Financial Stability Review – September 20242. Resilience of Australian Households and Businesses

2.1 Households

High inflation and interest rates continue to put pressure on household budgets.

Many households continue to experience pressure on their budgets from high inflation and restrictive monetary policy. Real disposable incomes – that is, income after tax and interest payments and adjusted for inflation – have declined sharply since the start of 2022 on a per-capita basis (Graph 2.1). Most mortgagors have experienced an increase in their minimum scheduled payments of 30–60 per cent since the first increase in the cash rate in May 2022. Despite the recent stabilisation in real incomes around pre-pandemic levels, broad-based cost-of-living pressures continue to weigh heavily on the budgets of many households.^[1] Information received through the RBA’s liaison program indicates that more people than usual are seeking support from community organisations, often for the first time, including dual-income households and mortgagors.

A small but increasing share of mortgagors have fallen behind on their loan payments. Reflecting the challenging environment for many households, housing loan arrears have risen steadily from the low levels of late 2022 (Graph 2.2).^[2] Highly leveraged borrowers – that is, those with high loan-to-valuation (LVR) or high loan-to-income (LTI) ratios – have been most likely to fall into arrears over this period (Graph 2.3).^[3] Borrowers with high leverage are more vulnerable to challenging economic conditions and also tend to have lower savings buffers, which makes them more likely to fall behind on their loan payments. By contrast, arrears rates of other mortgagor groups, such as recent first home buyers, have not risen as much. The same observation holds for those who borrowed at low (including fixed) rates, most of whom have now transitioned to loans with higher interest rates.

Financial stability risks from the recent increase in arrears remain contained.

Loans in arrears represent a small share of total housing lending. Less than 1 per cent of all owner-occupier housing loan balances are 90+ days in arrears. While banks expect arrears to increase slightly, arrears rates remain around their pre-pandemic levels.

Many lenders have taken steps to support borrowers struggling to meet their mortgage repayments. Following the release of the Australian Securities and Investments Commission’s (ASIC) report on lenders’ approach to supporting borrowers facing financial hardship, many institutions have improved processes to identify stressed borrowers at an early stage and set up hardship arrangements before borrowers fall behind on their repayments.^[4] Hardship arrangements can help borrowers make financial adjustments and return to servicing their loan. The number of borrowers that have given hardship notices to their lenders has risen significantly since 2022, though only around 1 per cent of total owner-occupier loan balances are in hardship. While a majority of borrowers that enter into hardship arrangements resume making repayments on schedule, around one-third fall back into arrears within nine months of exiting these arrangements.

Very few loans in arrears are estimated to be in negative equity, where the loan amount exceeds the estimated property resale value. For loans in arrears to lead to bank losses, borrowers must both default on the loan and be in negative equity. Around 0.5 per cent of loans in arrears are estimated to be in negative equity. Overall, less than 0.01 per cent of loans outstanding are estimated to be both in arrears and in negative equity. While selling a property is usually a last resort and a very disruptive solution for owner-occupier borrowers in financial difficulty, this would allow almost all to repay their loans in full and avoid defaulting. Liaison with lenders suggests that an increasing share of struggling borrowers are taking up this option before they fall behind on their loan repayments.

A small group of borrowers remain at high risk of falling behind on their loans …

A small share of borrowers is at risk of entering arrears. The share of variable-rate owner-occupier borrowers who are estimated to have had essential expenses and scheduled mortgage repayments exceed their income, leading to an estimated cash flow shortfall, has remained at around 5 per cent.^[5] In addition to cutting back their spending to mostly essential items and trading down in quality for some goods and services, these households have had to make other difficult adjustments to continue servicing their mortgages. These include drawing down on liquid savings, selling assets and working additional hours. Lower income borrowers are more likely to be in this group. The share of borrowers more at risk of falling behind on their loan – that is, those estimated to have a cash flow shortfall and low buffers – has remained less than 2 per cent of all variable-rate owner-occupier borrowers (Graph 2.4). Only a very small share of this group is in negative equity, including because of ongoing growth of housing prices. This group of borrowers who are both at risk of falling behind on their loans and in negative equity accounts for less than 0.2 per cent of variable-rate owner-occupier loans outstanding.

… though the vast majority of borrowers are expected to be able to continue servicing their debts.

After surging during the pandemic period of low interest rates, savings buffers have returned to pre-pandemic levels for most borrowers and are little changed since the last Financial Stability Review (Graph 2.5). Despite budget pressures remaining elevated, most borrowers were able to continue servicing their debts and covering their essential costs without dipping into their savings over the first half of 2024. The share of variable-rate owner-occupier borrowers persistently drawing down on their offset and redraw balances is higher than before the pandemic; the share of borrowers persistently adding to these balances is also lower. However, these shares have remained relatively stable over the past six months, and in aggregate households are still adding to their mortgage buffers. High-income borrowers are the only group that, in aggregate, are drawing down on their offset and redraw balances. That said, this group still holds the largest prepayment buffers, and some of the decline in offset and redraw balances is likely to reflect withdrawals to support discretionary consumption.

The central forecasts from the August Statement imply that budget pressures on households should start to ease in the second half of 2024. The implementation of the Stage 3 tax cuts and further declines in inflation are expected to result in a pick-up in real disposable income growth over the rest of the year. The central forecasts also assume that the cash rate declines in line with market expectations at the time of the Statement, while unemployment is forecast to increase somewhat. If overall budget pressures do in fact ease in line with these forecasts and assumptions, the share of borrowers with an estimated cash flow shortfall is projected to decline by a couple of percentage points by 2026 (the coloured bars in Graph 2.6 show the estimated effects of these different factors on the share of borrowers in cash flow shortfall).

While conditions will remain challenging for the group of borrowers already experiencing acute budget pressures, our projections imply that most mortgagors would remain able to service their debts. Less than 2 per cent of borrowers are projected to be at risk of depleting their liquid savings buffers at any time before the end of 2026.^[6] Further, these at-risk borrowers would not necessarily default on their mortgages. Many could still make other – often difficult – adjustments, such as temporarily reducing some expenses or – as a last resort – selling their property. It is important to note, however, that these adjustments may not be available for some borrowers, particularly those with lower incomes and/or greater leverage.

While the economic outlook is highly uncertain, the vast majority of borrowers would remain able to service their debt under a range of plausible scenarios.

Economic outcomes could differ materially from the central forecasts. There are a range of different scenarios that could unfold, each with different consequences for financial stress and mortgage defaults. In the near term, some key risks are that inflation and interest rates remain high for longer than expected and/or that the labour market deteriorates sharply.

Should inflation remain high for longer than forecast, the share of borrowers most at risk of being unable to service their debts would increase slightly, from low levels. This scenario was assessed in the April 2024 Financial Stability Review,^[7] where it was found that a small number of borrowers who are close to or in cash flow shortfall would have to make further difficult adjustments to their finances to meet their obligations. However, the financial stability risks from housing lending would likely remain contained.

A larger-than-expected increase in the unemployment rate would increase financial stress among affected borrowers; still, risks to the financial system would likely remain contained. Borrowers who experience job loss or reduced hours typically see substantial declines in their income, and as such are at risk of falling behind on their loans. Given the central role that unemployment plays in mortgage defaults, it is important to explore the resilience of households to much larger increases in unemployment than currently forecast, even if the likelihood of such scenarios is low. In such an adverse scenario, borrower defaults would likely remain low (see Box: Few borrowers would be at risk of default owing to a substantial deterioration in labour market conditions).

Further supporting resilience, most borrowers have strong equity positions, which protects them from default and limits lenders’ potential losses. Sound lending standards and the general increase in housing prices over recent years continue to support borrowers’ resilience. The share of loans estimated to be in negative equity at current housing prices remains very low, and below the pre-pandemic share (Graph 2.7).^[8] The share of new loans originated at high loan-to-value ratios (LVR) also remains around historical lows. Even under a severe downside scenario, where housing prices fall by 30 per cent from their June 2024 levels (all else equal), the share of loans in negative equity is estimated to increase to around 9 per cent (using the Securitisation System; although this is likely to be an underestimate given higher LVR loans are underrepresented in the dataset).^[9] Even then, lenders would only realise losses if borrowers in negative equity became unable to service their loans.

As a result, losses incurred by lenders are likely to remain manageable in most plausible adverse circumstances. As such, banks – supported by their strong profits and capital positions – are well placed to withstand such losses while continuing to lend to households and businesses (see Chapter 3: Resilience of the Australian Financial System). This is in line with the latest stress tests run by banks, the Australian Prudential Regulation Authority and the RBA.

Beyond the near term, resilience could be eroded if households respond to any actual or anticipated 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. Over the past two decades, the international experience has shown that assets that are heavily reliant on debt funding, such as property, can also see unsustainable price rises, increasing the risk of a substantial market correction that could deplete households’ equity buffers and result in broader economic disruption.

2.2 Businesses

Profitability for most businesses remains around pre-pandemic levels, but an increasing share are experiencing challenging conditions.

Growth in demand has continued to slow and input cost pressures remain elevated for many businesses. However, most businesses remain profitable. Most large and small businesses’ profit margins are around the level recorded over the decade prior to the pandemic, based on the latest available data and information from business liaison (Graph 2.8). This reflects revenue growth sufficient to cover elevated growth in costs of labour and non-labour inputs – such as electricity, insurance, warehousing, logistics and rents, but excluding interest payments (discussed below) – as well as many businesses taking cost-cutting measures. However, soft consumer demand has made conditions more challenging in some sectors exposed to producing, distributing and selling discretionary products and services. For example, margins have fallen for many small hospitality businesses. Conditions also remain more challenging for smaller businesses, with a higher share making losses compared with larger businesses; however, this is not unusual and the share is around its pre-pandemic average.

Past interest rate increases have added to costs and are still to fully pass through to larger businesses’ interest expenses. The increases in interest rates have been largely passed through to the interest expenses of small businesses (Graph 2.9). By contrast, pass-through has been lower to date and is ongoing for larger businesses, owing to the more widespread use of longer term fixed-rate debt and interest rate hedges. Most businesses are still able to meet higher interest payment obligations as their earnings have remained robust. However, interest coverage ratios (ICR) – which measure earnings relative to interest expenses – are declining for some businesses. This is consistent with messages from liaison, which point to some restructuring of loans where ICR covenants have been breached. Information from liaison also suggests that ICRs have declined for smaller businesses, though most have been able to manage their debt obligations by making adjustments to ease cash flows pressures.

Company insolvencies have risen further, driven by small businesses.

Company insolvencies have continued to increase, part of which reflects catch-up from the pandemic period when insolvencies were unusually low. Most businesses entering insolvency continue to be small businesses with little debt, limiting the impact on lenders (discussed below). The increase in company insolvencies over the past couple of years from the exceptionally low levels observed during the pandemic reflects three main developments:

• the removal of significant support measures put in place during that period
• more challenging trading conditions as the economy has slowed
• the Australian Taxation Office (ATO) resuming enforcement actions on unpaid taxes.

On a cumulative basis, insolvencies remain below their pre-pandemic trend (Graph 2.10).

The number of businesses across various industries entering insolvency has increased since the start of 2024, with the hospitality sector the most impacted. Despite this, in most industries, insolvencies (expressed as a share of all businesses operating in that industry) are only slightly above pre-pandemic levels (Graph 2.11, right panel). The sharp rise in insolvencies within hospitality is consistent with acute pressures on the profitability and cash flows of these businesses, as they typically rely heavily on discretionary consumer spending.

While conditions in parts of the construction industry continue to stabilise, they remain challenging in others, particularly for sub-contractors. The construction sector drove much of the earlier increase in insolvencies.^[10] In the past few months, however, the number of construction companies entering insolvency has begun to ease, driven by fewer large builders facing severe margin pressure. Nonetheless, insolvencies remain elevated among construction services firms; many are experiencing cash flow pressures, with some trades also facing a slowing in demand (Graph 2.11, left panel). Business and financial conditions also remain challenging for property developers. On the other hand, construction-related business personal insolvencies – which capture households owning and operating small construction businesses – have increased a little but remain at historically low levels.

While there has been some weakening in the balance sheets of businesses, many maintain strong financial positions …

Businesses’ financial positions have slightly weakened over the past year but remain strong relative to the decade prior to the pandemic. Most businesses built sizeable cash buffers during the pandemic, as they benefited from policy support measures and the rapid economic recovery that followed. Data available up to June 2022 indicates that this includes many small and medium businesses, which typically held cash buffers roughly equivalent to larger businesses after adjusting for expenses (Graph 2.12).^[11] These cash buffers have also partly mitigated the impact of higher interest rates on businesses. More recently, however, businesses have been drawing down on these buffers, and debt is likely to have increased for many. Among larger, listed companies, gearing remains within levels seen over the past decade or so. Small and medium businesses have increased their borrowing, and unpaid debts to the ATO remain elevated relative to pre-pandemic levels, which is largely owed by small businesses.

The strong financial positions of many businesses should help to limit the risk of widespread financial stress if the economic environment deteriorates by more than expected. As discussed above, most businesses remain profitable, with cash flow pressures expected to ease in the near term (based on the baseline forecasts for moderating inflation and cash rate declines in line with market expectations in the August Statement). Profitability could come under pressure should the economic environment deteriorate more than forecast. However, most larger listed companies are likely to be able to service their debts even if their earnings were to decline for a period or if interest rates rise or remain high for longer. This is because most businesses (on a debt-weighted basis) have an ICR well above 2, the threshold indicative of weaker debt servicing capacity and historically associated with an increased risk of insolvency (Graph 2.13).^[12] Consistent with this, market pricing of default risk among larger companies remains low. Smaller businesses are more vulnerable to adverse economic outcomes, as they tend to have higher year-to-year earnings volatility.^[13]

Lenders’ ongoing appetite to lend to businesses has supported access to finance and reduces the refinancing risk of existing debts. According to liaison, competition for business loans has increased over the past year. This is likely to have supported some businesses’ access to finance; growth in business lending has picked up to above its post-global financial crisis (GFC) average, largely driven by medium-sized businesses. Conditions in other business funding markets also remain favourable: spreads on corporate bonds have been declining, and issuance has been above its historical average.

… and financial system risks from business lending remain low.

Banks continue to have limited exposure to businesses that have entered insolvency and are well placed to manage a further worsening in credit quality from business loans. The businesses entering insolvency continue to generally be small and have little debt, particularly owed to banks. This is consistent with low rates of non-performing business loans with banks across most industries. While the share of non-performing loans (NPLs) is generally a little higher within construction, this has been declining over the past year or so. However, banks’ exposures would likely increase should more medium- or large-sized businesses enter insolvency.

Non-banks tend to be more exposed to riskier business loans, especially to small businesses. At the point of insolvency, most businesses have unsecured debts – likely with non-bank lenders and other businesses – and debts to the ATO. A couple of non-bank lenders that focus on lending to small businesses have reported elevated, but declining, arrears across most industries. One exception is retail trade where arrears are increasing for some (system-wide arrears data are not available across the non-bank sector). Business credit growth from non-bank lenders, particularly to small businesses, has been increasing since 2022. Despite this, non-bank lenders only provide a small share of total credit in Australia and around 11 per cent of business credit, and Australian banks have limited exposures to them. In a situation where these lenders experience large losses, they would likely pull back on credit provision to businesses, heightening refinance risks particularly for smaller and less financially secure businesses (see Chapter 3: Resilience of the Australian Financial System for more detail on risks stemming for non-bank financial institutions).

2.3 Commercial real estate

Risks remain elevated in global CRE markets, including in Australia.

Pressures on profitability and valuations have been uneven across sectors and locations. Weak leasing demand – reflected in higher vacancy rates and weak rental growth – and higher interest rates are weighing on many CRE owners’ profitability and asset valuations. These pressures have been particularly acute for lower grade office properties.^[14] They have been less severe in Australia relative to some other countries such as the United States, owing to a stronger recovery in office attendance rates, lower vacancy rates and a greater geographical concentration of office properties in fewer major cities. However, within Australia, there are some locations where office vacancy rates are particularly high.

Overseas stress could spill over to Australian CRE markets through interconnected funding and ownership sources. These linkages have increased over the past decade, as foreign participation in Australia’s CRE market has risen. This stress could directly impact market conditions in Australia if (realised or unrealised) losses on foreign assets lead to forced domestic sales and/or reduced lending into the Australian CRE market.

However, to date, there is no evidence of a withdrawal of foreign lending and investment from the Australian CRE market. Specifically:

• Listed Australian real estate investment trusts’ (A-REITs) access to offshore funding has not unduly tightened. As A-REIT debt maturities are not concentrated in the near term, they should be able to navigate temporary periods of tight funding market conditions.
• Foreign banks continue to lend to owners of Australian CRE. However, their exposures are growing at a slower pace than a couple of years ago (Graph 2.14, left panel).
• Foreign investors have maintained their exposure to Australian CRE. The level of foreign ownership of established CRE has remained relatively stable on net over the past couple of years (Graph 2.14, right panel). Additionally, liaison suggests that foreign interest in investing in Australian CRE via trusts remains strong.

There continues to be little evidence of financial stress among owners of Australian CRE …

Available information suggests that the financial positions of most CRE owners remain sound, reducing the immediate risk of forced asset sales at potentially steep discounts. These ‘fire-sale’ dynamics could occur if losses mean a leveraged investor can no longer meet loan covenants and they cannot contribute more equity or income to offset this. This can potentially spread stress between investors. However, strong financial positions among leveraged investors reduce this risk. Specifically:

• A-REITs maintain strong financial positions (Graph 2.15). Leverage has stabilised at modest levels as for many A-REITs the pace of asset write-downs has slowed. Additionally, for most A-REITs earnings remain equivalent to around three times their interest payments.
• Unlisted trusts are effectively managing liquidity pressures from redemption requests. The use of liquidity management tools, such as redemption limits and liquid asset buffers, have become more common since the GFC. Additionally, most unlisted trusts appear to have low leverage. While there is a small tail of highly leveraged funds that are more vulnerable to a decline in valuations, these are generally small and hold very little debt relative to the overall market, limiting the potential spillovers.
• The share of non-performing CRE loans at banks has increased a little but remains low by historical standards. Additionally, liaison suggests that some of this increase reflects downgrades of customers who are continuing to meet their repayment obligations. However, there remains an elevated number of borrowers on watchlists.

Ongoing access to credit and an increase in transaction volumes also reduce the immediate risk of forced asset sales at potentially steep discounts. As discussed above, foreign interest in investing in Australian CRE remains high. Moreover, while banks’ appetite for new CRE lending remains cautious in many sectors, liaison suggests that banks are showing interest in expanding lending to non-discretionary retail and industrial properties, and residential development. Additionally, banks remain willing to work with borrowers not currently meeting their loan covenants where there is a path back to meeting minimum requirements.

Transaction volumes are increasing, aiding price discovery and further reducing the risk of a disorderly decline in asset values. Transaction volumes had been very low, leading to uncertainty around asset valuations. Volumes have been picking up over the year to date, though they are still low by historical standards, particularly for office properties. Increased volumes appear to have led to a narrowing in the gap between seller and buyer price expectations.

… and risks to the financial system remain contained.

Challenges for owners of CRE would be magnified if inflation and interest rates were to remain high for longer or if economic conditions were to deteriorate by more than expected. The sector is particularly vulnerable to high interest rates as they put pressure on borrowers’ ICRs. A larger-than-expected deterioration in economic conditions is another risk, as this would place direct pressure on owners’ incomes and in turn on valuations. In such a situation, investors in CRE could realise large losses. Stress could also transmit to other participants (via sharply lower asset values) if leveraged owners in breach of loan covenants are forced to sell assets at steep discounts, as discussed above. This includes leveraged offshore owners, who could transmit stress from foreign CRE markets to Australia.

However, banks operating in Australia have conservative lending practices and small exposures to CRE. Liaison suggests that very few CRE bank loans would be in negative equity even under a scenario of large asset value declines. Additionally, banks in Australia have limited exposures to CRE, both relative to history and to other countries, such as the United States or some European countries. Loans to CRE account for around 6 per cent of total assets for the major banks. Exposures are slightly higher among foreign bank branches, reflecting their specialised Australian operations; however, their lending standards and NPLs are broadly in line with those at Australian banks.

Broader risks to the financial system from non-bank financial institutions, including those lending to CRE, also remain contained (see Chapter 3: Resilience of the Australian Financial System). Lending standards at non-bank financial institutions (such as registered financial corporates and private sources of credit) are typically weaker, as these institutions service a different segment of the CRE market. However, they are estimated to account for less than one-fifth of direct lending to CRE and have limited borrowings from the banking system.^[15] Visibility over these institutions remains limited.

Endnotes

For a discussion of the impacts of high inflation and interest rates on the finances of different cohorts, see Bullock M (2023), ‘Monetary Policy in Australia: Complementarities and Trade-offs’, Speech at the 2023 Commonwealth Bank Global Markets Conference, Sydney, 24 October; Bullock M (2024), ‘The Costs of High Inflation’, Keynote Address to the Anika Foundation Fundraising Lunch, Sydney, 5 September. [1]

See Morgan M and E Ryan (2024), ‘Recent Drivers of Housing Loan Arrears’, RBA Bulletin, July. [2]

Graph 2.3 is based on analysis using loan-level data from the RBA’s Securitisation System dataset. Arrears rates from these data can differ from arrears rates reported by lenders to the Australian Prudential Regulation Authority due to compositional or behavioural factors. For more information on the representativeness of the dataset, see Hughes A (2024), ‘How the RBA Uses the Securitisation Dataset to Assess Financial Stability Risks from Mortgage Lending’, RBA Bulletin, July. [3]

For a recent review of hardship arrangements and ASIC guidance on how lenders should support their customers experiencing financial hardship, see ASIC (2024), ‘Hardship, Hard to Get Help: Findings and Actions to Support Customers in Financial Hardship’, May. [4]

Since the March 2024 Financial Stability Review, the methodology for calculating household spare cash flows has been improved in two ways. First, we now use the Melbourne Institute’s Household Expenditure Measure adjusted for inflation at the individual expenditure item rather than at the aggregate level. Second, household income after tax now accounts for changes to legislated tax rates. [5]

This estimate includes some of the 2 per cent of borrowers who are currently estimated to have a cash flow shortfall and low buffers. However, not all those at-risk borrowers are predicted to deplete their buffers by the end of 2026. For example, some move out of cash flow shortfall due to the forecast growth in their real incomes. Conversely, we estimate that the expected increase in the unemployment rate would push some borrowers who are currently not classified as ‘at risk’ into cash flow shortfall; a small portion of those would be at risk of depleting their buffers. [6]

See RBA (2024), ‘4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates’, Financial Stability Review, March. [7]

In aggregate, borrowers have much stronger equity positions than before the pandemic (i.e. the LVR distribution has shifted to the left in Graph 2.7). [8]

For more information on the representativeness of the dataset, see Hughes A (2024), ‘How the RBA Uses the Securitisation Dataset to Assess Financial Stability Risks from Mortgage Lending’, RBA Bulletin, July. [9]

For more detail, see RBA (2022), ‘Box C: Financial Stress and Contagion Risks in the Residential Construction Industry’, Financial Stability Review, October; RBA (2023), ‘Box: Risks in the Residential Construction Industry’, Financial Stability Review, October. [10]

A forthcoming Bulletin article on small business economic and financial conditions will discuss this in more detail. [11]

For more detail, see RBA (2024), ‘4.1 Focus Topic: Scenario Analysis of the Resilience of Mortgagors and Businesses to Higher Inflation and Interest Rates’, Financial Stability Review, March. [12]

A forthcoming Bulletin article on small business economic and financial conditions will discuss this in more detail. [13]

For more detail, see Lim J, M McCormick, S Roche and E Smith (2023), ‘Financial Stability Risks from Commercial Real Estate’, RBA Bulletin, September. [14]

See Robinson M and S Tornielli di Crestvolant (2024), ‘Financial Stability Risks from Non-bank Financial Intermediation in Australia’, RBA Bulletin, April. [15]