The risks to the Australian financial system remain firmly rooted in our property sector, reflecting key risks to residential and commercial property, while evidence has emerged that bank lending standards were not as strong as initially envisaged by the Reserve Bank.
“Recent investigations by regulators have revealed that standards were somewhat weaker than had originally been thought,” the Reserve Bank said in its bi-annual Financial Stability Review.
“In some cases, practices have not met prudential expectations, potentially placing lenders at risk of breaching their responsible lending obligations under consumer protection laws.”
Poor documentation and verification by lenders has, in many instances, led to borrowers receiving interest-only loans that they were not suitable for. Serviceability assessments appear to have been inadequate in some cases.
According to the RBA, “the common practice (and prudent) practice of applying a buffer to the interest rate used when calculating the allowable new loan size had in some cases been undermined by overly aggressive assumptions in other parts of the serviceability calculations”.
More recently, lending standards have strengthened in direct response to supervisory actions taken by both APRA and ASIC. There are now tentative signs that growth has begun to ease across the investor segment for residential real estate.
Since most of these steps have occurred over the past few months, they are yet to impact the quarterly statistics published by APRA with regards to loan-to-valuation ratios and low-doc or interest-only loans.
The recent steps to improve lending standards were long overdue, with the household debt-to-income ratio and house price-to-income ratio surging to a record high on the back of solid credit growth and lacklustre income growth.
But it isn’t all bad news, with many households taking steps towards reducing their personal risk to adverse developments in economic or financial conditions. Many borrowers continue to pay down their mortgage faster than required and, in the process, have built up an important buffer to offset the effects of a financial downturn.
Australia’s central bank is optimistic that tighter lending standards and the decision by our major banks to raise around $20 billion in new equity capital are steps in the right direction, which help to mitigate some of the more misguided lending that took place in the past couple of years.
But it isn’t just buyers who are at risk, with the Reserve Bank particularly concerned about the risks facing property development.
“The possibility of a downturn in some apartment markets has also increased risks for residential property developers,” the bank said. “Any such fall in prices would reduce developers’ equity in projects underway and increase the likelihood of settlement failures on pre-sold apartments in these areas.”
The risk of oversupply isn’t particularly large across the nation, but within specific segments, such as in the Melbourne and Brisbane CBDs, there is mounting evidence that we may be on the verge of a property overhang.
Risks have also been growing in commercial lending related to property, which “historically has been a common source of financial instability both domestically and abroad”. Prices have increased rapidly and yields have tumbled; oversupply is evident in both Perth and Brisbane office markets.
There is greater risk of price falls across most commercial property markets, and these risks would escalate if foreign demand was to moderate. That prices have increased despite the fact that vacancy rates remains fairly high suggests that there is an irrational element to recent purchases.
The total value of office, retail and industrial property transactions has increased considerably over recent years and is now 50 per cent higher than its pre-crisis peak. Foreign buyers have accounted for around one-third of new purchases during the past two years. The figures give a sense of why so many Australian businesses struggle to compete globally: when the cost of buying or leasing a property is so high, you start at a disadvantage.
Outside of the property sector, “risks to the financial system from non-financial businesses remain low and the sector’s finances are generally in good shape”. Business failure rates have fallen significantly across most industries and states over recent years.
Credit growth remains relatively soft -- too soft, in fact -- with many businesses continuing to deleverage. That’s prudent risk management given the ongoing challenges faced by the non-mining sector, though it may come back to haunt some businesses if they fail to take advantage of key opportunities.
According to the RBA, “the current environment of low demand for intermediated business debt creates a risk that banks may further relax lending standards in order to attract customers”. This could be thrown into the spotlight as banks are forced to raise lending standards and interest rates of residential mortgages.
To the extent that risk exists in the business sector, it relates to the mining sector. The sustained fall in coal, iron ore and oil prices have made a mess of the earnings and profitability of producers of these commodities, particularly those higher up the cost curve.
The direct risk to domestic banks from the resource sector is limited because “their exposure to the sector is fairly low, though it has increased in recent years”. Most of their debt is sourced from corporate debt markets rather than domestic banks, although foreign banks also play an important role.
We shouldn’t underestimate the risk of spillover effects from the fallout in commodity markets. There is a risk that the collapse in mining investment and fall in commodity prices could eventually spill over into residential and commercial property. The direct risk to banks from the resource sector may be limited but the indirect risk may be much higher and more difficult to identify.