Contents

Overview 1

Box A: Risks in International Housing Markets 13

Box B: Households’ Investment Property Exposures:

Insights from Tax Data 26

Box C: Large Falls in Household Income 31

Box D: Stress Testing at the Reserve Bank 46

Copyright and Disclaimer Notices 61

OCTOBER 2017

Financial

Stability Review

the Bank’s website.

The graphs in this publication were generated using Mathematica.

Secretary’s Department

Tel: +61 29551 8111

Fax: +61 2 9551 8033

Email: rbainfo@rba.gov.au

ISSN 1449-3896 (Print)

ISSN 1449-5260 (Online)

Overview

Global economic conditions strengthened

further over the past six months, reducing

some near-term risks to financial stability and

improving the outlook for bank profitability.

Despite the gradual withdrawal of monetary

stimulus in the United States, financial

conditions remain accommodative. There are

concerns that the combination of low interest

rates and low volatility in financial markets is

promoting excessive risk-taking via a search for

yield. Indebtedness and asset prices have also

risen further in some countries, from already

high levels, increasing the risk of a disruptive

correction. A number of policy uncertainties

and geopolitical risks persist, which, if they were

to escalate, could trigger a reappraisal of asset

valuations and a spike in volatility while also

weighing on the economic outlook.

Risks remain elevated in China given high

corporate debt levels and the prevalence of

borrowing through opaque, less regulated

channels. This has led to considerable credit,

liquidity and contagion risks in the Chinese

financial system. Recent regulatory measures have

the potential to curb these risks over the longer

term, but the authorities face a challenging

transition away from growth strategies associated

with rising debt. In Europe, stronger growth,

regulatory developments and initiatives by

banks have generally improved the resilience

of the financial system, although vulnerabilities

remain in some countries given still weak banking

systems and high sovereign debt.

Turning to Australia, household balance sheets

and the housing market remain a core area of

interest. Household indebtedness is high and,

against a backdrop of low interest rates and weak

income growth, debt levels relative to income

have continued to edge higher. Steps taken by

regulators in the past few years to strengthen

the resilience of balance sheets, including

limiting the pace of growth of investor lending,

discouraging loans with high loan-to-valuation

ratios (LVRs) and strengthening serviceability

metrics, have seen the growth in riskier types of

lending moderate. The most recent focus has

been on limiting interest-only lending, and banks

have responded by further reducing lending

with high LVRs for interest-only loans, increasing

interest rates for some types of mortgages and

significantly reducing interest-only lending.

The tightening of banks’ lending standards for

property loans is constraining some households

and developers but, in doing so, making the

balance sheets of both borrowers and lenders

more resilient. Conditions are relatively weak

in the Brisbane apartment market, with a large

increase in supply reflected in declines in prices

and rents. There are, however, few signs of

significant settlement difficulties to date. More

generally, while housing market conditions vary

across the country, there are signs of easing of

late, particularly in Sydney and Melbourne where

conditions have been strongest.

Business conditions are generally favourable,

although there are some concerns about

non-residential commercial property markets. In

Sydney, price increases continue to outpace the

growth of rents for these properties. In contrast,

activity is more subdued in some other cities

and vacancies are elevated, especially in Perth.

Conditions are positive in most other parts of the

business sector, including the resources sector,

as corporate profitability remains at a relatively

high level and leverage and debt-servicing are

contained. Business failures remain low.

The financial system is in a strong position and

its resilience to adverse shocks has increased

over recent years. Non-performing loans remain

low in aggregate, though they are rising in some

cities and regions that have a greater exposure

to mining activity. Bank profitability is high and

banks are seeking to maintain this by reducing

their lower-yielding assets, both domestically

and abroad. The banks also have ample access

to a range of funding sources at a lower cost

than a year ago, despite many of them being

downgraded by credit rating agencies of late

(largely due to concerns about high and rising

household debt). The Australian Prudential

Regulation Authority (APRA) recently announced

details of its requirements for banks to have

‘unquestionably strong’ capital ratios. This will see

a further rise in minimum capital requirements,

so that the major banks are comfortably within

the top quartile of international peers when

measured on a comparable basis. Following

further examples of lapses in risk controls,

the government, regulators and banks are

taking steps to enhance accountability and to

strengthen the risk culture in the financial sector.

With the tightening of lending standards, there

is a potential that riskier lending migrates into

the non-bank sector. To date, non-bank financial

institutions’ residential mortgage lending has

remained small though their lending for property

development has picked up recently. While the

banking system has minimal exposure to the

non-bank financial sector, growth in finance

outside the regulated sector is an area to watch.

The insurance sector has remained generally

profitable, though returns on equity remain

lower than historically and the sector continues

to face a range of challenges over the medium to

longer term. Risks to the superannuation sector

are low in part due to its modest use of leverage.

Financial market infrastructures have continued

to function effectively.

Efforts to strengthen the resilience of the global

financial sector are continuing, though the

finalisation of the Basel III capital reforms has

been delayed. International bodies have also

been considering new potential sources of

financial stability risk, including the growth of

financial technology (‘fintech’) and cyber threats.

They are also assessing the broad effectiveness

of the post-crisis G20 financial reforms that have

been implemented and whether there have

been any material adverse developments that

require adjustments to policies. Domestically, the

Council of Financial Regulators has continued

its work on enhancing the crisis management

Global economic conditions have strengthened

contributing to financial risk-taking, and a range

of asset prices appear increasingly elevated.

High asset values and low financial market

volatility suggest that some investors may be

underestimating the downside risks they face,

which may increase the likelihood of a disruptive

correction. Favourable borrowing conditions

have encouraged corporates and households in

some jurisdictions to extend already historically

high levels of debt. This has raised concerns

about borrowers’ resilience to negative shocks

– such as a sudden rise in interest rates or fall in

earnings – and the potential flow-on effects to

banks and financial systems more broadly.

While risks have been building in asset markets,

to which banks are somewhat exposed, the

resilience of banking systems has otherwise been

improving. Profit expectations are being buoyed

by strengthening economic conditions, and

banks’ regulatory capital ratios have generally

increased further. In Europe, some uncertainty

has been removed by regulatory actions to deal

with several weaker banks in Italy and Spain,

although banks’ profits in these jurisdictions

are still low and overall the European financial

system remains vulnerable to negative shocks.

Risks remain elevated in China. Debt levels are

high, largely driven by corporate borrowing, with

a significant share of debt funded through less

regulated ‘shadow banking’ channels. This has led

to considerable credit, liquidity and contagion

risks in the Chinese financial system. However,

Environment

recent regulatory measures have the potential to

lower financial stability risks over the longer term.

Risks in other emerging markets have receded

somewhat. Nevertheless, some emerging

economies remain vulnerable to a shift in

sentiment and capital flight, which could expose

underlying weaknesses, such as high corporate

debt levels.

Major Advanced Economies

A range of asset prices in advanced economies

have risen further from already high levels over

the past six months. Long-term sovereign bond

yields generally remain at very low levels and

hence bond prices are very high (Graph 1.1).

This has contributed to high prices for riskier

assets, because risk-free rates are central to their

valuation. The return for bearing risk is also low.

Spreads on investment and non-investment

grade corporate debt securities, for example,

have fallen further over the past six months

1967 1977 1987 1997 2007 2017

-4

0

4

8

12

%

-4

0

4

8

12

%

Yield to maturity

Estimated

term premium

Sources: Bloomberg; Federal Reserve Bank of New York

to around their lowest levels since before the

financial crisis (Graph 1.2). Non-price lending

standards for wholesale corporate debt have

also eased in recent years. Favourable funding

conditions have allowed corporates in some

jurisdictions to maintain historically high

debt levels and in some cases increase them

further. In the United States, the increase in

corporate debt has included a notable pick-up

in issuance of riskier ‘leveraged loans’ (typically

loans to non-investment grade companies).

The combination of low compensation for risk

and low expected volatility – in addition to low

risk-free rates – suggests that some investors may

be underestimating the downside risks they face

(Graph 1.2; Graph 1.3). This could lead to a further

build-up of risks and could also increase the

likelihood that an adverse shock would lead to a

sharp and disruptive correction in asset prices.

Equity volatility*

1997 2007 2017

0

20

40

60

index

US

Euro area

US Treasury bond volatility**

1997 2007 2017

0

75

150

225

index

and VSTOXX index for the euro area)

Source: Bloomberg

Adverse shocks are, by their nature, uncertain and

mostly unexpected. A range of developments

could trigger a sharp repricing of many assets.

For example, long-term risk-free interest rates

could rise faster than expected, without being

accompanied by stronger growth, if markets were

to reappraise the record low levels of term premia

or the likely persistence of low inflation. Indeed,

To government bonds with equivalent maturity

Investment grade

2013 2017

0

100

200

300

bps

Euro

US dollar

Non-investment grade

2013 2017

0

300

600

900

bps

Source: Bloomberg

bond prices have become more sensitive to

interest rates as yields have fallen and new bonds

have been issued at longer tenors. Alternatively,

a significant geopolitical event, such as an

escalation of tensions on the Korean Peninsula,

could see a sudden increase in risk premia.

Regulatory reforms and changes in market

structure have altered how bond markets are

likely to respond to shocks. These regulatory

reforms have been designed to transfer some

liquidity risk away from financial intermediaries to

end investors. This has contributed to a decline

in bond market liquidity in the post-crisis period.

While the reforms are likely to better allocate

liquidity risk, the lower liquidity could exacerbate

Forced selling by bond investment funds could

also aggravate a sell-off if investors in these funds

redeem their holdings in response to price falls.

Bond funds have become increasingly important

holders of corporate bonds and often have a

mismatch between the relatively low liquidity

1 For more information on developments in market liquidity in the

post-crisis period, see CGFS (Committee on the Global Financial

System) (2016), ‘Fixed income market liquidity’, CGFS Papers No 55,

and CGFS (2014), ‘Market-making and proprietary trading: industry

trends, drivers and policy implications’, CGFS Papers No 52.

of these bonds and the easy redemption terms

offered to investors. Bond funds often have

tools to limit fire-sale risks, including options

to suspend redemptions, although they are

not available in all jurisdictions. International

standard-setting bodies have also taken steps

to better understand and address these risks,

though reform efforts are still ongoing.

Moderate falls in asset prices or upticks in

volatility are unlikely to threaten the solvency of

systemic financial institutions, especially given

regulatory and risk management measures taken

since the crisis. However, with imperfect visibility

of exposures, leverage and interconnection

across the financial system, there is always the

risk that some large concentrated losses could

adversely affect other financial institutions. The

cost and availability of funding for corporates

might also be adversely affected by an increase

in risk premia or disruption in credit supply,

particularly for those that borrow through bond

markets. This could lead to financial stress given

the trends in corporate leverage noted earlier.

A rapid and significant repricing of risk that

coincided with other negative shocks could

lead to a large increase in corporate defaults

and significant losses for systemic financial

institutions. Losses would be magnified if defaults

fed back into a larger and more sustained rise in

risk premia and greater redemptions and asset

sales by bond funds.

Very low interest rates have also contributed to

strong growth in property prices internationally

as investors search for yield. To the extent that

prices have moved beyond what their underlying

determinants suggest, this increases the risk

of sharp price falls if interest rates were to rise

suddenly or if risk sentiment were to deteriorate.

Commercial property prices have risen rapidly in

recent years in parts of the United States, Canada,

New Zealand and Europe. Housing credit and

price growth have also been strong in many parts

of the world, especially in a number of Englishspeaking

and Nordic countries (see ‘Box A: Risks

in International Housing Markets’). Prudential

policies have generally led to some improvement

in banking and household sector resilience, but,

to the extent that authorities were also hoping

to dampen growth in credit and housing prices,

the effects have often been more limited or

temporary.

The resilience of banking systems across most

advanced economies has been improving, leading

to large rises in bank equity prices over the past

year (Graph 1.4). Most banks’ regulatory capital

ratios have increased further and are well above

regulatory minimums. Profit expectations are

being buoyed by improved economic conditions,

with stronger loan demand and falls in bad loans.

Fines resulting from legal actions and restructuring

costs are also expected to be less of a drag

on profits going forward. In the United States,

proposals to roll back some financial regulations

have become somewhat clearer and appear to

focus on easing the regulatory burden for smaller

banks and reducing areas where US regulations

exceed international standards.

Monthly*

Advanced economy banks

2013 2017

0

1

2

ratio

Australia

Canada

US

UK

Euro area banks

2013 2017

0

1

2

ratio

France

Italy

Spain

Sources: Bloomberg; RBA

Important steps have been taken to bolster

the resilience of the European banking sector,

building on the effects of the ongoing economic

recovery. Regulatory capital ratios and asset

quality have improved following successful

capital raisings and sales of non-performing

loans (NPLs). Recent regulatory actions to deal

with problem banks have also partly addressed

long-standing sources of uncertainty in the

Italian and Spanish banking systems. In Spain,

the European Commission (EC) approved the

resolution of Banco Popular Español, which had

a large stock of non-performing real estate loans.

The bank’s equity and subordinated debt were

written down and the bank was sold to Banco

Santander for the notional sum of €1. The EC

authorised a ‘precautionary recapitalisation’ of

Italy’s fourth largest bank, Monte dei Paschi di

Siena, including the provision of €5.4 billion in

state aid. The EC also approved plans to transfer

the non-performing assets of two small Italian

banks to the Italian Government, with the banks’

other assets transferred to Intesa Sanpaolo along

with a €5.2 billion capital injection from the

government (plus substantial guarantees). These

resolutions were a test of the new European

resolution framework, which, among other

things, is intended to minimise the need for

governments to inject funds into weak banks.

In the event, there was some flexibility in the

approach, with varying degrees of public support

and creditor ‘bail-in’. While this led to pragmatic

solutions, it has raised some uncertainties around

the circumstances in which certain types of bank

debt would incur losses.

While recent developments have been positive,

European banking systems nevertheless remain

vulnerable to negative shocks. Bank profitability

remains low in several European countries,

reflecting both prolonged economic weakness

and structural factors (Graph 1.5). In particular,

high cost bases, legacy loss-making exposures

and excess capacity are constraining profits. Low

profitability makes it harder for banks to build

capital buffers to absorb unexpected shocks.

Stocks of NPLs have been falling but remain

high (Graph 1.6). Uncertainty about the value

of these loans means that banks’ capital buffers

could be much smaller than reported capital

ratios suggest.

Sovereign debt levels remain high in some

European countries, although associated

near-term risks have receded somewhat

2005 2009 2013 2017

-20

-10

0

10

20

%

-20

-10

0

10

20

%

Japan

US

UK

Other Europe

Euro area

number of banks varies by jurisdiction: Australia (4), Canada (6),

euro area (38), Japan (4), other Europe (10), United Kingdom (4) and

United States (18); adjusted for significant mergers and acquisitions;

reporting periods vary across jurisdictions

Sources: Bloomberg; RBA; S&P Global Market Intelligence

Share of loans

2009 2013 2017

0

2

4

6

8

%

Australia

Japan

Germany

France

US

UK

2009 2013 2017

0

10

20

30

40

%

Greece

Portugal

Ireland

Sources: APRA; Banks’ annual and interim reports; Bloomberg; FSA;

RBA; S&P Global Market Intelligence

over the past six months given stronger

economic conditions, improved fiscal positions

and pro-European Union election results.

Government bond spreads to German Bunds

have generally narrowed as a result (Graph 1.7).

Sovereign credit ratings for Ireland and Portugal

were also upgraded in September. However,

negative shocks – including a reversal in global

risk sentiment – could still precipitate higher

government bond yields and increase concerns

about debt sustainability in several European

countries. The Greek Government reached

an agreement with its creditors to access

another tranche of bailout funding in June, and

subsequently returned to the bond market for

the first time in three years. However, ongoing

disagreement between Greece’s European

creditors and the International Monetary Fund

remains a barrier to more comprehensive debt

restructuring.

to comfortably exceed minimum capital

requirements, and ongoing efforts to reduce

liquidity mismatches and cross-ownership

should further improve their resilience to

system-wide shocks.

New Zealand

All four major Australian banks have large

operations in New Zealand where, like Australia,

housing-related risks have been a key focus

given rapid growth in household debt and

housing prices. Vulnerabilities in the New

Zealand housing market appear to have lessened

slightly since late 2016. Further tightening of

loan-to- valuation (LVR) requirements in October

2016, a general tightening in credit standards

and reduced affordability in some regions appear

to have contributed to at least a temporary

slowing in housing credit and price growth.

These policies have also helped to limit the share

of some riskier loans on banks’ balance sheets;

the share of high-LVR loans has continued to

decline and the share of new investor lending

at high debt-to-income (DTI) ratios has fallen.

Despite this, the overall share of new loans with

high DTI ratios remains elevated by historical

standards. The Reserve Bank of New Zealand has

proposed adding DTI limits to its agreed set of

macroprudential policy tools, and is currently

considering feedback from stakeholders.

Conditions in the dairy sector in New Zealand

have improved alongside higher global dairy

prices over the past year (Graph 1.8). Most farms

are expected to return to profitability this year

and growth in dairy-related debt has slowed.

However, the sector remains highly leveraged,

leaving it vulnerable to any future dairy price

weakness or an increase in interest rates, raising

the risk of loan losses for banks.

To German Bunds

2009 2013 2017

0

200

400

600

bps

France

Spain

Italy

2013 2017

0

1 000

2 000

3 000

bps

Portugal

Greece

Sources: Bloomberg; RBA

In Japan, very low interest rates continue to

challenge banks’ profitability, with larger banks

responding by lending in offshore markets.

This has exposed some banks to additional

liquidity risk, due to the use of short-term foreign

currency funding, and to additional credit risk.

Nevertheless, large Japanese banks continue

China

Chinese policymakers have recently

strengthened efforts to address financial stability

risks. If sustained and calibrated appropriately,

these actions should help curb risks over

the longer term. For now, however, financial

stability risks in China remain high. Debt levels

have increased significantly over the past

decade, largely driven by corporate borrowing

(Graph 1.9). Relative to GDP, China’s corporate

debt exceeds that of most advanced economies,

and is more than three times higher than in

economies with comparable per capita incomes

(Graph 1.10). A significant part of the run-up in

corporate debt has been funded through less

regulated and less transparent ‘shadow banking’

channels. Lending standards in China are also

likely to have been, at times, undermined by

implicit government guarantees and other

distorted incentives. Many financial institutions

have funded the increase in lending with

short-term borrowing and wholesale finance

from other domestic financial institutions.

Together, these developments make the system

more vulnerable to adverse shocks, by raising

considerable credit, liquidity and contagion risks.

A large amount of corporate debt is owed

by state-owned enterprises (SOEs) and firms

in the industrial sector. Despite some recent

improvement, many of these firms have low

profitability, partly due to widespread excess

capacity. Low profitability reduces corporates’

ability to service their debts and increases their

vulnerability to adverse shocks. While measured

corporate distress has so far remained relatively

low, supported by policy stimulus and loan

forbearance, it has been rising. China’s local

governments have also borrowed heavily since

Household

Corporate – other sources

Corporate – from banks

2007 2009 2011 2013 2015 2017

0

50

100

150

200

%

0

50

100

150

200

%

Per cent to GDP

Sources: BIS; RBA

0 20 40 60

0

50

100

150

200

Real GDP per capita – US$’000**

Non-financial corporate debt – per cent to GDP

China

Australia

Germany

US

Fitted line

rates; figures are in 2011 dollars

Sources: BIS; RBA; World Bank

International milk powder prices

3

6

NZ$/kg

3

6

NZ$/kg

Debt-to-income ratio*

2006 2010 2014 2018

150

300

450

%

150

300

450

%

milk prices and milk production respectively; debt held constant at 2017

levels

Sources: ABARES; Bloomberg; RBA; RBNZ; USDA

the global financial crisis, including in recent

years to fund infrastructure projects. As with

SOEs, local governments enjoy favourable

access to finance, in part because of implicit

central government support, despite limited net

revenue streams. They also have an incentive to

maintain strong short-term growth. This can lead

to poor investment decisions and increase the

risk of repayment problems.

Non-bank financial institutions (NBFIs), or

so-called ‘shadow banks’, are less regulated than

banks and have rapidly expanded both their

lending to firms and purchases of financial assets

in recent years. Their growth has been aided by

that of small and medium-sized banks, which in

many cases have borrowed funds in short-term

wholesale markets to invest with NBFIs

(Graph 1.11). Assets of small and medium-sized

banks account for around one-half of banking

Increased lending through less regulated

channels raises several risks. Such lending

often involves multiple layers of intermediaries,

which can obscure the ultimate borrower. This

allows banks to avoid restrictions on lending

to some higher-risk sectors (such as property

2 See RBA (2016), ‘Box A: Recent Growth of Small and Medium-sized

development) thereby increasing their credit

risks. At the same time, it allows banks to lower

provisioning and capital requirements, which

reduces financial buffers. The lack of transparency

also increases contagion risk, as banks are more

likely to withdraw from interbank markets when

uncertainty about other banks’ solvency is high.

The expansion of NBFIs has raised liquidity risks,

as these institutions rely mostly on short-term

funding to make longer-term loans but they do

not have formal access to central bank liquidity

and are not backed by deposit insurance. As

noted above, many smaller banks have also

increased their use of short-term wholesale debt,

including interbank loans. Overall, this suggests

a heightened risk that loan losses and funding

pressures in the shadow sector could quickly

cascade through the financial system.

Risks persist in the Chinese property sector.

Housing price growth has been relatively strong

overall, despite slowing in many cities where

measures have been introduced to cool the

market. Household debt also continues to grow

rapidly, although households are not highly

leveraged by international standards. In contrast,

property developers are typically highly leveraged,

making them susceptible to large falls in the prices

of properties they have financed. Developers also

often obtain finance through shadow banking

channels, which may be particularly unreliable

during times of stress. A downturn in the property

market could also transmit to local governments.

Property is typically used as collateral for the debts

of local governments’ off-balance sheet financing

vehicles, while property-related taxes and land

sales are important sources of local government

revenue.

Over the past year, the Chinese authorities have

taken steps to address financial stability risks.

Backed by strong political support, regulators

have announced a range of measures to

Financial institutions’

deposits at banks*

Share of liabilities

2012 2016

0

5

10

15

20

% Bank claims on NBFIs

Share of assets

2013 2017

0

5

10

15

20

%

Sources: CEIC Data; RBA; S&P Global Market Intelligence

reduce leverage, improve transparency and

strengthen risk management in the financial

restrictions on some forms of shadow lending

and stricter enforcement of rules governing

banks’ capital, provisioning and interbank lending.

The authorities have also established a Financial

Stability and Development Committee to facilitate

better coordination among regulators. The

People’s Bank of China has extended coverage

of its macroprudential assessment framework to

include banks’ off-balance sheet activities and

facilitated an increase in money market rates

over the first half of the year. As a result of these

measures, NBFIs’ appetite for holding corporate

bonds has declined and growth in some less

visible forms of shadow credit has reportedly

slowed. Consequently, NBFIs have reduced

their holdings of financial assets, and financial

conditions have tightened for corporations,

although they generally remain favourable. Many

smaller banks have also signalled intentions to

raise equity to increase their capital buffers.

These latest regulatory measures should help

to curb financial stability risks over the longer

term. However, the authorities’ commitment

to moderate riskier financing could be tested

if economic growth targets are threatened.

Given the already high level of risk that has

built up in the financial system, the authorities

are likely to face a trade-off between strong

regulatory action that could trigger financial

and economic disruption and a more cautious

approach that may allow a further build-up

of risks. Further reform, such as facilitating the

restructuring of SOEs and enhancing the fiscal

discipline of local governments, will most likely

be needed to address the poor governance and

adverse lending incentives that have contributed

to increased leverage.

3 See RBA (2017), ‘Box B: Recent Developments in Chinese Financial

China’s banks remain profitable and well

capitalised overall, but their profitability has

been falling in recent years, in part due to higher

loan losses (Graph 1.12). Despite increasing loan

write-offs, reported NPL ratios have risen and

would likely be much higher if measured on

an equivalent basis to advanced economies.

The stock of marginal performing loans (where

loan repayment is at risk, but the loan is not

yet classed as non-performing) has also risen

strongly, possibly pointing to further increases

in NPLs. Authorities in China have launched a

number of programs to restructure corporate

debts and help banks repair their balance sheets,

such as a debt-to-equity swap program and the

establishment of firm-level creditor committees

comprising all relevant stakeholders to manage

debt workouts. While these are having some

effect on the resolution of distressed loans, NPLs

will likely remain a headwind to bank profitability

for some time.

Return on equity

10

20

% CET1 capital ratio

5

10

%

Non-performing loans

Stock

2009 2013 2017

0

1

2

CNY tr Non-performing loans

Share of loans

2013 2017

0

5

10

%

Incl. special

mention loans

Sources: CEIC Data; RBA; S&P Global Market Intelligence

If financial risks were to materialise in China, the

negative effect on China’s economy could be

substantial. Direct financial linkages between

China and other economies are generally

still small, limiting the spillovers through this

channel. Rather, a disruption would most

directly affect countries with strong trade links

2005 2008 2011 2014 2017

-200

-100

0

100

US$b

-200

-100

0

100

US$b

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

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

Turkey and Ukraine; data for Saudi Arabia are included from

March 2008; June 2017 observation excludes Argentina

Sources: CEIC Data; IMF; national sources; RBA; Thomson Reuters

Per cent to GDP

Commodity-exporting

economies

2007 2012 2017

0

20

40

60

%

Russia

Brazil

South Africa

Indonesia

Malaysia

Other economies

2007 2012 2017

0

20

40

60

%

Turkey

India

Mexico

Thailand

Sources: BIS; CEIC Data; RBA; Thomson Reuters

to China, including Australia, with second-round

effects on a broad range of countries through

weaker global growth. Weaker confidence and

higher volatility in financial markets would also

have global effects. As noted earlier, Chinese

authorities have increased their focus on

financial stability risks, and they retain a wide

range of economic and financial policy tools to

address them. But the more that leverage and

risky lending grow, the more likely that China’s

economic transition will include a significant

financial disruption of some form.

Other Emerging Markets

Risks in other emerging market economies

have receded somewhat over the past year.

Economic growth is expected to continue

recovering on the back of accommodative

policy settings and stronger global trade. Capital

inflows have been relatively strong this year,

following a temporary decline in the wake of

the US presidential election (Graph 1.13). Most

emerging market economies have also made

progress in addressing financial vulnerabilities

by increasing their banking systems’ capital and

liquidity ratios. Nonetheless, emerging markets

remain exposed to a shift in sentiment and

capital flight, which could reveal or exacerbate

underlying weaknesses. One area of concern is

the corporate sector, where low global interest

rates have fuelled strong growth in debt in the

post-crisis period, though debt has stabilised or

fallen recently in many economies (Graph 1.14).

Higher corporate debt levels are particularly

evident in commodity-exporting economies,

with the rapid pace of growth increasing the

probability that some recent lending may be of

low quality. A particular risk for emerging market

economies is that currency depreciation would

inflate unhedged foreign currency borrowing

(and interest costs) at the same time that foreign

lenders are less willing to roll over or extend new

debt. This risk is somewhat mitigated by the large

proportion of listed emerging market firms that

have at least some foreign currency earnings.

Rising US interest rates will also make it more

difficult for emerging market firms to service their

foreign currency debts.

Despite challenging economic conditions in

recent years, banking systems in the larger

emerging market economies are generally

profitable and most appear to be well capitalised.

However, bank performance varies widely

within and across jurisdictions, with some banks

having weak profitability and thin provisioning

and capital buffers (Graph 1.15). NPL ratios have

increased over recent years in some commodityexporting

economies (Graph 1.16). NPL ratios

are also high and rising in India, although this

partly reflects regulators’ efforts to improve

NPL recognition. Efforts by Indian authorities to

address the risks posed by high NPLs include

clamping down on loan forbearance, reviewing

the asset quality of banks, and strengthening

insolvency and regulatory frameworks to

facilitate the resolution of distressed assets. The

Indian Government has also injected capital into

some weaker public sector banks and is pursuing

reforms to strengthen bank governance. In

Russia, the central bank recently took control of

two large private lenders, as it continues efforts

to strengthen and consolidate the Russian

banking sector. Bank equity valuations remain

low in a number of emerging economies where

corporate debt has risen fastest, suggesting that

investors remain concerned about underlying

asset quality.

The potential for emerging market financial

stress to spill over to advanced economies has

risen over time due to their increased size and

integration in the global economy. Advanced

economies’ direct financial linkages to emerging

markets remain small despite some increased

links, such as holdings of emerging market

corporate bonds. Accordingly, any distress would

be most likely transmitted through trade links

Range

Median

-75 -50 -25 0 25 50 %

Thailand

Turkey

India

Malaysia

Indonesia

Russia

As of June 2017

Sources: RBA; S&P Global Market Intelligence

Latest available

End of 2013

0 2 4 6 8 %

Russia

India

Brazil

Turkey

South Africa

Indonesia

Thailand

Mexico

Malaysia

Share of loans

Sources: CEIC Data; RBA; World Bank

Box A

Risks in International Housing Markets

Housing debt in a number of countries has

risen from already high levels in recent years

and has coincided with some evidence of

riskier lending and strong growth in housing

prices. This has raised concerns about the

resilience of households and banks to negative

shocks, particularly as interest rates start to rise

from very low levels. This box outlines: recent

developments in the housing markets of Canada,

New Zealand, Norway and Sweden; key risks

associated with these developments; and recent

policy actions to address these risks.

Recent Developments in

International Housing Markets

Housing debt and prices in these four small open

economies have been rising from already high

levels, outpacing growth in incomes and rents

(Graph A1). As in Australia, much of the recent

housing price growth has been concentrated

in major cities, while smaller cities and rural

regions have generally experienced much slower

price growth or in some cases price declines

(Graph A2).

Housing prices have been boosted by an

increase in demand and constrained supply.

On the demand side, low interest rates have

enabled households to borrow more to purchase

housing. In some major cities, strong population

growth and heightened investor activity have

also increased demand for housing. Housing

supply generally has not risen to the same extent

as demand due to the usual constraints of lags

in planning, approval and construction. Building

new housing in major cities can face more

31 December 2010 = 100

Debt-to-income

2004 2010 2016

40

60

80

100

120

index

Norway

Sweden

Price-to-income**

2004 2010 2016

40

60

80

100

120

index

Canada

Australia

NZ

to the non-financial sector (including education-related debt, and

overseas debt held by migrants); some countries compile these

measures on a ‘best endeavours’ basis only

Sources: Canadian Real Estate Association; CoreLogic; national sources;

OECD; RBA; REINZ; Thomson Reuters

31 December 2010 = 100

Canada

100

150

200

index

Major cities*

New Zealand

100

150

200

index

National average

Norway

2009 2013 2017

70

100

130

160

index Australia

2009 2013 2017

70

100

130

160

index

Vancouver (Canada); Auckland (New Zealand); Greater Oslo (Norway);

Sydney and Melbourne (Australia)

Sources: CoreLogic; RBA; Statistics Canada; Statistics New Zealand;

Statistics Norway

serious constraints because of restrictions on

the availability of land, including natural barriers

and zoning requirements. Rent controls and

the scaling back of some social home-building

programs have also played a role in constraining

supply in some cities.

Key Vulnerabilities

Authorities in the affected countries have

expressed concern that high, and rising,

household debt relative to income, together

with riskier lending, has likely made households

less resilient to negative shocks. At the same

time, there is concern that the rapid increase

in housing prices has increased the risk of a

subsequent sharp price fall, particularly if it

has been partly driven by speculation. Taken

together, these developments have increased the

risk of financial and macroeconomic instability.

While household debt levels are high, and

rising, to date the impact on households’

ability to service their debt has been muted by

falls in interest rates to historically low levels.

Nonetheless, highly indebted households are

more likely to struggle to repay their debts,

or substantially reduce their consumption, in

response to a negative shock, such as a rise in

unemployment, an unexpectedly large increase

This could lead to bank losses and slower

economic growth. Banks in turn might be less

able or willing to provide credit to the economy,

amplifying any downturn.

The distribution of debt is also important in

identifying where risks lie as typically it is not

the ‘average’ household that gets into financial

1 Academic studies find non-linearities in the consumption patterns of

highly indebted households. See, for example, Mian A, K Rao and A Sufi

(2013), ‘Household Balance Sheets, Consumption, and the Economic

Bunn P and M Rostom (2014), ‘Household Debt and Spending’, Bank of

difficulties. In Canada and Sweden, for example,

the risks from high household debt may be

heightened since the debt is concentrated

among younger and low‑to-middle-income

households, who are likely to be more vulnerable

As in Australia, national authorities have also

been concerned about riskier lending, which

lending at high loan-to-valuation ratios (LVRs)

has worried regulators in many countries, in

part because households that borrow at high

LVRs are more likely to fall into negative equity

if housing prices decline. In this scenario, such

households would be unable to repay their debts

by selling their homes or to cushion income

falls by drawing down on equity. Increasingly,

regulators are turning their attention to loans

that are large relative to borrowers’ income. Such

loans could stretch the ability of households

to repay their debts and make them more

sensitive to falls in income or unexpected

rises in interest rates. Further, interest-only (IO)

lending has been identified as increasing risks

remain more indebted throughout the life of

the loan than if they had been paying down the

loan principal, making them more vulnerable

to higher interest rates, reduced income, or

lower housing prices. Such households are also

more vulnerable to ‘payment shock’ due to the

increase in repayments following the end of the

interest-only period of the loan.

2 See Bank of Canada (2015), ‘Report on Indebted Households

and Potential Vulnerabilities for the Canadian Financial System:

and Ölcer D and P van Santen (2016), ‘The Indebtedness of

3 See the ‘Household and Business Finances’ chapter for an assessment

of housing-related vulnerabilities in Australia.

4 For recent developments in IO lending in Australia, see the

‘Household and Business Finances’ chapter and APRA (2017),

‘Further Measures To Reinforce Sound Residential Mortgage Lending

Practices’, Letter to Authorised Deposit-Taking Institutions, 31 March.

Much like in Australia’s largest cities, investor

demand has been strong in several fast‑growing

markets, including Auckland, Toronto and

Vancouver. Rapidly rising prices and low rental

yields suggest that this demand is at least

partly based on expectations of capital gains.

If speculation has played a role, this can raise

the risk of housing price falls in the future. Past

episodes in several countries also suggest

that investors may be more likely than owneroccupiers

to sell their properties in a downturn

or default on their loans in times of stress, posing

risks to the broader market and the banking

Vancouver, foreign investor activity has boosted

demand for housing, contributing to the

upswing in some segments of the market. It is

uncertain how foreign investors will behave in a

downturn.

Macroprudential Policy Responses

Low interest rates, which central banks view as

appropriate given their inflation and output or

employment objectives, have contributed to

the run-up in housing debt and prices in many

economies. National authorities have, therefore,

been increasingly using macroprudential policies

to address the associated risks.

Foreign authorities’ macroprudential policies

have focused on three key areas:

strengthened by the use of tighter LVR

restrictions – often specifically targeting

investors – to lower the proportionate

amount households can borrow (such as in

Canada and New Zealand). IO lending has

also been restrained by the implementation

5 See, for example, McCann F (2014), ‘Modelling Default Transitions in

the UK Mortgage Market’, Central Bank of Ireland Research Technical

the Leverage Cycle, and the Housing Market Crisis’, Federal Reserve

Bank of New York Staff Reports No 514.

of minimum amortisation requirements for

loans at high LVRs (in Norway and Sweden),

which ensure faster repayment of mortgage

imposing maximum loan-to-income ratios (in

Norway) and debt-service ratios, which cap

the proportion of income that households

can allocate to repaying their mortgage in

Banks in Canada and Norway are also

required to check that households are able to

service their debts if faced with significantly

higher interest rates.

regulatory capital requirements by raising

mortgage risk weights or increasing

countercyclical capital buffers (as in Sweden).

Regulators have also raised the minimum

loss rate that banks can assume when setting

aside capital against potential mortgage

losses. These policies aim to boost bank

resilience by raising capital reserves to cover

potential losses in downturns.

It is difficult to assess the effectiveness of

these measures and macroprudential policies

more generally. These policies do not have a

long track record; they often have differing

objectives; and their effects are hard to isolate

and measure, especially because they are often

implemented in combination with other policies.

National authorities have indicated that so far

macroprudential policies have generally led to

some improvement in household and banking

sector resilience. For example, the share of

high‑LVR loans on banks’ balance sheets has

been falling in New Zealand. Macroprudential

6 Other countries, such as China and Singapore, have banned

IO lending.

7 A range of other jurisdictions have also introduced limits on

loan‑to‑income ratios, such as the United Kingdom and Ireland, or

caps on debt-service ratios, such as Hong Kong and the Netherlands.

increased taxes on investor properties held for

Overall, available evidence suggests that a range

of policies (including both macroprudential and

other tools) have led to some improvement

in household and banking sector resilience

in several markets. However, household debt

levels and housing prices remain high and

continue to grow rapidly in many regions, so

risks persist. Macroprudential policies can at best

moderate the growth of credit and prices for a

while, but they cannot address the high levels

of debt and prices. Further, there continues to

be much uncertainty around the calibration

and effectiveness of these tools. Ongoing

analysis and experience will be important for

understanding the impact that such policies can

8 Similarly, both the New South Wales and Victorian governments

have increased stamp duty for foreign housing purchasers and

removed the deferral of stamp duty payments for some off-the-plan

purchases. The New South Wales Government has also implemented

an additional land tax for foreigner property owners, while the

Victorian Government has imposed a tax on vacant residential

land and an absentee owner surcharge. Governments in several

other jurisdictions, such as Hong Kong and Singapore, have also

introduced tax policies targeting speculative purchases.

policies also appear to have contributed to

slower growth in credit and housing prices,

although experiences in countries such as

New Zealand suggest that these effects tend

to diminish over time (Graph A3). Some policies

appear to have led to leakages and spillovers,

such as avoidance behaviour, increased lending

by less regulated institutions and a shift in price

growth to smaller cities. However, these effects

have been fairly limited so far.

2011 2012 2013 2014 2015 2016 2017

-10

0

10

20

30

%

-10

0

10

20

30

%

Six-month-ended annualised growth

Tax changes

High-LVR speed limit

introduced

Housing credit*

Auckland

prices*

LVR

changes**

Rest of New

Zealand prices*

targeting Auckland investors, which were subsequently tightened

further and extended to investors in the rest of New Zealand in October

2016

Sources: RBNZ; REINZ

Other Policy Responses

A number of authorities have also used other

policy tools to mitigate housing market risks.

Some governments have implemented tax

policies to limit speculative activity. Provincial

governments in Canada introduced higher taxes

on investor purchases (particularly by foreign

investors), and the New Zealand Government

Finances

The key domestic risks in the Australian financial

system continue to stem from household

borrowing. Household indebtedness, most

of which is mortgage borrowing, is high and

gradually rising against a backdrop of low

interest rates and weak income growth. While

some households have taken advantage of

low interest rates to make excess mortgage

payments, others have increased their borrowing.

Higher interest rates, or falls in income, could see

some highly indebted households struggle to

service their debt and so curtail their spending.

Recent regulatory actions have been taken to

build the resilience of authorised deposit-taking

institutions (ADIs) and borrowers to ensure that

borrowers could service their mortgage with

higher mortgage rates. These actions include

limiting the growth of interest-only lending and

emphasising that banks should also limit other

forms of higher-risk lending. These measures

have already seen significant declines in the

share of interest-only lending. Since their

introduction, there has been some moderation in

housing market conditions.

Strong demand for housing over recent years

has contributed to a large increase in apartment

construction. Substantial additions to the stock

of apartments in particular locations raise the

possibility of price falls as the new stock is

absorbed. To date the adjustment has been

orderly with the rate of price decline slowing in

Brisbane and prices falling a little in inner-city

Melbourne. While there have been some reports

of settlement delays, there is little evidence of

settlements actually failing. In Brisbane, however,

apartment market conditions are relatively weak,

with declining prices and no growth in rents.

The Bank is continuing to closely monitor

conditions in non-residential commercial

property markets. Growth in commercial property

prices in Sydney and Melbourne continues to

exceed that in rents, and office vacancies are

elevated in the cities with greater exposure to the

mining sector, especially in Perth. In other parts of

the business sector, conditions remain generally

favourable, with corporate profitability relatively

high and gearing at relatively low levels. However,

the economic slowdown in mining-exposed

areas has seen business failure rates in Western

Australia and Queensland rise to above those of

the other Australian states, although they are still

at a generally low level.

Household Sector

Mortgage and housing markets

A core area of focus has been trends in

household borrowing, with most of that

borrowing for the purpose of housing. Regulators

have responded to the build-up of risk associated

with household mortgage lending with a

sequence of measures. These have aimed to

increase household and banking sector resilience

by improving the quality, and balancing the

composition, of housing sector lending. In

particular, there has been greater regulatory

focus on ADIs’ lending standards, prompting

lenders to strengthen a range of serviceability

standards, such as interest-rate buffers to assess

serviceability, the assessment of minimum living

expenses and discounting less stable income

sources. The Australian Prudential Regulation

Authority (APRA) is continuing its focus on

serviceability standards, resulting in many new

borrowers now having greater buffers against

income losses or higher interest rates.

APRA announced further regulatory actions on

31 March, after discussions by the Council of

Financial Regulators. For all ADIs, a 30 per cent

cap on interest-only loans as a share of loan

originations was imposed, and the 10 per cent

benchmark on investor credit growth, imposed

in December 2014, was reaffirmed. Deposit

requirements were raised by strengthening

prudential expectations regarding banks’ limits

on high-LVR interest-only loans and increasing

scrutiny of serviceability assessments.

ADIs have changed their lending conditions

in response to the latest APRA measures.

ADIs have increased interest rates on investor

and interest-only loans, and allowed existing

interest-only borrowers to switch to principaland-

interest (P&I) loans at no cost. Lenders have

also lowered maximum LVRs on interest-only

loans, both for owner-occupiers and investors.

Interest-only loans as a share of new approvals fell

sharply in the June quarter, and the outstanding

stock of these loans has declined (Graph 2.1).

The combination of a renewed focus on the

10 per cent benchmark on investor lending and

the cap on interest-only loans (which are more

commonly used by investors) has contributed

to the recent significant moderation in investor

credit growth across all states (Graph 2.2).

While these regulatory measures should help

make household and bank balance sheets

more resilient, they will constrain some types

of (potential) borrowers. In particular, some

households will not be able to borrow as

much as previously, though their smaller loan

households may find it more difficult to obtain

finance for apartments purchased off the plan

some time earlier, which could, in particular,

affect some apartment markets such as Brisbane

that are adjusting to large increases in supply.

Some borrowers, including investors, could

experience increased financial stress as a result

1 See also Simon J and Stone T (2017), ‘The Property Ladder after the

Financial Crisis: The First Step Is a Stretch but Those Who Make It Are

Doing OK’, RBA Research Discussion Paper No 2017-05.

Share of new loan approvals

Total

15

30

% Owner-occupier

LVR > 90

Investor

15

30

%

2012 2017

0

30

60

%

2012 2017

Interest only

2012 2017

0

30

60

%

Low doc

are seasonally adjusted

Sources: APRA; RBA

Share of total loan approvals by state, excludes refinancing*

NSW

20

40

% VIC

20

40

%

QLD

2007 2012 2017

0

20

40

% WA

2007 2012 2017

0

20

40

%

based on RBA estimates

Sources: ABS; APRA; RBA

of higher repayments from either switching to

a P&I loan, or higher interest rates if they retain

an interest-only loan (for a discussion of the

characteristics of investors and their borrowing,

see ‘Box B: Households’ Investment Property

Exposures: Insights from Tax Data’). However,

most borrowers should be able to absorb these

changes given progressive improvements in

lending standards since the financial crisis. For

loans taken out over more recent years, the

initial serviceability assessment would have

been rigorously based on the higher repayments

required after the interest-only period and also

include a larger buffer against interest rate rises.

Further, given the decline in interest rates over

recent years, most households with older loans

would have initially borrowed at rates that were

higher than current interest rates.

Housing market conditions appear to have eased

in recent months. In Sydney and Melbourne,

housing price growth has slowed and auction

clearance rates have fallen (Graph 2.3). A range

of factors have contributed to the slowing,

including increased housing supply, higher

interest rates for some borrowers, and an

apparent reduction in demand from foreign

buyers. In Melbourne, these factors appear to

have offset the impact of strong migration flows

into Victoria, both from overseas and interstate.

Nationally, apartment prices have continued

to record weaker price growth than detached

housing, consistent with the increased relative

supply of apartments. Some concerns remain

about the process of absorbing the substantial

increase in new apartments in Brisbane. Brisbane

apartment prices continue to fall, although

the rate of decline has slowed, and apartment

prices in inner-city Melbourne have been falling.

Weak conditions in Western Australia and a

significant increase in new apartment building in

Brisbane have increased the potential for further

localised housing price corrections. In Perth, the

Households’ financial position

While most indicators of household financial

stress remain fairly benign, there are some

concerns. The aggregate debt-to-income ratio

is high (Graph 2.5). Households with high debt

burdens could be vulnerable to financial stress

Six-month-ended annualised

Sydney

0

20

%

Apartments

Melbourne

0

20

%

Houses

Brisbane

2009 2013 2017

-20

0

20

% Perth

2009 2013 2017

-20

0

20

%

Source: CoreLogic

Quarterly, seasonally adjusted*

3

6

%

Sydney

3

6

%

Melbourne**

1987 1997 2007 2017

0

3

6

%

Brisbane

1987 1997 2007 2017

0

3

6

%

Perth

Sources: RBA; REIA; REIVA

vacancy rate is the highest in 25 years and more

than double the average of other capital cities

(Graph 2.4). The constraints on mortgage finance

could compound the weakness in some localised

property markets.

if they experience large declines in income

(see ‘Box C: Large Falls in Household Income’).

At the same time household net wealth has

been rising, and has been growing of late at an

above-average pace, driven primarily by housing

and superannuation assets.

Improvements in lending standards over recent

years should have increased household resilience

and low mortgage rates have contained

debt-serviceability metrics. In line with these

developments, Census data suggest that the

share of indebted owner-occupier households

making mortgage payments at or above 30 per

cent of gross income declined from 28 per cent

in 2011 to around 20 per cent in 2016 (around

1/2 million households). However, the Census data

overstate debt-servicing requirements as they

include households’ voluntary prepayments.

Other indicators of repayment stress such as

the ‘50/40’ measure of the share of households

in the lowest 40 per cent of income earners

making total mortgage payments – required

and prepayments – above 50 per cent of

their income, show a similar trend (Graph 2.6).

The overall share of non-performing housing

loans has also declined between 2011 and

2016 and remains low at around 0.8 per cent,

although it is rising somewhat of late primarily

due to trends in the more mining-exposed areas

(Graph 2.7; see also ‘The Australian Financial

System’ chapter). The recently released 2015/16

Household Expenditure Survey shows that the

number of households experiencing financial

stress has steadily fallen since 2003/04.

Debt-to-income ratio

1997 2007 2017

0

60

120

% Repayments-to-income ratio

1997 2007 2017

0

5

10

%

Scheduled

principal

Interest

Total scheduled

repayments

debt balances net of offset accounts; income is household disposable

income before housing interest costs

Sources: ABS; APRA; RBA

0 0 2 5 5.0 7.5 10.0 %

Australia

Mandurah

Sydney – City and Inner South

Richmond – Tweed

Melbourne – West

Melbourne – North West

Melbourne – South East

Melbourne – Inner East

Sydney – Parramatta

Sydney – Inner South West

Sydney – South West

Share of mortgagor

owner-occupier households by region, 2016**

NSW Vic WA 2011

ratios above 50 per cent, estimated using actual mortgage repayments reported

in the Census

Sources: ABS; RBA

1997 2002 2007 2012 2017

0 0

0 2

0.4

0.6

0 8

%

0.0

0.2

0.4

0.6

0.8

%

Share of loans outstanding, domestic books

Past-due*

Non-performing**

data includes resident and non-resident loans and numerator is on a

consolidated basis

Sources: APRA; RBA

Further, although aggregate measures of

household financial stress are little changed

over the past year, conditions vary across

states and regions. Recent ABS estimates

suggest that the share of households making

high mortgage repayments (both required

and excess payments into offset and redraw

accounts), while lower than in 2011, remains

relatively high in some parts of Sydney and

Melbourne. And weak economic conditions,

underemployment and falling housing prices

present ongoing challenges to households in

some regions with greater exposure to mining

activity. The rate of personal administrations in

Western Australia rose further over the first half

of 2017 and remains elevated in Queensland,

and applications for property possessions have

increased over recent years in Western Australia.

Prepayments are an important dynamic in

the Australian mortgage market as they allow

households to build a financial buffer to cushion

mortgage rate rises or income falls. Aggregate

mortgage buffers – balances in offset accounts

and redraw facilities – remain around 17 per

cent of outstanding loan balances, or over

2½ years of scheduled repayments at current

interest rates (Graph 2.8; left-hand side). These

aggregates, however, mask substantial variation;

about one-third of mortgages have less than

one months’ buffer (Graph 2.8; right-hand side).

Not all of these are vulnerable given some

borrowers have fixed rate mortgages that

restrict prepayments, and some are investor

mortgages where there are incentives to not pay

down tax deductible debt. This leaves a smaller

share of potentially vulnerable borrowers with

new mortgages who have yet to accumulate

prepayments, and borrowers who may not be

able to afford prepayments. Partial data suggest

that the share of households with only small

buffers has declined in recent years, in part due

to declines in mortgage rates. Households with

small buffers also tend to be lower-income or

lower-wealth households, which could make

them more vulnerable to financial stress.

Commercial Property

Residential development

risks posed by the large pipeline of apartment

construction in some areas. So far, the areas

where new apartments have represented a larger

proportionate addition to supply, particularly in

pockets of inner-city Melbourne and in Brisbane,

have not experienced significant disruption

(Graph 2.9). In inner-city Melbourne, strong

population growth has helped to absorb the

new supply, with vacancy rates declining and

apartment prices only falling a little (Graph 2.10).

In Brisbane, for some lower-quality apartments,

valuations at settlement have declined relative

to the purchase price. In contrast, valuations

for high-quality apartments, or those mostly

marketed to owner-occupiers, continue to be

realised at or above the purchase price. In Sydney

there are reports of small declines in prices in a

few apartment development projects.

Aggregate

2009 2013 2017

0

10

20

30

mths

(LHS)

(RHS)

Share of housing loans

outstanding

Number of months

Distribution*

Share of loans by number

< 1 1–6 6–12 12–24 24 +

0

10

20

30

%

Months

Sources: APRA; RBA; Securitisation System

will continue to absorb the new supply despite

tighter financing conditions for buyers. Continued

weakness in rents, and so rental income, remains

a debt-servicing risk for investors.

Developers’ access to bank finance for new

projects has tightened over the past year,

particularly in areas where a large volume of

new supply has yet to come on line. As a result,

some developers have turned to non-bank

lenders for finance, which liaison indicates is

generally more expensive than bank financing.

Building approvals for new projects in Brisbane

and Melbourne have fallen from their recent

highs. In Perth, builders and developers face

weak demand for new dwellings. Several small

to medium builders – including those involved

in commercial or multi-unit developments –

have filed for bankruptcy in Perth and Brisbane,

and market analysts anticipate more failures in

coming months.

Other commercial property

As in many other countries, strong demand for

commercial property has seen prices rise and

yields fall (Graph 2.11). Despite this, yields on

commercial property in Australia remain high

internationally, attracting foreign and domestic

investors. But if these higher commercial

valuations are not sustained, say because of a

marked increase in global long-term interest rates,

highly leveraged investors close to the maximum

LVR covenants on bank debt could become

vulnerable to breaching loan covenants. Typically,

they could then be required to provide additional

equity to reduce the LVR below the maximum,

potentially triggering sales and further price falls.

Conditions in commercial property markets

vary significantly by state and property type.

Investor demand remains strongest in Sydney

and Melbourne where the prices of office and

industrial properties have risen substantially. In

contrast, Brisbane office prices have remained

To date, the adjustment in the Brisbane apartment

market has not resulted in significant stress.

Settlement failures appear to have remained in

line with historical norms, although the peak of

new supply is yet to come. Some developers,

however, report that tighter financing conditions

are contributing to delays in the settlement of

off-the-plan purchases, as valuations below the

purchase price reduce the amount banks will

lend. In liaison, industry participants and banks

express confidence that the Brisbane market

City, inner and middle-ring suburbs, share of 2016 apartment stock

Sydney

6

12

% Melbourne

6

12

%

Brisbane

2009 2014 2019

0

6

12

% Perth

2009 2014 2019

0

6

12

%

City Inner Middle

Sources: ABS; RBA

Six-month-ended annualised growth**

Prices

0

10

20

%

0

10

20

%

Sydney

Brisbane

Rents

2007 2009 2011 2013 2015 2017

-10

0

10

20

%

-10

0

10

20

%

Melbourne

Sources: CoreLogic; RBA

flat, while prices in Perth have edged lower and

conditions remain difficult. In Brisbane, Perth and

Adelaide, elevated office vacancy rates and falling

rents have seen tenants relocate into better

quality office space. This continues to place

pressure on secondary-grade markets where the

outlook remains weak (Graph 2.12).

Conditions in retail property markets across

Australia have been relatively subdued. Rents

have been flat and price growth has lagged that

of other commercial property segments. Liaison

with industry suggests that strong competition

in the retail sector, particularly from online and

new entrants, is compressing retailers’ margins,

constraining their ability to accommodate rent

increases. In liaison, banks have also expressed

concern over the outlook for the retail sector

due to this increased competition, as well as

changing consumer preferences and the failures

of some well-known retailers. Banks are closely

monitoring segments such as clothing and

footwear but to date have seen failures around

the long-run average, with low loan losses in

their retail portfolios. Despite the concerns

expressed, both foreign and major banks have

continued to grow their exposures to new

retail properties by providing funding to new

developments (Graph 2.13). New developments

and refurbishments have an increased emphasis

on entertainment, hospitality and services. This

has cushioned the impact on retail property from

online retailers, but the expanded available floor

space has still put downward pressure on rents.

Following APRA’s 2016 review of commercial

property lending, banks have continued to

tighten their commercial property lending

standards and assess their portfolio allocations.

Australian banks have slowed the growth of their

2009 = 100

CBD office

1997 2007 2017

25

50

75

100

125

150

index

Rents**

Industrial

1997 2007 2017

Retail

1997 2007 2017

25

50

75

100

125

150

index

Prices

centres

Sources: ABS; JLL Research; RBA

By property grade*

Sydney

10

20

30

% Melbourne

10

20

30

%

Secondary grade

Brisbane

1997 2007 2017

0

10

20

30

%

Prime grade

Perth

1997 2007 2017

0

10

20

30

%

space; secondary grade includes B grade, C grade and D grade stock

weighted by floor space

Sources: Property Council of Australia; RBA

Consolidated Australian operations

2005 2011 2017

0

20

40

60

$b

Office

Residential

Land development

2005 2011 2017

0

20

40

60

$b

Industrial

Other

Tourism & leisure

Retail

Sources: APRA; RBA

Business Sector

Outside of the mining-exposed states,

businesses’ finances generally remain in good

shape. Survey measures of business conditions

are above their long-run averages and business

loan performance continues to improve.

Non-resource-related listed companies appear

well placed to meet their financial obligations,

supported by a rise in profits in the June 2017

half (compared with the previous June half ).

The gearing ratio of these listed corporations

was broadly unchanged compared with the

previous period; debt-servicing ratios continued

to decline, reflecting higher profits and a decline

in interest expenses; and market measures of

default risk declined over the period (Graph 2.15;

Graph 2.16). Smaller businesses have also seen

profits rise and their aggregate debt-servicing

ratio has remained at a low level.

overall commercial property exposures, pulling

back on lending to all asset types except for retail

and residential development. In contrast, Asian

banks’ exposures to commercial property have

continued to grow strongly (Graph 2.14).

For the resources sector, higher commodity

prices have also underpinned improved

conditions. Listed resource companies appear in

sound financial health and market-based default

risk measures declined further over the past six

months (Graph 2.17). Higher commodity prices

supported by ongoing cost reductions drove a

rise in profits over the June half compared with

the same period last year (Graph 2.18). Many

listed resource-related companies have used this

to further reduce their debt. For listed mining

Banks’ consolidated operations

2005 2011 2017

0

75

150

225

$b

All banks*

Major banks*

Non-major banks by

ownership

2005 2011 2017

0

15

30

45

$b

European

Australian

Other

foreign

Asian**

Sources: APRA; RBA

1997 2001 2005 2009 2013 2017

0

20

40

60

80

100

%

0

20

40

60

80

100

%

Book value of debt-to-equity

Resource-related

Other

Sources: Bloomberg; Morningstar; RBA

1982 1989 1996 2003 2010 2017

0

10

20

30

%

0

10

20

30

%

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

All businesses*

Listed corporations**

Unincorporated businesses*

(excl. resource-related)

financial institutions

foreign-domiciled corporations

Sources: ABS; APRA; Bloomberg; Morningstar; RBA

Recent liaison with industry suggests overall

conditions are improving in Western Australia

despite stress in some industries, namely

residential construction and retail, amid tighter

lending conditions and weak consumer

services corporations, however, earnings remain

under pressure given the focus on cost reduction

by resource producers.

In Queensland and Western Australia, the

challenging conditions faced by non-resourcerelated

businesses are reflected in indicators of

financial distress. Business failures rose to record

highs in Western Australia over the June quarter

and remain elevated in Queensland (Graph 2.19).

Debt-weighted, three-month moving average

Resource-related

2005 2011 2017

0

3

6

9

std

dev

25th

percentile

Other

2005 2011 2017

0

3

6

9

std

dev

Median

10th

percentile**

corporations listed on the ASX by debt; excludes financial and

foreign-domiciled corporations

for around 100 non-resource-related companies, implying a high

probability of default; of these, around one-third went on to default

Sources: Bloomberg; Morningstar; RBA

Annual

2001 2009 2017

0

6

12

18

24

30

$b

Mining services

Other resource

producers**

2001 2009 2017

0

12

24

36

48

60

$b

BHP Billiton

& Rio Tinto

Sources: Bloomberg; Morningstar; RBA

Share of unincorporated business owners, six-month annualised*

2007 2012 2017

0.0

0.2

0.4

0.6

0.8

%

Qld

SA

WA

2007 2012 2017

0.0

0.2

0.4

0.6

0.8

%

Vic

NSW

September quarter 2015

Sources: ABS; AFSA; RBA

Box B

Households’ Investment Property

Exposures: Insights from Tax Data

The strong growth of investor borrowing

for property in recent years has potential

implications for financial and macroeconomic

stability. The characteristics and risk profile of

households’ investment property exposures

differ in important ways from those of

owner‑occupiers. This box uses the most

recent data from the Australian Taxation Office

(ATO) that cover 13 million individual tax

returns to provide insights into households’

Several features of households’ property

investment point to areas of potential risk.

Many investors are lower-to-middle-income

earners with a substantial share of households

in lower‑income occupations experiencing

losses on their rental properties. There is also

some evidence that changes over time may be

increasing risks, namely the rise in the share of

households with multiple investment properties

and in the share of investors over the age of 60

with mortgage debt, as well as investment across

state borders where the investors’ knowledge of

the property market can be lower.

Investor Lending Risks

There are reasons to expect that the risk

attributes of investor housing lending differ

from those of owner-occupier lending. Some

characteristics suggest that investor loans might

have lower risk for the lender. Investor loans

1 Two caveats of these data are that they are only available with a

lag (currently covering up to the 2014/15 tax year) and they cannot

separate commercial from residential property, although most

property investments are residential.

tend to have lower loan-to-valuation ratios

(LVRs) at origination than owner-occupier loans.

Some institutions require lower LVRs for investor

loans and investors may choose an investment

property such that their equity exceeds 20 per

cent of the price in order to avoid the cost of

lenders’ mortgage insurance. In addition, the

most indebted investors tend to have higher

income and/or wealth and so may be more able

to absorb income falls or interest rate rises, and

the lender is less likely to suffer a loss given the

other features of investor lending that suggest

that the risks of investor lending may exceed

those of owner-occupier lending, at least for the

economy if not also for the lender.

expenses on investment properties are tax

deductible, investors have less incentive than

owner-occupiers to pay down their debt.

Many take out interest-only loans so that

many investor loan balances not declining

as rapidly as those of owner-occupiers, it is

more likely that an investor’s loan will exceed

the property value should housing prices fall,

increasing the risk to the lender.

cycles in borrowing and housing prices

contributing to economic risks. Investors

might be more likely to sell their property

if they expect prices to fall because it is

2 For further details, see RBA (2017) ‘Box C: Characteristics of Highly

3 For further details, see RBA (2017) ‘Box B: Interest-only Mortgage

an investment rather than their home.

Conversely, periods of rapidly rising prices

might create the expectation of further price

rises, drawing more investors into the market

as capital gains can be a larger part of their

decision to purchase.

purchase more off-the-plan dwellings than

owner-occupiers, so they might contribute

to larger upswings in construction with the

risk of future oversupply for some types of

properties or in some locations. Conversely,

they could amplify any subsequent

downswing, increasing risks to the broader

housing market and household sector.

Investor Characteristics

The share of taxpayers who are property

investors has increased steadily over the past few

adult population, or just over 2 million people,

had one or more investment properties. The

share of these with mortgage debt has remained

around 80 per cent since 2008. In recent years

4 The number of property investors is the number of tax return lodgers

reporting net rental profit or loss. Geared investors are the number

of investors making interest deductions and negatively geared

investors are those reporting net rental losses.

the share of negatively geared investors has

declined in line with interest rates, but remains

over 60 per cent of total investors. With many

not earning positive income from their property,

prospective capital gains are more likely the

primary rationale for investing.

Number of properties

Around 70 per cent of investors own just one

property. However, around half of investment

properties are owned by investors with multiple

properties; 20 per cent of investors own two

properties and 10 per cent own three or more.

The number of investors with multiple properties

has grown relative to those with a single property,

particularly between 2013/14 and 2014/15

(Graph B2). Indeed, the number of investors

with five properties grew by 7½ per cent in that

one year, compared with average growth of

4½ per cent over the previous nine years. The data

do not provide information on the characteristics

of investors with multiple properties and so they

cannot shed light on the risks associated with

these holders of multiple properties. However,

given the strong growth in investor housing

credit and riskier types of borrowing over this

period, investors with multiple properties have

likely contributed to higher risk.

Number of investors

2005/06

2014/15

500

1 000

1 500

’000

500

1 000

1 500

’000

Annualised growth rate

1 2 3+

0

3

6

%

0

3

6

%

Source: ATO

Investors*

1999 2007 2015

4

8

12

% Geared investors

Share of property investors

1999 2007 2015

40

60

80

%

Geared

Negatively geared

revisions

Source: ATO

Income

Higher-income taxpayers are more likely to

own investment properties than those on

lower incomes. About 11 per cent of taxpayers

earning under $50 000 have investment

properties compared with around 30 per cent

of taxpayers earning between $100 000 and

$500 000. (The definition of income used here

includes gross rent before deductions but

excludes non-taxable sources of income such

as drawdowns from superannuation.) However,

while lower and middle-income households

are less likely to own investment properties,

they make up a larger share of property

investors because there are more of these

types of households (Graph B3). Lower-income

households are just as likely as higher-income

households to be negatively geared, with

interest payments and other property expenses

exceeding rental receipts. Indeed, the majority of

investors with a mortgage are negatively geared.

The absolute size of rental loss is largest for

to total income, however, the rental loss is

largest for the lowest income bracket and

gets progressively smaller for higher income

brackets. This suggests that lower-income

taxpayers may be more vulnerable to increases

in debt repayment obligations or reductions

in income. They might also be more reliant on

rental income to meet their repayments. About

35 per cent of individuals in the lowest income

bracket are over the age of 60 and the majority

of this income group did not have any salary

income (though they may have superannuation

or other non‑taxable income not included in this

classification). This suggests that this group could

include people who are retired or temporarily

out of the workforce. About 70 per cent of

5 Interest payments make up around half of rental property expenses.

There are many other smaller expenses that contribute to investors

making a net loss such as council rates and capital works deductions.

2003/04

2013/14

<18 2 18.2–37 37–87 87–180 180+

0

10

20

30

%

0

10

20

30

%

Income brackets – $’000

Share of all property investors by income*

Source: ATO

Average rental interest deduction

Average rental loss*

<18 2 18.2–37 37–90 90–180 180+

0

5

10

15

20

$’000

0

5

10

15

20

$’000

Income brackets – $’000

By total income, 2014/15

expenses exceed rental income

Source: ATO

investors in this group also indicated that they

have a partner; for these households, partner

income might provide another source to service

investor loans.

Profession

Professionals, for example teachers, lawyers and

doctors, account for the largest share of property

investors, reflecting their large share as taxpayers

and their greater propensity to be investors;

Age

There has been a marked increase in the age of

property investors since the mid 2000s. Over

the decade to 2014/15, the share of property

investors who were aged 60 years and over

almost doubled (Graph B5). This shift reflected

both the increase in the share of the population

aged over 60 and an increase in the extent of

investment property ownership within this age

group. Overall, around 20 per cent of taxpayers

aged over 40 are property investors compared

with less than 10 per cent of those under 40.

There has also been a significant increase in the

share of geared investors aged over 60. While this

seemingly could increase risks, there are some

mitigating factors. Although this age group is

more indebted, the average retirement age has

increased over time, so older investors are more

they account for 17 per cent of taxpayers and

22 per cent of investors (Table B1). Managers and

professionals together account for over one‑third

of property investors, likely due to their relatively

high median income. In contrast, lower-income

occupations exhibit a lower propensity to invest

in property; in general, they account for a smaller

share of property investors than of their share

as taxpayers. Even among some lower-income

occupations, however, large proportions of

investors are negatively geared. For example,

72 per cent of community and personal service

worker investors and 67 per cent of sales worker

investors are negatively geared compared with

an average of 62 per cent across all occupations.

These investors could be particularly vulnerable

to an income shock affecting their ability to meet

mortgage repayments.

2014/15

Occupation

Median

salary

income

($)

Share

of all

taxpayers

(%)

Share

of all

investors

(%)

Share of

investors in

occupation

(%)

Share of

occupation’s

investors that

are negatively

geared

(%)

Managers 65 784 10 15 23 71

Professionals 65 755 17 22 21 70

Machinery operators

& drivers 55 542 5 3 11 74

Technicians &

trade workers 54 256 9 8 14 73

Clerical & administrative

workers 42 926 12 12 16 68

Labourers 32 396 8 3 7 66

Community & personal

service workers 31 790 8 5 10 72

Sales workers 27 788 7 4 8 67

(a) About 80 per cent of the ‘other’ category is individuals who did not report an occupation

(b) Totals do not equal the sum of components due to rounding and measures to ensure the data meet privacy regulations

Source: ATO

State

In most states, the share of the Australian

population who own an investment property

is similar to the overall share of investment

properties located in that state. Queensland

is a notable exception – around 25 per cent

of all rental properties are in Queensland but

less than 20 per cent of investors are from

Queensland. This suggests a sizeable share of

investment properties in Queensland are owned

by investors with multiple properties or people

not residing in the state, who are possibly less

informed about the local property and rental

market. This could increase the likelihood of

many investors selling in a sharp downturn.

Information from liaison suggests there was

strong investor demand due to dwelling price

and yield differentials with other states and the

active role of property marketers, particularly

in areas of Queensland exposed to the

likely to be working, increasing their capacity to

withstand shortfalls in rental income or higher

interest rates. In 2004, just under 50 per cent of

indebted investors over the age of 60 received

salary income, but this had increased to 60 per

cent in 2015. Older investors may also have

greater accumulated wealth that could enable

them to withstand lower rental income or higher

mortgage interest. They might also have lower

personal expenses.

Overall, however, borrowing has remained far

more prevalent among younger investors, with

almost all investors below the age of 40 years

being indebted. While these investors generally

have stable wage and salary income, they also

have relatively high personal expenses that can

reduce their ability to cushion changes in rental

income and interest rates.

Share of all property investors

2003/04

<30

30–39

40–49

50–59

60+

0

10

20

30

% 2014/15

<30

30–39

40–49

50–59

60+

0

10

20

30

%

Source: ATO

Box C

Large Falls in Household Income

Households that experience large income falls

can struggle to meet mortgage repayments.

This box uses annual data from the Household,

Income and Labour Dynamics in Australia (HILDA)

Survey to look at the typical characteristics of

households that experience large declines in

income. It focuses mainly on households with

owner‑occupier housing debt as HILDA data on

investor housing debt are only available every four

years. Overall, on average the households that are

more likely to experience large falls in income tend

to be those with lower debt-servicing burdens or

higher incomes and so are best able to continue

servicing their financial debts, though there is

clearly a range of experiences.

Households with Large

Income Falls

In this box, households are classified as having

a ‘large’ income fall if their annual disposable

income declines by more than 20 per cent

relative to their minimum income level over the

previous two years. This definition abstracts from

large income falls that reflect the unwinding of

temporary income gains such as redundancy

payments. Based on this measure, HILDA data

indicate that, on average, around 6 per cent of

indebted households experience large declines

in their total disposable income in any given year

(Graph C1).

Households receive income from a range of

sources, some of which are more volatile and

hence more likely to experience large declines

(and large rises). For example, around 30 per cent

of households earning business or investment

income (which includes rent from investment

properties) reported large declines in these

income types in a given year, even though these

types of income are only a relatively small share

expects lenders to apply a discount (or ‘haircut’)

to volatile income sources when assessing a

share of households experience annual declines in

transfer income (especially government assistance

payments), these declines are often accompanied

by increases in wage and salary income.

1 The large spike for transfer income during the financial crisis period

was likely due to the unwinding of the various temporary bonus

payments made by the federal government.

2 APRA notes that it is prudent practice for lenders to apply a discount

of at least 20 per cent on most types of non-salary income such as

bonuses, overtime, rental income and other investment income.

See APRA (2017), ‘APG 223 Residential Mortgage Lending’, Prudential

Practice Guide, February.

Share of indebted households**

2005 2010 2015

0

15

30

%

Total***

Wages and salary

(69%)

(10%)

Government

transfers

2005 2010 2015

0

15

30

%

Investment

(6%)

Business

(5%)

20 per cent relative to the lowest value reported for that income type

in the previous two years

type in total household income in 2015

Sources: HILDA Release 15.0; RBA

While wage and salary income comprises

around 70 per cent of total household income

on average, less than 10 per cent of households

reported large annual declines in this type of

income. However, given that wage and salary

income makes up a sizeable proportion of

total income, large declines in households’

total disposable income are in practice most

commonly driven by falls in wage and salary

income. HILDA data suggest that two drivers of

large declines in wage and salary income are

household members becoming unemployed or

dropping out of the labour force, for instance due

to child care and/or retirement, and relationship

breakups, such as divorce, which change

household composition or reduce a household’s

Experiencing a sizeable decline in household

income does not necessarily imply that a

household will struggle to repay its debts.

Some households plan for income falls, such as

choosing to leave the workforce to study, have a

child or retire. Households with low debt relative

to income – for example those who initially

borrowed small amounts or whose income

has grown since they took out the debt – may

have sufficient disposable income to still make

their debt repayments. Other households may

have accumulated funds through pre‑payments

that can be drawn on to smooth through

temporary falls in income. Nonetheless,

households experiencing large income declines

are more likely to experience mortgage stress;

the characteristics of these households are

outlined below.

3 Over the sample period, roughly 15–20 per cent of households

experiencing large declines had a household member who reported

a transition from being employed to being unemployed or not in

the labour force from one year to the next. This does not include

shorter‑term episodes of labour market transition that are reversed

within one year, which can also negatively impact household

income.

Household Characteristics

Two characteristics associated with households

experiencing large income declines are the

income quintile of the household and the

employment type of the household head. More

households in the top income quintile report

large declines in income than other households

(Graph C2; left panel). This appears to partly

reflect that high-income households typically

earn a greater share of their income from

investment and business income, both of which

tend to be more volatile than other sources of

income. Nonetheless, higher-income households

are still likely to be better placed to service their

debts than low-income households even after

experiencing a large income fall. In contrast,

fewer households in the bottom income quintile

experience large income declines, partly because

more of their income tends to come from

relatively stable sources.

Households with self-employed heads are also

more likely to experience large income falls

(Graph C2; right panel). These households,

on average, earn a much higher share of their

total income from volatile business income

(20–25 per cent) compared with other households

(1–2 per cent). Similarly, households in which the

head works part time are more likely to experience

large income declines compared with households

where the head works full time.

Households with owner-occupier mortgage

debt are less likely to experience large income

falls than those without mortgage debt

(Graph C3). Further, the HILDA data suggest

that of households with owner-occupier debt,

the more indebted households are less likely

to experience large income falls. Specifically,

the share of households with debt-servicing

ratios (DSRs) above 30 per cent that report large

declines in income is lower than for households

applying a haircut to volatile income sources) or

whether households seek out more stable forms

of income before or soon after borrowing. In

addition, households with higher DSRs are less

likely to choose to cut down their working hours

or to exit the labour force.

These observations, however, do not

necessarily imply that households with greater

debt‑servicing burdens are less likely to suffer

mortgage distress. Previous research has found

that households with high DSRs are more likely

reconcile these results is that, while households

with high DSRs are less likely to suffer large

income declines than households with low

DSRs, if they do experience a sharp fall in

income, they are much more likely to experience

5 See Read M, C Stewart and G La Cava (2014), ‘Mortgage-related

Financial Difficulties: Evidence from Australian Micro-level Data’,

RBA Research Discussion Paper No 2014–13.

this reflects that households with volatile income

borrow less (either by choice or because of the

lending policies of financial institutions, such as

4 The DSR is the share of disposable income devoted to meeting

repayments. Over the sample period, a DSR above 30 per cent

corresponds to around the 75th percentile of the DSR distribution.

Share of households by type

Income quintile

Bottom Middle** Top

0

5

10

% Employment type

Employee Self-employed

0

5

10

%

2003–09 2010–15

of more than 20 per cent relative to the lowest income value reported

in the previous two years; households are classified by their

characteristics in the previous year

Sources: HILDA Release 15.0; RBA

Share of households by type

Whether indebted

No mortgage Mortgage

0

3

6

9

% Debt-servicing ratio

0

3

6

9

%

2003–09 2010–15

of more than 20 per cent relative to the lowest income value reported

in the previous two years; households are classified by their

characteristics in the previous year; includes owner-occupier housing

debt only

Sources: HILDA Release 15.0; RBA

The Australian financial system remains

resilient and its ability to withstand adverse

shocks continues to be strengthened. Banks’

capital levels are well above current regulatory

minimums and, for the major banks, are around

the top quartile of international peers on a

comparable basis. Banks’ capital has been

boosted by high profit levels over recent years.

While net interest margins have trended lower

they are now widening as funding conditions

improve and the effects of recent loan repricing

are realised. Bad and doubtful debts remain

around historical lows, despite rising mortgage

loan arrears in mining-related regions.

In July, the Australian Prudential Regulation

Authority (APRA) announced the additional

capital required for Australian authorised

deposit-taking institutions (ADIs) to be

considered ‘unquestionably strong’. The major

banks will need to target a Common Equity

Tier 1 (CET1) capital ratio of around 10.5 per cent

by January 2020 (based on the current capital

framework), while the effective increase in capital

requirements for smaller ADIs will be around

50 basis points. APRA also announced that it

intends to set new capital standards, expected

to become effective from 2021, that will include

minimum requirements consistent with these

benchmarks. Banks are well placed to meet these

higher requirements through retained earnings

and dividend reinvestment plans, having already

increased their capital in anticipation of these

changes. After reaching these new benchmarks,

banks will have completed a substantial increase

in their capital ratios since the onset of the

financial crisis. APRA plans to release a discussion

paper later this year setting out modifications

to the underlying capital framework, including

changes to address banks’ high concentration of

residential mortgages. APRA’s intention is that any

changes to this framework will not result in further

increases to aggregate capital requirements.

The increase in banks’ capital over recent years has

made them more resilient and lowered their return

on equity (ROE). Despite this, investors appear to

still be expecting similar returns to those sought

a decade ago. This tension could motivate banks

to seek higher returns by taking on additional

risks. Regulators have increased their focus on

the risk culture of banks and the industry is taking

steps to strengthen their approach to certain risks.

Tighter standards for banks’ lending to the

property market over recent years have created

an opportunity for shadow banks to expand.

Yet available evidence indicates that shadow

banks’ share of residential mortgage lending

has increased only slightly, and from a low level.

There are several constraints to such lending

growing rapidly. Shadow banks’ lending for

property development has increased more

strongly, but it has not been enough to fully

replace the pullback by banks.

Non-bank financial institutions are also in

good condition, though they face some

challenges. General insurers are addressing

historically low profitability by reversing earlier

declines in some commercial premiums. Life

insurers are responding to ongoing structural

issues by reducing risk through greater use of

reinsurance and raising capital ratios. Risks from

the superannuation sector remain limited

due to its modest use of leverage, even in

self-managed superannuation funds. Financial

market infrastructures have also continued to

function effectively and are working to reduce

possible vulnerabilities.

Banks’ Domestic Asset

Performance

The performance of Australian banks’ domestic

assets was little changed overall in the first half of

2017, although this masks some variation by asset

type (Graph 3.1). The share of non-performing

housing loans increased a little. However, banks’

non-performing housing loans are mostly

well secured, with the impaired share very low

in Western Australia, Queensland and South

Australia. In liaison with the Reserve Bank, some

banks continued to report that they do not expect

loan performance to deteriorate much further

in Western Australia. Banks also reported some

worsening in the performance of personal loans.

Weaker economic conditions in Western Australia

and Queensland have contributed to higher

arrears on personal loans. Changes in banks’

reporting of loans granted hardship concessions

also pushed up the share of non‑performing

personal loans. This has little impact on banks’

overall loan performance as personal lending

remains a very small share of banks’ total lending.

In contrast to household loans, aggregate

business loan performance has improved further,

supported by low interest rates. Impairments on

commercial property exposures remain low.

Future asset performance will continue to

be influenced by developments in property

markets and the resources sector, as well as

macroeconomic conditions more generally.

1 Impaired loans are those that are not well secured and where there

are doubts as to whether the full amounts due will be obtained in a

timely manner. Past-due loans are at least 90 days in arrears, but well

secured.

The strengthening in housing lending standards

over recent years should support future

loan performance.

Credit Conditions

Total credit growth was little changed over the

past six months and is still slightly faster than

nominal income growth (Graph 3.3). Housing

credit growth was stable in aggregate, with some

slowing in the growth of investor credit being

Domestic books

Share of all loans

2007 2012 2017

0

1

2

3

4

%

Total

Share by type of loan*

2007 2012 2017

0

1

2

3

4

%

Personal

Housing

(4%)

Business**

(35%)

(61%)

in parentheses

non-household loans

Sources: APRA; RBA

2005 2009 2013 2017

0 0

0 3

0.6

0 9

%

0.0

0.3

0.6

0.9

%

Domestic books, share of housing loans

Impaired

Past-due

Total

loans are in arrears or otherwise doubtful and not well secured

Sources: APRA; RBA

been tightened in response to APRA’s onsite

reviews of commercial property lending. It will be

important to remain vigilant about risks that can

be precipitated by foreign bank lending.

International Exposures

Australian-owned banks have continued to

reduce their international lending exposures

over the past year, other than in New Zealand

(Graph 3.5). The decline has been spread across

a range of countries and is consistent with

the desire of several banks to scale back from

lower return businesses, particularly lending

to institutional customers. Exposures to Asia

are expected to fall further as ANZ completes

the sale of some retail banking and wealth

management businesses over coming months.

In contrast, Australian-owned banks’ lending

exposures in New Zealand and their international

sovereign exposures (which mainly comprise

government bonds and central bank deposits)

have grown a little faster. The increase in

lending to New Zealand has been mainly for

housing, where risks are elevated, as discussed

in ‘The Global Financial Environment’ chapter.

While arrears for New Zealand housing are

currently at their lowest level in at least a

Six-month-ended annualised

2007 2012 2017

-10

0

10

20

%

Total

Household

2007 2012 2017

-10

0

10

20

%

Owner-occupier

Investor

Sources: APRA; RBA

offset by faster growth in owner-occupier credit.

The moderation in investor credit follows the

increases in investor and interest-only interest

rates and is broadly akin to the slowing observed

after APRA announced limits on investor housing

credit growth in late 2014.

Business credit growth has picked up in recent

months following a slowing earlier in the

year, although it remains modest relative to

history. The major banks have reduced their

commercial property exposures and reported

a further tightening in standards for residential

development lending. However, lending by

foreign-owned banks operating in Australia has

continued to increase, driven primarily by banks

headquartered in Asia (Graph 3.4). Asian banks

now supply 12 per cent of total business credit in

Australia, compared with 6 per cent in 2012, with

this growth driven particularly by infrastructure

and commercial property lending. Some Asian

banks have concentrated exposures to particular

companies or sectors. Rapid expansion by foreign

banks has in the past exacerbated asset price and

economic cycles by amplifying the credit supply

cycle and could lead domestic banks to loosen

lending criteria to remain competitive. To date,

these risks to lending standards appear to have

been contained, and indeed standards have

By region of headquarters, share of total business credit

Asia

2007 2012 2017

0

2

4

6

%

Japan

China

Other

Non-Asia

2007 2012 2017

0

2

4

6

%

Europe

North America

Sources: APRA; RBA

decade, the rising share of banks’ exposures to

New Zealand and Australian housing markets has

reduced their diversification given the correlation

of these housing markets over an extended

period. However, this shift towards housing

lending, which historically generates higher

return on equity, has also supported their profits.

Liquidity and Funding

Australian banks have maintained resilience

to potential liquidity and funding shocks.

Banks’ Liquidity Coverage Ratios, which measure

their buffers of liquid assets against short periods

of liquidity stress, are reasonably above the

100 per cent minimum requirement. Banks’ Net

Stable Funding Ratios, which measure the extent

more stable liabilities are used to fund less liquid

assets and which will become binding from next

year, have mostly risen close to banks’ target levels.

Australian banks have ample access to a range

of funding sources at a lower cost than one

year ago. Deposits inflow has been strong, such

that despite reducing the interest rates paid on

deposits, they have grown more quickly than

assets over the past year (Graph 3.6). Spreads

on banks’ short-term and long-term wholesale

funding have also narrowed considerably, with

long-term spreads around their lowest level since

the financial crisis (Graph 3.7). The strong growth

in deposit funding has meant banks have only

slightly increased their funding from wholesale

markets in absolute terms, and reduced it as a

share of total liabilities. Conditions in residential

mortgage-backed securities (RMBS) markets

have also improved: spreads have declined a little

but remain well above pre-crisis levels. RMBS

issuance by smaller Australian banks has picked

up, but is also well below pre-crisis levels.

Share of assets, ultimate risk basis

Non-bank private sector

2013 2017

0

2

4

6

8

%

Asia

Other

NZ

Other sectors

2013 2017

0

2

4

6

8

%

Banks

Public sector*

bank deposits

Sources: APRA; RBA

2011 2012 2013 2014 2015 2016 2017

-10

-5

0

5

10

15

%

-10

-5

0

5

10

15

%

Semi-annual average compared with year earlier

Deposits

Assets

Long-term

wholesale debt

Short-term

wholesale debt

Sources: APRA; RBA

Spread to swap

Short term*

2009 2013 2017

0

25

50

75

bps Long term**

2009 2013 2017

0

50

100

150

bps

to four-year interest rate swap

Sources: AFMA; Bloomberg; Tullett Prebon (Australia); UBS AG, Australia

Branch

The ratings of many Australian financial

institutions were downgraded by credit rating

agencies in recent months, largely due to

concerns about high and rising household debt.

but affirmed the ratings of the major banks

(because of an unchanged assumption of

sovereign support) and Macquarie Bank. Moody’s

downgraded 12 institutions, bringing its ratings

for the major banks into line with other major

ratings agencies at AA–. These ratings actions led

to some deposit outflows for some non-major

banks, but the impact was small and temporary

because of the strong growth in deposit markets.

Capital and Profits

Australian banks’ resilience to adverse shocks is

underpinned by their capital positions, which

are above current minimum requirements. Each

of the major banks’ CET1 capital ratios are well

above the current 8 per cent threshold, and

around the top quartile of large international

banks when measured on a comparable basis

(Graph 3.8). Capital ratios at most other ADIs

are higher still. The leverage ratios of the major

banks – the ratio of Tier 1 capital relative to total

non-risk-adjusted exposures – are also around

the top end of the 3–5 per cent range that

was expressed as ‘appropriate’ for a minimum

requirement in the 2014 Financial System

Inquiry (FSI). However, the major banks’ leverage

ratios have typically been around or a bit below

the median of international banks because of

Australian banks’ greater exposure to residential

mortgages, which have historically experienced

fewer losses and so have lower risk weights.

APRA released an information paper in

July that set out the additional capital

required for Australian ADIs to be considered

2 APRA (2017), ‘Strengthening Banking System Resilience – Establishing

Unquestionably Strong Capital Ratios’, Information Paper, 19 July.

main recommendations from the FSI. APRA’s

expectation is that all ADIs meet the new capital

benchmarks by 2020.

CET1 capital ratio of around 10.5 per cent

(based on the current capital framework).

This corresponds to a CET1 capital ratio of

more than 15 per cent on an internationally

comparable basis, and should put the major

banks’ CET1 ratios comfortably within the top

quartile of large international banks.

approach to credit risk, the effective increase

in CET1 capital requirements will be around

0.5 percentage points.

APRA plans to release a discussion paper later

this year with proposed revisions to the capital

framework that are expected to be implemented

from 2021. In this, APRA intends to outline how

it will implement changes to the international

Basel III capital framework if it is finalised by then.

It intends to also address the Australian banking

system’s high concentration of residential

mortgages. In particular, APRA has indicated that

Regulatory

requirement

Major banks Other ADIs

0

2

4

6

8

10

%

0

2

4

6

8

10

%

APRA Basel III basis, June 2017

CET1 minimum Capital conservation buffer

Domestic systemically important bank add-on*

Sources: APRA; RBA

it will seek to target higher-risk lending, building

on the revised Basel III framework that will likely

modify risk weights for higher loan-to-valuation

(LVR) loans and identify separate risk weights for

investor lending. APRA expects that any changes

to the capital framework will not necessitate

Banks are well positioned to meet the

‘unquestionably strong’ capital targets, having

increased capital markedly over recent years in

anticipation of higher regulatory requirements

(Graph 3.9). APRA estimates that the major

banks should be able to generate the additional

required capital from retained earnings, without

significant changes to asset growth or dividend

policies, or the need for equity raisings. Many

smaller ADIs already hold enough capital to meet

the effective increase in requirements.

Reaching a CET1 capital ratio of 10.5 per cent

will complete a substantial strengthening of

the major banks’ capital position over recent

years. Their CET1 capital ratio will be around

3 The level of required capital under the new capital standards need

not increase if risk weights are increased for a particular type of

lending because this could be offset by other changes to the capital

framework.

2½ percentage points higher than when the FSI’s

proposal was released in late 2014 (including the

effect of higher residential mortgage risk weights

applied from mid 2016) and their Tier 1 capital

ratio will be around 6 percentage points higher

than before the financial crisis. APRA has also

estimated that the major banks’ leverage ratio

could increase to around 6 per cent following the

substantial strengthening in capital, somewhat

higher than the current international median.

A sizeable portion of banks’ capital accumulation

in recent years has come from retained profits

or reinvested dividends flowing from their

high profits. Profits remained high in the latest

period, but there has been very little growth

since 2014, both in headline and underlying

terms (Graph 3.10). One reason for the lack of

profit growth is that banks have divested wealth

management and life insurance operations;

another is that their net interest margins have

compressed, partly reflecting increased holdings

of low-yielding, high-quality liquid assets. In

addition, while charges for bad and doubtful

debts remain around historically low levels, they

are no longer falling and so are not adding to

profits as they did prior to 2014. (Profits are an

important contributor to banks’ resilience during

stress, as highlighted in ‘Box D: Stress Testing at

the Reserve Bank’.)

Analysts expect profits to increase over the

coming year. Recent loan repricing and reduced

funding costs are expected to drive some

increase in the net interest margin, leading to

higher income growth and profits.

The increase in capital over recent years, despite

flat profits, has reduced banks’ ROE below its

historical average. Banks have partly offset this

by making some adjustments to their lending

4 For more information, see Atkin T and B Cheung (2017), ‘How Have

Australian Banks Responded to Tighter Capital and Liquidity

1992 1997 2002 2007 2012 2017

0

4

8

12

%

0

4

8

12

%

Consolidated global operations

Total

Tier 1

Tier 2

CET1

introduction of Basel II; break in March 2013 due to the introduction of

Basel III

Source: APRA

towards housing lending, which requires less

capital, and has generated higher ROE than other

activities. Banks have also scaled back activities

that are more capital intensive and do not

generate sufficient returns to offset the capital

required. As noted earlier, this has included some

international activities and institutional lending.

Most of the major banks have also sold (or are

in the process of selling) parts of their wealth

management and life insurance operations.

The share prices of Australian banks

have declined over the past six months,

underperforming global peers. The price fall has

seen banks’ forward earnings yields – a proxy

for investors’ expected rate of return – rise both

in absolute terms and relative to the broader

market (Graph 3.11). Banks’ current forward

earnings yields are around their pre-crisis

average, despite a large decline in risk-free rates

since then.

Profits and return on shareholders’ equity

6

12

18

$b

6

12

18

%

ROE

(RHS)

Bad and doubtful debts

Per cent of average assets

2005 2008 2011 2014 2017

0 0

0.1

0 2

0 3

%

0.0

0.1

0.2

0.3

%

Sources: APRA; RBA

2005 2008 2011 2014 2017

4

6

8

10

12

%

4

6

8

10

12

%

ASX 200

ASX 200 Banks

(excl. banks)

Sources: RBA; Thomson Reuters

Bank Culture

Global experience is that the culture within banks can have a major bearing on how a wide range of risks are identified and managed.

There have been a number of examples where the absence of strong positive culture has given rise to a deterioration in asset performance, misconduct and loss of public trust. In Australia, there have also been examples of weak internal controls causing difficulties for some banks.

A central element to address this issue is to ensure that banks build strong risk cultures and governance frameworks. Regulators have therefore heightened their focus on culture and the industry is taking steps to improve in this area. APRA’s powers will be strengthened once the Banking Executive Accountability Regime (BEAR) announced in this year’s Federal Budget is legislated. The BEAR strengthens APRA’s abilities to impose civil penalties and dismiss bank executives for poor conduct, and requires a significant share of executives’ incentive remuneration to not vest for at least four years (although banks already largely adhere to this).

APRA has also established an independent inquiry to identify whether there are deficiencies in governance, culture and accountability frameworks and practices at the Commonwealth Bank of Australia and, if so, how these can be addressed. The banking industry’s own initiatives to improve culture include background checks aimed at preventing individuals with a history of misconduct moving within the industry, and rewriting the Code of Banking Practice to strengthen its commitment to customers.

Shadow Banking

Shadow bank lending can support economic

growth by providing credit to borrowers that

don’t easily meet bank standards but, because it

is less regulated, on a large enough scale it could

damage financial system resilience. While tighter

post-crisis prudential regulation for banks

increases the chance that credit activities migrate

to the less regulated shadow banking sector,

there is little evidence of this so far in Australia.

The shadow banking sector remains small – only

7 per cent of the financial system – and about

half the size it was in 2007 (Graph 3.12). The fall

in the shadow bank market share occurred

as the crisis intensified and sourcing funding

became more difficult, and the sector has not

regained market share as funding markets have

normalised. Systemic risks to the financial system

are limited by banks’ exposures to the sector,

which are only a few per cent of their assets.

Property lending by shadow banks warrants

attention given the tightening of lending

standards at prudentially regulated entities.

In line with the trends noted above, the available

evidence suggests that shadow banks’ share of

residential mortgage lending has increased only

slightly over the past few years and remains well

development, there are limited data on the

extent of shadow banks’ lending. However, liaison

suggests that this type of lending has increased

relatively strongly over the past year or so, but

has not fully offset the pullback by large banks.

Much of this shadow bank finance is expensive

mezzanine debt that poses less risk to financial

stability, in part because it occurs with some

regulatory oversight if a bank provides the senior

debt. However, there has also been some growth

in shadow banks’ provision of senior debt.

A key constraint to a rapid expansion of shadow

bank property lending is the cost and availability

of funding. Non-bank mortgage originators

require warehouse funding (revolving finance

until mortgages are securitised), which banks

5 See Gishkariany M, D Norman and T Rosewall (2017), ‘Shadow Bank

pp 45–52 for more details.

Financial assets, by economic function*

Value

2007 2012 2017

0

250

500

750

$b Share of financial system**

2007 2012 2017

0

5

10

15

%

Hedge funds***

Other funds investing in credit products

Non-prudentially consolidated finance companies

Securitisation vehicles (excluding self-securitisation)

Sources: ABS; APRA; ASIC; Australian Fund Monitors; RBA

could be reluctant to provide due to regulatory

issues. Longer-term funding is typically through

RMBS and while this market is recovering, RMBS

pricing is still well above the cost of bank funding

(deposits or senior unsecured bank debt).

This tends to push shadow banks using this

business model to lend to borrowers with lower

credit quality that pay higher interest rates.

Proposed legislation will improve the quality of

data supplied to regulators by some shadow

banks, making it easier to monitor these activities

and assess their impact on financial stability.

Related legislation will also grant APRA powers to

impose rules on non-ADIs if their activities pose a

threat to financial stability.

Insurance

General insurers’ profits have been broadly

steady over the past year, but ROE for the

sector remains around the bottom of the range

observed over the past decade (Graph 3.14).

The decline in ROE compared with its historical

average has mainly resulted from a material

fall in investment income as interest rates

declined. Underwriting performance has also

been weaker than historically, but has recovered

a little over the past year as insurers managed

to reverse earlier downward pressure on some

commercial premiums. Despite higher natural

disaster claims due to cyclones, earthquakes and

hailstorms, the claims ratio (net incurred claims

relative to net premium) also fell as lower-thanexpected

inflation allowed insurers to release

more reserves. The general insurance industry

remains well capitalised, with capital equivalent

to 1.8 times APRA’s prescribed amount.

Lenders mortgage insurers’ profits remain under

pressure, but the sector remains well capitalised

at 1.6 times APRA’s prescribed amount. Profits

continue to decline due to a decrease in revenue,

as banks reduce high-LVR mortgage lending,

and claims increase in Western Australia and

Queensland. These headwinds seem likely to

persist, given APRA’s efforts to limit the flow of

new high-LVR interest-only loans.

Life insurance profitability has stabilised due

to an improvement in the individual death

and total and permanent disability parts of

the industry, and because large write-downs

in prior periods have not been repeated.

However, ROE remains low and the industry is

still reporting considerable losses on individual

2005 2009 2013 2017

0

2

4

6

8

%

0

2

4

6

8

%

Year-average*

Sources: APRA; RBA

Financial year

Contributions to return on equity

-15

0

15

30

%

-15

0

15

30

%

Claims ratio*

2005 2009 2013 2017

50

60

70

%

50

60

70

%

Return on equity

Underwriting result

Investment income

Tax and other

basis after June 2010

Sources: APRA; RBA

disability income insurance (commonly known as

‘income protection insurance’) due to structural

issues (Graph 3.15). These include longstanding

deficiencies in pricing, loose product definitions

and rising claims, especially for mental health.

Problems in the life insurance industry will

take some time to resolve given the long-term

nature of life insurance contracts. Given that, the

industry has responded by reducing risk through

additional reinsurance and by increasing its

capital to 1.9 times APRA’s prescribed amount.

in advance of changes to the concessional

contributions cap that took effect on 1 July.

The financial stability risks inherent in the

superannuation industry are lower than for

other parts of the financial system because

debt funding accounts for a very small share

of its total liabilities. This is particularly true

for APRA-regulated funds, which are not

generally permitted to borrow. Self-managed

superannuation funds (SMFS) are permitted to

use debt with limited recourse and the use of

such debt has increased in recent years, mainly

to fund the purchase of property (Graph 3.16).

Despite this, leverage in SMSF as a whole remains

very small (only a few per cent of total assets) and

at this stage poses little risk to financial stability.

2009 2011 2013 2015 2017

-5

0

5

10

15

%

-5

0

5

10

15

%

Annualised

Individual death/TPD*

Group death/TPD*

Individual disability

Non-participating investment-linked

Other**

Return on equity

Sources: APRA; RBA

2013 2014 2015 2016* 2017*

0

1

2

3

4

%

0

1

2

3

4

%

Proportion of total SMSF assets, as at 30 June

Sources: ATO; RBA

Superannuation

The superannuation sector remains a large and

growing part of Australia’s financial system.

Total assets amount to $2.3 trillion, accounting for

three-quarters of the assets in the managed fund

sector (a higher share than in other advanced

economies) and equivalent to around half the

size of the Australian banking system. Total

superannuation assets grew by 10 per cent in

the year to June 2017, slightly higher than the

post-crisis average. Growth was supported by

stronger investment returns as global share

markets rallied and higher member contributions

Financial Market Infrastructures

Financial market infrastructures (FMIs) are

institutions that facilitate the clearing, settlement

or recording of payments, securities, derivatives

or other financial transactions. Over recent years

there has been considerable effort to strengthen

the regulation and supervision of FMIs because

of their central role in the financial system.

The Reserve Bank has oversight responsibilities

for the stability of FMIs operating in Australia.

The key FMIs located in Australia are the Reserve

Bank Information and Transfer System (RITS) –

which banks and other approved institutions

use to settle payment obligations on a real-time

basis – and the ASX clearing and settlement

facilities – which facilitate the clearing and

settlement of trades in securities and derivatives.

RITS processed around 6 million transactions in

the six months to September, with an aggregate

value of $22 trillion. There have been no major

incidents impacting RITS during this time and

the number and frequency of incidents remained

at historical lows. All of the key ASX facilities

also met their operational availability target of

99.9 per cent during this period. However, in

light of a number of operational incidents, ASX

has commissioned an external assessment of its

operational risk management arrangements.

One recent focus of the Reserve Bank’s oversight

of ASX has been the margining arrangements

of its two central counterparties (CCPs). Margin

posted to the CCP by each participant is the first

layer of financial protection against potential

losses in the event of that participant’s default.

Overall, the Reserve Bank concluded that

these CCPs had well-established margining

arrangements that have been enhanced over

recent years. However, the Reserve Bank noted

that ASX Clear (Futures) does not currently have

the operational capacity to collect margin during

the night session, when almost 40 per cent of

trading in its futures contracts occurs. This exposes

the CCP to the risk of holding inadequate collateral

against default if market prices move sharply

during this time. In response to the Reserve Bank’s

concerns, ASX Clear (Futures) has started to require

certain participants to lodge a ‘buffer’ of additional

margin during the night session. In the longer

term, ASX plans to manage its overnight risk by

implementing real-time margining capabilities

on a 24/6 basis, including scheduled overnight

margin runs.

A second focus of the Reserve Bank’s oversight

of ASX CCPs has been their management of

investment risk. This has seen ASX recently

implement changes to its treasury investment

policy that limits its unsecured exposure to

individual non-government-related issuers or

counterparties; each exposure can be no larger

than the level of business risk capital held across

the two CCPs (currently $75 million).

In line with other areas of the financial system,

management of cyber risk is a significant and

growing focus for FMIs. The Reserve Bank has

conducted a detailed assessment of the main

domestic FMIs against the governance chapter of

To complement this assessment, the Reserve

Bank has required these FMIs to conduct a

self-assessment against the remaining chapters

of the guidance and have their arrangements

externally reviewed against industry standards

on cyber resilience. These assessments have

been completed for RITS and work is underway

for the ASX clearing and settlement facilities.

To date, these assessments have not identified

any significant issues. Consistent with the

international guidance, these FMIs have also

developed concrete plans to improve their

capabilities to recover from a cyber attack.

Work is also progressing to enhance the cyber

resilience of FMI members. RITS recently updated

its Business Continuity Standards for RITS

members to specifically address cyber security.

SWIFT, a key provider of payments messaging

infrastructure to the financial industry, has also

announced a new policy framework for ensuring

users of its infrastructure apply appropriate

d146.htm>.

Box D

Stress Testing at the Reserve Bank

Stress testing is a tool used to assess the health

and resilience of the banking sector. It typically

involves modelling the impact of an adverse

macroeconomic scenario on credit losses and

bank profitability in order to assess the potential

effect on capital. Stress tests have become

an increasingly important part of the bank

regulation toolkit since the financial crisis and in

some countries they are now used as an input to

set macroprudential policy and capital standards.

There are two types of stress-testing frameworks,

‘bottom up’ and ‘top down’. In the bottom-up

framework individual banks are required to

determine the impact of a common scenario

using detailed data on their assets and liabilities,

internal risk models and recovery plans, in a

process overseen by the regulator. These stress

tests usually focus on the impact on individual

institutions rather than risks to the system as

a whole. In contrast, a top-down framework

typically involves central banks and other public

authorities using their own models to estimate

the impact of a scenario on the banking system

without any involvement from individual banks.

Each bank is assumed to respond to a scenario

in uniform, pre-defined ways, so that variation

in results across banks only reflects differences

in their balance sheet structure, capital and

profitability. The relative simplicity of top-down

models makes them less resource intensive and

more flexible, allowing authorities to run any

number of scenarios. However, this simplicity

comes at the cost of detail. They abstract from

differences in banks’ risk appetite, business

models and behaviour. They also produce less

granular results because they do not use the

detailed data about banks’ balance sheet and

profitability available in bottom-up modelling.

Stress Testing in Australia

In Australia, bottom-up stress testing is undertaken

periodically by the Australian Prudential Regulation

Authority (APRA). APRA’s stress test program

aims to assess the adequacy of banks’ capital

and assist Australian banks in improving their

risk management and capital planning. Indeed,

banks now regularly conduct internal stress

tests as part of their risk management processes.

More recently, stress‑testing results were used

as input in formulating APRA’s benchmarks

for unquestionably strong capital ratios for

authorised deposit-taking institutions.

To supplement this work, the Reserve Bank is

developing a top-down stress-testing framework.

The top-down approach can help explain the

differences in results across banks in bottom‑up

tests by applying the same parameters and

assumptions to all banks. The model can also

highlight the sensitivity of the overall system to a

change in parameters. In addition, the top-down

framework is more transparent to the public

authorities as it can clearly identify how shocks

propagate through a bank’s balance sheet. This

framework can be extended to capture systemic

aspects of bank stress, such as flow-on effects to

the financial system as a whole and amplification

of economic downturns. This is consistent with

the Reserve Bank’s focus on risks affecting the

whole banking sector, rather than bank-specific

risks that are the focus of prudential regulators.

The remainder of this box outlines the current

state of the Reserve Bank’s model. As further

development continues, the model will be used

to explore the resilience of the Australian banking

system with insights presented periodically

communications.

Features of the Reserve Bank’s

Framework

The Reserve Bank’s top-down framework maps

the impact of an adverse macroeconomic

scenario through the major banks’ balance

sheets. Using assumptions about their credit

losses, funding costs and non-interest income

in such a scenario, the stress test generates a

projection of the banks’ profits, dividends, loan

growth and capital positions. As is standard

with top-down stress testing in other countries,

many actions to mitigate the impact – such as

capital raising and loan repricing – are typically

not incorporated into the primary stress tests in

order to isolate the impact from the potential

response and also because the efficacy of these

actions is uncertain in times of stress. However,

the effect of mitigating actions can be explored

in subsequent stress-test specifications.

The Reserve Bank model primarily relies on

behavioural rules and accounting identities to

generate projections of bank profitability and

capital from a scenario (Table D1). In particular,

behavioural rules are used to determine the

pace of asset growth and dividend payments:

Pre-specified outside of the model Accounting identity Behavioural rule

Credit losses Net interest income Asset growth

Risk weights Capital Dividends

Funding costs Profits Additional funding costs

Lending rates

Non-interest income

as capital ratios fall below normal levels, banks

choose to reduce their dividend payout ratios

and constrain lending growth, while investors

demand higher returns when providing funding

to banks. In addition, there are some variables

that are pre‑specified outside the model, notably

credit losses, the evolution of risk weights and

funding costs.

Credit losses are determined by benchmarking

from historical episodes and past stress tests in

Australia and abroad, and from Australian banks’

Pillar 3 disclosure requirements. Graph D1 and

Graph D2 show relationships that could be used

to estimate the loss rate on mortgages and

commercial property lending. These illustrate

the highly uncertain, and possibly non-linear,

relationships between economic variables and loss

rates that need to be incorporated in a scenario.

An alternative approach used by many central

banks is to use statistical techniques to model

credit losses based on historical relationships

between observable default rates and economic

variables (such as the unemployment rate and

asset prices). This approach has not been used

for Australia because large credit loss events

have been rare and existing models have limited

explanatory power. The only sizeable credit

loss event in modern Australian history was

during the 1990s recession and there are limited

granular data from this period. In addition,

structural changes to banks’ balance sheets

and lending standards since that time make it

hard to draw implications from that event for

Risk weights are an important determinant of

a bank’s capital ratio and tend to rise during

stress as they take into account changes in

economic conditions. The magnitude of changes

is, however, difficult to predict and can vary

substantially across banks. The Reserve Bank

model therefore calibrates the evolution of risk

weights using the results of previous bottom-up

stress tests conducted by APRA.

Changes in banks’ funding costs are also

pre‑specified, given that shocks to markets are

not easy to model. The interest rates at which

banks can access deposit and wholesale funding

are calibrated based on historical episodes.

Banks are then assumed to experience additional

increases in wholesale funding costs as capital

ratios fall in the scenario. The model assumes

banks absorb any increase in funding costs to

abstract from the potential feedback effects of

higher lending rates on household stress and

hence loss rates, which cannot be determined

without a credit loss model.

Sensitivity to Changes in Key

Variables

The simplicity and flexibility of a top-down

framework means a number of different scenarios

can be considered quickly. For example, the

framework can assess the sensitivity of the results

and extent of non-linearities to adjustments to

key variables or alternative assumptions.

This flexibility is demonstrated in this box by a

simulation that shows the sensitivity of banks’

CET1 capital ratios to changes in the severity of the

stress event. It takes a similar stress event to APRA’s

2014 bottom-up stress test, and then assumes

current times. These challenges are illustrated by

research models such as Rodgers (2015), Bilston,

Johnson and Read (2015) and Kenny, La Cava and

Rodgers (2016), which produce either very low

credit losses when subject to quite severe stress

scenarios or do not find a robust link between

1 See Rodgers D (2015), ‘Credit Losses at Australian Banks: 1980–2013’,

RBA Research Discussion Paper No 2015-06; Bilston J, R Johnson and

M Read (2015), ‘Stress Testing the Australian Household Sector Using

the HILDA Survey’, RBA Research Discussion Paper No 2015-01; and

Kenney R, G La Cava and D Rodgers (2016), ‘Why Do Companies Fail?’,

RBA Research Discussion Paper No 2016-09.

0 2 4 6 8 10 12

0

2

4

6

8

Change in unemployment rate – ppt

Loss rate – %

(2009–13)

Ireland

(2008–12)

US

(1991–95)

UK

(2009–13)

(2008–12)

(1991–93)

Sweden

APRA 2014

stress test

Sources: APRA; Bank of England; Federal Reserve; IMF; RBA

0 10 20 30 40 50

0

2

4

6

8

10

Price fall – %

Loss rate – %

Australia

(2008–12)

(2008–12)

US

APRA 2014

stress test

UK

(2009–13)

Sources: APRA; Bloomberg; ESRB; MSCI; RBA

episodes. However, the impact of credit

losses on CET1 capital becomes larger when

accompanied by greater declines in revenue.

An alternative way to understand the sensitivity

of capital ratios to various shocks is to run reverse

stress tests. These tests estimate the magnitude

and duration of stress that would result in

banks breaching various thresholds. This can be

used, for example, to assess how much more

severe a past event or scenario would need to

be in order to breach certain prudential capital

credit losses, the fall in revenue or the rise in risk

This exercise generates a few key observations.

non-linear effects on banks’ capital ratios:

the deviation in banks’ capital ratios from

the baseline is larger when the degree

of stress is increased than when it is

decreased (Table D2). This non-linearity is

mostly attributable to the behavioural rule

governing dividend payments. As profits

decline in a stress scenario, lower dividend

payouts help to cushion the impact on

capital. But that ceases when profits fall to

zero and losses directly reduce capital.

evolves, the CET1 capital ratio is most

sensitive to the consequent changes in risk

weights. It is about twice that from changes

in credit losses in the scenario (Table D2).

capital in these scenarios because the banks

currently enter the stress period with very

large pre-impairment profits. This enables

them to continue generating capital through

retained earnings in even quite severe

2 In the 2014 scenario, real GDP falls by as much as 4 per cent per

annum, the unemployment rate rises to 13 per cent and house

prices fall by around 40 per cent. For more information, see Byres

W (2014), ‘Seeking Strength in Adversity: Lessons from APRA’s 2014

Stress Test on Australia’s Largest Banks’, AB+F Randstad Leaders

Lecture Series, 7 November.

Deviation in CET1 ratio from baseline scenario; in basis points

Less severe(a) More severe(a)

Credit losses 15 –30

Bank revenue 10 –15

Risk weights 60 –60

(a) The more (less) severe scenario assumes that either credit losses or the change in income or risk weights is 50 per cent larger

(smaller) than in the baseline. Only one variable is changed at a time

Source: RBA

System Architecture

The Financial Stability Board (FSB) and global

standard-setting bodies have continued to

progress work across a range of post-crisis reform

areas. These include addressing ‘too big to fail’, as

well as strengthening the regulatory framework

for central counterparties (CCPs). These bodies

have also been monitoring and, where necessary,

responding to, potential new sources of risk to

financial stability. This has included examining

the implications of financial technology (‘fintech’)

and the related issue of cyber security, and

continuing work to reduce misconduct in the

financial sector. Evaluating the effectiveness of

post-crisis reforms also remains a key focus. The

FSB recently released a new framework to guide

such evaluations. Discussions continue at the

Basel Committee on Banking Supervision (BCBS)

to finalise remaining Basel III capital reforms,

which are aimed at reducing the variability in

banks’ risk-weighted assets (RWAs).

Domestically, the Council of Financial

Regulators (CFR) agencies have focused on

strengthening and testing crisis management

frameworks, ongoing implementation of

international reforms, and reducing misconduct

and enhancing the culture within financial

institutions. The Australian Prudential Regulation

Authority (APRA) has published proposals

on counterparty credit risk and a prudential

standard on margining for non-centrally cleared

derivatives. A number of measures have been

announced, or are under consideration, for better

facilitating innovation in the financial sector.

International Regulatory

Developments

Addressing ‘too big to fail’

A key focus of the G20 post-crisis reforms has

been to address the ‘too-big-to-fail’ problem –

that is, mitigating the moral hazard and financial

stability risks associated with institutions that are

very large, perform critical functions or are highly

interconnected with other parts of the financial

system. One of the recent measures in this area

is the FSB’s total loss-absorbing capacity (TLAC)

standard for global systemically important banks

(G-SIBs). To comply with this standard, G-SIBs

must hold certain TLAC-eligible liabilities that can

be ‘bailed in’ during resolution. Implementation

of this standard has progressed further, with

the FSB reporting to the G20 in July that TLAC

issuance strategies are now in place for almost all

of the 30 G-SIBs identified by the FSB.

A related issue is how to ensure that, where

a G-SIB operates in another jurisdiction as a

subsidiary, host authorities have the confidence

that there is sufficient loss-absorbing capacity

available to that subsidiary. This is being achieved

through ‘internal TLAC’, which is a mechanism for

a subsidiary’s losses to be absorbed by its parent

G-SIB without the need for the subsidiary to

enter into resolution. After consulting on internal

TLAC earlier this year, the FSB issued final guiding

principles in July. These provide guidance on

the size and composition of the internal TLAC

requirement, coordination between home and

host authorities, and the trigger mechanism for

internal TLAC.

More broadly, over recent years the FSB and

standard-setting bodies have worked on

improving resolution frameworks, in line with

The FSB has regularly monitored global progress

the FSB published a stocktake of the resolvability

of systemically important financial institutions

(SIFIs). The stocktake found that the development

of policies to help ensure that SIFIs can be

resolved without wider disruption is largely

complete. Despite this, the FSB reported that

further work on implementation in some areas

remains. In particular, implementing measures

to address cross-border resolution issues will be

a priority over the coming year. This includes

the adoption of cross-border cooperation

agreements between authorities, and ‘resolution

stay protocols’ – which help prevent cross-border

over-the-counter (OTC) derivatives contracts

from being terminated disruptively in the event

of a foreign counterparty entering resolution.

CCP recovery and resolution frameworks

Another major component of the post-crisis

reforms was mandating the clearing of

standardised OTC derivatives through CCPs,

to reduce the scope for contagion in financial

markets. As the use globally of central clearing

has increased in derivatives markets, standardsetting

bodies have pursued an international

work plan to ensure that CCPs themselves do

not become ‘too big to fail’, and that they are

subject to strong regulatory requirements and

supervisory oversight. Several key elements of

the plan were finalised in July:

Infrastructures (CPMI) and the International

Organization of Securities Commissions

(IOSCO) published guidance to further

strengthen CCP resilience in the area of

financial risk management. At the same time,

these bodies issued revised guidance on

recovery arrangements for financial market

infrastructures (FMIs). The recovery guidance

included a discussion of scenarios that may

trigger the use of recovery tools and the

characteristics of appropriate recovery tools

in the context of such scenarios. The Bank will

take both sets of guidance into account in its

oversight of clearing and settlement facilities

licensed to operate in Australia.

resolution frameworks. The guidance sets out:

the powers that resolution authorities should

have to maintain the continuity of critical CCP

functions; details on the use of loss allocation

tools; and the steps authorities should take

to establish crisis management groups for

relevant CCPs and develop resolution plans.

The Bank and other CFR agencies are working

to develop an Australian resolution regime

for CCPs and FMIs more generally.

an analysis of CCP interdependencies.

The aim of this analysis was to develop an

understanding of the connections between

CCPs, clearing participants and other financial

entities that provide critical financial services

to CCPs. The report, based on data from

26 CCPs globally (including the two domestic

CCPs operated by the Australian Securities

Exchange (ASX)) found that some clearing

participants are also important providers of

critical services to CCPs, which could lead

to operational difficulties at a CCP if one or

more of these clearing participants defaulted.

Further work will be conducted on this topic

over the coming year.

In June, the FSB published a review of OTC

derivatives market reforms. It found that

the implementation of most reforms is now

well progressed. However, in some cases

implementation has taken longer than originally

intended due to the scale and complexity of the

reforms and other challenges, such as the need

to establish new FMIs or upgrade existing FMIs

to meet new standards. As part of the increasing

focus on evaluating the effectiveness of reforms,

in July the FSB and relevant standard-setting

bodies commenced a study of the effect of the

reforms on incentives to centrally clear OTC

derivatives. A final report is due in late 2018.

Shadow banking

In July, the FSB reported to the G20 that

examples of shadow banking activity, which it

previously labelled as ‘toxic’ (such as subprime

residential mortgage-backed securities and

collateralised debt obligations), had declined

substantially since the crisis. Accordingly, the

types of shadow banking that contributed to

the financial crisis are no longer considered to

be a key financial stability concern. Nonetheless,

the asset management sector remains an area

in May, investment funds are large in certain

jurisdictions and many have inherent structural

vulnerabilities, especially leverage and the risk of

a redemption run.

IOSCO released a consultation paper in July

that seeks to operationalise earlier FSB policy

recommendations to address the mismatch

between the relative illiquidity of certain fund

investments and the ease of redemption in

open-ended funds. Future IOSCO work will

focus on developing consistent and risk-based

measures of leverage in funds. This will facilitate

more meaningful monitoring of leverage for

financial stability purposes and better capture, for

example, the use of ‘synthetic leverage’ and the

effects of netting and hedging.

Building resilient financial institutions

Much of the work aimed at building resilient

financial institutions, namely the Basel III capital

and liquidity reforms, has been completed.

the BCBS is yet to finalise the remaining Basel III

capital reforms. These are intended to reduce the

variability in banks’ RWAs, and more generally

to increase the simplicity, comparability and risk

sensitivity of the Basel capital framework. The

BCBS originally planned to finalise these reforms

by the end of 2016, but discussions are still

ongoing to reach an agreement. Areas yet to be

finalised include:

ratings-based’ approaches to credit risk,

which determine capital risk weights based

on a fixed standard and banks’ own models,

respectively

benefit a bank derives from using its own

models to estimate risk weights.

Separately, over the past six months, the BCBS

has proposed revisions to other aspects of the

Basel framework.

approach for market risk were announced.

The changes will remove some of the more

complex capital requirements as well as

simplify calculations in other parts of the

framework.

out the criteria for identifying ‘simple,

transparent and comparable’ (STC) short-term

securitisations as well as additional guidance

on their capital treatment. The criteria for

identifying STC short-term securitisations

build on earlier BCBS-IOSCO principles for STC

securitisations. The new criteria are designed

to help the parties to such transactions

conduct due diligence and evaluate the

risks of a particular securitisation. According

to the BCBS, STC short-term securitisations

warrant reduced capital requirements due to

increased confidence in their performance.

Accordingly, the BCBS is proposing to apply

preferential capital treatment for banks

acting as investors in, or as sponsors of, STC

short-term securitisations.

In July, the International Association of Insurance

Supervisors (IAIS) released ‘version 1.0’ of the

Insurance Capital Standard (ICS) for extended

field testing. This is another key step by the IAIS in

its development over recent years of a risk-based

global capital standard for the insurance sector.

All internationally active insurance groups will be

included in the test and there will be supervisory

consequences for groups that do not meet the ICS

requirements. Implementation of the final version

of the standard is expected to take place in 2019.

Risks and reforms beyond the post-crisis

agenda

As the post-crisis reforms are implemented,

increasing emphasis is being placed on

evaluating whether they have met their intended

objectives, and on identifying any material

unintended consequences. In July, and following

a consultation process, the FSB published a

framework to guide such evaluations. The

framework outlines the types of evaluation that

could be undertaken, the techniques that could

be employed, and the analytical issues that may

be encountered. The FSB will be responsible for

selecting and prioritising the policy evaluation

proposals submitted by its members. In line with

the FSB’s prioritisation, the standard-setting body

that issued the relevant standard will conduct

the evaluation. Where possible, evaluations

should build on existing implementation

monitoring and assessment frameworks and be

conducted with input from external stakeholders,

including academics and industry. At its October

meeting, the FSB Plenary agreed that the FSB,

in coordination with relevant standard-setting

bodies, should undertake an evaluation of the

effects of reforms on financial intermediation.

This will be the second evaluation under the

FSB’s framework (the first being a review of the

incentives for central clearing of OTC derivatives

noted above).

These evaluation studies will complement

the FSB’s annual report to G20 Leaders on the

implementation and effects of reforms. In July,

the FSB’s third such annual report suggested

that the post-crisis reforms have increased

resilience, consistent with the conclusions of

previous annual reports. The latest report noted

that reforms to OTC derivatives markets have

had a meaningful impact on mitigating systemic

risk. It also noted that the policies implemented

to address shadow banking risks have been

effective, with no new shadow banking risks that

warrant additional regulatory action. The report

pointed out some possible consequences of

the reforms that merit ongoing attention. For

instance, there is some evidence of reduced

liquidity in certain markets, although the report

largely attributed these changes to other factors,

such as a decline in banks’ risk appetite, historically

low interest rates and unconventional monetary

policy, as well as an increase in electronic trading.

The report noted that these changes require

ongoing analysis and may be assessed under the

FSB’s new evaluation framework.

In addition to the evaluation of existing

reforms, international bodies continue to

monitor emerging risks. In May, the FSB and

the Committee on the Global Financial System

(CGFS) of the Bank for International Settlements

(BIS) published a report on fintech credit. The

report noted that fintech lending activity may

help diversify economies’ credit channels and

reduce the risk of a credit contraction if bank

lending is interrupted. However, regulators

should remain mindful that competitive pressure

from fintech firms may encourage greater

risk-taking by banks and erode lending standards.

In June, the FSB published a report outlining

the regulatory and supervisory issues raised

by fintech. Echoing the FSB-CGFS report, the

FSB study found that fintech can help diversify

the sources of credit in an economy, as well as

increase efficiency and competition. However,

the FSB noted that it could introduce or increase

procyclicality, cyber risk and operational risk

from third-party service providers. While fintech

activity is still very small in most countries, the

report also noted that issues such as contagion

(where distress in a fintech entity could be

transmitted to other institutions or sectors, for

example, through direct exposures) may emerge

as fintech activities increase in size. Also, where

fintech expands into critical areas, such as FMIs

or core banking systems, it is important that risks

are identified and managed effectively.

In August, the BCBS issued a consultation

document on the sound practices banks and

bank supervisors can adopt to respond to the

new risks and opportunities presented by fintech.

The BCBS made several recommendations,

including that banks and bank supervisors

should ensure the safety and stability of

the banking system without inhibiting

beneficial financial sector innovation. Other

recommendations include that:

manage operational, cyber and compliance

risks effectively

both domestically (with authorities

responsible for fintech regulation) and with

foreign authorities, given the potential global

growth of fintech companies.

Cyber risk in the financial sector has been

another area of international focus recently.

The FSB has undertaken a stocktake of existing

publicly available regulations, guidance and

supervisory practices with the aim of identifying

effective practices. In a progress report to the

G20 in July, the FSB noted that all member

jurisdictions have released regulations or

guidance that address cybersecurity for at least

part of the financial sector. The FSB will deliver

the stocktake to the G20 in October.

Over recent years, the FSB together with relevant

bodies, has been progressing a work plan to

reduce the risk of misconduct in the financial

sector. A key aspect of this work has been the

development of the Global Code of Conduct

for wholesale foreign exchange markets, which

was launched in May. The Code was developed

under the auspices of the BIS and in partnership

with industry, and sets out global principles of

good practice in the foreign exchange market.

Adherence to the Code should help to restore

confidence in, and promote the effective

functioning of, the wholesale foreign exchange

market.

Misconduct risk is also being addressed by

enhancing the integrity of major interest

rate benchmarks, following past instances of

manipulation. In particular, over recent years

regulators have been working with benchmark

administrators and market participants to

strengthen the key interbank offered rates,

including the bank bill swap rate (BBSW)

in Australia. A recent focus has been the

sustainability of benchmarks. The UK Financial

Conduct Authority (FCA) recently expressed

concern that wholesale funding markets are

not sufficiently active for the London Interbank

Offered Rate (LIBOR) – a set of key interest

rate benchmarks for several major currencies

including the US dollar and British pound – to

be based on transactions. Banks on the LIBOR

panel are also reluctant to continue making

submissions based on ‘expert judgment’. To

manage the risk of an unplanned cessation of

LIBOR, the FCA has obtained agreement from

the panel banks to voluntarily sustain LIBOR until

2021; beyond that, the FCA anticipates that it will

no longer be necessary to persuade, or compel,

banks to make submissions to LIBOR. Therefore,

market participants and regulators must now

focus on the transition to alternative benchmarks.

In the United States, a committee convened by

the Federal Reserve Bank of New York proposed

alternative reference rates to LIBOR that better

reflect actual transactions. And in September,

the European Central Bank stated that in coming

years it will publish a new unsecured overnight

interest rate based entirely on transactions, to

complement existing benchmarks.

Domestically, the Australian regulators are

currently working with market participants to

strengthen BBSW. Importantly, for BBSW there

are enough transactions in the local bank bill

market each day relative to the size of the

Australian financial system to calculate a robust

benchmark, which is not the case for LIBOR. The

ASX (the administrator of BBSW) is developing

a new methodology that would measure BBSW

directly from transactions. In October, the ASX

issued guidance on the trading of bank bills

during the ‘rate set window’ and on how these

trades should be reported to the ASX to support

the timely calculation of BBSW. The Australian

regulators have also been working on a new

regulatory framework for benchmarks, which

should help to provide more certainty to market

participants. A bill was recently introduced into

parliament that would establish the regulatory

framework, and the Australian Securities and

Investments Commission (ASIC) has consulted

with market participants about how the

regulatory regime would be implemented.

More generally, in its July progress report to

the G20, the FSB reviewed a number of other

measures taken by international bodies relating

to misconduct issues.

to strengthen governance frameworks.

Drawing on these findings, the FSB plans to

develop a toolkit for supervisors and firms

to help strengthen financial institutions’

governance in relation to culture, employees

with a history of misconduct, and the

responsibilities of the board and senior

management.

implemented for banks in all FSB member

jurisdictions. These were developed to align

compensation in the financial industry with

prudent risk-taking. In June, the FSB issued

for consultation supplementary guidance to

the principles and standards. Once finalised,

the guidance will provide information for

firms and authorities on how compensation

practices and tools (such as ‘clawback’ – the

repayment of remuneration after it has been

paid) can be used to reduce misconduct risk

and address misconduct incidents.

regulatory approaches and tools used

to prevent misconduct in wholesale

markets. The report identified tools that

are particularly important for minimising

misconduct risk given the characteristics

of wholesale markets; they are often

opaque, increasingly automated, exhibit

conflicts of interest and are dominated by

organisationally complex market participants.

Some of the tools discussed include

whistleblower protection, supervisor liability,

and information sharing to identify ‘bad

apples’ and suspicious trades.

The FSB and other international bodies are

continuing their work on assessing and

addressing the decline in correspondent banking

(due to ‘de-risking’). In addition to adverse effects

on financial inclusion, the concern is that the

decline in the number of correspondent banking

relationships may affect the ability to send and

receive international payments, or may drive

some payment flows to less regulated channels.

In July, the FSB published its third progress

report on this initiative, along with a separate

update on the decline in correspondent banking,

based on an FSB survey of banks in nearly

50 jurisdictions, including Australia. Similar to the

experience of banks in peer countries, Australian

banks reported a modest fall in the number of

correspondent banking relationships, with more

pronounced declines taking place in regions

such as Africa and the Caribbean as well as in

several Pacific island economies.

In a related development, the BCBS finalised

recognise that not all correspondent banking

relationships bear the same level of risk.

Accordingly, extra guidance is provided to banks

on the application of a risk-based approach to

managing relationships by including an updated

list of risk indicators that correspondent banks

should consider in their assessment of money

laundering and financing of terrorism risks.

Domestic Regulatory

Developments

Council of Financial Regulators

The CFR is a non-statutory body whose role is to

contribute to the efficiency and effectiveness of

financial regulation and to promote stability of

the Australian financial system. The CFR provides

the primary mechanism for coordination

between financial regulatory agencies, both

on ongoing policy matters and in response to

financial disruption, such as occurred during the

2008 financial crisis. Its membership comprises

the Reserve Bank (which chairs the CFR), APRA,

ASIC and the Australian Treasury. It meets

quarterly, or more frequently when required.

Over the past year, the CFR met in December,

March, June and September, focusing on crisis

management and resolution frameworks for

banks and FMIs, housing lending, competition,

cyber security and distributed ledger technology

(DLT). At the June meeting, the CFR convened

with a broader group of agencies with an interest

in regulation of the financial sector and the CFR

will continue to engage with these agencies in

the future.

A key role of the CFR is to ensure Australian

agencies are jointly prepared for any financial

disruption and to coordinate the response in

such an event. In this context, CFR agencies have

continued work in two important areas that

affect agencies’ ability to deal with a distressed

bank – crisis management powers and the level

and structure of loss-absorbing capacity.

In August, the government released draft

legislation for consultation that would enhance

APRA’s crisis management powers. The draft

legislation would align APRA’s powers more

the new legislation provides APRA with:

planning and to ensure banks and insurers are

better prepared for a crisis (for example, giving

APRA the power to direct an entity to take

actions to change its organisational structure

so as to ensure that critical functions could

continue if the firm needed to be resolved)

that would allow APRA to act decisively to

facilitate the orderly resolution of a distressed

bank or insurer (such as by enabling APRA to

appoint a statutory manager to an authorised

holding company and certain subsidiaries

where necessary).

Development of an FMI crisis management

framework is also underway. Drafting of legislation

that will grant the relevant resolution authority

crisis management powers to resolve a failing

domestic FMI is expected to start later this year.

A second important workstream has been

Australia’s approach to implementing an

appropriate loss-absorbing capacity framework

for Australian banks. While none of the Australian

banks are G-SIBs bound by the FSB’s TLAC

standard, APRA continues to consider options for

a loss-absorbing capacity framework, consistent

with a government-endorsed recommendation

by the Financial System Inquiry. The CFR has

supported this work during 2017, discussing

possible approaches and considering the

implications of those approaches for Australia.

Crisis simulations are an important tool to both

test the preparedness of the CFR to manage the

failure of a financial institution and to identify

areas that require further attention. In March, the

CFR undertook an exercise to step through the

range of decisions and actions that would need

to be taken in the event that a major Australian

bank became distressed. This domestically

focused exercise was followed by a larger

cross-border crisis simulation in September.

The simulation involved all CFR agencies

and their New Zealand counterparts under

the auspices of the Trans-Tasman Council on

Banking Supervision (TTBC). The TTBC has been

working to strengthen the cross-border crisis

management framework over a number of years,

recognising the need for effective cooperation

and coordination on crisis resolution. The

September simulation was aimed at testing

parts of that framework and identifying further

refinements to crisis management arrangements.

Findings from both exercises will be incorporated

in the work programs of the CFR and the TTBC in

the period ahead.

In addition to crisis management, a key

focus of the CFR over the past year has been

vulnerabilities related to lending standards in the

housing market and household indebtedness.

The CFR has considered developments in the

housing market and emerging risks at each of

its meetings over the past year. Given concerns

about trends in some types of housing lending

in early 2017, it discussed the merits of various

policy actions. APRA subsequently announced

additional measures in March (see ‘Household

and Business Finances’ chapter). The CFR

continues to assess the effects of those measures

and broader developments in housing markets.

The CFR has recently undertaken two

competition-related workstreams, both in

collaboration with the Australian Competition

and Consumer Commission (ACCC).

recommendations from the Review of the

Four Major Banks conducted by the House

of Representatives Standing Committee

on Economics, along with other possible

measures for improving competition in the

banking sector.

competition in the settlement of cash

equities in Australia, complementing existing

guidance on competition in the clearing

of cash equities. The policy framework

also includes regulatory expectations for

conduct in operating cash equity clearing

and settlement services. These apply to a

market structure in which the ASX remains a

monopoly provider of cash equities clearing

or settlement services. The CFR and ACCC will

work with the government over the coming

year to develop and consult on legislative

amendments to provide the relevant

agencies with the powers necessary to fully

implement the framework.

Other areas of focus of the CFR over the past

year have been cyber security and DLT. A CFR

working group has been exploring the regulatory

approach to cyber security by CFR agencies. As

part of this effort, the group has been working

on a comprehensive stocktake of the cyber risk

landscape in the financial sector, drawing on

supervisory information and industry liaison, as

well as information from cyber-focused bodies

and programs such as the Australian Cyber

Security Centre and the government’s Cyber

Security Strategy. Another working group has

been reviewing regulatory gaps that may be

relevant to the uptake of DLT and has identified

a number of areas where regulation could be

updated or clarified in order to promote financial

innovation.

Where CFR discussions are relevant to other

government agencies, the heads of those

agencies are invited to join the meeting or

those agencies are consulted. This has included

the ACCC attending recent CFR discussions on

competition matters. The CFR this year sought to

put in place more formal arrangements with other

regulators that have an interest in the financial

sector. In June, a meeting was held between the

CFR agencies, the ACCC, the Australian Taxation

Office and the Australian Transaction Reports

and Analysis Centre (AUSTRAC). Topics discussed

included the activities of the CFR, the work of the

Black Economy Taskforce and the Productivity

Commission’s inquiry into competition in the

financial system. The respective chairmen of the

Black Economy Taskforce and the Productivity

Commission attended.

Other domestic regulatory developments

A number of other regulatory developments

reflect the focus of the main international

workstreams discussed earlier in this chapter.

In addition to its announcement on

‘unquestionably strong’ bank capital (discussed

further in ‘The Australian Financial System’

chapter), APRA has continued its program of

implementing internationally agreed BCBS

reforms. In August, it released a discussion paper

on the standardised approach for measuring

counterparty credit risk. The discussion paper

outlines a series of modifications to an earlier

version of the framework, made in response

to issues raised during consultation. Among

other measures, APRA is proposing a simpler

methodology for the measurement of

counterparty credit risk exposures for authorised

deposit-taking institutions (ADIs) with immaterial

exposure to such risk.

APRA has also released the final version of

its prudential standard on the margining

requirements for non-centrally cleared

derivatives. Margin is collateral exchanged to

reduce both the counterparty credit risk posed

by the default of a market participant and the

potential contagion stemming from such a

default. Under the standard, compliance with the

margining requirements of foreign authorities

listed in the standard – such as those in the

European Union, Japan or United States – will

satisfy APRA’s margining requirements in some

cases (‘substituted compliance’). Substituted

compliance is intended to alleviate the burden of

foreign firms having to comply with the rules of

multiple jurisdictions.

Another area of focus has been mitigating

misconduct risk. CFR agencies continue to

monitor and encourage improvements in the

culture of banks and other financial institutions.

In particular, over recent years, APRA has

heightened its supervisory focus on culture for

all regulated entities. For ADIs as well as general

and life insurers, this has emphasised the need

for their boards to identify desired changes to

risk culture and ensure steps are taken to address

those changes. The importance of enhancing

culture was highlighted by apparent deficiencies

in anti-money laundering practices at the

Commonwealth Bank of Australia that were

recently revealed by AUSTRAC (discussed further

in ‘The Australian Financial System’ chapter).

As noted above, global bodies have increased

their focus on fintech (including DLT), and

assessing its possible implications for financial

stability. A key theme of these efforts is to

balance the facilitation of fintech, given its

potential benefits, with effectively managing

any risks it poses. There have been a number of

developments domestically regarding fintech:

announced several new measures to facilitate

the development of the fintech sector, such

as reducing barriers for new entrants into the

banking sector (see below). The government

also stated that it would legislate an

enhanced ‘regulatory sandbox’. This will build

on an existing licensing exemption by ASIC,

allowing eligible fintech businesses to test

certain services on a limited scale without

an Australian financial services or credit

licence. Firms operating under the sandbox

arrangements remain subject to consumer

protection and disclosure requirements.

licensing framework for ADIs. Consistent with

government policies noted above, these

revisions aim to increase competition and

innovation in the banking sector, by making

it easier for new entrants (including fintech

firms) to navigate the ADI licensing process.

APRA’s proposals would introduce a phased

approach to ADI authorisation and would

allow eligible firms to obtain a ‘Restricted

ADI’ licence, so that they can begin limited

operations without yet fully meeting APRA’s

prudential standards. The Restricted ADI

licence would be granted for up to two

years. So as not to compromise financial

stability, APRA expects these ADIs to conduct

banking business on only a small scale

during this time, with explicit limits applying

to deposits covered by the Financial Claims

Scheme. Within the two years, the ADI would

be expected to build up the capabilities

and resources to fully meet prudential

requirements and progress to a full ADI

licence, or to exit the banking industry in an

Copyright and Disclaimer Notices

HILDA

The following Disclaimer applies to data

obtained from the HILDA Survey and used in the

chapter on ‘Households and Business Finances’

and reported in ‘Box C: Large Falls in Household

Disclaimer

The Household, Income and Labour Dynamics

in Australia (HILDA) Survey was initiated and

is funded by the Australian Government

Department of Social Services (DSS), and is

managed by the Melbourne Institute of Applied

Economic and Social Research (Melbourne

Institute). The findings and views based on these

data should not be attributed to either DSS or

the Melbourne Institute.