The Financial System 25556

Topic 1 Australias banking system and the global financial crisis

Use the data presented in the RBAs September 2008 Financial Stability Review to describe the financial position of Australias banking system as at September 2008 and explain the main impacts of the GFC on Australias banking system.

Overview The past decade has seen the global banking system experience optimal conditions in the market with high interest rate margins, shrinking equity risk premiums and rising asset values. However the onset of the global credit crunch in July 2007 has seen the emergence of challenging conditions where every favourable factor seems to be simultaneously reversing. Thus the new riskier, falling asset value economy has had major negative effects on the banking systems worldwide. As a result the deteriorating economic circumstances have seen Australian banks underperform in comparison to previous periods, since the onset of the GFC. Emergence of the GFC The GFC largely emerged from the market impact of the US sub-prime crisis that resulted from US banks declining credit standards and reliance on the predicted increase in housing values. However the banks failed to speculate that what goes up must eventually come down, which is exactly what happened due to increased loan defaults causing a surge of excess housing supply on the market and consequently decreasing housing prices. This trend snowballed, creating toxic loans, as outstanding loan values became even greater than the falling house values causing the loan defaults to escalate further. The losses on the housing loans decreased return on Mortgaged Backed Securities (MBS) in the market and in turn their prices fell as the required market yield for MBS, increased due to the increasing risk. This loss to the market and to investors caused a contraction in the flow of funds in the wholesale credit markets, due to the

reluctance of banks to lend to each other or to their clients. The total impact was exacerbated by fear of exposure to the underpriced credit risk. Financial position of Australias banking system and the Impact of the GFC The RBA highlights the fact that the Australian banking system is more robust that many banking systems around the world, because the Australian banks maintained their high credit rating standard and have had minimal exposure to the US subprime market. Despite these factors, the economic downturn, according to the RBA, has still negatively impacted the Australian banking system due to the capital market tightening the supply of funds, decrease in asset values, the need for increased holdings of liquid assets, volatility in the financial markets and the need for the implementation of tighter lending standards to avoid exposure to a potentially worsening market. Although the major Australian banks continue to access global debt markets with their AAA credit rating, the cost of access to funds has increased due to the wholesale credit market tightening in the wake of the GFC. The tightening of the capital markets is highlighted by the increased interest rate spread between BBSW and the OIS, which has risen rapidly from around 10 basis points in mid 2007 when the GFC emerged, to 80 basis points for short term rates (see Figure 1 below) and even further for long term rates to around 100 basis points (see Figure 2). This is indicative of the declining confidence levels of investors and the decreased willingness of the market to lend. Due to the tightening of funds we have seen banks become more cautious and implementing tighter lending standards with higher levels of equity required for loans. (RBA 2008, P.29) Figure 1 Short-term Interest Rates Figure 2 Long-term Interest Rates

Source: RBA, September 2008, p.29

Source: RBA, September 2008, p.30

An increased cost of funding emerging from the credit tightening can be seen through the interest rate margin contraction to 2% (see Figure 3 below). This decline in the ratio of net interest income to average interest earning assets reflects not only the increase in funding but also the fact that banks did not initially pass on the higher wholesale funding costs (RBA 2008, P.22). Not passing on the higher cost of funding caused pressure on their profitability through margin contraction.

Figure 3: Net Interest Income

Source: RBA, September 2008, p.22

The effect on profitability from the decreased net interest income and banks not passing on the rise in the cost of funding is reflected in the 5 largest banks profit after tax for the July-June 08 period reduced by 7% in comparison to previous periods. This decline in the recent profit figures has also been influenced by rise in provisional charges to approximately 0.3% of the banks assets due to the continued instability in the financial market. Although these charges have increased due to problem loan levels in Australia, these levels have still remained relatively small compared to the US. Even with the decline of 7% net profit it still sits around $10 billion, showing that although worldwide market conditions are declining Australias banking still remains strong (RBA 2008, P.21). Although profit margins on loans contracted Australias

banking sectors still remains relatively strong with a net interest income growth of 10%, this is partly due to the following three factors. The first being strong growth in deposits from surplus units. These deposits have grown substantially, by around 20%, since the onset of the GFC (see Figure 4 below) as bank deposits are viewed as one of the safest places to keep money in this declining economy (RBA 2008, P.32). The increase in funding deposits has buffered the impact of the tightening wholesale credit. Figure 4 Bank deposits

Source: RBA, September 2008, p.32

The second factor promoting the relative strong growth is the reduction in competition for banks due to the impact of funding costs on non ADI mortgage originators. This section of the market has been dramatically affected because of its reliance on funding only through the issue of MBS via securitisation vehicles. These MBS have become relatively illiquid in the market, making it difficult for the mortgage originators to fund their loans and rollover existing ones. (RBA 2008, P.33) The third factor working in favour of the Australian banking system has been the RBA and ARRAs measure to strengthen liquidity management to include the repurchase in RMBS backed by mortgages. Banks in the financial market Banks domestic share prices have come off about 30% since there peak toward the end of 2007. However this is in line with the volatility and falling prices of the whole share market which has also come off about 30% (RBA 2008, P.34). The fall in share prices has lowered the banks P/E ratio and increased its dividend yield; however these dividends are being increasingly funded by way of diluted dividend reinvestment.

Conclusion The GFC triggered by the US subprime crisis has resulted in a major contraction in the flow of credit funds. This deteriorating economy has seen Australian banks underperform in comparison to previous quarters. This is due to the decrease in asset values and the increased cost of funding. However the banks still remain strong due to their low exposure to the subprime crisis, increased deposits and decreased competition. References Hunt & Terry, 2008, Financial Institutions and Markets, 5th edition, Cengage Learning, Melbourne, pp.51-100 Chris Terry, 2009, Notes on the US sub-prime loan crisis RBA, 2008, The Australian Financial System, Financial System Stability, September, pp. 21-35