Financial Stability Review - APRIL 2020 - Reserve Bank of Australia
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Financial Stability Review APRIL 2020
Financial Stability Review
APRIL 2020
Contents
Overview 1
1. The Australian and Global Financial Systems 5
2. Household and Business Finances in Australia 17
3. Annex: Selected Policy Responses to the COVID-19 Pandemic 25
Copyright and Disclaimer Notices 27The material in this Financial Stability Review was finalised on 8 April 2020 and uses data through to 8 April 2020. The Review is published semiannually and is available on the Reserve Bank's website (www.rba.gov.au). The next Review is due for release on 9 October 2020. For copyright and disclaimer notices relating to data in the Review, see page 27 and the Bank's website. The graphs in this publication were generated using Mathematica. Financial Stability Review enquiries: Secretary's Department Tel: +61 2 9551 8111 Email: rbainfo@rba.gov.au ISSN 1449–3896 (Print) ISSN 1449–5260 (Online)
Overview
The COVID-19 pandemic is causing spotlight on a number of pre-existing global
significant strains in the global financial vulnerabilities, including: areas of high
financial system leverage in some non-bank financial institutions;
The COVID-19 pandemic brought to an end an weak banking systems in Europe that are
extended period of stable (but only moderate) intertwined with high sovereign debt; high debt
growth, low inflation, and low financial market in some corporate and household sectors; and
volatility. Prior to the pandemic, the prices of a investment vehicles that offer a high level of
broad range of risky assets had been at high liquidity, despite their underlying assets being
levels, underpinned by low risk-free interest rates illiquid. It is also noteworthy that the market for
and low risk premiums that presumed very little US Treasuries has been dislocated, partly due to
possibility of adverse outcomes. The outbreak of leveraged accounts selling their most liquid
the virus, which was not even a feature in the assets in order to increase their cash holdings.
outlook at the start of the year, has changed this. Financial dislocation has also spread to
emerging market economies, with a sharp
The exceptional measures taken to contain
reversal in capital flows.
COVID-19 are having a major effect on
economic activity and the global financial Central banks have responded to the develop-
system. The high level of uncertainty ments by rapidly easing monetary policy and
surrounding the size and duration of the implementing a range of policies designed to
economic downturn is accentuated by the support the functioning of the financial system.
uncertainty around the effectiveness of the But monetary policy cannot address the driver
various measures in containing the spread of the of the economic contraction. Rather it can only
virus. Financial market uncertainty is also serve as a bridge, while substantial fiscal
elevated because of the difficulty of pricing risk stimulus is being implemented to offset the
given the correlated effect of the virus on a economic contraction and, most importantly,
broad range of assets globally. This heightened authorities attempt to stop the spread of
uncertainty related to the pandemic is COVID-19 and respond to the health crisis. The
compounding the usual volatility in financial economic policy actions seek to ensure
markets that occurs as economic and financial businesses, households and financial institutions
conditions turn down. are well placed to resume activity when
COVID-19 is contained.
The various regulatory reforms since the
2008 financial crisis have increased the resilience
of the global financial system, with banks having
more capital and liquidity than previously. Banks
also have less complex business structures. Even
so, the COVID-19 pandemic is putting the
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 1Australia’s financial system faces Australian businesses generally have low levels
increased risks, but is well placed to of gearing and most have significant liquid
manage them assets which will help them to weather the
The economic downturn resulting from the economic contraction. Government and bank
pandemic is changing some of the risks facing support will assist those businesses with sharp
the Australian financial sector. reductions in revenue, particularly those for
whom income has completely dried up and
In Australia, the spread of COVID-19 has slightly
small businesses with few assets that would
trailed other advanced economies, but financial
otherwise be in a perilous position. Commercial
markets have moved with their global
property prices have risen faster than rents in
counterparts. The Australian government debt
recent years given the decline in risk-free interest
market has at times been severely dislocated,
rates. Owners who are more highly leveraged
reflecting the same forces affecting US
could struggle if tenants are unable to pay rent,
Treasuries. Equity prices have fallen sharply and
particularly in retail property given the very
corporate term debt markets have been
weak retail sector.
significantly impaired.
The turnaround in housing markets in the
With many staff working from home and from
second half of last year reduced the risk that
different locations, financial institutions face
falling housing prices would result in
increased operational risks and may have less
widespread negative equity and larger potential
capacity to take on and manage market risk. It
losses for lenders. Most households now have
has changed the nature of some IT and cyber
substantial equity in their homes. The economic
risks.
downturn, uncertainty and social distancing are
As discussed in previous Financial Stability likely to result in very little turnover in the
Reviews, the level of household debt and housing market. It remains unclear how this will
elevated housing prices are longstanding risks affect residential property prices.
for the Australian financial system. In the period
The Australian financial system enters this
ahead, many households will find their finances
challenging period in a strong starting position.
under strain due to efforts to contain the virus.
Capital levels are high and the banks’ liquidity
Some of these households will be able to draw
position has improved considerably over recent
on significant financial buffers, including large
times. This strong liquidity position combined
mortgage prepayments, although many highly
with slow credit growth means that banks have
indebted households have only small buffers
limited need to issue debt in the period
and so are more vulnerable to lost income.
immediately ahead. The Australian banks also
Repayment deferrals (‘holidays’) being offered by
enter the downturn with high profitability and
the banks and the Government’s recently
very good asset performance.
announced wage subsidy should both help
avoid large increases in arrears. More generally, The regulatory authorities have been working
tightened lending standards over the past five closely together to minimise the economic
years or so have improved the quality of harm caused by the pandemic, to avoid the
outstanding household debt while Government impairment of household and business balance
income support policies and access to sheets and to support financial market
superannuation balances for the worst-affected functioning. These measures, along with the
households will cushion falls in household strong starting position of the banking system,
income. increase the financial system’s ability to absorb,
rather than amplify, the effects of the pandemic.
2 R E S E R V E B A N K O F AU S T R A L I AIt is important that financial institutions remain
strong so that they are able to support
households and businesses during this difficult
period and during the recovery once the health
crisis has passed.
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 34 R E S E R V E B A N K O F AU S T R A L I A
1. The Australian and Global Financial
Systems
The shock to global financial markets asset classes. At times even advanced economy
from the COVID-19 pandemic has been sovereign debt prices fell, with a large increase in
very large demand for cash consistent with leveraged
The spread of the COVID-19 pandemic investors needing to meet margin calls, and
precipitated sharp falls in the prices of risky funds needing to meet actual or expected
assets. Extreme volatility and poor liquidity in redemptions.
financial markets has been amplified by Globally, funds that invest in bonds have
dysfunction in government bond markets, experienced significant outflows driven by
particularly for US government bonds, which investors’ rebalancing. The resulting demand for
play a crucial role as a pricing benchmark for liquidity highlighted the vulnerability of funds
other assets. that offered easy redemption terms while
Major global sharemarkets have been extremely investing in illiquid assets. Large redemptions
volatile, with falls of around 35 per cent from late from prime money market funds in the United
February peaks before some recovery States – with assets under management falling
(Graph 1.1). The prices of corporate bonds and by around US$150 billion since early March –
leveraged loans have also fallen, with yield prompted the Federal Reserve (Fed) to set up
spreads widening sharply to around the highest the Money Market Mutual Fund Liquidity Facility
levels seen since the global financial crisis (GFC). to provide them with liquidity. A range of
Access to credit in a range of markets has at property funds in the United Kingdom, with
times been severely restricted, although market assets totalling more than £20 billion, have
access has improved for high-quality borrowers
with very large issuance used to bolster their
liquidity positions. Graph 1.1
Market Movements
The significant repricing reflected expectations index MSCI equity indices* Volatility indices** std dev
for a steep fall in corporate earnings, with larger 200
Emerging markets
8
US equities
price declines for industries most exposed to the 150 4
economic slowdown (including aviation, energy 100 0
and leisure). It also represented a reversal from Developed markets US Treasuries
bps Investment-grade corporate High-yield corporate bps
previously very low compensation for credit, bond spreads bond spreads
600 1,950
liquidity and interest rate risks.
400 1,300
Euro USD
Investors globally had taken on greater risk over
200 650
recent years, driven in part by a search for yield
0 0
in the low interest rate environment. As a result, 2010 2015 2020 2010 2015 2020
*
most investors were not well placed to weather **
Index = 100 on 1 Janurary 2006
Number of standard deviations away from historical median
highly correlated price declines across multiple Sources: Bloomberg; ICE Data used with permission; RBA
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 5suspended redemptions because of uncertainty Lower business and household incomes
about the values of their illiquid property assets are increasing financial stress
and their inability to quickly sell such assets. While substantial policy stimulus measures have
Most financial markets experienced a significant been announced, the COVID-19 pandemic will
widening of bid-ask spreads, with turnover also significantly reduce the incomes of many
declining in most markets other than equities. businesses and households. This will make it
Indeed, the functioning of the usually highly harder for them to service, roll over and repay
liquid and resilient market for US government their debts, raising the prospect of widespread
bonds was even impaired, with bid-ask spreads defaults. The increase in financial stress may be
for 10-year bonds reaching multiples of their more pronounced in jurisdictions that have
usually low levels (of around 0.2 basis points). experienced a large rise in household or
This mostly reflected large-scale investor selling business debt over recent years. Corporate debt,
to raise cash, which overwhelmed the usual in particular, has risen in some advanced (and
increase in demand for safe assets during emerging) economies to historically high levels
periods of high risk aversion. Selling pressure relative to GDP, most notably in the United
was driven in particular by the unwinding of States, France and Canada.
leveraged relative-value funds. Market liquidity In the business sector, sharply lower incomes are
was also constrained by reduced dealer balance being exacerbated by the pronounced
sheet capacity since the GFC and lower tightening in financial conditions. Access to
operational capacity due to firms operating split credit has become more costly and restricted,
sites and working from home in response to the especially for riskier borrowers. For many large
pandemic. Given US government bonds’ role as corporations, this is partly mitigated by their
a critical benchmark for the global financial back-up lines of credit with banks, which have
system, this dysfunction exacerbated price been rapidly drawn down in recent weeks, and
volatility in a broad range of asset markets. In large term issuance by higher-rated
response, central banks around the world corporations. Central banks and fiscal authorities
introduced or expanded programs for buying have taken a wide range of policy measures to
government bonds, which saw some support incomes and the provision of credit to
improvement in market conditions. businesses. These include purchases of
Commercial paper markets, which are corporate bonds, as well as term funding for
particularly important in supplying short-term banks with incentives to lend to smaller
funding to corporations in the United States and businesses.
Europe, also seized up. There was a sharp rise in
yields amid low liquidity. Initially this reflected While banks will be tested they are
liquidity risk (demand for cash) but increasingly mostly more resilient
this morphed into credit risks as output Post-GFC reforms have ensured that large banks
contracted. To restore the smooth functioning of had much bigger capital and liquidity buffers
these markets, central banks, including the Fed, before the onset of the pandemic than they did
Bank of England and European Central Bank prior to the GFC. Regulators are encouraging
(ECB), announced facilities to purchase banks to draw down these buffers rather than
commercial paper. curtail lending and other activities. Other parts
of the global financial system have also been
strengthened over the past decade, including
over-the-counter derivatives markets. Consistent
6 R E S E R V E B A N K O F AU S T R A L I Awith this, there have been few signs of systemic Existing vulnerabilities in several regions
stress to date among large banks in advanced are exacerbating stress
economies. For example, the widening in bank The pandemic is threatening to expose financial
credit spreads has been in line with those on vulnerabilities in Europe, particularly in Italy,
comparable securities for non-financial firms, given the large scale of the outbreak in the
and banks can still access most forms of funding region. European banks have increased their
at reasonable rates. capital and liquid asset holdings since the GFC,
Nevertheless, banks globally will be challenged although they still have rather low profitability
by the pandemic. Credit losses will inevitably rise and high non-performing loan ratios. Govern-
because of higher business and household ment debt exceeded 90 per cent of GDP in
defaults. And an extended period of very low seven euro area economies in 2019, including
interest rates could further weigh on banks’ Italy, Spain and France, and is set to increase
profitability. Reflecting this, prices of bank equity sharply as policies to help cushion the impact of
and debt have fallen sharply (Graph 1.2). the shock on economic activity increase fiscal
deficits. This has raised debt sustainability
Financial institutions have rapidly adjusted their
concerns, leading to higher spreads on
operating arrangements to respond to the
European government debt (relative to German
pandemic and containment measures, including
Bunds). The resulting falls in the market value of
through staff working at split sites and remotely.
European government bonds threaten to further
While business continuity plans have needed
undermine the health of European banks, as
rapid adaptation, they have generally worked
government debt accounts for a sizeable share
well to date. The new arrangements will
of their assets (often around 10 per cent for large
however test the operational resilience of banks,
banks in countries with very high sovereign
and financial institutions and infrastructure more
debt). This raises the prospect of an adverse
broadly. Operational capacity has been reduced
feedback loop re-emerging, whereby
– which is already impacting market functioning
deteriorating bank health reduces the
– and the chance of technology failures or cyber
creditworthiness of the sovereign (due to the
attacks has increased.
potential need for bank bailouts), leading to
further capital losses for banks. However, the
increase in European government bond yields
has been restrained by the ECB significantly
Graph 1.2 expanding its euro area government bond
Advanced Economies – Large Banks buying program.
ratio bps
Share-price-to-book ratio* CDS premiums**
Australia The COVID-19 pandemic affected China first and
Canada economic activity there is slowly recovering after
2 240
a very sharp contraction in January and
Euro area
February, reflecting the lockdown of substantial
US
1 120
parts of the country. Industrial production and
fixed asset investment both fell by over
Japan 25 per cent in February. The financial system has
UK
0 0 been resilient to date, aided by a wide range of
2012 2016 2020 2012 2016 2020
* Number of banks: Australia (4), Canada (6), euro area (25), Japan policy actions. However, financial vulnerabilities
(4), United Kingdom (4) and United States (18)
** 5-year senior CDS premiums; number of banks: Australia (4), Canada
(5), euro area (8), Japan (3), United Kingdom (4) and United States (6)
present before the onset of the virus remain
Sources: Bloomberg; RBA; Refinitiv; S&P Global Market Intelligence
elevated and near-term challenges are
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 7considerable. As in other economies, Authorities globally have responded
significantly lower business cashflow and with a wide range of policy measures
income as a result of containment measures, A wide range of policy measures have been
combined with the very high level of corporate implemented to mitigate the effect of the
debt in China, raise the prospect of widespread pandemic on macroeconomic and financial
defaults. Real estate firms in particular are facing stability. Central banks have eased monetary
acute pressures as they have high debt, policy aggressively, including through policy
including in US dollars, and their income and rate reductions and large increases in asset
liquidity has been adversely impacted by lower purchases. Large fiscal stimulus packages have
sales. Local government finances are also likely been announced in many countries to support
to be further stretched. Stress tests by the incomes. An array of measures seek to support
People’s Bank of China suggest that some larger the provision of credit to businesses and
banks would see substantial declines in their households:
capital with weaker growth and higher defaults.
• Central banks have provided substantial
Many smaller banks had seemed vulnerable
funding to banks, including with incentives
before the COVID-19 pandemic, with thin capital
to expand lending to smaller businesses.
buffers and already high levels of distressed
debt. Extensive credit and liquidity risks in the • Governments have offered guarantees on
non-bank financial sector could also crystallise business loans, direct grants and tax relief.
and cascade through the financial system via a • Authorities have encouraged banks to use
web of complex interconnections. their capital and liquidity buffers.
In other emerging market economies (EMEs), Businesses and households are also being
the weaker global economic outlook and supported by temporary freezes on loan
reappraisal of risk in financial markets have repayments, foreclosures and evictions in some
triggered significant capital outflows. Currencies countries. Some policies aim to support market
of the most affected economies depreciated by functioning, including central banks’ purchases
15–25 per cent, equity prices fell by of government, and even corporate, bonds.
35–45 per cent, and the price and availability of Prudential regulators are closely monitoring
debt funding deteriorated. Oil-exporting EMEs financial institutions and reviewing their
have also been negatively affected by the sharp pandemic plans to ensure operational resilience.
decline in oil prices, which fell by as much as They have also postponed regulatory changes
two-thirds from levels at the start of the year. As and other supervisory activities to reduce the
a result, financial conditions have tightened operational burden on institutions.
abruptly. This is exacerbating the adverse effects
of the pandemic on economic activity and is The Australian financial system has also
threatening financial stability. EMEs with high been substantially disrupted by the
amounts of external financing or foreign COVID-19 pandemic
currency debt are particularly vulnerable
The Australian equity market also fell sharply and
because they are more exposed to tighter
credit spreads widened significantly as investors
financial conditions offshore, such as in US dollar
found it difficult to price the anticipated shock
funding markets. Reflecting these pressures,
to the economy, in particular firms’ incomes.
over 90 countries had requested emergency
Reflecting the uncertainty and unwinding of
financial assistance from the International
various market positions, fixed income markets,
Monetary Fund (IMF) as of early April.
including for government and corporate debt, at
8 R E S E R V E B A N K O F AU S T R A L I Atimes lacked liquidity. The weaker outlook and likely to have made losses on their investment
substantial rise in risk premiums in global equity portfolios at the same time as their liabilities
markets have seen Australian banks trading at have increased (because of lower discount
their lowest level (relative to book value) since rates). They are also likely to experience some
the early 1990s. increase in claims as a result of the pandemic.
Australian banks are well placed to withstand General insurers are highly profitable and have
this current period of stress. Their liquidity strong capital positions that make them resilient
positions are strong, and had strengthened over to these effects. And while life insurers’
2019 given growth in deposits and soft demand profitability has been significantly eroded over
for credit. The Reserve Bank’s Term Funding recent years by chronic underpricing of income
Facility (TFF), which commenced at the start of protection insurance, their healthy capital
April, and strong deposit growth will provide positions should enable them to manage the
enough funding for authorised deposit-taking current challenges.
institutions (ADIs) to offset almost all of their
maturing bond funding for the next six months Financial markets in Australia have been
(see ‘Annex: Selected Policy Responses to the dysfunctional at times …
COVID-19 Pandemic’). Major banks’ capital ratios Risk premiums have increased sharply across a
are estimated to be well within the top quartile range of financial markets since the start of the
of banks internationally and are also within the year. Australian equity prices fell by one-third
range that would have been sufficient to from their peaks and credit spreads on BBB-rated
withstand historical bank crises. Bank corporate bonds rose by almost 100 basis points.
profitability has been very healthy leading into Volatility in the price of equities and fixed
this period, and bad debt charges have been income securities also rose to similar or higher
historically low. As a result, banks can absorb a levels than recorded during the GFC (Graph 1.3).
large increase in bad debts before making a loss. And bid-ask spreads in the Australian Govern-
Stress tests suggest that Australian banks’ strong ment Securities (AGS) market were many times
capital positions and profitability should enable higher at their peak than they had been over
them to withstand a reasonably prolonged 2019, as market depth evaporated at times.
period of economic contraction without Conditions have since improved as a result of
breaching their prudential minimums. measures implemented by the Reserve Bank,
Other financial institutions have also been particularly direct purchases of AGS and semi-
resilient to date. Financial market infrastructures government bonds.
(FMIs), such as central counterparties (CCPs), The primary driver of dislocation in financial
securities settlement facilities and payment markets has been the substantial deterioration
systems, have maintained their operations in the economic outlook, which triggered a
despite a large share of staff working from home material reduction in risk appetite. However, the
and sharply higher trading volumes. They have impact on markets was amplified by various
also effectively managed large fluctuations in investment strategies that were predicated on
variation margin. Managed and superannuation being able to quickly liquidate AGS when
funds have required additional liquidity to fulfil needed; more generally, the discount applied to
member requests to redeem or reallocate assets illiquid assets over recent years has been very
and to make variation margin payments but low. This resulted in a wide range of investors
they have, to date, been able to accommodate simultaneously seeking to sell their AGS to meet
this. General and life insurance companies are client redemptions or margin calls on
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 9derivatives, creating a one-sided market at times. borrowing Australian dollars in offshore markets
The use of leverage also amplified selling to increase significantly, despite the cost of
pressure in the AGS market. In particular, swapping US dollars to Australian dollars falling
leveraged funds were heavy sellers of AGS due slightly. In response, Australian banks have
to losses arising from volatility in the relative largely stopped issuing debt offshore.
price of these derivatives and the underlying
security, as well as a desire to rebalance their … but banks are well placed to navigate
portfolios following sharp losses on equity difficulties in funding markets …
holdings. Reserve Bank purchases of AGS Australian banks have not needed to issue term
addressed these issues by increasing available funding since late February, given their strong
liquidity and ensuring the AGS market was no liquidity positions leading into this period. In
longer one-sided. particular, strong deposit growth and limited
A rapid repricing of securities also occurred in asset growth over 2019 meant that several
bank funding markets. Spreads on Australian banks had increased their holdings of liquid
bank bonds (issued offshore) rose to levels last assets in the months prior to the recent market
seen in the GFC (though yields remain much turmoil and had little need to replace maturing
lower; Graph 1.4). This occurred amid a sharp bonds. Consistent with this, banks’ Liquidity
reduction in turnover of bank bonds, especially Coverage Ratios (LCRs) – which measure their
domestically, as firms that normally invest in holdings of liquid assets relative to the potential
such debt refrained from buying in order to outflows of funding that could occur in a short-
preserve liquidity. Domestic short-term debt lived but severe stress scenario – were around
funding markets have been more resilient; 125–135 per cent at the end of 2019, well above
liquidity has still generally been present and, the regulatory minimum of 100 per cent.
while spreads rose, they have not exceeded their Outflows of superannuation deposits have, in
trading range of recent years and fell back to some cases, seen LCRs decline a little since the
very low levels. However, short-term debt pandemic began, while in other cases retail
markets in the United States, which Australian deposit inflows have supported increases. The
banks use in normal times to manage introduction of the Reserve Bank’s TFF also
fluctuations in their liquidity needs, remain very significantly increased banks’ LCRs very recently.
stressed. This has caused the implied cost of
Graph 1.3 Graph 1.4
Australian Financial Market Volatility Australian Banks’ Debt Pricing
% % Spread to swap
Australian Government Securities* bps bps
Short-term* Long-term**
1.5 1.5
1.0 1.0 80 200
0.5 0.5 Offshore
60 150
% Australian Equities** %
60 60 40 100
40 40
20 50
20 20
Domestic
0 0
2008 2011 2014 2017 2020 0 0
* 2010 2015 2020 2010 2015 2020
22-day rolling standard deviation of relative daily price changes
in 10-year AGS * Three-month bank bill swap rate to overnight indexed swap
** S&P/ASX 200 VIX index ** Spread of major banks’ bonds to swap; three-year target tenor
Sources: Bloomberg; RBA Sources: Bloomberg; RBA
10 R E S E R V E B A N K O F AU S T R A L I AOver-the-counter withdrawals of cash from well within the range that would have been
banks were elevated over the second half of sufficient to withstand historical bank crises
March as some customers with large balances (Graph 1.6).[1] Their capital ratios are also
sought to hold precautionary funds. This estimated to be within the top quartile of large
included a small number of customers making banks internationally when measured on a
very large withdrawals (more than $100,000, and comparable basis. Compared with the 2008/09
in some cases into the millions of dollars). The financial crisis, the major banks have entered this
Reserve Bank worked closely with the large period with much stronger capital positions.
banks and cash-in-transit companies to ensure Major banks’ Tier 1 capital ratios are
branches had sufficient cash supplies. The focus 6 percentage points higher than they were in
of this work was on the logistics of moving cash 2007, and their leverage ratios (the ratio of
to the right places as there was adequate total Tier 1 capital to non-risk-weighted exposures)
supply. The elevated demand has since abated. have increased to be well above proposed
Around $30 billion of Australian bank bonds will minimum requirements of 3½ per cent now
mature during the June quarter, with a further starting in 2023 (Graph 1.7). Smaller ADIs also
$50 billion maturing over the second half of have healthy capital ratios that are comparable
2020 (Graph 1.5). This equates to less than with, or higher than, those of the major banks.
3 per cent of system-wide funding. The Reserve Despite their strong positions, large falls in
Bank’s TFF will provide banks with enough low- banks’ share prices reflect the fact that investors
cost funding to replace almost all of their expect the pandemic will have a substantial
maturing bond funding over the next six effect on banks’ profits. Price-to-book ratios for
months if bond markets remain dysfunctional. Australian banks declined to their lowest levels
Banks’ funding allowance under this facility since the early 1990s and are currently below
equates to at least $90 billion (3 per cent of total one for most Australian banks (Graph 1.8). This
credit). The facility also enables banks to access reflects both a decline in the earnings outlook
additional funding beyond this if they expand and a reduction in investors’ risk appetite, given
business lending, through either drawdowns on uncertainty around this outlook. The fall in
existing committed credit facilities or new banks’ share prices also implies that the distance
commitments. For credit extended to small and to default, which measures the implied size of a
medium-sized enterprise (SME) customers, this shock required to cause a bank to default, has
‘additional allowance’ is five times the credit
extended. If some banks experience higher-
Graph 1.5
than-normal superannuation deposit outflows
Banks’ Bond Maturities*
or drawdowns by households of their offset Quarterly
$b $b
accounts or committed credit facilities, they
have excess high-quality liquid assets to manage 40 40
their liquidity flows.
30 30
… and have sufficient capital to 20 20
withstand a prolonged period of stress
10 10
The four major banks’ Common Equity Tier 1
(CET1) ratios are all above the level that the 0 0
2010 2014 2018 2022
Australian Prudential Regulation Authority * Includes unsecured, securitised, covered and Tier 2 bonds;
maroon bars depict upcoming maturities
(APRA) considers ‘unquestionably strong’ and Source: Bloomberg
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 11reduced sharply.[2] However, during periods of for use in times of stress, such as this, provided
heightened volatility and market dysfunction, banks remain above their minimum prudential
the signal from equity pricing may be distorted. requirements. ‘Reverse stress tests’ – which
Stress tests of Australian banks show they have estimate the magnitude and duration of stress
sufficient capital to withstand quite severe that would result in banks breaching various
downturns. ‘Top-down’ stress tests indicate that capital thresholds – suggest that Australian
even if there is no economic recovery in the banks would only breach their prudential
second half of 2020 (so that asset quality issues minimums if a severe downturn lasts for at least
grow) banks will remain above their minimum 12 months, with the unemployment rate rising
capital ratios, although they may need to make by more than 10 percentage points. There is
use of their capital conservation buffer.[3] This always uncertainty about whether these models
would be consistent with APRA’s recent capture all elements of stress and even more so
emphasis that banks’ capital buffers are available at present, given the unprecedented nature of
the current situation. The nature of the
substantial fiscal stimulus could reduce the
Graph 1.6 impact on banks, even for a given contraction in
CET1 Capital Ratios
Using current capital framework, December 2019
GDP, because job and income support measures
% %
Pro-forma boost*
Additional capital
enhance households’ ability to continue
D-SIB add-on**
Regulatory repaying their debt. Banks’ willingness to defer
15 requirement** 15
‘Unquestionably
strong’ customers’ loan repayments should also reduce
benchmark
10 10
defaults, but losses could still emerge quickly
due to the recent move towards forward-
5 5 looking provisioning (which could cause loan
losses to be concentrated in the near term).
0 0
Major banks Other ASX-listed Unlisted ADIs***
ADIs
* Due to completed capital raising and announced asset sales
Strong profitability also supports the
** Requirement includes capital conservation buffer; domestic
systemically important bank (D-SIB) add-on only applies to the major
resilience of banks
banks
*** Some ADIs have capital ratios above 20 per cent (not shown)
Sources: APRA; RBA
Return on equity (ROE) for Australian banks
leading into the pandemic was high by
international standards. It was also significantly
Graph 1.7 above their cost of equity (estimated to be
Major Banks’ Capital Ratios*
Consolidated global operations
% %
Graph 1.8
15 15
Total capital ratio Market Measures of Bank Resilience
ratio Price-to-book ratio ratio
13 13
5 5
Range
4 4
11 11 Weighted-average
3 3
9 9 2 2
1 1
CET1 capital ratio
7 7
std dev Distance to default std dev
Tier 1 capital ratio
Leverage ratio**
5 5 9 9
6 6
3 3
2007 2011 2015 2019
*
3 3
Break in March 2008 due to the introduction of Basel II; break in Range Median
March 2013 due to the introduction of Basel III
** Estimated prior to September 2015 as Tier 1 capital as a per cent 0 0
of assets 1995 2000 2005 2010 2015 2020
Sources: APRA; RBA Sources: APRA; RBA; Refinitiv
12 R E S E R V E B A N K O F AU S T R A L I Aaround 9–10 per cent), despite the gap between Additional policy announcements by the
the two narrowing as ROE drifted down over the Reserve Bank will also reduce this pressure. In
prior five years (Graph 1.9). Banks also entered particular, the TFF will provide banks with term
the current period of financial market turmoil funding at a spread that is about 50 basis points
with bad debts that have been at historical lows. lower than they had been accessing three-year
They are therefore well placed to withstand the funding late last year. The lift in the rate of
inevitable deterioration of asset quality. remuneration of exchange settlement balances
Lower interest rates have contributed to a (relative to the cash rate target) will also add a
narrowing of net interest margins (NIMs). This little support to profits.
reflects that a portion of banks’ deposits receive
no or very low rates of interest, making them The outlook for credit quality has
difficult to reprice lower when the cash rate weakened, but from a strong position
declines. Larger banks hedge the interest rate Asset quality is expected to deteriorate with the
risk on their non-interest bearing deposits (and likely substantial economic downturn resulting
capital), but these hedges expire after a few from the COVID-19 pandemic. The closure of
years and so only delay the effect. However, the non-essential services will adversely affect the
effect of low interest rates on bank profitability credit quality of a wide range of business loans.
has been less in Australia than in some other This will be alleviated to a significant extent by
economies. In part this is because a large share fiscal support for businesses; this support
of Australian banks’ deposits pay above the cash includes wage subsidies, credit guarantees for
rate (approximately two-thirds) and so interest SMEs, assurance that responsible lending
rates on these have been able to fall with the guidelines should not impede new lending, and
cash rate. In addition, wholesale funding makes temporary relief measures to support the
up a greater share of total funding for large management of insolvency risks (See ‘Annex:
Australian banks than many global peers, Selected Policy Responses to the
insulating them from a sustained period of low COVID-19 Pandemic’). Banks are also offering
rates because wholesale interest rates are not repayment moratoriums and other hardship
constrained at zero. More generally, while low arrangements for affected firms. The expected
rates cause NIMs to narrow, the effect on profits rise in unemployment will lower households’
is less clear because low interest rates also ability to service their debts, but government
reduce credit losses and stimulate lending. transfers to directly affected households and
wage subsidies for affected employees will
mitigate this to some extent. Moreover, loan
Graph 1.9
performance for businesses had been very
Banks’ Profitability
$b Profits Return on equity % strong leading into this period and the
20 18
performance of household loans had begun
15 14
10 10 improving (Graph 1.10). Most housing loans
5 6 remain well secured, limiting the share of non-
% NIM Bad and doubtful debts* bps performing loans that are impaired.
2.2 32
2.0 24
1.8 16 Reduced liquidity has affected fund
1.6 8 managers
1.4 0
2009 2014 2019 2009 2014 2019 Fund managers have faced reduced liquidity for
* Relative to average assets
Sources: APRA; RBA some assets at the same time as many have had
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 13greater need for liquidity. The decline in liquidity deposits to increase their liquidity. Some
of some assets held by fund managers has been trustees have also lowered the value of their
most notable for fixed income, including even unlisted assets to ensure that investors reducing
sovereign debt. Some other assets they hold are their exposures now are not overcompensated
never liquid, such as property and infrastructure. at the expense of remaining members. However,
This has made it difficult for managed funds that superannuation funds have also had to prepare
invest in loans and bonds (‘credit funds’) to for members using the changed early release
rebalance and/or liquefy their assets. At the option, which was included in the Government’s
same time, fund managers have needed stimulus package. For some funds, in particular
additional cash for a range of reasons. those with many young members working in
Redemption requests by investors in open- industries heavily affected by the pandemic, this
ended managed funds have been elevated as will represent a relatively large share of funds
investors sought the additional safety and under management and therefore a large
liquidity of cash. Several credit funds have liquidity drain.
responded to this situation by increasing the A substantial rise in the cost of issuing asset-
cost of redeeming. This, along with drawdowns backed securities has also limited the ability of
on funds’ cash reserves and sales of short-term non-ADI lenders to raise new funds. Some
debt, has so far enabled them to meet cash planned issues were subsequently deferred.
demands without having to suspend Non-bank lenders have been able to do this
redemptions, as permitted under legislation. because their warehouse funding facilities have
Superannuation funds have similarly required been ample, having increased over recent years.
additional liquidity to cover higher member However, the initial transactions from the
requests to switch from high- to low-risk Australian Government’s $15 billion fund for
investment options, in addition to needing to investing in asset-backed securities and
pay variation margin on the derivatives they use warehouse facilities has already resulted in a
to hedge foreign currency assets. significant easing in funding conditions for these
Superannuation funds hold liquidity buffers that lenders.
have enabled them to manage these liquidity
demands and have been redeeming term Other parts of the financial system have
been resilient to the effects of the
pandemic …
Graph 1.10
Banks’ Non-performing Assets Providers of FMIs operating in Australia have
Domestic books
% Share of all assets* Share of assets by type** % maintained their critical functions during the
COVID-19 pandemic, despite the operational
3 3 challenge of a high number of staff working
Business* from home. There have been no material system
(52%)
2 2 outages affecting FMIs during this time. FMIs
Personal
Total (3%) have also appropriately dealt with the risks
1 1 arising from increased market volatility and
Housing
trading volumes over this time. The CHESS
(45%)
0 0 system used by the ASX to clear and settle cash
2007 2013 2019 2007 2013 2019
* Includes lending to financial businesses, bills, short-term and long-term equities experienced processing delays during
debt securities and other non-household loans
** Each category’s share of total domestic lending at December 2019 record trading volumes in March, but more than
is shown in parentheses
Sources: APRA; RBA 99 per cent of trades still settled on time. CCPs
14 R E S E R V E B A N K O F AU S T R A L I Ahave also required firms to regularly post large should be readily managed by general insurers,
amounts of additional variation margin as given their high ROE and strong capital position.
market prices have moved erratically. They have However, life insurers’ profits have been very
also increased margin requirements to cover weak over recent years, reflecting chronic
risks associated with further volatility. These underpricing in individual disability (‘income
margins calls have been met without apparent protection’) insurance.
difficulty.
The financial effects of the COVID-19 pandemic … and institutions are so far managing
are unlikely to be material for insurers, despite the operational risks that have arisen
the severity of the pandemic. Claims for both Australian banks, insurers and FMI providers
general and life insurance are likely to rise have all successfully enacted pandemic plans
somewhat, but various limitations and some which are designed to ensure they can continue
specific exclusions mean that pandemic-related operating even if COVID-19 spreads more widely
claims are not always covered by insurance in Australia. These plans address considerations
policies. General insurers have potential such as how to enable critical functions to
exposure in workers’ compensation to hospital continue (and ensure they are appropriately
or healthcare workers who are infected in the resourced) while protecting staff from
course of their employment, but the impact is transmission (for example, by working remotely
likely to be small except in an extreme scenario. or in split-team arrangements). Despite this, the
For life insurers, payouts may increase but the unprecedented nature of the pandemic has
severity of the outbreak would have to be tested financial institutions’ business continuity
extreme to have a material impact on mortality plans and has strained systems. One challenge
insurance. There could also be income has been how robust various IT systems are
protection insurance payouts, but waiting times when a large share of employees are accessing
significantly limit the extent of these claims. them remotely from home and have slow or
Similarly, the implications for health insurers are unreliable internet access. Many institutions
likely to be limited because most of the cost will have successfully rapidly increased the number
be borne by the public health sector. Both of staff who can simultaneously work remotely.
general and life insurers are likely to have revised Institutions have also had to quickly bring some
up the present value of their future liabilities as critical functions back onshore. The risk of cyber
risk-free rates have fallen, and to have attack has also increased given institutions will
experienced losses on their holdings of be operating with reduced staffing and/or with
corporate bonds and equities. These effects more staff working remotely.
Endnotes
[1] An IMF study found a Tier 1 capital ratio of 15 to [2] The implied probability of default can be derived
23 per cent is appropriate for many advanced using a Merton-style ‘distance-to-default’ model, as
economies (see Dagher J, G Dell’Ariccia, L Laeven, done in MacDonald C, M van Oordt and R Scott
L Ratnovski and H Tong (2016), ‘Benefits and Costs of (2016), ‘Implementing Market-Based Indicators to
Bank Capital’, IMF Staff Discussion Note No 16/04). In Monitor Vulnerabilities of Financial Institutions’, Bank
comparison, the major banks’ Tier 1 capital ratios are of Canada Staff Analytical Note No 2016–05.
equivalent to at least 17½ per cent on an [3] For further details on the model, see RBA (2017),
internationally comparable basis, accounting for ‘Stress Testing at the Reserve Bank’, Financial Stability
APRA’s stricter application of global bank standards. Review Box D, October, pp 46–49.
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 1516 R E S E R V E B A N K O F AU S T R A L I A
2. Household and Business Finances in
Australia
Australian businesses and households are mostly Most households had sizeable cash and/or
well placed to face the large contraction in equity buffers going into the economic
economic activity associated with the downturn. Many affected workers will have
COVID-19 pandemic although it will test their access to wage subsidies and superannuation
financial resilience. As a result of the shock, many balances to compensate for lost income, and
businesses have limited or no income, and many repayment deferment will also provide a safety
workers have been stood down, at least net for those households that would otherwise
temporarily. But most businesses and struggle to service their obligations. These
households entered this difficult period in good factors will help households manage their debts
financial health, with large cash and/or equity during this difficult period. However, other
buffers to help withstand a temporary fall in households are not as well placed to withstand
income. Significant fiscal and monetary policy the downturn. To date, a large number of
stimulus, as well as measures introduced to help workers have been stood down, and many jobs
affected households and businesses to manage have already been lost or are expected to be lost
their debt and rent obligations, will also support in the period ahead. The associated uncertainty
them. Preserving the financial positions of is clearly weighing on household perceptions of
households and businesses will aid the ultimate their own financial situation (Graph 2.2).
economic recovery when the health crisis
passes.
Most businesses were in good financial health
before the pandemic. However, some pockets of
vulnerability were evident in the retail trade,
food and accommodation services, agricultural Graph 2.1
and construction sectors. Businesses in these Listed Corporations’ Debt at Risk
Probability of default multiplied by total debt
industries typically have high levels of gearing $b $b
and low levels of liquidity, making them
especially vulnerable to significant declines in 150 150
cash flow. The sharp decline in economic activity
is placing additional stress on these already 100 100
challenged sectors but will also test the
resilience of some businesses that were 50 50
previously in good health. There are signs of
corporate vulnerability increasing, with financial 0
2004 2008 2012 2016
0
2020
market pricing of risk for publicly listed * Calculated up to 6 April 2020, using a sample of the 300 largest (by
debt) non-financial domestically-domiciled firms listed on the ASX
companies rising sharply (Graph 2.1). Sources: Bloomberg; Morningstar; RBA
F I N A N C I A L S TA B I L I T Y R E V I E W – A P R I L 2 0 2 0 17Business sector conditions are in a broader and more pronounced impact
deteriorating through March. Some retailers, such as
Business balance sheets were generally in a supermarkets, have experienced high levels of
good state before the economic downturn demand, and this has raised their short-term
driven by the temporary health crisis. Liquidity cash flow. But many other businesses in
and profitability were at high levels, gearing industries such as cafes, restaurants and
ratios were low, and the ability to service debts accommodation services, and arts and
had risen significantly alongside reductions in recreational services, have been severely
interest rates. However, the adverse shock to affected, in many cases temporarily closing.
business conditions is already large and Alongside the unexpected decline in cash flow,
expected to grow substantially. Fiscal and these businesses tend to be more geared and
banking support will help businesses, but many more illiquid than those in other industries
will struggle. Revenues for many firms servicing (Graph 2.3). The challenges faced by businesses
the household sector – including those in the in regional communities are compounded by
retail trade, food and accommodation services, the effects of the drought and the recent
and tourism industries – have dried up. Some bushfires.
firms have already closed, at least temporarily. Despite the healthy state of listed corporates’
Many have stood down workers. Economic balance sheets ahead of the pandemic and
activity across a wider range of industries has substantial government support, the size of the
subsequently fallen, as flow-on effects work shock will still test the financial resilience of
though manufacturing supply chains and many businesses. About one-quarter of
business services. businesses typically do not have enough liquid
The impact of the COVID-19 pandemic in assets to cover one month of expenses
Australia was initially most pronounced for (including wages) and closer to half could not
tourism and education-related industries. pay for three months of expenses. Valuations for
Demand had dropped, starting with restrictions listed corporates have declined sharply from late
on travel from mainland China at the start of
February. Widespread restrictions in the Graph 2.3
domestic economy have progressively resulted Businesses’ Liquidity and Gearing Ratios
By industry, median, FY2016/17*
% %
Gearing
Graph 2.2 150
Liquidity
150
Households’ Financial
Position Compared with a Year Ago
Weekly 100 100
index index
50 50
100 100
0 0
on
Tra Arts
rt
Ot e ser re
Ad r se ices
n. vices
tru es
om duca n
nic on
Uti ons
s
fes Reta ture
Ma l ser e
Wh ufac ices
sa ring
Mi de
g
Ag litie
E ctio
ad
nin
po
tat th ca
Co rvic
ati
ti
tra
ati
il tr
u
ns
ul
v
v
od
t
r
ric
le
se
al
mm
ns
80 80
He
mu
na
he
n
ole
mi
co
sio
es
Ac
lec
al
Re
Pro
Te
* Liquidity is calculated as the ratio of current assets to current liabilities,
60 60 gearing is calculated as the ratio of debt to total assets (excludes
2008 2012 2016 2020 firms with no debt)
Source: ANZ-Roy Morgan Sources: ABS; RBA
18 R E S E R V E B A N K O F AU S T R A L I AFebruary, and a number of listed corporates through the coming months in terms of both
have suspended forward earnings guidance due liquidity and credit availability, and this will
to the uncertainty around the outlook for better position them for the recovery that will
economic activity. follow.
Business failures had been at low levels
(Graph 2.4). However, increases in business Many households have enough liquid
failures and loan arrears are likely over the assets to manage temporary falls in
coming months, even with the policy measures income …
designed to minimise insolvencies and offset Most households entered this difficult period in
any tightening in credit availability and cost (see good financial health. Surveys indicate that most
‘Annex: Selected Policy Responses to the households had enough liquid assets to cover
COVID-19 Pandemic’). There is considerable basic living expenses and current obligations,
uncertainty around the trajectory of the such as mortgage and rent payments, for three
economic shock and subsequent recovery. Firm- months (Graph 2.5). Households with mortgage
level analysis suggests that a decline in annual debt typically had sizeable liquidity and/or
sales of, for example, 20 per cent would lead to equity buffers. Among these borrowers, over half
an increase in the annual business exit rate of these loans had enough prepayments to
(failures as well as takeovers etc) from around service their loan repayments for at least three
8 per cent to 9½ per cent. This would be an months (Graph 2.6).
increase of around 35,000 business exits.
However, this estimate is based on historical … but some households have little
data and does not explicitly account for govern- savings and are vulnerable to
ment policy measures designed to temporarily financial stress
raise business cash flow. There were some pockets of vulnerability prior
Generally, a substantial rise in loan losses would to the pandemic, with some households having
be expected to result in a tightening in the
supply of credit to businesses. There have
Graph 2.5
therefore been significant policy measures
Household Liquidity Buffers*
implemented to avoid this effect. These Share of respondents in each category, 2018
% %
By housing tenure By labour force status
measures will help to support businesses
3 toless liquidity to manage declines in income. support and wage subsidies provided by the
Surveys indicate that about one in five Australian Government will help many of these
households only have enough liquid assets to affected workers.
get from one pay period to the next. These Increasing financial stress among renting
liquidity constrained households are typically households does not pose direct risks to the
young, twice as likely to be renting and twice as banking sector because these households
vulnerable to unemployment compared with typically hold little debt. But they pose indirect
other households. Amongst households with risks if they have trouble paying rent, and their
mortgage debt, just under one-third of landlords in turn have trouble making their own
mortgages have less than one month of debt repayments. Mortgage repayment
prepayments, and about half of these appear
particularly vulnerable to a sharp decline in
income. Graph 2.7
These households with small liquidity buffers are Financial Stress Incidence*
Share of respondents in each category, 2018
much more likely to report being in financial %
By housing tenure By labour force status
%
stress, regardless of their age, income or labour
45 45
force status. More than one-third of renting
households typically report in surveys that they
have experienced financial stress in a given year 30 30
(such as difficulty paying bills or having to go
without meals) (Graph 2.7). The most vulnerable 15 15
include those working in jobs more exposed to
unemployment risk, such as casual workers, and 0 0
Employed**
labour force
owner-occupier
owner-occupier
Renter
Underemployed
Unemployed
Not in
those in industries most affected by the
Indebted
Outright
COVID-19 containment measures, such as
accommodation and food services. Workers in
* Experienced at least one of the following difficulties due to a shortage
these most exposed industries are both more of money: missed bills, missed rent or mortgage payments, sold
something, unable to heat home, went without meals or asked family
or welfare groups for help
likely to rent and more likely to be liquidity ** Does not include underemployed
Sources: HILDA Release 18.0; RBA
constrained (Graph 2.8). Additional income
Graph 2.6 Graph 2.8
Household Mortgage Prepayments* Household Liquidity and Housing Tenure
By months of prepayments** Share of respondents in each industry
% % %
New loans Accommodation
No prepayment facility and food services
Investor and/or fixed rate loans***
Share of households that rent
35
Other Arts and
36 36
recreation services
30
Retail trade
24 24
25
Real estate
12 12
20
0 0 15
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