-300

0

300

600

$m

-600

-300

0

300

600

$m

Non-participating investment-linked

Group death/TPD**

Individual death/TPD**

Individual disability

income

* Includes profit from other non-risk business

** TPD = total and permanent disability

Source: APRA

back if a policyholder chooses to withdraw from a

policy. These initiatives, if implemented, should more

closely align the incentives of advisers, insurers and

customers.

Financial market infrastructures (FMIs) – such as

payment systems, central counterparties (CCPs)

and securities settlement systems – support most

financial transactions in the economy. Because FMIs

concentrate both services and risk, they need strong

regulation and supervision of their financial position,

governance and risk management practices. The

cyber resilience of FMIs is one area that has attracted

greater attention from regulators in recent years.

Default management and stress testing are also

important elements of risk management, and were

therefore key themes in the Reserve Bank’s most

recent assessment of ASX.9

Since participants in the financial system rely on

FMIs to support most financial transactions, a

significant operational disruption at an FMI could,

in turn, disrupt the financial system. For this reason,

it is essential that FMIs maintain a high level of

operational resilience, and this is reflected in the

years, the growing threat of cyber attacks poses

an increasing risk to FMIs’ operational resilience.

Recognising this, FMIs and their regulators, both

in Australia and internationally, are making the

resilience of FMIs to cyber threats a strategic priority.

While domestic FMIs have robust frameworks in

place to protect against cyber threats, they have

been taking a number of actions to enhance their

resilience to the growing threat. The Reserve Bank

has initiated two projects to increase the resilience

9 The Bank’s most recent assessment of ASX against the Financial Stability

Standards was published in September and is available at <www.rba.

gov.au/payments-system/clearing-settlement/assessments/2014-2015/

index.html>. It covers the default of BBY and enhancements to stress

testing.

of the Reserve Bank Information and Transfer System

(RITS) – Australia’s wholesale payment system – to

cyber threats:

place to prevent a cyber-related incident

recover from a wide range of potential operational

disruptions, including a cyber attack; this review

will include the identification of additional

measures that could improve RITS’ resilience in

this area and an examination of the benefits,

challenges and costs of implementing them.

Separately, ASX has carried out a high-level

self-assessment against a widely used cyber

resilience standard, the US National Institute

self-assessment concluded that ASX’s cyber security

practices generally aligned with the upper two tiers

of ‘maturity’ levels under this framework.

Globally, FMI regulators are also working together

through international standard-setting bodies to

develop guidance in the area of cyber resilience to

support relevant requirements in the PFMI. Once

published, the guidance is intended to help FMIs

enhance their cyber resilience and to provide a

framework for supervisory dialogue.

A CCP stands between the counterparties to a

financial market trade and performs the obligations

that each has to the other under the terms of that

trade. Accordingly, in the event of the default of a

participant in a market that is centrally cleared, the

CCP takes on the defaulting participant’s obligations

to the remaining participants. This was the case for

ASX Clear, when a broker participant, BBY Limited

(BBY), entered into voluntary administration on

17 May 2015. To neutralise its exposure to market

risk, ASX Clear had to ‘close out’ the financial risk

associated with BBY’s obligations by entering into

offsetting trades or transferring client positions to

another clearing participant (the latter process is

known as ‘porting’). In the event, ASX Clear was able

to manage the default without any evident market

impact and held sufficient collateral from BBY to

absorb all losses arising in the close-out process.

The first early warning of potential governance,

control and financial issues at BBY occurred in June

2014. At that time, BBY submitted an unusually large

concentrated cash market transaction for clearing, but

was unable to fully meet the collateral call triggered

by this transaction. ASX permitted a delayed payment,

but imposed restrictions on BBY’s ongoing clearing

activity and required BBY to improve its governance

framework and risk control systems.

On 6 May 2015, BBY was again unable to meet

a collateral call. At that time BBY had more

than 1 000 derivatives clients, which together

accounted for around 10 per cent of ASX Clear’s

derivatives exposures (as measured by total margin

requirements). By the time BBY entered voluntary

administration it had closed out or transferred open

client positions representing around one-third

of its derivatives exposures. Where arrangements

to transfer client positions to another clearing

participant were sufficiently well advanced at the

time of default, ASX proceeded with these transfers.

Ultimately, over half of the outstanding derivatives

exposures at 6 May were able to be ported. The

remaining exposures were closed out by ASX.

ASX Clear was able to port derivatives client

positions because it uses individually segregated

accounts, which ensures that each client’s exposure

is collateralised to a high degree of confidence. The

BBY incident nevertheless highlighted a number

of specific impediments to the porting process.

In particular, portability relies on the willingness

and capacity of another participant to take on

the affected clients within a short period of time.

The BBY default demonstrated that porting may

not be possible if transfer arrangements have not

already been pre-positioned prior to a clearing

participant’s default, because it takes time for

receiving participants to complete due diligence

and ‘know-your-customer’ processes. ASX has

begun to consider how account structures, transfer

arrangements and operational processes could be

enhanced to assist the efficient porting of clients

when a broker defaults.

ASX, in consultation with the Reserve Bank, has

begun to assess some of the experiences gained.

In addition to the impediments to porting, the BBY

default has highlighted that the diversity of ASX Clear

participants may justify a more risk-sensitive

approach to determining minimum capital and

other financial requirements. The Reserve Bank, in

its recent assessment of ASX, has also encouraged

ASX Clear to consider the experience gained from

BBY’s default as part of its broader review of the

calibration of its margin model parameters.

Beyond defaulter pays resources, CCPs maintain

additional pre-funded pooled financial resources

to ensure their resilience to a participant default.

by the Reserve Bank, which are based on the PFMI,

a CCP’s pre-funded pooled resources must be able

to withstand the default of the participant and its

affiliates to which it has the largest exposure under

stressed market conditions. Where a CCP clears

complex products or is systemically important in

multiple jurisdictions, as is the case for the ASX CCPs,

the test is more stringent, requiring coverage for the

simultaneous default of the largest two participants

and their affiliates.

A CCP is required to conduct regular stress tests

to verify the adequacy of its pre-funded financial

resources; this includes testing the adequacy of its

liquidity arrangements. ASX Clear and ASX Clear

(Futures) also use daily stress testing to calculate

requirements for additional initial margin, which

they collect to cover large and concentrated

exposures. In order to ensure that stress tests remain

appropriate, ASX reviews its set of stress scenarios

on a monthly basis by using forward-looking and

current market indicators. In addition, ASX performs

monthly ‘reverse stress tests’ to identify scenarios in

which its financial resources would be exhausted.

This involves varying the assumed magnitude and

direction of both shocks and participant positions, as

well as the number of participant defaults assumed.

In line with a Reserve Bank recommendation,

in 2014/15 ASX’s capital and liquidity stress test

models were subject to a full evaluation by an

external expert. ASX’s approach was found to be

broadly comparable to that of its peers, but ASX has

implemented a number of changes to bring it closer

into line with international best practice as identified

by the benchmarking study. In particular, ASX has

extended its holding period for exchange-traded

products from one day to a minimum of three

days and introduced a series of forward-looking

hypothetical scenarios motivated by external ‘macro’

events, such as shocks stemming from natural

disasters, collapses in commodity prices or offshore

sovereign defaults. These changes are part of a first

phase of enhancements to ASX’s stress testing.

A second phase will be partly dependent on any

additional guidance coming out of the international

stocktake of existing measures for CCP resilience,

including stress testing (see ‘Developments in the

Box C

The Regulatory Capital Framework for

Residential Mortgages

Simply put, a bank’s capital represents its ability

to absorb losses. To promote banking system

resilience, regulators specify the minimum amount

of capital that banks should allocate against various

risks. Of particular importance is the amount of

capital allocated against credit risk – the risk that

borrowers will not repay their debt obligations – as

this is typically the main risk that commercial banks

assume. From mid 2016, the Australian Prudential

Regulation Authority (APRA) will require some banks

to increase the capital that they allocate against

credit risk in their residential mortgage exposures.

This box outlines the regulatory capital framework

in Australia in order to provide some context for this

recent decision.

The framework for credit risk requires banks to

determine the capital that they need to allocate

against their credit exposures by assigning each

exposure a ‘risk weight’ that reflects the potential

for unexpected losses.1 For instance, a risk weight of

25 per cent on a $100 loan equates to a risk-adjusted

exposure of $25, so a bank would need to allocate

$2.50 in capital to achieve a capital ratio of 10 per

cent of risk-weighted assets.2 Average risk weights

can differ significantly across classes of credit

exposures: for example, most corporate lending

exposures attract risk weights that are well above

those on most residential mortgages (Graph C1).

In Australia, the four major banks and Macquarie

Bank are approved to use the internal ratingsbased

(IRB) approach to credit risk, whereby they

1 Technically speaking, capital is required to cover unexpected losses

up to a 99.9 per cent level of confidence. A bank’s expected losses

should be covered by its credit provisions.

2 A capital ratio of 10 per cent is used here for illustration. Required

regulatory capital ratios are somewhat higher than this, although they

may be lowered by supervisors in stressed conditions.

use internal models accredited by APRA to derive

the risk weights on their credit exposures. All

other authorised deposit-taking institutions (ADIs)

currently use the standardised approach, where

the risk weights are prescribed by APRA. The set of

prudential standards for both of these approaches

in Australia are consistent with the international

capital standards issued by the Basel Committee on

Banking Supervision (BCBS).

The IRB approach to measuring credit risk was a

centrepiece of the international Basel II capital

framework that was implemented in Australia in

2008. Its aim was to enable banks to more accurately

estimate the risk of their credit exposures using

their own data and experience, and to ensure that

SME

corporate

Corporate Revolving

retail*

Residential Sovereign

0

15

30

45

%

0

15

30

45

%

By selected lending portfolio, June 2015

* Excludes retail SME

Sources: APRA; RBA

internal models, supervisors play an important

role in reviewing and approving the modelling

approach. Indeed, APRA grants approval to use

the IRB approach only after a bank has met strict

governance and risk modelling criteria. Purely

statistical models or other mechanical methods

are not acceptable, and banks must have policies

detailing how judgement and model results should

be combined. Model outputs also need to be

supplemented with insights from stress tests.

In addition to overseeing banks’ internal modelling

processes, national supervisors may use discretion

under the Basel II framework to require banks to

maintain capital above the international minimum

for a particular exposure class, as circumstances can

differ materially between jurisdictions. The residential

mortgage asset class is one area where APRA has

adopted a more conservative local stance than

the minimum requirements set out in the Basel II

framework. Specifically, in 2008 APRA set a ‘floor’

of 20 per cent on the LGD for residential mortgage

exposures, rather than the 10 per cent floor

prescribed by the BCBS. The higher floor was judged

necessary in the Australian context to guard against

banks underestimating the losses on their mortgage

portfolio in a downturn. There are no historical data

that cover a severe loss episode, because there has

not been a major housing downturn in Australia

since the 1890s.5

In recent years, some national regulators have made

adjustments to the IRB approach for residential

mortgages in response to concerns that modelling

practices were not adequately capturing the full

range of risks. In particular:

weight floor

5 See Stapledon N (2012), ‘Trends and Cycles in Sydney and Melbourne

52(3), pp 293–317.

capital varies according to changes in measured risk

over time.3

Under the IRB approach, the risk weight for each

type of credit exposure is based on an estimated

probability distribution of credit losses. The shape of

this distribution is affected by the following key inputs:

borrower default in the course of a year

outstanding if the borrower defaults

of the exposure that the bank would lose if the

borrower defaults.

Banks typically estimate these inputs internally after

rating their exposures according to a number of risk

characteristics – hence the term ‘internal ratings-based’

approach.4 For instance, a mortgage for a borrower

that has a poor repayment history and a high loan-tovaluation

ratio (LVR) may be assigned a relatively weak

rating and a higher estimated PD and LGD; differences

in the composition of mortgage types is one reason

why risk weights vary between IRB banks.

An additional input, a ‘correlation factor’, is specified

by APRA for each broad type of credit portfolio.

The correlation factor can be thought of as the

dependence of exposures within a portfolio on the

general state of the economy.

Although IRB banks largely determine the risk

weights on their credit exposures using their

3 The IRB Basel II framework was also a way of addressing incentives for

capital arbitrage that had become apparent under the simple Basel I

framework – that is, the incentive to accumulate assets in areas where

risks were under-recognised in the previous capital framework. See

Ingves S (2013), ‘Strengthening Bank Capital – Basel III and Beyond’,

address to the Ninth High Level Meeting for the Middle East & North

Africa Region, Abu Dhabi, 18 November.

4 For non-retail exposures, such as corporate lending, there are two

tiers within the IRB framework: ‘advanced’ IRB banks have supervisory

approval to model the PD, EAD, LGD and M parameters, whereas

‘foundation’ IRB banks must use supervisor-specified estimates for

LGD and EAD. Currently Macquarie Bank is a foundation bank whereas

the four major banks are all advanced banks.

loans with high LVRs.

Relative to the IRB approach, the standardised

approach is a simpler way of measuring credit risk

and determining minimum capital requirements.

Risk weights are prescribed by supervisors based on

some observable risk characteristics. For residential

mortgage exposures, risk weights in Australia are

based on:

(e.g. loans with low documentation)

insurance (LMI).

Depending on the mix of characteristics, residential

mortgage exposures can attract a risk weight of 35,

50, 75 or 100 per cent (Table C1). APRA’s prudential

standard applies more risk-sensitive prudential

criteria than in some jurisdictions, which typically

impose risk weights of 35 per cent for loans with an

LVR of less than 80 per cent.

The standardised approach is not as risk-sensitive

as the IRB approach for residential mortgages

in Australia. One consequence is that certain

mortgage exposures with the same risk profile can

attract a different risk weight (and hence capital

requirement) under the IRB approach than the

standardised approach. In practice, risk weights tend

to be lower under the IRB approach, although APRA’s

adjustments to the Basel II framework have reduced

the difference somewhat. The difference in average

risk weights between the two approaches provides

an incentive for banks to invest in developing and

maintaining the models and risk management

processes required to achieve IRB accreditation;6 a

number of smaller banks are currently progressing

towards meeting the necessary criteria.

In July APRA announced an increase in capital

requirements for Australian residential mortgage

exposures under the IRB approach. The increase

will be implemented via an adjustment to the

correlation factor prescribed by APRA. The average

risk weight of residential mortgage exposures using

6 The standardised and IRB credit risk-weights are not directly comparable

for a given product. First, ADIs that use the standardised approach tend

to be relatively undiversified across geographies and products, as well

as have greater business/strategic and credit concentration risks than

the larger, more diversified banks using the IRB approach. Second, IRB

banks are subject to other capital requirements that are not applied to

standardised banks, including for interest rate risk in the banking book.

Per cent

Standard loans Non-standard loans

LVR With LMI(a) Without LMI With LMI(a) Without LMI

0–60 35 35 35 50

60.01–80 35 35 50 75

80.01–90 35 50 75 100

90.01–100 50 75 75 100

> 100.01 75 100 100 100

(a) A minimum of 40 per cent of the original loan amount must be insured

Source: APRA

the IRB approach will increase to at least 25 per cent

by mid 2016, from an average of around 17 per cent

at the end of June 2015. By comparison, the average

risk weight for residential mortgage exposures under

the standardised approach was around 40 per cent.

The increase in IRB mortgage risk weights addresses

a recommendation of the 2014 Financial System

Inquiry that APRA raise the average IRB mortgage

risk weight to narrow the difference between

average mortgage risk weights for banks using the

IRB approach and those using the standardised

approach. The increase is also consistent with the

direction of work being undertaken by the BCBS on

changes to the global capital adequacy framework

for credit risk.

The increase in IRB mortgage risk weights in Australia

is an interim measure. The final calibration between

the IRB and standardised mortgage risk weights will

not be finalised until the BCBS’ broader reviews of

International regulatory reform efforts continue to

focus on finalising and implementing post-crisis

reforms, while remaining attentive to potential new

and evolving risks. Work is ongoing across the four

core reform areas identified following the financial

crisis: addressing ‘too big to fail’; responding to

shadow banking risks; making derivatives markets

safer; and building resilient financial institutions.

Attention has increased more recently on areas

such as potential risks stemming from asset

management activities and reduced market liquidity,

as well as market misconduct and the increasing

importance of central counterparties (CCPs) to the

financial system.

Domestically, in line with recommendations by

the Financial System Inquiry (FSI) for the banking

sector, the Australian Prudential Regulation

Authority (APRA) has taken steps to narrow the

competitiveness gap between banks vis-à-vis their

capital requirements for mortgages and, more

generally, to increase their resilience. Separately,

authorities continued to work on implementing

internationally agreed reforms, particularly in the

area of over-the-counter (OTC) derivatives markets.

One major element of the G20’s post-crisis financial

reform agenda has been to address the moral hazard

and financial stability risks posed by ‘too big to fail’

or systemically important financial institutions (SIFIs).

Policy development in this area has focused on

strengthening resolution frameworks for SIFIs as well

as enhancing their supervision and resilience.

focus recently has been to develop a proposal for

total loss-absorption capacity (TLAC) requirements

for global systemically important banks (G-SIBs). This

additional loss absorbency is intended to ensure

that G-SIBs can be resolved in an orderly way that

avoids using taxpayer funds for recapitalisation and

limits the effect of failure on financial stability. The

TLAC proposal aims to achieve these goals, in part,

by allowing eligible debt instruments that can be

‘bailed-in’ (i.e. written down or converted into equity)

to count towards the requirement, in addition to

regulatory capital instruments. The Financial Stability

Board (FSB) will present a final TLAC proposal to

the G20 Leaders’ Summit in November, taking

into account feedback on a consultative proposal

released in late 2014, as well as the results of a recent

quantitative impact study.

While no Australian banks are directly captured by

this proposal (as they are not G-SIBs), it is relevant

for Australia because the final requirements will

shape bank resolution frameworks, capital structures

and funding markets internationally. Moreover,

the FSI recommended that APRA should develop

a framework for minimum loss-absorbing and

recapitalisation capacity for Australian banks in line

with emerging international practice. The Bank

and other Council of Financial Regulators (CFR)

agencies have maintained a close interest in the

development of this international standard through

their membership of the bodies, such as the FSB and

the Basel Committee on Banking Supervision (BCBS),

where these discussions are taking place.

The orderly resolution of large, complex banks

with cross-border operations is another ongoing

issue being considered by the G20 and the FSB.

Following an earlier consultation process, the

FSB will publish guidance later this year on the

effectiveness of cross-border recognition of

resolution actions, including bail-in and temporary

stays on financial contracts. The motivation of this

work is that, unless resolution measures taken by

one jurisdiction are recognised promptly by other

jurisdictions, authorities are likely to face obstacles

in implementing effective group-wide resolution

plans. In 2014, the International Swaps and

Derivatives Association (ISDA), in coordination with

the FSB, developed a contractual solution (known

as the ‘ISDA 2014 Resolution Stay Protocol’) to help

prevent cross-border OTC derivatives contracts

from being terminated disruptively in the event of

a foreign counterparty entering resolution. Parties

that adhere to the protocol agree to ‘opt in’ to laws

that govern temporary stays in jurisdictions that are

identified under the protocol. Legislative proposals

are currently being developed in Australia to provide

for a temporary stay regime that would be eligible to

be identified under the protocol.

Work also continues on the implementation of

previously agreed reforms to improve resolution

frameworks. In April, the FSB launched the second

sector resolution powers available to authorities, and

countries’ progress in implementing recovery and

resolution plans for domestic banks that could be

systemic if they failed. Australia is participating in the

review and the findings will be published in early

2016.

In May, the FSB published the findings of a

thematic peer review on supervisory frameworks

and approaches for systemically important banks,

which highlighted the role that effective supervision

plays in reducing moral hazard. The review

found that national authorities had significantly

enhanced their supervisory frameworks since the

financial crisis, and recommended that supervisors

strengthen cross-border cooperation, develop

clear and transparent supervisory priorities and

increase engagement with banks, particularly at the

board level.

While much of the post-crisis regulatory focus on

SIFIs has been on bank resilience and resolution,

work also continues on addressing risks posed

by systemically important non-bank entities. In

particular:

in October, the International Association of

Insurance Supervisors (IAIS) released the first

version of the higher loss absorption (HLA)

requirement for global systemically important

insurers (G-SIIs). Under the HLA requirement

G-SIIs will need to hold additional capital on

top of a ‘basic capital requirement’. The HLA

requirement, expected to be endorsed by G20

Leaders in November, will be further reviewed by

the IAIS, and refined where necessary, before it

comes into effect for G-SIIs from 2019.

Organization of Securities Commissions (IOSCO)

received responses to their second consultation

paper on methodologies for identifying

non-bank non-insurer global SIFIs such as brokerdealers,

investment funds and asset managers.

The FSB announced in July that it has decided

to delay finalisation of these methodologies until

its current work on potential risks from asset

management activities is completed, which is

likely to be in the first half of 2016 (discussed

further below).

workplan to promote CCP resilience, recovery

planning and resolvability (see below).

Domestically, CFR agencies continued to collaborate

on strengthening Australia’s resolution and crisis

management arrangements.

reforms that will include updated proposals

to strengthen APRA’s crisis management

powers and introduce a resolution regime for

financial market infrastructures (FMIs), broadly

a government consultation on FMI resolution

regimes earlier in the year.

crisis simulation exercise to test aspects of the

crisis management framework, particularly

those relating to inter-agency and external

communication, and determine the scope for

further refinements.

In a related development, the government

announced in September that, consistent with an

FSI recommendation, the existing post-funding basis

of the Financial Claims Scheme will be maintained.

As such, the proposals of the previous government

for an ex-ante levy on authorised deposit-taking

institutions (ADIs) and a Financial Stability Fund will

now not proceed.

International bodies and national regulators continue

to address the risks posed by shadow banking

entities and activities that are more lightly regulated

than the banking sector. With many of the post-crisis

shadow banking reforms finalised, focus has shifted

to implementation monitoring. In September, IOSCO

published the results of peer reviews on money

market funds (MMFs) and securitisation.

the implementation of IOSCO’s 2012

recommendations, which sought to introduce

common standards for the regulation of MMFs,

including for these funds’ valuation methods,

liquidity management and disclosures. In doing

so, the reforms aimed to address the investor

run risk faced by some MMFs. The peer review

found that jurisdictions had made progress in

adopting the reforms, particularly countries

with large MMF sectors, such as the United

States. However, liquidity management and

fund valuation policies were highlighted as areas

where further work was needed in a number

of jurisdictions. The Australian Securities and

Investments Commission (ASIC) is currently

working with the Financial Services Council to

develop a set of industry standards addressing

several IOSCO recommendations relevant to the

Australian market.

adoption of IOSCO’s recommendations, also

released in 2012, relating to aligning the

incentives of investors and securitisers in

the securitisation process, including, where

appropriate, through mandating retention of risk

in securitisation products. The peer review noted

that several countries had fully implemented

the reforms, but a number of others, including

the United States and some European countries,

were yet to complete them. The report

suggested that potential issues arising from

cross-border differences in incentive regimes

were yet to be addressed and that jurisdictions

had a wide variety of exemptions that may need

to be assessed in future reviews.

IOSCO finalised criteria for identifying ‘simple,

transparent and comparable’ securitisations.

These criteria are intended to help investors

and other transaction parties evaluate the

relative risks of similar securitisation products.

Currently, they only serve as a guide and have

no regulatory implications; however, the BCBS is

considering options for incorporating the criteria

into its capital framework for securitisation.

coming months its revised ADI prudential

standard for securitisation, taking into account

submissions on its 2014 proposals to simplify the

regulatory framework for securitisation.

An FSB peer review is currently underway on

countries’ implementation of its policy framework

for shadow banking entities (other than MMFs).

The Bank coordinated with the other CFR agencies

on preparing Australia’s input for the review, and a

senior officer from the Bank is on the peer review

team. Preliminary findings of the peer review are to

be presented to the G20 Summit, with the report to

be released in early 2016.

In addition to this implementation monitoring, the

FSB and BCBS are continuing to work on aspects of

the regulation of securities financing transactions

(SFTs), given the scope for procyclicality and leverage

in SFT markets:

the FSB’s previously released haircut framework

for bank-to-non-bank SFTs into the Basel capital

framework.

applying its framework of numerical haircut

floors for non-bank-to-non-bank SFTs, to address

excessive leverage in these transactions.

a new data collection standard for SFTs, which

jurisdictions will be expected to implement.

Meeting one of the FSB’s SFT recommendations, the

Bank recently consulted on the case for central clearing

in the domestic repo market. The Bank is currently

finalising a response paper, taking into consideration

submissions received on the consultation paper.

In the most recent progress report on the G20

OTC derivatives market reforms, released in

July, the FSB found that the implementation of

central clearing of standardised OTC derivatives

continues to be uneven across jurisdictions. In

recent months, Australian authorities have made

significant progress in implementing this aspect

of the reforms. Following an earlier consultation, in

September, the government issued a determination

imposing mandatory central clearing obligations for

internationally active dealers in Australian dollar-,

US dollar-, euro-, British pound- and Japanese

yen-denominated interest rate derivatives. ASIC

is expected to soon make Derivative Transaction

Rules (Clearing), which will set out the details of the

requirements and the effective date.

Australian regulators also continue to make

progress in establishing cooperative arrangements

with overseas authorities to support the rollout of

regulatory reforms in OTC derivatives markets and

the regulation of cross-border FMIs:

Bank and the Monetary Authority of Singapore

was signed in April to gain access to the data of

DTCC Data Repository (Singapore), the only trade

repository licensed in Australia.

announced in April that ASX Clear (Futures) and

ASX Clear were in the first group of non-EU CCPs

to be recognised under the European Markets

Infrastructure Regulation.

permanent exemption from registration as a

Derivatives Clearing Organisation in the United

States, the first CCP globally to be granted such

an exemption.

regulatory community has been working to

overcome legal and other barriers to the reporting,

sharing and aggregation of key information from

trade repositories. The FSB will soon publish a peer

review report on these issues. In particular, the report

will include an agreed timeline for addressing these

challenges. Separately, the Committee on Payments

and Market Infrastructures (CPMI) and IOSCO are in

the process of developing detailed guidance on the

form of key data elements, which will facilitate the

aggregation of data across trade repositories.

CPMI and IOSCO continue to monitor the

standards for CCPs and other types of FMIs. As part

of this, a detailed assessment of the consistency

of Australia’s framework is currently in progress.

Also, a peer review is assessing the extent to which

authorities in member jurisdictions are observing

the parts of the PFMI that relate to their roles as

regulators and supervisors of FMIs. Both assessments

are expected to be published by the end of 2015. In

July, CPMI and IOSCO announced that they have also

commenced assessing the consistency in outcomes

achieved by FMIs’ implementation of the PFMI,

beginning with an assessment of derivatives CCPs’

financial risk management. The scope of this review

includes ASX Clear (Futures) and both the overseas

CCPs licensed to clear OTC derivatives in Australia.

Given the growing use of CCPs, a workplan has been

developed by the FSB, the BCBS, CPMI and IOSCO

to promote CCP resilience, recovery planning and

resolvability. The key elements of the workplan,

which extends into 2016, include:

CCP resilience and recovery planning to inform

whether additional guidance to the international

standards in these areas is needed;

and resolution-planning arrangements, and

considering whether there is a need for more

detailed standards or for additional pre-funded

financial resources in resolution; and

and the banks that are their clearing members,

and potential channels for transmission of risk.

In September, the four bodies noted above published

a report outlining progress on the workplan. CPMI

and IOSCO are in the process of analysing responses

to a series of surveys conducted as part of the

stocktake on CCP resilience and recovery planning.

On the basis of a survey of authorities, the FSB

concluded that CCP resolution planning regimes are

currently not well developed. As a result, the FSB has

established a cross-border crisis management group

for FMIs. The group’s initial focus will be on resolution

planning for CCPs.

With most of the post-crisis reforms aimed at building

resilient financial institutions completed, work in this

area continues to focus on implementation and

on largely technical improvements to the Basel III

capital framework. Work is progressing on the policy

measures identified in the November 2014 report

to the G20 addressing the excessive variability in

banks’ risk-weighted assets (RWAs); for example, in

April, the BCBS published a list of national discretions

it intends to remove from the capital framework

to enhance comparability across jurisdictions and

reduce variability in RWAs.

The BCBS has released consultation documents on

two other areas of policy development:

regulatory treatment of interest rate risk in the

banking book, which is intended to replace the

document proposed two approaches for the

capital treatment: a minimum requirement and

an approach based on supervisory review. The

latter approach requires quantitative disclosure

based on the proposed minimum requirement,

but at the same time accommodates differing

market conditions and risk management

practices across jurisdictions. This consultation

ended in September.

Valuation Adjustment (CVA) risk framework.

Under the proposal, banks will be required to

hold capital against potential future changes

in the CVA, which is essentially an adjustment

made to the price of derivative instruments to

account for the credit risk of the counterparty.

The consultation period ended in early October.

As discussed in ‘The Australian Financial System’

chapter, APRA has recently taken steps that improve

the resilience of Australian banks. In July, APRA

responded to the FSI recommendation to ensure

Australian banks’ capital ratios are ‘unquestionably

strong’ and published the results of an international

capital comparison study. Overall, the study found

that the Australian major banks are well capitalised,

though not in the top quartile of international peers.

Soon after this, APRA also announced an increase

in average residential mortgage risk weights for the

currently five banks using the internal ratings-based

(IRB) approach to credit risk. This announcement is

consistent with the BCBS work aimed at reducing

the excessive variability in banks’ RWAs, and also

addresses the FSI’s recommendation to narrow the

difference between the mortgage risk weights of IRB

banks and banks using the standardised approach.

Two areas identified as new and evolving financial

stability risks have been a focus of G20/FSB efforts

in recent months: asset management activities and

market misconduct.

Consistent with the G20/FSB’s interest in financial

stability risks arising from shadow banking,

international attention on the risks posed by asset

managers has increased, given the growing size

of the funds they manage and their potential

to exacerbate movements in financial markets

where underlying liquidity has reduced.1 The work

is evaluating the role that existing or additional

activity-based policy measures could play in

mitigating potential risks. This work is being

undertaken by two FSB committees: the Standing

Committee on Assessment of Vulnerabilities, of

which the Reserve Bank Governor became chair in

April; and the Standing Committee on Supervisory

and Regulatory Cooperation. The FSB Plenary

meeting in late September discussed the work

on asset management activities, calling attention

to elevated near-term risks, and encouraging

appropriate use of stress testing by funds to

assess their ability individually and collectively to

meet redemptions under difficult market liquidity

1 For more information about asset management, see Price F and

C Schwartz (2015), ‘Recent Developments in Asset Management’,

conditions. Following a review of the initial work

on the structural vulnerabilities in the asset

management sector, areas for further analysis

were identified, including: (i) mismatch between

liquidity of fund investments and redemption

terms and conditions for fund units; (ii) leverage

within investment funds; (iii) operational risk and

challenges in transferring investment mandates

in a stressed environment; (iv) securities lending

activities of asset managers and funds; and (v)

potential vulnerabilities of pension funds and

sovereign wealth funds. The FSB, jointly with

IOSCO, will continue to conduct further analysis

in these areas, and, as necessary, develop policy

recommendations in the first half of 2016.

The G20 has increased its focus on misconduct risk

given the potential for it to create systemic risks

by undermining trust in financial institutions and

markets. The FSB is currently following a workplan to

address misconduct risks which focuses on corporate

governance, financial benchmarks and enforcement

of existing misconduct reforms. It also addresses the

unintended consequences from prior reforms of the

potential withdrawal from correspondent banking

in response to rising compliance costs of anti-money

laundering and other regulations and reputational

risks. Several international bodies released reports in

the market misconduct area in recent months.

credible strategies for deterring market

misconduct. The report identifies a number of

factors as helpful in preventing misconduct,

including swift investigation of offences, public

communication, cross-country cooperation,

proportionate sanctions, and enhancing the

quality of legal and regulatory frameworks to

provide legal certainty.

governance principles for banks. The revised

principles place particular emphasis on

risk governance in promoting the sound

functioning of banks. They provide guidance

to boards and others in risk management roles

on implementing effective risk management

systems, and highlight the importance of

compensation arrangements in communicating

a bank’s risk culture.

on the implementation of recommendations

regarding major interest rate benchmarks.

The report found that administrators of major

benchmarks had made significant progress in

reforming benchmarks, including by conducting

reviews of methodologies and definitions, and

increasing data collection. Market participants

from countries without major benchmarks

have also taken steps to reform rates in their

own jurisdictions. And in early October, the FSB

released a progress report on implementation

of its 2014 recommendations for reforms to

foreign exchange benchmarks. The report drew

on assessments of market participants’ progress,

which were undertaken by the main foreign

exchange committees as well as by central

banks in other large foreign exchange centres.

The report, the preparation of which was led by

the Bank’s Assistant Governor (Financial Markets),

found that good progress had been made overall

in implementing the recommendations. The

Assistant Governor also chairs a working group

set up by the Bank for International Settlements

to establish a single global code of conduct for

the foreign exchange market and to encourage

greater adherence to the code.

outlined the importance of financial benchmarks

and provided recommendations to help market

participants avoid financial benchmark-related

conduct issues. Key recommendations in the

report were: dealers should review their past

conduct, report misconduct and review internal

oversight, culture and incentive arrangements

to ensure they fully address conduct risk;

benchmark administrators are encouraged to

and publish self-assessments against those

principles; and wealth managers and other

clients should understand how dealers handle

their orders and information and how they have

done so in the past. Relatedly, the Bank has been

promoting industry discussions to improve

the functioning of interest rate benchmarks in

Australia.

In line with a request from the G20, the FSB is

also conducting work on climate change and the

financial sector. In September, the FSB hosted

a meeting of public sector and private sector

participants to consider the implications of climaterelated

issues for the financial sector, with a focus

on any financial stability issues that might emerge.

The meeting discussed possible financial stability

risks and mitigants, such as encouraging disclosure

and exploring stress testing. The FSB is to report to

the G20 on potential follow-up work that would

complement existing industry initiatives.

the Final Report of the FSI, the Bank’s Payments

System Board (PSB) commenced a review of the

framework for the regulation of card payments with

the publication of an Issues Paper in March 2015.

This review was flagged in the Bank’s March 2014

submission to the FSI, when the Bank noted that it

would be reviewing aspects of the regulation of card

payments, including interchange fee arrangements,

the regulatory treatment of ‘companion’ card

issuance and surcharging. The broad direction of the

review received support from the FSI Final Report,

which also recommended several areas for the

PSB to consider further reform. In August, the PSB

asked Bank staff to liaise with industry participants

on the possible designation of certain card systems,

including the bank-issued American Express

companion card system, the Debit MasterCard

system and the eftpos, MasterCard and Visa prepaid

card systems. Following this liaison, the Bank

designated these systems. Designation does not

impose regulation; rather, it is the first of a number

of steps the Bank must take to exercise any of its

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and Business Finances’ and ‘The Australian Financial

© 2015 Investment Property Databank Ltd (IPD). All

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