Financial Stability Review – September 20243. Resilience of the Australian Financial System

Summary

The Australian financial system is well placed to continue supporting the economy through challenging economic conditions, but building and maintaining operational resilience – in an increasingly digitalised and interconnected world – requires ongoing effort.

  • 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. The share of bank loans that are in arrears has increased from low levels, reflecting a small but rising number of borrowers who are encountering financial stress. But this has had a limited impact on the resilience of the banking system. This is largely because the increase in arrears has been gradual and expected, robust lending standards have been maintained, and banks have capital and liquidity buffers well above regulatory requirements.
  • Arrears in the loan books of non-bank lenders have picked up but system-wide risks to financial stability remain contained. The non-bank lender sector has continued to grow, in part due to favourable funding conditions, the expansion of lending to borrowers less serviced by banks, and lower competition from banks for mortgage lending. While liaison suggests that arrears in the sector’s business lending have increased, available data implies that systemic risks from the sector are limited by its small size and constrained connections to the rest of the financial system. Detailed analysis of the underlying credit quality of business lending is precluded by data limitations.
  • The significant growth of the superannuation sector and its connections to Australian banks has increased its importance to financial system stability. The closed nature of the sector, its long-term investment horizon, limited use of leverage and the largely defined contribution structure of most funds (where returns are passed straight through to end investors) limits systemic risks. However, given the superannuation sector now comprises one-quarter of the assets in the Australian financial system, fund investment decisions have the potential to amplify shocks. This is particularly the case in parts of the financial system where the sector has an unusually large footprint, such as in the market for bank debt securities. The management of liquidity risk will require ongoing vigilance, including in respect to margin calls on foreign exchange hedges.
  • Financial institutions’ and infrastructures’ operational resilience is critical to the overall resilience of the Australian financial system and remains a regulatory priority. (See Box: Initiatives to enhance operational resilience in Australia.)

3.1 Banks

Asset quality has declined but not resulted in material losses for banks.

Asset quality has gradually declined since the start of 2023. Cost-of-living pressures and higher interest rates have contributed to an increase in loans with payments overdue for more than 90 days; lenders expect these ‘loans in arrears’ to continue rising throughout the remainder of this year. As of March 2024, the share of total loans in arrears (housing, personal and business) was around the levels observed during the global financial crisis (GFC) and the COVID-19 pandemic. The share of housing loans in arrears was 0.8 per cent in June 2024, around 30 basis points higher than the low point in 2022 (Graph 3.1). This pick-up has been driven by arrears in housing loans with higher risk characteristics, such as high loan-to-value ratios (see Chapter 2: Resilience of Australian Households and Businesses).

Graph 3.1
Graph 3.1: A time-series line graph of banks’ loans in 90-day arrears as a share of balances outstanding, with a line for each lending category: housing, business, personal. The graph shows that arrears rates have increased for all categories since the end of 2022.

The increase in system-wide loan arrears has not caused material losses for banks. Banks had expected loan arrears to increase from the 2022 lows and have worked more proactively than in previous cycles to identify and support borrowers encountering financial stress. Strong labour market conditions have helped some borrowers to recover from temporary periods of financial stress. And housing price growth has enabled some borrowers to refinance or, as a last resort, to sell their property to repay debts and has limited banks’ losses in the event of default. The share of housing loans in negative equity is estimated to be very small. Banks do not anticipate a surge in loan losses under their central forecast for the economy over the period ahead, though a sharp deterioration in economic conditions, especially a sharp increase in unemployment, would lead to higher losses.

Loan arrears have remained small relative to banks’ capacity to absorb losses. Banks hold provisions as insurance against expected loan losses and capital as insurance against unexpected losses. Bank provisions have remained around 0.7 per cent of gross lending over the past year. Most loans in arrears are well secured, reducing the risk of losses for banks. Loans in arrears that are not well secured are equivalent to less than 3 per cent of banking system total capital.

The quantity and quality of bank capital has continued to improve …

Banking system capital ratios have remained well above regulatory requirements. The ratio of Common Equity Tier 1 (CET1) capital – the highest quality of regulatory capital – to risk-weighted assets was 12.6 per cent in June 2024 (Graph 3.2). This ratio has increased 3.6 percentage points over the past decade, which has significantly strengthened the resilience of the banking system to adverse shocks.

Graph 3.2
Graph 3.2: A two-panel column graph showing banks’ capital ratios as a share of risk-weighted assets, with the panels split by bank size into large banks and other standardised banks. The columns show the composition of banks’ capital ratios. The majority of banks’ capital is common equity tier 1 (CET1) capital and all banks sit well-above the CET1 requirement.

The Australian Prudential Regulation Authority (APRA) recently proposed to replace Additional Tier 1 (AT1) capital with other forms of capital in its capital framework for banks.[1] AT1 capital is designed to absorb losses to support the recovery of banks in stress and to support the resolution of banks to avoid disorderly failure. Following consultation with industry and other agencies on the Council of Financial Regulators (CFR), and based on international experience, APRA has determined that AT1 capital has not proven to be effective at supporting banks in stress nor does AT1 capital have advantages over other forms of capital in supporting the resolution of banks. The proposed changes to replace AT1 capital in the capital framework maintain consistency with international standards for large, internationally active banks and do not alter the total level of capital that banks are required to hold. The proposals are also designed to strengthen the proportionality of APRA’s capital framework by embedding a simpler approach and lower capital requirements for small and mid-size banks relative to larger banks. APRA is currently seeking stakeholder feedback on the proposal before formally consulting on specific changes to its standards in 2025. Changes to the capital framework are proposed to be phased in with the transition period commencing in 2027.

… and bank liquidity has been resilient.

The banking system has retained significant reserves of liquid assets, well above regulatory requirements. This helps banks to manage large and unexpected drains on their cash – for example, during a temporary period of funding market disruption. Banking system liquidity ratios declined in the June quarter of 2024 and liquidity buffers for smaller banks are now quite some way off their pandemic highs. But liquidity ratios for large and small banks have remained above pre-pandemic levels (Graph 3.3).

Graph 3.3
Graph 3.3: Two-panel graph of time series of bank regulatory liquidity measures (LCR for larger banks, MLH for smaller banks). Liquidity measures have decreased since their peak in 2020. Both LCR and MLH banks remain well above their regulatory requirements.

Banks were well prepared for Term Funding Facility (TFF) funding repayments and the TFF has now been fully repaid. The RBA established the TFF in 2020 to lower interest rates for borrowers and support business lending during the pandemic. This was done by providing low-cost three-year funding to banks. The TFF increased banks’ liquidity ratios as banks used it to borrow ES balances (cash held at the RBA which are liquid assets) and provided mostly assets that do not count as liquid assets in liquidity ratios as collateral. Repaying the TFF funding – including $95 billion in the June quarter of 2024 – unwound this boost to banks’ liquidity ratios. To manage this impact, banks increased their wholesale and deposit funding prior to repaying the TFF funding.

Last year’s banking turmoil in the United States highlighted that the digitalisation of financial services has heightened banks’ liquidity risks. APRA is reviewing bank liquidity standards to address lessons learnt from the banking turmoil in 2023, and announced changes to strengthen bank liquidity standards in July 2024.[2] These included changes to ensure that the value of liquid assets on banks’ balance sheets reflects their market value and that banks have robust processes for providing the required information about their solvency in the rare event they need to request exceptional liquidity assistance from the RBA.[3] APRA will also heighten its supervisory engagement with banks that have material holdings of debt securities of other banks in their liquid asset portfolios. This reflects APRA’s expectation that banks hold diverse liquidity portfolios, which is an established objective of APRA’s existing liquidity regulations and guidance.

The potential for rapid deposit withdrawals in a world with faster payments and interconnected communication networks reinforces the need for banks to manage liquidity risks carefully. This includes constant reassessment of the adequacy of liquidity buffers. Past events have shown that the effectiveness of bank debt securities in serving as a reliable source of liquidity in stressed market conditions can be limited when there are sharp price declines; the sharp widening in yield spreads between bank debt securities and risk-free rates at the onset of the pandemic and during the GFC were examples of this risk (Graph 3.4). In addition, during the early stage of the pandemic, banks faced liquidity pressure from a surge in early redemptions of their debt securities (see below). Cross-holdings of bank debt securities could also contribute to liquidity stress spreading between banks, if stressed banks raise liquidity by selling other banks’ debt securities.[4] These considerations feature in APRA’s concern about banks relying on the debt securities of other banks as liquid assets.

Graph 3.4
Graph 3.4: Two-panel chart of the spread of the yield on bank debt securities to their respective risk-free rates, with a line for the major bank 3-year bond pricing spread to AGS, 3-month BBSW spread to 3-month OIS and 6-month BBSW to 6-month OIS. Panel 1 shows the yield spreads during the global financial crisis (January 2007 to December 2009) and panel 2 shows the yield spreads during the pandemic (January to December 2020). Both panels show a spike in yield spreads.

3.2 Non-bank financial institutions and financial market infrastructures (FMIs)

Ongoing growth of the superannuation sector could have financial stability implications.

Superannuation funds are a large and increasingly important part of the Australian financial system. As of June 2024, the sector was managing nearly $4 trillion of assets, equivalent to around 150 per cent of GDP and 25 per cent of total financial system assets. The sector provides critical financial services to Australians and is a key source of capital and funding in the economy. As long-term investors, superannuation funds can support financial stability by deploying capital in a counter-cyclical manner, including when volatility spikes and asset prices fall. The sector also has structural features that help limit the build-up of systemic risks. For example, most superannuation funds are defined contribution funds, which do not offer guaranteed returns to members, and funds are restricted in their ability to borrow. This is a notable contrast with some other countries, such as the United Kingdom, where leverage in defined benefit pension funds was a key driver of stress in the government bond market in September 2022.[5]

At the same time, the superannuation sector’s significant growth, rising connectedness with banks and increasing footprint in financial markets creates new risks, including the ability to amplify shocks. The value of assets managed by superannuation funds doubled in the decade to 2024 and is expected to continue to grow faster than the overall financial system. As the sector has grown, its financial connections with the banking system have increased: superannuation funds directly hold nearly one-third of bank short-term debt securities and over one-quarter of equity issued by domestic banks (Graph 3.5). Consequently, superannuation funds have the potential to amplify shocks in the financial system.[6] This could occur if the investment actions of superannuation funds were to become more correlated or concentrated in times of generalised market stress – for example, in response to members’ correlated reaction to a shock. A recent illustration occurred during the onset of the pandemic in Australia when superannuation funds increased their sale of bank debt securities back to issuing banks, adding to bank funding pressures – which in turn increased funding costs across the financial system.[7]

Graph 3.5
Graph 3.5: Two-panel time series graph of superannuation fund claims on the domestic banking system. Panel 1 shows super funds holdings of short-term debt securities relative to total domestic issuance of short-term debt securties by the banking system. Panel 2 shows listed equity claims relative to total listed equity issued by domestically incorporated banks. The graph shows that super fund claims on the banking system have been increasing.

The sector’s growth will require superannuation funds to continue to strengthen their liquidity risk management practices. Unexpected liquidity calls – including capital calls on private asset exposures, abrupt policy shifts (like the introduction of the Early Release Scheme) or margin calls on foreign exchange hedges – could lead to synchronised asset sales in some domestic markets as funds attempt to raise cash quickly.[8] The management of liquidity demands resulting from margin calls on foreign exchange hedges (when the Australian dollar depreciates) will become increasingly important as foreign assets are expected to comprise a larger share of superannuation fund investment portfolios in the future. Over time, a reduction in the flow of net contributions into the sector, and the eventual transition to outright cash outflows (as more and more members enter the decumulation phase of retirement), will also present new challenges for liquidity management. However, these developments will be gradual and largely predictable. APRA has strengthened its prudential standards and guidance on investment governance in superannuation funds following a review of its superannuation prudential framework in 2019.[9] As a result, APRA now requires a greater degree of sophistication in liquidity risk management practices across the sector.

Higher premiums have supported general insurers but have contributed to affordability challenges; this could become a long-term problem, in part due to climate change.

General insurers’ profits and capital positions were supported by higher premiums and investment returns in the year to March (Graph 3.6). Insurers’ capital positions remain well above APRA’s prescribed capital amount, supported by profitability growth in 2023. Profitability has risen as general insurers raised premiums in recent years in response to increased costs stemming from higher reinsurance costs and higher claim payouts – in turn, the result of inflation and more frequent and larger claims for natural disasters. Reinsurance costs rose sharply in 2022–2023 as reinsurers repriced risk higher, in part due to a rise in global catastrophic events. However, reinsurance costs have since stabilised.

Graph 3.6
Graph 3.6: Three panel time series graph of insurers profitability metrics and capital ratios. Panel 1 shows an annualised four-quarter moving average of the insurance sectors return on equity. Insurers profitability has recovered over the past year due in-part to premium increases. Panel 2 shows insurers claims ratio (annualised four-quarter moving average). Claim events have been declining the past year and premiums have increased, lowering the ratio. Panel 3 shows General Insurers and LMI’s capital relative to the prescribed capital amount (PCA). There is a structural series break for all panels due to the adoption of AASB 17 which affects from the September 2023 quarter.

Home insurance affordability is likely to be a long-term challenge. A decline in affordability could impact financial stability by increasing the number of uninsured and underinsured households, weakening their resilience to loss events and exposing mortgage providers to larger losses if the loss events cause mortgage defaults. According to a recent Actuaries Institute report, an estimated 15 per cent of Australian households face annual home insurance premiums that exceed four weeks of income – a 3 percentage point increase over the year to March 2024.[10] APRA is collaborating with other CFR agencies, the Insurance Council of Australia and the five largest general insurers to better understand how home insurance affordability may change over the medium term under different climate scenarios.[11] The Australian Government recently established the Insurance Affordability and Natural Hazards Risk Reduction Taskforce to understand the issues impacting insurance affordability and coordinate solutions to reduce risk from natural hazards.[12]

Risks from non-bank lenders are contained by the small size of the sector and their funding being sourced mainly from sophisticated investors.

The systemic importance of non-bank lenders is limited by the sector’s small size. Non-bank lenders – that is, lenders that are restricted from offering at-call deposits – account for 6 per cent of financial system assets. Registered financial corporations (RFCs) – which make up around half of non-bank lenders by size – increased their housing lending and business lending in the year to July 2024 (Graph 3.7). This growth is partly due to: favourable funding conditions, including in securitisation markets used by some RFCs; strong growth in lending to borrowers typically less serviced by banks, such as lending to self-managed super funds and novated leases; and a reduction in mortgage competition from banks over the past year.

Graph 3.7
Graph 3.7: Four panel time series graph. The top two panels show banks and non-banks housing loan growth and business loan growth in panel one and two respectively. The panels show non-banks housing loan growth increasing again and business loan growth remaining high. The bottom two panels show non-banks share of each of the respective loan markets (for the panel directly above). The third panel shows non-banks housing share relatively flat over the past year, and the fourth panel shows non-bank business loan share increasing over the past two or so years.

The sector lends to a growing proportion of Australian businesses. As of July, around 11 per cent of business lending and one-quarter of lending to small businesses was provided by RFCs. RFCs have expanded their share of business lending by targeting areas that are less serviced by banks, primarily lending to small businesses for purchases of plant and equipment (including vehicle financing). However, demand for this type of lending might ease, as investment growth is expected to moderate over the year ahead.

The level of non-banks’ housing lending arrears is not particularly elevated compared with the past decade. However, the share of RFCs’ housing lending that is in 90-day arrears has increased from the recent lows in 2022 to around 1 per cent and is higher than bank housing lending arrears (Graph 3.8). The increase partly reflects prime borrowers refinancing to banks over the period.

Graph 3.8
Graph 3.8: Time series graph of 90-day arrears rates for banks and non-banks housing loans in separate series. Shows both series trending up since 2022, with non-banks rising sooner and higher than banks.

Insights on non-bank lenders’ business lending asset quality is limited due to a lack of data. Liaison with some non-bank lenders suggests that some areas of stress are emerging, including in the construction sector and among borrowers with relatively low credit ratings for vehicle financing. These areas of stress are small and isolated, and liaison contacts do not expect them to become more widespread at this stage given the overall resilience of their borrowers to date and the expected resilience of the domestic economy in the period ahead.

Sophisticated investors are most exposed to non-bank lenders. The funding structure of RFCs tends to vary based on their business model.[13] RFCs that mainly provide residential housing lending or vehicle financing initially fund their lending mostly from banks (through warehouse facilities that provide credit for loans waiting to be packaged into a security) and then from securitisation markets once loans are packaged and sold to investors. Australian banks’ exposure to RFCs via warehouse facilities is small at around 1 per cent of banks’ assets. By contrast, RFCs that primarily lend to businesses are largely funded by equity and loans from specialist investment funds and high net worth individuals; such investors could be expected to be well placed to understand and manage the associated risks. These RFCs have higher capital levels than those funded mainly through securitisation, reflecting the credit risk associated with the loans they retain on their balance sheets; however, their capital levels vary widely.

FMIs identify and manage a range of risks to ensure their critical services remain resilient.

FMIs and their participants have remained resilient despite the occasional outbreak of market volatility. Global equity volatility increased sharply in early August owing to concerns about a potential US recession and an unexpected interest rate rise by the Bank of Japan. While this caused margin requirements to increase at central counterparties in Australia, overall liquidity demands were less than those experienced during other periods of heightened volatility over recent years.

Robust operational risk management frameworks minimise the likelihood and severity of operational events and support recovery efforts when these events occur. Operational incidents at systemically important FMIs – such as ASX and LCH SwapClear – have the potential to propagate stress throughout the financial system. The RBA regularly engages with FMIs on the support arrangements they have in place to provide reliable clearing services. Various multi-year projects are underway that will significantly change the operating environment of FMIs operating in Australia, with the goal to improve their operational resilience. These include upgrades to ASX’s CHESS system, the migration of core services to the cloud and programs to strengthen defence against cyber-attacks.

Box: Initiatives to enhance operational resilience in Australia

Australian authorities are taking steps to support the operational resilience of the Australian financial system.

  • APRA has finalised the cross-industry guidance to support its Operational Risk Management Standard (CPS 230 Operational Risk), which focuses on the resilience of critical operations and strengthening third-party risk management.[14] The uplift aims to provide more confidence that financial service providers are able to quickly recover critical customer services and activities in the event of an operational disruption. A key element is ensuring third parties are managing risks in accordance with the risk appetites of the entities they serve.
  • Under the Industry Resilience Initiative, APRA and the other CFR agencies are working with financial institutions to explore strategies to address a potential significant outage that impacts payments availability and might affect customer confidence. Initial focus has been on short-term continuity of customers’ access to cash and card payments during multi-day outages.
  • In 2023, the RBA extended its oversight of the safety and resilience of payment systems from systemically important payment systems to include ‘prominent’ payment systems. Prominent payment systems are defined as systems where an outage could cause significant economic disruption and damage confidence in the financial system (even when this damage might not result in a threat to financial stability). Currently, the Payments System Board has determined that the New Payments Platform, eftpos, Mastercard, Visa and the Bulk Electronic Clearing System meet these criteria.[15]
  • To complement the work on the resilience of individual payment systems, the RBA is conducting analysis of the resilience of the payments system as a whole.
  • The CFR continues to run the Cyber Operational Resilience Intelligence-led Exercises program, led by the RBA, which assists in raising cyber resilience testing capabilities and highlighting cyber resilience strengths and weaknesses in the financial industry.
  • Separately, in March 2024, the RBA hosted a tabletop cyber-attack simulation exercise with a range of industry stakeholders that rehearsed the coordinated response to a hypothetical cyber event that affected the Australian payments system. The exercise identified opportunities to improve industry coordination plans and industry-wide communication protocols.
  • The RBA and other CFR agencies have also been participating in whole-of-government scenario exercises to strengthen agency coordination and enhance industry resilience to large-scale cyber-attacks.

Endnotes

See APRA (2024), ‘APRA Proposes Update to Bank Capital Framework to Strengthen Crisis Preparedness’, Media Release, 10 September. [1]

See APRA (2024), ‘APRA Proposes Targeted Changes to Strengthen Banks’ Liquidity and Capital Requirements’, Media Release, 24 July. [2]

RBA (2024), ‘Liquidity Facilities’, Technical Note. [3]

See Debelle G (2011), ‘The Committed Liquidity Facility’, Speech to the APRA Basel III Implementation Workshop 2011, Sydney, 23 November. [4]

See Choudhary R, S Mathur and P Wallis (2023), ‘Leverage, Liquidity and Non-bank Financial Institutions: Key Lessons from Recent Market Events’, RBA Bulletin, June. [5]

The extent to which different types of superannuation funds amplify shocks in the financial system is likely to differ. For example, the ability to amplify shocks could vary between self-managed super funds and superannuation funds regulated by APRA due to differences in their typical asset allocations. [6]

See Aziz A, C de Roure, P Hutchinson and S Nightingale (2022), ‘Australian Money Markets through the COVID-19 Pandemic’, RBA Bulletin, March. [7]

During the pandemic, superannuation funds’ demand for liquid assets increased as members switched their portfolio allocations to cash and other low-risk investment options. At the same time, funds had to draw on their liquid asset buffers to meet cash outflows from the Early Release Scheme, which allowed some members to withdraw early from their superannuation balances, and margin calls on their currency hedges. See RBA (2021), ‘Box C: What Did 2020 Reveal About Liquidity Challenges Facing Superannuation Funds’, Financial Stability Review, April. [8]

See APRA (2023), ‘APRA Publishes Final Investment Governance Guidance’, Media Release, 20 July. [9]

See Actuaries Institute (2024), ‘Home Insurance Affordability and Home Loans at Risk’, Report, August. [10]

See CFR (2024), ‘Council of Financial Regulators Climate Change Activity Stocktake Paper 2024’, September. [11]

See Jones S (2024), ‘Insurance Affordability and Natural Hazards Risk Reduction Taskforce’, Media Release, 31 May. [12]

See Hudson C, S Kurian and M Lewis (2023), ‘Non-bank Lending in Australia and the Implications for Financial Stability’, RBA Bulletin, March. [13]

See APRA (2024), ‘APRA Finalises Cross-industry Guidance on Operational Resilience’, Media Release, 13 June. [14]

RBA (2024), Payments System Board Annual Report, September. [15]