RBA’s Financial Stability Review All About Interest Rate Rise

By Sophia Rodrigues

(Sydney, April 8, 2022)—The Reserve Bank of Australia warned that globally there is a risk that both short and long term interest rates could increase by more than financial markets currently expect because inflation is higher and more persistent than forecast.

The RBA made the comment in its twice-yearly Financial Stability Review published Friday, but the review itself had a surprisingly “hawkish” tone, given it also provided a detailed analysis of how higher interest rates would impact various borrowers, assuming domestic interest rates rose by 200 basis points.

An assumption of 200bps indicates how far the RBA expects to raise interest rates in the rate hiking cycle that is expected to begin as early as June.

The RBA said a 200 basis point increase in interest rates would lower real housing prices by around 15% over a two-year period.

The biggest impact of interest rate rise would be on fixed interest-only loans as these borrowers would face adjustment to the principal, apart from higher interest rates when the fixed-rate period ends.

In the case of variable mortgage holders, 20% of them are expected to face an increase of a maximum 20 per cent, and another 20% are expected to see increase of more of 30%,

But the RBA’s expectation is the majority of indebted households, including fixed-rate borrowers, are well placed to manage higher minimum loan repayments. One reason is that sizeable interest rate buffers are built into loan serviceability assessments.

In the case of fixed-rate mortgages, the RBA said the risk of borrowers experiencing repayment difficulties would be partly mitigated by some splitting their mortgages between fixed and variable rates, resulting in smaller and more gradual increases in their total repayment.

The RBA said its calculations assume household income after other expenses is unchanged.

“If rising inflation was to erode real household incomes, some borrowers may have to draw down their accumulated excess payment buffers much more quickly and/or cut back on other spending,” the RBA said.

The RBA said systemic risks remain elevated, increasingly slightly in the past year, as rise in housing credit pushed up household credit to income from an already high level.

The Australian Prudential Regulation Authority’s move to increase the interest rate buffer to assess mortgage serviceability had modest impact which was largely expected, but further impact is likely as inflation would increase Household Expenditure Measure living expenses benchmarks.

The RBA said share of new lending at high debt-to-income ratios remained significant, with one-quarter of new loans at DTI over six.

The RBA issued a warning on housing prices, saying lenders and borrowers should consider the potential for falls in housing prices, particularly for loans at high loan-to-valuation ratios.

“Housing demand and the outlook for prices are uncertain due to a range of factors, including significant changes in population growth. Future increase in interest rates could also weigh on housing and other asset prices,” the RBA said.

In case of businesses, the RBA said most listed firms had adequate earnings at the end of 2021 to absorb a 200 basis point increase in average business lending rates, which would be roughly equivalent to their level in late 2019.

The Australian financial system overall remains robust, and is well placed to continue supporting the expansion, the RBA said.

Importantly, the RBA upcoming wind-down of the Committed Liquidity Facility and the refinancing of the funds borrowed via the Term Funding Facility over the next two years are not expected to pose a challenge for the banking sector.

The RBA noted market pricing for 300 basis point increase in interest rates over the next couple of years. Banks – and financial institutions more broadly – face little direct risk to their balance sheets from rising interest rates, but exposures will still need to management, the RBA said.

RBA’s analysis:

If interest rates rise by 200 basis points:

--Lower real housing prices by around 15% over 2-year period

--Current excess payment buffers to variable-rate mortgages would be equivalent to just 19 months of scheduled payment from 21 months in the recent February data (was 10 months at the start of pandemic)

If variable mortgage rates rise by 200 basis points (60% of all borrowers have variable rate loans, with two-thirds of these being owner-occupiers):

--Just over 40% made payments over past year that would be large enough to cover increase in repayments

--20% would face an increase of maximum 20 per cent

--20% of owner-occupiers would see repayment increase by more than 30 per cent

--Share of borrowers facing debt servicing ratio greate than 30% would increase to 20% from 10%.

If all fixed-rate mortgages roll over to variable rates at the end of fixed-rate period:

--90% of them will face repayment increase in the range of zero to 20%

--One-third have terms beyond 2023 but could face largers shocks, depending on rate rises

--Interest-only mortgages would face largest adjustments as they will also face to principal.

--Contact: Sophia@centralbankintel.com