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Australian, New Zealand Banks Remain Sound During Global Crisis

Sydney Opera House: Banks in Australia and New Zealand are among the strongest internationally (photo: Newscom)

GLOBAL ECONOMIC CRISIS

Australian, New Zealand Banks Remain Sound During Global Crisis

By Patrizia Tumbarello
IMF Asia and Pacific Department

January 22, 2010

  • Banks in Australia and New Zealand have been resilient to the global crisis, despite some vulnerabilities
  • Risks from loans to households and corporates appear manageable
  • Still, tougher stress tests are warranted given the severity of the worldwide downturn

Banks in Australia and New Zealand are sound by international standards, despite the global financial turmoil, according to two recent IMF studies.

But the studies encouraged bank supervisors in both countries to step up stress tests to assess how well banks would perform in the event of a further deterioration of economic and financial conditions.

Banks in both countries were healthy at the outset of the financial turmoil—which began in mid-2007 in the U.S. mortgage market and quickly spread to other sectors and other advanced economies—and the institutions continue to be resilient to the global crisis. Economic downturns in Australia and New Zealand contributed to an increase in impaired assets, but banks’ capital ratios have remained well above regulatory requirements.

Effects of the global turmoil

The direct impact of the financial crisis on the quality of assets on bank books has been limited so far, especially for large banks. This reflects the small exposure these banks had to U.S. subprime mortgage loans and collateralized debt obligations (CDOs). Conservative capital adequacy rules imposed by the banking regulatory authorities and regular stress testing of banks also helped limit risks.

The large banks are less leveraged than banks in comparable countries and financial soundness indicators have remained strong. The international financial turbulence reduced profitability, but major banks retained their AA credit ratings and the major banking groups were able to raise private equity capital.

Banks did have sizable external debt obligations and there was a risk that this debt would become more difficult to roll over. Wholesale funding accounts for about 50 percent of total funding at Australian banks, and access to offshore wholesale markets was disrupted by the collapse of the Wall Street investment firm Lehman Brothers in September 2008. The four large banks in New Zealand, which are wholly owned subsidiaries of the four large Australian banks, similarly rely on funding from offshore markets.

But the establishment of deposit and wholesale funding guarantees by the Australian and New Zealand governments in October 2008 and central bank actions in both countries to provide sufficient liquidity helped maintain confidence in the financial sector. Despite the most intense turmoil in international markets in decades, banks in both countries generally maintained access to capital market funding (both domestic and offshore) and experienced strong growth in deposits.

Mortgage defaults

Despite a relatively high share of loans to the domestic household sector, the analyses found that banks in Australia and New Zealand could handle an increase in mortgage defaults. Moreover, a number of factors tend to mitigate risks of a large increase in bank losses from mortgage lending:

• Interest rates on new and existing mortgages fell substantially from mid 2008, which makes it easier for households to service the loans.

• A portion of the high loan-to-valuation ratio mortgages is insured, usually by third parties.

• The legal framework makes the homeowner liable for remaining debt after repossession by a bank.

• Only a small share of owner-occupied households belonged to the higher risk group with debt-service ratios over 30 percent of disposable income and loan-to-valuation ratios above 80 percent. For Australia this share was 7 ˝ percent, and for New Zealand the share was even lower, at 3˝ percent.

Potential corporate loan defaults

The studies look at balance sheet and market-based indicators to determine the danger to banks from their corporate loan portfolios.

Balance-sheet indicators show that the corporate sectors in both Australia and New Zealand are sound. Leverage—whether defined as the debt to assets ratio or the debt to equity ratio— has remained stable and broadly similar to other advanced countries. Corporate profitability has improved considerably since the late 1990s and liquidity has increased.

Yet, as the global crisis unfolded, balance sheets of nonfinancial firms across the globe began to weaken, including those in Australia and New Zealand. Market-based indicators such as spreads on credit default swaps (CDS) suggest that corporate solvency risks increased from 2008 through early 2009, in line with all the other advanced economies, but that those risks remain manageable.

A contingent claim analysis (CCA)—which combines balance sheet information with prices prevailing in financial markets to obtain forward-looking measures of the risk of defaults—estimated that Australian and New Zealand banks’ losses could amount to about 2 percent of total loans, based on April 2009 data. That performance would be better than that of other countries, both in the region and elsewhere. Indeed, since April, prospects have improved. CDS spreads have narrowed substantially, suggesting that potential losses could be appreciably lower.

Assuring continued soundness

By a wide variety of criteria, including market-based indicators and financial ratios, Australian and New Zealand banks are among the strongest international banks. Nevertheless, the IMF papers concluded, the Australian Prudential Regulation Authority and Reserve Bank of New Zealand should conduct more rigorous stress tests of their banks, given the severity of the global crisis. These tests should be conducted jointly across the two countries given their inter-connected banking systems.

This article is based on two IMF Working Papers: “Australian Bank and Corporate Sector VulnerabilitiesAn International Perspective,” by Előd Takáts and Patrizia Tumbarello; and “New Zealand Bank Vulnerabilities in International Perspective,” by Ray Brooks and Rodrigo Cubero.


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