Financial stability review

Since March this year, “conditions in the global financial system have improved significantly”, according to the Reserve Bank of Australia (RBA) in its latest six-monthly Financial Stability Review.

A major theme in the RBA’s assessment is the resilience of Australia’s financial system compared to those of other countries.

Often the target of populist criticism at home, Australian banks have experienced only a modest decline in profitability, are well capitalised and have managed to strengthen their balance sheets with new equity raisings.

Australian banks have been helped by the transmission mechanism of monetary policy in Australia, with the benefits of lower official interest rates being passed on to customers.

If there is a concern about Australian banks, it is around their ability to continue to attract offshore funding to ensure a reasonable amount of credit growth continues to support economic activity. If this falters, banks will need to ensure there is enough domestic credit creation and will rely more on deposit funding.

Some concern has been expressed about house prices in Australia on a price-to-income metric. But this has continually been proved wrong. Defaults on housing lending in Australia has picked up over the past year or so, but at around 0.6 per cent remain extraordinarily low when compared with other major nations.

Overall, sentiment on the economy is more positive, although the next quarter will be a challenge. There is still a high probability of increased regulation in the global banking system, with the G20 leading the charge. Much of this will be centred on lifting the amount of capital banks will need to hold. This could take various forms and could include counter-cyclical capital buffers, tougher liquidity tests and systemic capital requirements.

This increase in regulation will make financial intermediation more costly. The big worry is that this could lead to avoidance behaviour, with credit provided outside the regulated system.

Concerns remains that after the recovery from the financial crisis credit growth will be slower and this could dampen economic growth. However, the RBA is unlikely to have a desire to target credit growth as part of monetary policy setting as this is too problematic.

The RBA has made the point that higher capital ratios in the US would not have prevented the crisis. The hope from the current G20 meeting is that any changes to regulation will be implemented after there is a sustained global economic recovery, as any changes before this could dampen the recovery.

The real test for the Australian economy will likely be mounting a sustained recovery in the fourth quarter for 2009 following the government stimulus packages and RBA rate cuts.

A positive sign is that Australian household net worth has started to improve again after significant falls in 2008. The RBA has also noted that overall borrowings by households has continued to expand over the past couple of years, though at a more moderate pace.

Countering that is borrowing by businesses from financial institutions has been declining, reflecting both reduced demand for credit and stricter lending standards.

The RBA has also indicated that the re-emergence of a two-speed Australian economy (ie, strong resources but weaker elsewhere) does not present a significant challenge for monetary policy, but it does make it harder to sell the message.

Finally, one key issue remains: a large part of the improvement in credit markets is due to government policy intervention. Policy settings are far from normal. The stimuli implemented over the past 12 months, including government guarantees, need to be withdrawn at some stage, and the RBA remains unsure how the market will deal with this.

Stephen Halmarick is head of investment markets research at Colonial First State.