3. The Australian Financial System The Australian financial system has remained There are a number of other longer-term resilient through a tumultuous year for the challenges for financial institutions to manage. economy and financial markets. The risks posed by information technology (IT) After a substantial decline in the first half of malfunctions and malicious cyber attacks are 2020, banks’ profitability recovered in the growing and a significant event could threaten second half and analysts expect it to strengthen financial stability. Another challenge will be to further in 2021. This has helped raise banks’ manage the broad range of risks arising from capital positions from already strong levels. climate change. These do not currently pose a Banks have abundant liquidity and funding. substantial risk to financial stability, but they Measures of banks’ asset quality have could over time if climate change risks to deteriorated a little in recent months as loan Australian financial institutions grow and are left repayment deferrals have come to an end and unaddressed. And financial institutions need to support for households and businesses has continue to maintain a focus on governance and tapered. However, banks had increased their embed a healthy culture to address the provision balances to absorb the impact of misconduct that has become apparent over the future defaults. past few years. Available information also points to other Banks resilience is supported by their financial institutions being resilient. The financial profitability … impacts of the pandemic tested the liquidity management of superannuation funds, but their Profitability recovered over the second half of systems proved effective in navigating this 2020 as banks raised provisions for credit challenge (see ‘Box C: What did 2020 Reveal impairments at a slower pace than in the initial about Liquidity Challenges Facing stages of the pandemic (Graph 3.1). Bad debts Superannuation Funds?’). General insurers will rise over 2021 as fiscal support is reduced remain well capitalised and have increased their and a small share of loans previously granted provisions for potential business interruption repayment deferrals move into arrears (see claims arising from the pandemic. However, the below). However, banks have bolstered their life insurance industry has to address stock of provisions in anticipation of these longstanding issues that continue to result in losses. Current provisions are around 40 per cent losses. Financial market infrastructures have above recent years, though still below the levels recently experienced some operational in the aftermath of the global financial crisis. Net disruptions, underscoring the importance of interest income was broadly unchanged over continually assessing and improving their 2020, while costs increased a little relative to resilience. income. Analysts expect banks’ headline return FINANCIAL STABILITY REVIEW – APRIL 2021 37 on equity (ROE) to continue to recover over the to-earnings ratios have risen since the middle of coming year, and be above their cost of equity. last year and the implied cost of capital has As interest rates have fallen a larger share of declined relative to other listed companies bank deposits has paid low interest rates (Graph 3.2). More generally, estimates of the (between zero and 25 basis points). This can equity risk premium for listed companies (the squeeze net interest margins (NIMs) because as implied cost of equity minus the risk-free interest rates fall, deposits that already receive zero or rate) indicate that increased risk-taking by very low interest rates have not been repriced investors has not unduly bid up the prices of lower in line with lending rates or the return on equities over 2020, since the equity risk liquid assets. premium is marginally above its average of recent years. Despite this, the evidence for Australia is that lower rates do not have a meaningful impact on … and strong capital ratios overall bank profitability. Lower rates are generally associated with a small reduction in Australian banks’ profitability over recent years banks’ NIMs, but this effect is offset by a has enabled them to build substantial capital reduction in borrowers’ debt-servicing burdens buffers to absorb future losses. Their Common (lowering bad and doubtful debts) and an Equity Tier 1 (CET1) capital ratios are increase in aggregate demand. NIMs are also substantially above their prudential minimum being supported in the current environment by requirements, giving them large management the broad reduction in banks’ funding costs. capital buffers in addition to 2½–3½ percentage Funding costs are estimated to have fallen by a points of regulatory capital buffers (Graph 3.3). little more than the cash rate since the start of Reflecting this, the 4 major banks’ capital ratios 2020 because of a shift in the composition of on an internationally comparable basis are deposits (towards cheaper at-call deposits) and estimated to be towards the top of the range of the Reserve Bank’s package of policy measures similarly sized banks globally and at a level that (including availability of cheap funding provided has historically been sufficient to withstand [2] by the Term Funding Facility (TFF)).[1] almost all previous banking crises. Mid-sized and smaller banks are also well capitalised. Financial market indicators also suggest Additional capital over regulatory minima for investors are confident that banks’ future earnings will remain resilient. Banks’ share price- Graph 3.1 Graph 3.2 Bank Valuations Banks’ Profitability ratio Forward price-to-earnings ratio ratio % Return on equity* % 20 20 Pre-provisions 16 16 15 15 8 8 10 10 ASX 200 banks % Equity risk premiums* % % Provisions as a share of loans % 10 10 1.0 1.0 7 7 0.5 0.5 4 4 ASX 200 (excl. banks) 1 1 0.0 0.0 2005 2009 2013 2017 2021 2005 2009 2013 2017 2021 * Forward earnings yield spread to 10-year real Australian Government * Dot represents forecast based on 12-month forward earnings Bond Sources: APRA; RBA; Refinitiv Sources: RBA; Refinitiv 38 RESERVE BANK OF AUSTRALIA these banks are generally similar to, or larger Liquidity in the banking system is than, those of the major banks. also high Banks have also been able to increase their Banks’ holdings of high-quality liquid assets capital ratios since the onset of the pandemic. (HQLA) have increased over the past year, CET1 capital ratios for the banking system as a facilitated by ample access to low-cost funding whole rose by over 100 basis points over this (in part due to RBA bond purchases) and low time, with around $16.9 billion in additional demand for credit. This, in combination with the CET1 capital being generated. More than half of undrawn portion of the TFF (which is treated as this came from retained earnings, reflecting a liquid asset), has caused banks’ liquidity continued profitability and reduced dividend coverage ratios (LCRs) to rise substantially payout ratios (in line with guidance from the compared with late 2019 (Graph 3.4). The Australian Prudential Regulation Authority increase has been even more pronounced for (APRA)). The remainder mostly reflected NAB’s smaller banks than for the 4 major banks. LCRs $4.25 billion in new issuance in the June quarter are currently above banks’ targeted levels but last year and new issuance associated with could shift back to within targets over the next dividend reinvestment. Looking ahead, planned 12 months. Banks’ LCRs could reduce when the asset sales are expected to provide further window of taking up remaining TFF allowances support to banks’ capital positions. expires on 30 June 2021. The size of this reduction will depend on the extent to which In recognition of banks’ healthy capital positions, banks draw down on remaining allowances as and the improved economic outlook, from well as how TFF funds are invested. Many banks December 2020 APRA relaxed its guidance on have indicated in liaison that they plan to take banks’ dividends. However, banks will need to up most or all of their remaining allowances retain sufficient capital to ensure they have the ahead of the deadline. capacity to continue to provide credit to the real economy and in doing so support the economic APRA recently approved requests from banks for recovery from the COVID-19 recession. a reduction in their allocations under the Reserve Bank Committed Liquidity Facility (CLF), reducing the total CLF available by $84 billion to $139 billion. The CLF is intended to be large Graph 3.3 CET1 Capital Ratios Graph 3.4 Using current capital framework, December 2020 % % Liquidity Coverage Ratio All currencies % % 15 15 180 180 Range across all banks* 160 160 10 10 140 140 5 5 120 120 Major banks** 0 0 100 100 Major banks Other ASX-listed Unlisted banks** banks Minimum requirement Regulatory buffer* 80 80 2015 2016 2017 2018 2019 2020 Additional capital * * Excludes confidential Pillar II requirements From the 10th to 90th percentile of all banks’ liquidity coverage ratios ** Some banks have capital ratios above 20 per cent (not shown) ** Weighted average of the major banks’ ratios Sources: APRA; RBA Sources: APRA; RBA FINANCIAL STABILITY REVIEW – APRIL 2021 39 enough to offset the limited amount of HQLA expiration and managing the timing mismatch available in Australia due to low levels of govern- through holding excess liquid assets. Liaison ment debt. Over the past year, issuance of with banks indicates that they are carefully Australian Government Securities and semi- planning for this task and will choose based on government bonds has increased significantly to the relative cost and efficiency of these options fund the fiscal policy response to the pandemic. closer to the time. In doing so, banks are also In its announcement APRA noted that if the mindful of the potential impact of expiring TFF amount of government securities outstanding funds on their Net Stable Funding Ratios, which continues to increase beyond 2021, the CLF may could fall by up to 4 percentage points (from a no longer be required in the foreseeable future.