Bank Of Ireland Mortgages

Another Tick for our Banks

The strength of Australia's banks, especially the big four, is better than first seems, judging by comments in the International Monetary Fund's latest report on the Australian economy.

Buried in the Fund's latest report is a big vote of confidence in the health and stability of the Australian banking system.

The IMF also reckons Australia's big four banks are so well capitalised that they could withstand a surge in home loans going bad and still maintain their capital levels at the minimum required by regulators.

That's a big difference to the US, UK, Ireland and several other countries where plunging home prices, mortgage sales and falling property values have wreaked havoc on capital levels and forced big capital raisings

The information in this report from the IMF is likely to underpin the analysis and commentary in the RBA's semi-annual Financial Stability Report to be released later this morning.

Australian banks and their health have been questioned by investors and commentators since the credit crunch erupted over a year ago, with nerves getting very frayed last week as the US financial system shook under rising pressures and soaring short term rates for cash.

As well a shortage of US dollars (hard to believe) caused short term interest rates to spike in the UK and Europe and forced the Fed into over a quarter of a trillion dollars US in currency swaps with central banks around the world (including Australia).

Some commentators fret about the level of debt in Australia and the house borrowing boom and the still high levels of prices and have warned of a debt binge driven slump.

But not so the chaps from the IMF.

They did admit that "Australia's banking system is sound, but some vulnerabilities remain." The banks were on the rollover risk in wholesale funding markets overseas with banks being forced to pay a lot more for new funds as existing loans rollover and have to be renewed.

But the IMF said "The authorities' response to the credit market turmoil has been timely and fitting, with the RBA providing liquidity support and APRA intensifying its monitor of banks.

"The four large banks remain profitable and well capitalized, but the turmoil highlighted their vulnerability to rollover risks arising from short-term wholesale funding.

"The planned introduction of liquidity guidelines will be helpful to reduce the risk of disruptions arising from loss of access to offshore funding.

"Requiring the publication of more detail on the maturity structure of banks' funding, especially from offshore markets, would also encourage banks to reduce their exposure to rollover risk."

"APRA plans to introduce liquidity guidelines with a focus on improved disclosure and stress testing.

"The aim should be to encourage banks to reduce the risk of disruptions from restricted access to wholesale markets by diversifying their funding sources, lengthening the maturity of their funding, and holding sufficient liquidity.

"The staff advised that requiring banks to publish more detail on the maturity structure of their funding, especially from offshore markets, would impose additional discipline."

(That's a good news story on moves by the key regulators to force the banks to upgrade their disclosure on liquidity and funding.)The IMF said that "Banks are exposed to households, but appear resilient to an increase in default rates on mortgages. Households have become increasingly indebted, with debt reaching almost 160 percent of disposable income and debt-servicing costs at about 14 percent of disposable income.

"As more than half of banks' loans are mortgages, banks' asset quality would likely deteriorate with a large increase in interest rates, rise in unemployment, or fall in house prices.

"Staff analysis show that a very large increase in default rates (to 10 percent of all housing loans) would be required to reduce capital ratios of the four major banks below 8 percent.

"Moreover, staff estimates suggest that house prices are only moderately overvalued (5-15 percent) and that continued strong immigration and household income growth could increase equilibrium house prices."

The IMF points out that to get a 10% default rate on all housing loans would require "a default on about half of mortgages with loan to value ratios of over 80 percent".

House loans with an LVR of 80% or more are among the most stretched, but at the moment Australian banks have an arrears rate of 0.2% for impaired assets (including housing) and small banks a rate of 0.50%.

But in the most interesting stress test, the IMF says that its staff "using extreme stress test scenarios applied to the large banks suggests that they could suffer a significant fall in profits from an increase in funding costs associated with loss of access to offshore markets for 90 days, but that their capital would remain adequate."

"This scenario is more severe than anything that Australian banks have had to face to date. As a result of the loss of access to offshore markets, banks have to refinance their offshore liabilities due in less than 90 days domestically.

"In the most severe case where all wholesale funds (domestic and offshore) due in less than 90 days have to be refinanced at an interest rate that is 500 basis points higher than before the shock, the aggregate capital ratio for the system only falls to 8 percent.

"The worst affected among the four large banks has the capital ratio drop to 7 percent.

"Banks' profitability suffers a more serious hit, which is not surprising, given their heavy reliance on short-term wholesale funding. Nevertheless, it takes a 500 basis points increase in interest rates on liabilities to generate losses for banks."

In other words, if that was to happen now, wholesale interest rates would have to rise to well above 12% (indicating mortgage rates above 15%) for three months for there be any significant damage to bank capital levels and the amount of capital in the financial system as a whole.

"That assumes the banks can't get any money from offshore in that period, which hasn't happened so far.

Even when the stress tests were applied at even more intense levels, the IMF team said the results showed the resilience of the system

"Even in a more extreme case where the interest rates on all deposits (including checking) also rise by 500 basis points, the aggregate capital ratio drops to 5 percent for the system, and to 5 percent for large banks.

"While this is a significant reduction in capital, the fact that the banks are able to maintain their capitalization ratios above 5 percent under a shock of that magnitude (and under a number of conservative assumptions that were made) underlines the resilience of the system.

"All four large banks were analyzed individually, and were shown to be sufficiently sound to handle a large interest rate shock. Small banks, however, were only looked at as a group.

"Some of these banks have smaller deposit bases, rely more heavily on securitization, and could be more vulnerable to certain shocks. Nevertheless, given their small size and the strong aggregate results, they are also not likely to present a threat to systemic stability."

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