Financial Vulnerabilities

The IMF has just released a Working Paper on Australian financial sector vulnerabilities.
Australian Bank and Corporate Sector Vulnerabilities—An International Perspective by Előd Takáts and Patrizia Tumbarello WP/09/223.
In a generally benign report, the authors point out some of the problems that could face Australia's banking sector dominated by the Big Four.

The report outlines:

1. The Australian banking sector entered the financial turmoil in a sound position and has been resilient to the global crisis. Banks’ capital ratios are well above the regulatory requirements. The major banks’ AA credit ratings have remained unchanged since the crisis unfolded, and they were able to raise private equity capital in the midst of the global crisis. Impaired assets are still low by international standards, although they have increased in the past year.

Most people have been surprised by the resilience of the Australian banking sector, although there has been a fair bit of luck involved with Australia managing to stay ahead of the economic cycle. The fact that Australian growth has been so strong for so long matters a lot. This has enabled unemployment to stay low and the corporate sector to stay profitable. It is clear that having a very severe financial sector shakeout made the banks more cautious and madfe the regulatory authorities nore vigilant.

2. The international downturn points to several vulnerabilities. On the liabilities side, banks remain exposed to rollover risks on short-term wholesale funding. On the assets side, banks are vulnerable to the household sector as well as to possible corporate sector distress.

This is exactly the point, remembe rthe hosuehold sector in Australia is more indebted than ever before and a period of slow growth and rising unemployment will no doubt make things more difficult for the banks. While the rest of the world has been severely tested and Australia has done very very well, there are more tests to come. Despite the high levels of confidence around, just as in 2007, supposed strenth brings its own problems. Rising interest rates (and expectations of further rate rises) will cause households to tighten their belts putting a dampener on spending. A higher currency helped along by rising interest rates will lessen the profitability of those earning income overseas and make our exports less affordable.

3. Nonetheless, the risks from the corporate and household sectors appear to be manageable. ...

No doubt this is true as long as we don't get another external shock or a long period pof low growth. .

6. However, a deterioration in banks’ asset quality has been evident since early 2008.

7. A key remaining vulnerability is the roll-over risk associated with sizable short-term external debt. Banks’ wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore (Table 3). Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009.

The ability to roll over funds could be a problem in 2010. There are alsoa considerbale number of corporates that need to roll over debt in 2010. See "‘Twin Towers of Debt’ Loom Over Australian Companies, NAB Says".

8. The establishment of deposit and wholesale funding guarantees in October 2008 helped maintain confidence in the financial sector. As a result, banks were able to raise about $A 140 billion between December 2008 and early July 2009 (Figure 2) and have rolled over short-term debt. Recognizing the increased importance of liquidity and rollover risks associated with short-term liabilities, banks have started to increase medium-term funding.

The danger lies in a confluence of negative events (I don't want to use the cliche of the past couple of years - "perfect storm") that could undermine the current rosy picture. Fiancially-based recessions traditionally take longer to clear and one has to wonder about the underlying health of the US and European financial sectors.

Credit markets are still impaired and competition for debt is likely to remain high given the extensive amout of money needed to fund bailouts and stimulus measures throughout the world.

This crisis is not over yet, despite the cheery views of RBA Governor Glen Stevens. He might be right and thus far it appears that Australia has done well under his monetary managenent, but its the performance of the Australian economy and our ability to deal with long-term vulnerabilities that matters most.