Financial Stability Review – September 20241. The Global and Macro-financial Environment

1.1 Key developments

In most advanced economies, households and businesses have remained resilient despite continued pressure from high inflation and interest rates.

Savings buffers and labour income have continued to support households’ debt-servicing ability. Strong labour markets have been key in maintaining the resilience of households. However, in many advanced economies unemployment has risen, and some central banks are increasingly focused on the risk of a sharper-than-expected softening in labour market conditions. In some economies – including Canada, the euro area and the United Kingdom – saving ratios have increased a little alongside a pick-up in real wage growth (Graph 1.1). Mortgage debt-servicing ratios have increased in several advanced economies, as households have had to refinance fixed-term mortgages taken out during the pandemic at higher rates. Regulators in Japan and the United Kingdom have noted a growing proportion of households with high mortgage debt-servicing ratios. This refinancing has largely occurred in Australia, but a significant portion of households in Canada and the United Kingdom will need to refinance onto higher rates over 2025 and 2026. Across most advanced economies households have adjusted to higher interest rates by reducing consumption; and in Canada, New Zealand and the United Kingdom, households have opted for longer term mortgages or drawn down on prepayment buffers.

Indicators of household financial stress continue to increase, but from low levels. Overall, households have remained resilient to the effects of high interest rates and inflation. However, pockets of stress remain, and debt-servicing and cost-of-living pressures continue to disproportionately affect lower income households. Mortgage arrears in most advanced economies have risen modestly from low rates (Graph 1.2). In the euro area, Canada and the United Kingdom, lower income households and renters have increasingly accessed consumer credit to support consumption and manage cost-of-living pressures. While consumer credit arrears have exceeded pre-pandemic levels in some economies, consumer credit comprises less than 20 per cent of bank lending to households in most advanced economies.

Strength in housing prices continues to support household balance sheets, but valuations remain around the top of their historical ranges in some economies, creating potential vulnerabilities. Housing prices have continued to increase or stabilise across most advanced economies, supported by strong labour market conditions, high immigration and a structural undersupply of new housing (Graph 1.3). This can help mitigate lenders’ losses in the case of loan default, as has been noted by regulators in Canada and New Zealand, where most homeowners have positive equity in their homes despite housing prices being below recent peaks. However, the Bank of Japan, the European Central Bank (ECB) and the US Federal Reserve have expressed concerns that elevated housing prices in their economies could make them more vulnerable than usual to large declines. Should prices fall, this would put more homeowners into negative equity and increase the risk of losses to banks in the event of a default.

Corporate debt-servicing capacity continues to be supported by robust earnings and cash buffers. Strong earnings have bolstered listed corporates’ balance sheets in advanced economies, while cash buffers at listed non-financial corporates are still above or close to their long-term average levels, despite having declined from their pandemic highs (Graph 1.4). Most borrowers have been able to roll over their debt without severe difficulties, supported by accommodative financing conditions; year-to-date corporate bond issuance has been strong. Spreads on investment grade and speculative grade corporate bonds remain around the lower end of historical ranges, suggesting markets anticipate low risk of default among issuing firms.

However, some borrowers are experiencing increased stress, and higher risk corporations are likely to face challenges refinancing in coming years. Default rates for floating rate leveraged loans (which are often used to fund corporate buyouts) are elevated, due in part to more complete pass-through of higher rates to financing costs (Graph 1.5). However, most of the defaults are still concentrated among smaller issuers; and so far, stress among non-bank financial institutions (NBFIs) – which hold a large portion of this debt – has not increased. Speculative-grade borrowers may find refinancing more challenging in 2025 and 2026: a large amount of European and US corporate debt is due to mature and policy rates are expected to be above levels seen over the past decade, notwithstanding the expected easing by central banks.

Private equity markets, which have increased in significance as a source of finance for many companies, are experiencing lower activity in part due to higher interest rates. This likely means that debt will be refinanced at higher rates over the medium term, adding further pressure on these firms. To address this issue, private equity sponsors are turning to alternative funding sources or restructuring the debt. These methods aim to extend the lifespan of highly leveraged assets until market conditions improve and thus allow private equity sponsors to exit at a better price. However, if market conditions continue to deteriorate, further restructuring or an increase in default rates may occur.

High interest rates and weak demand continue to weigh on CRE prices, although the decline has been orderly to date, and conditions have become more variable across market segments. The shift to remote work and online shopping has resulted in structurally lower demand for CRE, causing elevated vacancy rates. CRE prices in advanced economies have decreased further over the past year; in Europe and the United States, they have fallen by more than 20 per cent from their most recent peak (Graph 1.6). In the United States, CBD offices have led price declines over the past year, while the industrial sector has picked up and retail sector valuations appear to have stabilised. Furthermore, nearly US$500 billion in CRE debt is set to mature each year over the next five years. Many of these loans were originated when policy rates were very close to zero and will experience a sharp increase in repayments when they are refinanced at higher rates. Lenders, including in Australia and the United States, continue to report that they are actively working with borrowers to manage their loan terms and offering repayment flexibility where required to avoid default. However, risks to the sector remain elevated and holders of CRE debt could incur further losses. Real estate investment trusts, for example, continue to hold large amounts of CRE assets and could be forced into fire-sales of assets to meet liquidity demands if large redemption requests arise.

Banks are expected to remain resilient even amid a downturn in economic conditions.

Bank capital ratios in advanced economies remain above regulatory minimums and regulators assess that they would remain resilient in the event of a severe economic downturn. Supervisory reviews in advanced economies indicate that all but a few small banks would maintain adequate Common Equity Tier 1 ratios even in the case of a severely adverse economic downturn. Bank profits in advanced economies have continued to support capital buffers, which are well above regulatory minimums. Net interest margins (NIMs) have recovered as banks have been able to raise the interest rates charged to borrowers by more than the increase in their funding costs during the current tightening cycle (Graph 1.7). Additionally, non-interest revenue (such as investment banking fees) has increased alongside the pick-up in brokerage and merger and acquisition activity over the first half of 2024, further supporting bank earnings. Liquidity coverage ratios remain steady and above regulatory minimums, although the banking stresses in the United States and Switzerland in early 2023 demonstrated that deposit outflows can occur more rapidly than anticipated under current regulatory frameworks.^[1]

Banks continue to increase provisions in anticipation of future loan losses, even though the share of non-performing loans (NPLs) remains broadly steady and low by historical standards. Provisions have increased slightly in most advanced economies, except the euro area and the United Kingdom, while the share of NPLs remains steady and well below historical levels. Given the weakness in CRE market fundamentals (see above), banks – particularly in the United States, where exposures are largest – have increased CRE provisions in anticipation of higher loan losses, though the share of NPLs has increased only very marginally. Lenders are especially concerned about consumer credit, particularly in the United States, with recent US bank earnings reporting that credit card delinquency rates have increased by around 1½ percentage points over the recent tightening cycle.

1.2 Key vulnerabilities that could affect financial stability in Australia

Threats originating from outside the international and domestic financial system, including geopolitical risks and risks associated with climate change, continue to build. Geopolitical tensions in Ukraine and the Middle East are high, and there is policy uncertainty associated with upcoming elections that could result in further geopolitical fragmentation. Climate change presents both physical and transition risks, which could result in unexpected losses for lenders, increased claims on insurers and write-downs for investors.^[2] These risks from outside the financial system have the potential to adversely interact with vulnerabilities in the global financial system, including through damage to digital financial infrastructure and disruptions to global saving and investment flows. The importance of these issues was highlighted at the most recent Council of Financial Regulators (CFR) meeting, where members agreed that non-traditional risks to financial stability – including geopolitical risk, operational risk relating to digitalisation, and climate change – require ongoing vigilance by industry and are areas of heightened regulatory focus.^[3]

Digitalisation is leading to a financial sector that is dependent on increasingly complex and interconnected operational systems.

Digitalisation is transforming the provision of financial services. Technological innovation is expanding the set and changing the delivery of financial services and products available, facilitating the entrance of new providers, and changing the ways that risks arise and are managed.^[4] An example of this is the exploration of generative AI applications in the financial system (see 4.1 Focus Topic: Financial Stability Implications of Artificial Intelligence). As a result of digitalisation, the financial system is becoming more technologically complex and interconnected and the vulnerability to, and impact from, technology outages and cyber-attacks is increasing.^[5]

Recent incidents highlight the growing complexity of IT systems, reliance on third parties and importance of operational resilience. Recently, there have been two operational incidents of note at third parties that provide services to companies across the globe that have highlighted critical interdependencies on third-party providers (see Box: Recent operational incidents at third parties). While the impact on the Australian financial system was minimal, these incidents demonstrate how operational issues at different points in the ecosystem can affect the functioning of the financial system as a whole. The outages at retail brokers during the recent global market volatility, which affected retail investors’ ability to trade at a critical time, provides another example.^[6]

Box: Recent operational incidents at third parties

In July 2024 there were two significant incidents at third parties that had the potential to materially affect segments of the Australian financial system. Both incidents were caused by operational issues at the third-party provider, rather than malicious attacks.

Swift

An incident occurred on 18 July at Swift and had a moderate impact in Australia. Swift provides critical services to financial institutions and financial market infrastructures across the globe. It is a cooperative organisation that operates a global network for the exchange of payment and other financial messages between financial institutions. The incident disrupted the exchange of particular types of financial messages for a number of hours. As the incident occurred outside the Australian business day, its impact on payment systems in Australia was minor. However, it caused significant delays to high-value and time-sensitive payments in the United Kingdom and euro area.

CrowdStrike

An incident originating from CrowdStrike occurred on 19 July and, in Australia, primarily disrupted a subset of end users’ ability to access the financial system. It has been estimated that over 8.5 million devices were affected worldwide by the CrowdStrike incident, with disruptions across all sectors of the economy, including emergency services, aviation, health, financial services, public transport and supply chains. The incident occurred when CrowdStrike, a third-party provider of cybersecurity software to end customers, pushed out a faulty update that caused workstations and servers running Windows operating systems to restart continuously. The CrowdStrike incident had no material impact on systemically important financial market infrastructure in Australia. Yet, it did affect the functioning of some payment systems and services offered by payment system providers. For example, there were reports of disruptions in access to the New Payments Platform and/or PayID for specific institutions, and point-of-sale terminals were disrupted for certain retailers, leading to reliance on cash or temporary closures by retailers. An initial fix was available in under two hours and most Australian financial institutions had remediated their issues by the following morning. The remaining issues at Australian banks were remediated by that afternoon.

CFR agencies monitored the CrowdStrike incident closely. In response to phishing campaigns and misinformation targeting those affected by the event, regular updates encouraging greater vigilance to scam attempts were provided via the ACCC’s ScamWatch website, government social media channels and financial institutions.

Low risk premia in global credit and equity markets leaves them vulnerable to a disorderly adjustment.

Inflation in advanced economies has moderated and global financial market participants generally continue to expect a soft landing in the global economy. The moderation in inflation has prompted many central banks to lower their policy rates, and market participants expect most other advanced economy central banks – aside from the Bank of Japan – to begin lowering policy rates in coming months. To date, this has occurred under generally modest rises in unemployment rates across many advanced economies, supporting hopes of slowing inflation without a material economic slowdown.

However, in recent months strong (though temporary) negative reactions have followed the release of disappointing economic data. The central expectation for many economies, including Australia, remains a modest economic cycle, but this outcome is by no means assured. Global economic news perceived to be inconsistent with a modest economic cycle led to a bout of heightened volatility in early August. The release of weaker-than-expected US labour market data was followed by sharp moves in equity and currency markets, with the volatility in the US equity markets reaching levels not seen since the start of the pandemic and Japanese equities experiencing their largest ever three-day fall (Graph 1.8). This occurred in a seasonal period of low liquidity, but the market moves were also amplified by leveraged trading positions, which had been built up amid the low volatility in recent years.^[7] While this episode did not result in outright market dysfunction and the market moves have largely been retraced, the structural features that amplified volatility remain; risk-taking in financial markets remains elevated, and there is evidence that some leverage positions have been rebuilt.

Risk premia in global credit and equity markets are low by historical standards, and leave asset prices susceptible to a disorderly adjustment, particularly if prospects for a soft landing fade. Investment grade debt spreads are close to historical lows, and most sub-investment grade spreads are also low, except for small pockets of riskier borrowers. In equity markets, particularly in the United States, numerous valuation metrics are around historical highs. While these metrics are not as extreme as those observed during the 2000 dot-com bubble, they are sensitive to growth assumptions, leaving equity markets vulnerable to sudden repricing if global growth expectations were to be revised down sharply. Valuation metrics have been especially elevated for companies whose revenue projections are closely tied to the application of AI. Should a correction in valuations occur, spillovers could be exacerbated by the concentration to AI-exposure in investor portfolios. This has the potential to lead to disruptions in key international funding markets that transmit to Australia via financial linkages and an increase in risk aversion.

Risk premia in advanced economy sovereign bond markets could also widen sharply if large increases in the issuance of government debt, and the absence of strong fiscal frameworks, leads to concerns over debt sustainability. Across advanced economies, sovereign indebtedness remains above pre-pandemic levels, and has risen significantly in some economies since the global financial crisis (GFC). Fiscal support provided in the wake of the GFC and during the pandemic explains part, but not all, of this increase; it is historically unusual to observe large fiscal deficits outside of wartime. Sovereign interest burdens have risen in the United States and the United Kingdom (Graph 1.9, left panel). Upcoming elections across several advanced economies, including in the United States, have also increased uncertainty around the medium-term trajectory of sovereign debt levels (and thus future borrowing needs). As in most other economies, Australian Government debt levels and interest costs have increased since the pandemic (as have state and territory borrowing) but are relatively low by global standards (Graph 1.9, right panel).^[8] Demand for sovereign bonds from investors locking in higher yields ahead of a significant expected easing in monetary policy has kept sovereign risk premia contained for much of this year. However, the International Monetary Fund and the Bank for International Settlements continue to highlight concerns over medium-term debt sustainability challenges in a number of large advanced economies, following the stress in the United Kingdom bond market in September 2022.^[9]

NBFIs’ leverage and interlinkages with banks could amplify shocks, as highlighted in recent years. Highly leveraged investment strategies used by NBFIs – such as FX carry trades and the US Treasury cash-futures basis trade – have the potential to amplify market dysfunction.^[10] Interconnectedness between banks and NBFIs, through direct lending and common asset holdings, increases contagion risk. Another recent focus area for authorities globally has been the small, but rapidly growing, private credit sector, where the lack of visibility over leverage and interlinkages has raised financial stability concerns (see Box: Growing risks from the global private credit market).

Vulnerabilities in the Chinese financial sector could spill over to the rest of the economy, and to Australia and the world, through trade and global risk aversion channels.

Some Chinese banks and non-bank lenders remain under pressure amid a further deterioration in the Chinese property market. Despite various policy actions, growth in new residential property prices declined further to reach its weakest pace since January 2015, and construction activity in the sector remains very low. This has contributed to further stress among property developers, with more large developers entering liquidation in recent months. Banking sector exposures to the property sector remain substantial and asset quality has deteriorated. And while reported NPL ratios remain low and stable, some commentators have suggested these ratios are under-reported.^[13] The share of loans overdue by more than a year, thus categorised as a ‘loss’, has grown across all categories of banks – particularly large and city banks – over the three quarters to June 2024 (Graph 1.11). Loan write-offs have also accelerated.^[14] NIMs continue to fall across all bank categories, reflecting weak profitability.

Chinese authorities have recently expressed concern over interest rate risk among financial institutions. The People’s Bank of China (PBC) has raised concerns about large holdings of long-term bonds by non-banks, including the wealth management sector, and emphasised the need for financial institutions to adequately monitor interest rate risk at a time of low interest rates. Additionally, the PBC has issued guidance to regional and rural banks to curtail holdings of ultra-long-term bonds amid historically low bond yields and recently intervened in bond markets, aimed at steepening the yield curve. The PBC has noted that large holdings of fixed-income securities at low yields could give rise to financial stability challenges if yields were to increase, while also noting that low yields do not accurately reflect the state of the broader Chinese economy. At the same time, vulnerabilities in the financial sector related to local government debt appear to have eased for the time being. Authorities carried out a debt swap program, resulting in the refinancing of a portion of the local government financing vehicles’ debt in highly indebted regions. Nevertheless, the absolute size of outstanding local government debt remains large, and local government reliance on debt issuance and revenues from real estate development activity, poses a major challenge for the authorities.

Stress in China’s financial system could affect the global financial system, including Australia, via slower economic growth and increased risk aversion in financial markets. The direct links between the Australian and Chinese financial systems are small; this is also true for most other advanced economies. The key channels of transmission of financial stress in China to Australia would likely be via increased risk aversion in financial markets, a sharp slowing in global economic activity, lower global commodity prices and reduced Chinese demand for Australian goods and services.

Endnotes

Basel Committee on Banking Supervision (2023), ‘Report on the 2023 Banking Turmoil’, October. [1]

Jones B (2023), ‘Emerging Threats to Financial Stability – New Challenges for the Next Decade’, Speech at the Australian Finance Industry Association Conference, Sydney, 31 October. [2]

Council of Financial Regulators (2024), ‘Quarterly Statement by the Council of Financial Regulators – September 2024’, Media Release No 2024-04. [3]

Basel Committee on Banking Supervision (2024), Digitalisation of Finance, May. [4]

RBA (2023), ‘5.5 Focus Topic: Operational Risk in a Digital World’, Financial Stability Review, October. [5]

Schmitt W and M Darbyshire (2024), ‘Retail Brokers Hit by Outages during US Stock Sell-off’, Financial Times, 6 August. [6]

Aquilina M, M Lombardi, A Schrimpf and V Sushko (2024), ‘The Market Turbulence and Carry Trade Unwind of August 2024’, BIS Bulletin, 90. [7]

Batchelor S and M Roberts (2024), ‘Recent Developments in the Semi-government Bond Market’, RBA Bulletin, January. [8]

See, for example, International Monetary Fund (2024), ‘Chapter 1: Financial Fragilities along the Last Mile of Disinflation’, Global Financial Stability Report, April; Bank for International Settlements (2024), ‘I. Laying a Robust Macro-financial Foundation for the Future’, BIS Annual Economic Report, June. [9]

An FX carry trade generally involves borrowing money in a low-yielding currency and investing in a high-yielding currency – that is, taking a leveraged position on the interest differential between two markets. The impact of unexpected high volatility on carry trade returns is discussed in Menkhoff L, L Sarno, M Schmeling and A Schrimpf (2012), ‘Carry Trades and Global Foreign Exchange Volatility’, Journal of Finance, 62(2), pp 681–718. The US Treasury cash-futures basis trade involves exploiting the price differential between Treasury securities and the related Treasury futures contract by purchasing the asset that is undervalued and selling the other on the assumption that prices between the two assets will converge on maturity. There has been a resurgence in the US Treasury cash-futures basis trade in recent years. See Glicoes J, B Iorio, P Monin and L Petrasek (2024), ‘Quantifying Treasury Cash-Futures Basis Trades’, FEDS Notes, 8 March. [10]

For further details on the private credit market, including estimates of the size of private credit markets in Australia, see Chinnery A, W Maher, D May and J Spiller (forthcoming), ‘The Recent Growth in Global Private Credit’, RBA Bulletin. [11]

Cai F and S Haque (2024), ‘Private Credit: Characteristics and Risks’, FEDS Notes, 23 February. [12]

See, for example, Charoenwong B, M Miao and T Ruan (2023), ‘Non-Performing Loan Disposals without Resolution’, Management Science, 25 October. [13]

These developments may reflect: ongoing implementation of changes that were made in 2023 to the loan classification system; broader economic weakness, including in the property sector; and a hangover from pandemic-era loan forbearance. [14]