Financial instability: Prevention is better than cure
Wayne Byres, Chairman – Remarks to the European Australian Business Council, Melbourne.
APRA recently issued its four-year Corporate Plan for 2019-2023. In it, we called out four key outcomes we will be seeking to deliver for the Australian community: maintaining financial stability and resilience within the financial system; improving member outcomes in superannuation; transforming governance, culture, remuneration and accountability in the financial sector; and improving cyber resilience.
The vast bulk of the questions and media coverage we received on the Plan related to the last three. Despite the volatile and somewhat perilous macro and geopolitical environment in which we are operating, there was less interest in financial stability and resilience.
So I would like to use my time today to make some remarks on that somewhat forgotten topic. I am doing that because it’s useful to remind ourselves every now and again about how vital financial stability is. And, particularly for this audience, a simple comparison of the Australian and European financial and economic experience since the global financial crisis shows how important it is to get policy settings for financial stability right. It is a good reminder on why stability shouldn’t be taken for granted.
To briefly recap the different experience:
- The return on equity (RoE) of the Australian major banks has certainly declined but has not fallen below 10 per cent, even during the GFC, and is now in the order of 12 per cent; for large global European banks, RoE was negative at the height of the crisis, and has struggled to get much above 5 per cent since then.
- Reflecting this, the price-to-book (PTB) ratio of the Australian majors averages around 1.5x, and capital is readily available; for large European banks, PTB has typically been in the order of 0.5x and new capital is therefore expensive.
- In 2018, a decade after the crisis, the four Australian majors were ranked in the top 35 banks in the world by market capitalisation. Europe, despite a much larger banking system and population, only had four banks in the top 35.
- All four Australian major banks enjoy AA credit ratings, and ready access to funding; very few European banks (without explicit government support) enjoy similar ratings.
Australia’s ongoing economic prosperity has therefore been supported by a functioning banking system, intermediating savings and credit within the economy as needed. In contrast, parts of Europe continue to suffer from a banking system that remains fragile, and in places heavily dependent on on-going public sector support in one shape or form. This weakness in the banking system has impeded growth in the real economy, which in turn has fed back into weakness in the banking system. Even a decade after the onset of the crisis, it is proving a difficult cycle to break.
How did that divergent experience come about?
First, there was the pre-crisis positioning. Australian banks generally went into the crisis with strong balance sheets, and largely sticking to conventional commercial banking business models. The largest European banks had become much more leveraged and involved in investment banking activity, and a number of smaller institutions had invested heavily in high risk structured products to ostensibly diversify their local business risks.
Second, there was the impact of the financial crisis itself. Australia was on the periphery. Europe was at the epicentre, heavily impacted by the subprime crisis in 2008/09 and then mutating into the European debt crisis that consumed the Euro area for much of the next few years. It’s inevitable that bank balance sheet would be badly impaired in such circumstances.
Third, the immediate response. Australia had a large stimulus and extensive public sector support, as well as a major trading partner that continued to support economic activity. Europe struggled with the political dynamics of burden-sharing across the continent, and was far less well-equipped to respond collectively as contagion took hold.
And fourth, the economic aftermath of the crisis. Real GDP growth, as we know, has been positive in Australia over the whole period. Unemployment did rise initially from 4 to 6 per cent, but has been in that healthy range pretty much the whole time since. On the other hand, GDP in Europe fell more than 5 per cent at the height of the crisis, didn’t make it back to 2008 levels for another five years, and has struggled to sustain anything above 2 per cent growth for any length of time. Unemployment in Europe started at 6 per cent, rose sharply to 11 per cent, and has only slowly made its way back down. That has made it a very tough environment for European banking to recover.
In highlighting the contrasting experiences in Australia and Europe over the past decade, I do not want to sound hubristic. Rather, I want to highlight the cost of financial instability as large and long-lasting. And I particularly want to emphasise the importance of an unwavering focus on financial safety and stability given the current environment of macroeconomic vulnerabilities, geopolitical tensions and technological disruptions and threats. Now is not the time to take our eye off the ball.
Thankfully, as the storm clouds gather, the Australian banking system is broadly in good prudential shape. That reflects an unrelenting focus on steadily building resilience within the system.
First and foremost has been building balance sheet strength, primarily through bank capital. Australia was able to adopt the Basel III reforms without the long transitional arrangements necessary to protect fragile banks elsewhere. And APRA was then urged to do more by the 2014 Financial System Inquiry, which recommended ‘unquestionably strong’ policy settings. We advocated that banks seek to achieve our unquestionably strong benchmarks by the beginning of 2020. By and large, it appears that will be achieved. Australian banks have therefore been on a journey of building capital strength for much of the past decade.
But that is not the end of the capital story. As much as the aggregate amount of capital is important, equally important is how it is allocated to different types of loans. We are continuing a major reform of the capital framework, designed to better allocate capital to risk, and to improve the framework’s transparency, comparability and flexibility. Without getting into great detail, one important impact will be to lift capital requirements against mortgage lending relative to other types of lending, reflecting amongst other things the concentration in mortgages that is evident in the balance sheet of the Australian banking system.
That provides a natural segue to mortgage lending standards. It is not enough just to make sure there is appropriate capital held against mortgage risks. If there is a concern about poor quality lending, the best solution is to improve the underlying lending standards themselves. Back in 2014/15, we were concerned that the banking system was not responding prudently to an environment of high house prices, high household debt, low interest rates, and subdued income growth. Speculative activity was increasingly prominent. Such an environment would, one might think, see prudent bankers trimming their sails and battening down the hatches. Instead, intense competitive pressures across the industry saw a tendency for standards go by the wayside – for lenders, it was full steam ahead.
We therefore felt it necessary to intervene quite firmly to drive standards back to more prudent levels, in keeping with the external environment. In parallel, the Australian Securities and Investments Commission (ASIC) intensified its focus on responsible lending. The result has been, in recent years, a much more disciplined approach to lending.
We now find ourselves at an interesting juncture. With lending standards more robust, we have been able to remove the major temporary benchmarks that we introduced in earlier years. The downward adjustment in prices has occurred in an orderly fashion and been positive for stability. However, it is worth remembering that the original risks we were concerned about in 2014 – high prices, high debt, low interest rates and subdued income growth – have not gone away, and in some cases increased. When it comes to the supply of credit, it would therefore be unwise for lending standards to be allowed to erode again as a means of generating lending growth. And on the demand side, it would be unhelpful if recent (and prospective) interest rate reductions led to a resurgence in speculative activity.
Which brings me to low interest rates, something Australian banks are having to get used to. For European banks, of course, it is nothing new – Europe has operated with its interest rate on the ECB’s main refinancing operations at 1 per cent or below since late 2011, and zero since early 2016.
In that regard, the European experience illustrates some of the challenges potentially ahead for Australian banks. A very low interest rate environment will see margins squeezed, adding to the headwinds from slow lending growth. Profitability, and therefore capital generation, will come under more pressure. And given their different funding profiles, these trends may well impact smaller banks more forcefully than larger ones, reducing the ability of the former to apply competitive pressure to the latter. But to be clear, neither group will welcome further rate reductions.
For our part, we have always assumed low rates within our stress testing scenarios. Typically, low rates have been seen as a mitigant to periods of economic adversity. But we will need to think harder about the path and impact of interest rates given the current starting position in Australia. And even without a period of stress, we will also need to think harder about the impact on business models and business lines of a very low interest rate environment persisting for a lengthy period of time.
Finally, I’d like to make a quick comment on trans-Tasman arrangements, given the presence of the Australian banks as the shareholders of the major banks in New Zealand. Both regulators – APRA and the RBNZ – are in the process of substantial reforms, designed to ensure each fulfils its respective mandate. There has been some suggestion that this reflects some kind of falling out between us, or evidence of trans-Tasman one-upmanship. In fact, the opposite is the case.
The relationship between APRA and the RBNZ is strong, and we communicate frequently at all levels. The processes underway are a natural by-product of both regulators working to protect their respective communities from the costs of financial instability. In New Zealand’s case, there is an understandable desire to have greater ex ante protection in the form of higher capital on the ground in New Zealand. And in APRA’s, we have sought to make sure that our changes in relation to intra-group exposures (which I should note apply generally, and not just to New Zealand banking subsidiaries) allow New Zealand’s objectives to be achieved without jeopardising the unquestionably strong capital requirements that ultimately protect Australian depositors. The result will, in all likelihood, be higher capital requirements in New Zealand, funded by the retention of profits from the New Zealand business. We are entirely comfortable with that.
All up, it is a challenging time. The banking system is resilient, but no system founded on fractional reserve banking is crisis-proof. I’ve mentioned some of the issues we are currently grappling with. Time has not permitted me to cover others, such as the potential for shocks from geopolitical tensions, technology failures or cyber-attacks. But hopefully I’ve made the point that financial stability doesn’t happen by chance. And looking at the European experience over the past decade, it is not something we should neglect or take for granted. To put it simply, experience tells us loudly and clearly that prevention is far better than cure.