RDP 2001-06: The Effect of Macroeconomic Conditions on Banks' Risk and Profitability 1. Introduction

The principal source of banking fragility is credit risk: the risk of loss resulting from counterparty default. This paper compares the relative contributions of interbank variation and the variation through time to the overall variability in Australian banks' credit risk. A simple model, which imposes the constraint that each bank responds to macroeconomic developments in the same way, is used to examine the ability of macroeconomic variables to explain movements in individual banks' risk. Since consistent data on banks' credit risk are only available since 1990, discussion of banks' credit risk during the 1990s is supplemented with analysis of the rate of return on assets earned by banks since the 1960s.

While most of the variability in banks' credit risk and profitability is due to differences between banks, macroeconomic variables are found to exert a strong influence on each bank's risk and profitability. In particular, the share of interest payments in the corporate and household sectors' income, real credit growth and property prices are most strongly correlated with banks' risk and profitability.

These findings offer support to three strands of theoretical analysis of the interaction between financial institutions and the real economy. Firstly, the effect of real credit growth on banks' credit risk and profitability is in line with the view that difficulties in monitoring bank performance can lead banks to weaken their credit standards in times of rapid expansion of aggregate credit. Secondly, the observed relation between property prices and bank risk supports the proposition that the difficulties banks have in monitoring borrowers' viability (and the effect of collateral values in signalling borrower credit worthiness) play an important role in determining the supply of credit. Thirdly, our results are consistent with theoretical analysis suggesting that cyclicality in agents' preferences for gearing is an important influence on bank risk and profitability.

The following section discusses the potential sources of variation in banking risk and profitability. The third section presents an analysis of banks' credit risk during the 1990s. A longer-run analysis of bank profitability is presented in the fourth section. Section five concludes.