RBA: Global Financial Stability Risks Could Magnify If High Inflation Persists

• Published on
• 07 Oct 2022, 11:32 AM

-- Risks to global financial stability have increased over recent months
--Global financial stability would magnify if financial conditions tighten a lot
-- Australia entering challenging global environment in strong position
--But risks to financial stability if jobless rate rises sharply, large decline housing prices
-- Small share of borrowers managed transition to variable rate loans recently
-- More timely sentiment-based measures of financial stress among households started to turn

By Sophia Rodrigues

(Sydney, October 7, 2022)—Risks to global financial stability have increased over recent months and a further substantial tightening in financial conditions should inflation persist at high levels for longer would magnify these risks, the Reserve Bank of Australia said.

In the twice-yearly Financial Stability Review publication, the RBA said that in Australia, households, firms, and banks are entering the more challenging global environment in a strong financial position but the resilience across private sector balance sheets is unevenly distributed.

“The outlook for financial stability over the coming years will hinge in large part on the ability of households and businesses to weather challenging economic conditions both in Australia and internationally, including higher interest rates, high inflation and slower growth,” the RBA said.

WARNINGS

Still, there were warnings in the review.

Higher interest rates and inflation will slow aggregate household consumption and the pace of economic growth more broadly, but the direct financial stability risks posed by vulnerable borrowers appears modest.

However, a large increase in unemployment combined with a historically large decline in housing prices would pose a more material risk to loan arrears and defaults, and therefore financial stability, the RBA said.

Currently, financial stability risks from the large stock of household debt have been mitigated by a large increase in liquidity buffers and the tight labor market since the start of the pandemic.

Another source of uncertainty is the magnitude of potential declines in asset prices, including for housing and commercial property, following the significant price increases of recent years in most markets.

One warning was on financial stress with the RBA noting that more timely sentiment-based measures of financial stress among households have started to turn.

It cited examples of:

--considerable weakening in household perceptions of their own financial situation to be around levels reached early in the pandemic.

--rise in google searches on financial stress and negative sentiment in financial news articles, which have historically borne some relationship with loan arrears.

--its own liaison program also suggests that demand for a range of social and community services - including low-cost housing and food services - has increased of late. Increases in indicators of financial stress are likely in the period ahead.

BANK STRESS TESTS

The review analysed the potential impact of higher interest rates on bank capital from a baseline scenario of cash rate peaking at 3.5% and a severe scenario of an additional 300bps over 3.5%.

But even in the severe scenario, bank capital levels are expected to remain well above regulatory minimums, though some banks would breach their regulatory buffers.

The stress testing results, however, focuses on credit risk and hasn’t accounted for the impact on banks’ capital ratios from any losses on banks’ trading and banking books due to higher interest rates.

HOUSEHOLDS REASONABLY WELL-PLACED

The RBA also analysed the impact on households from rise in interest rates broadly in line with market pricing (around 3.5%) out to the end of 2023.

In this scenario, its projections show aggregate scheduled interest and principal payments rise to a level that is roughly on par with the total payments households were making (including excess payments into offset and redraw accounts) prior to the commencement of the tightening cycle.

“This suggests that households in aggregate are reasonably well placed to adjust to a period of higher interest rates,” the RBA said.

One bright spot was the RBA noting that the small share of borrowers who recently moved to variable-rate loans at the expiry of their fixed-rate terms appeared to have managed the transition so far.

--Contact: Sophia@centralbankintel.com