Financial Stability Assessment

Economic

Summary:

While inflation has eased, the global economic outlook continues to be uncertain and vulnerabilities in the global financial system remain.

The finances of many households and businesses in advanced economies continue to be resilient, despite ongoing pressure from tight monetary policy and inflation. This resilience has been supported by firm, albeit softening, conditions in labour markets, a stabilisation or pick-up in real household incomes, and solid corporate earnings. While there is a small but growing group of borrowers experiencing financial stress in these economies, a further easing in inflation − and with it, lower policy rates − is expected to support the balance sheets and cash flows of households and firms over the period ahead.

The central expectation for many countries, including Australia, remains a modest economic cycle, but this outcome is by no means assured. Considerable uncertainty about the outlook remains, and there have been bouts of market volatility over recent months. A significant economic downturn, including a sharp deterioration in labour markets, is the principal risk to the resilience of borrowers. The sizeable capital buffers maintained by large banks worldwide position them well to handle rising loan impairments in such a scenario and continue supporting the economy. However, threats originating from outside the financial system – including geopolitical risks and risks associated with climate change – also continue to increase and have the potential to adversely interact with vulnerabilities in the global financial system.

Three vulnerabilities stand out as having the potential to significantly impact financial stability in Australia:

Operational vulnerabilities resulting from increased complexity and interconnectedness in the digital economy.Digitalisation and rapid technological development are transforming how the economy and financial system operate. This is delivering speed and efficiency gains, lowering costs and improving the consumer experience. But it also comes with an increase in complexity and interconnectedness. Technological innovations – such as artificial intelligence and cloud computing – have led to increasing concentration risk in third-party providers and raised the risks of central points of failure in the financial system. Recent incidents have highlighted the vulnerability of the economy and financial system to technological outages and underscored the need to strengthen operational resilience within firms and across their networks. Advancing digitalisation is occurring at a time of heightened geopolitical tensions, which increases the prospect of cyber-attacks that could have systemic implications.

Low risk premia and leveraged positions increase the potential for a disorderly adjustment in global asset prices in response to negative news. Low risk premia in a number of major asset classes, particularly equities and credit, makes global asset prices sensitive to negative surprises. This could set off disorderly price adjustments and disrupt the funding markets that Australian businesses and financial institutions use extensively. The bout of heightened global market volatility in early August highlighted the risk that disappointing economic or earnings news, or worsening geopolitical tensions, could trigger such an event. Further increases in government debt in key advanced economies could also make these markets more sensitive to adverse shocks, including those that exacerbate concerns about debt sustainability. As recent years have shown, the leverage and interlinkages of non-bank financial intermediaries with banks could also amplify the effects of shocks to the global financial system.

Imbalances in China’s financial sector. Longstanding vulnerabilities in part of the Chinese financial system – including banks, non-banks and local governments – have been exacerbated by the ongoing weakness in the Chinese real estate sector. A further loss of confidence – absent a timely and significant response from the Chinese authorities – could see stress spill over to the rest of the Chinese economy and financial system, which would likely affect the global economy and financial system

Should these risks and vulnerabilities materialise, spillovers to the Australian financial system could occur in the following ways:

Directly and rapidly through a severe operational disruption– including to national infrastructure or to a key financial institution.

Via a significant increase in risk aversion in global financial markets– to the extent that it sharply raises costs and limits Australian firms’ and financial institutions’ access to funding and liquidity in global markets. This would exacerbate financial pressures on domestic borrowers and, to the extent this puts significant strain on financial institutions’ balance sheets, limit access to credit in the Australian economy. However, the exchange rate would also depreciate, providing an economic and financial stabilising mechanism.

Via the impact on the real economy– through trade and investment channels, particularly in the case of a sharp downturn in China.

Risks to the Australian financial system from lending to households, businesses and commercial real estate (CRE) remain contained.

Budget pressures from high inflation and restrictive monetary policy continue to be felt across the Australian community, but the share of borrowers experiencing severe financial stress remains small. While a small but rising share of Australian households are falling behind on their mortgage repayments, the vast majority of borrowers continue to be able to service their debts and most have maintained, if not added, to their mortgage buffers. Many businesses also continue to manage pressure on their cash flows and balance sheets, supported by their strong financial positions prior to the rise of inflation and interest rates. Nevertheless, business conditions remain challenging for many firms, and small businesses in particular. Business insolvencies have increased sharply over the past couple of years following the removal of pandemic-era support, though they are only slightly above pre-pandemic levels as a share of all businesses.

Financial pressures are expected to ease in the period ahead, but the economic outlook is highly uncertain. Based on the forecasts presented in the August Statement on Monetary Policy, budget pressures are expected to ease as inflation moderates further and Stage 3 tax cuts take effect. However, the expected easing in labour market conditions and subdued growth in activity will be challenging for some households and businesses. Stress on households and businesses would be magnified if economic conditions deteriorated further than anticipated and/or if inflation and interest rates were to remain high for longer than expected.

The risk of widespread financial stress remains limited due to the generally strong financial positions of most borrowers. Very few mortgage borrowers are in negative equity, limiting the impact on lenders in the event of default and supporting their ability to continue providing credit to the economy. Most businesses that have entered insolvency are small and have little debt, limiting the broader impact on the labour market and thus household incomes, and on the capital position of lenders.

Domestic vulnerabilities could increase if households respond to any easing in financial conditions by taking on excessive debt. Historically, periods of low and/or falling interest rates have coincided with borrowers taking on higher levels of debt and, in some cases, lenders extending credit to riskier borrowers. This could be magnified if lending standards drop. International experience has highlighted the danger of boom-bust asset price cycles, particularly those amplified by the widespread use of borrowed money. Residential property stands out in this regard.

Conditions in segments of international and domestic CRE markets remain challenging, particularly in secondary grade office buildings, but the financial stability risks in Australia remain contained. Despite large declines in asset valuations over the past couple of years, overall indicators of financial stress in the Australian CRE market are low by historical standards. One risk scenario is that stress in overseas CRE markets spills over to Australian market conditions via interconnected sources of ownership and funding. While this could lead to losses for some investors and non-bank lenders, it is unlikely to materially affect the asset quality of domestic banks given their relatively limited CRE exposures and conservative lending standards to the sector.

The Australian financial system continues to display a high level of resilience.

Australian banks have maintained prudent lending standards and are well positioned to continue supplying credit to the economy. A deterioration in economic conditions or temporary disruption to funding markets is unlikely to halt lending activity. Banks have anticipated an increase in loan arrears and have capital and liquidity buffers well above regulatory requirements.

Arrears in Australian non-bank lenders’ loan books have picked up, but system-wide risks to financial stability remain contained. The sector has continued to expand, including by taking market share from banks in business lending. However, systemic risks from the sector remain limited due to the sector’s small size and that its core funding is not sourced from banks. That said, detailed analysis of underlying credit quality is challenging due to limited data availability.

The significant growth of the superannuation sector and its connections to Australian banks has increased its importance to financial system stability. The sector has historically posed little risk to the financial system owing to its smaller footprint in funding Australian banks and corporations, limited use of leverage, and steady inflows of defined contributions that simply pass-through (rather than guarantee) returns to members. However, the sector’s rapid growth (now making up one-quarter of the financial system), the rise in herding around common benchmarks and increased exposure to margin calls (including from the hedging of foreign asset exposures) mean the sector’s investment decisions and liquidity risk management practices have a greater potential than before to amplify shocks in the financial system. For this reason, APRA is stepping up the intensity of its prudential supervision of superannuation funds.

Lifting and maintaining operational resilience in an increasingly digitalised and interconnected financial system will require a sustained and proactive effort.

The operational resilience of financial institutions and infrastructures is crucial for the stability of the Australian financial system. Digitalisation brings many benefits, but also new and more complex operational risks and vulnerabilities. These could interact with (and amplify) other risks, including geopolitical risk, with potentially severe consequences.

Strengthening operational resilience remains a regulatory priority in Australia and globally. Strong governance and operational risk management practices by financial institutions is essential in today’s high-threat environment. This requires an ongoing effort by industry, and regulators in Australia and internationally are stepping up the intensity of their demands in response.

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