Buried in the latest report on the Australian economy from the International Monetary Fund is a big vote of confidence in the health and stability of the Australian banking

The IMF reckons Australia’s big four banks are so well capitalised that they could withstand a surge in home loans going bad and still maintain their capital levels at the minimum required by regulators.

That’s a big difference to the US, UK, Ireland and several other countries where plunging home prices, mortgage sales and falling property values have wreaked havoc on capital levels and forced big capital raisings

Australia’s banks have been questioned by investors and commentators since the credit crunch erupted over a year ago, with nerves getting very frayed last week as the US financial system creaked and groaned under rising pressures and soaring short term rates for cash.

Some commentators fret about the level of debt in Australia, the house borrowing boom and the still high levels of prices and have warned of a debt binge driven slump. But not so the chaps from the IMF.

They did admit that while “Australia’s banking system is sound, but some vulnerabilities remain.” They were on the rollover risk in wholesale funding markets overseas with banks being forced to pay a lot more for new funds as existing loans rollover and have to be renewed.

But the IMF said:

The authorities’ response to the credit market turmoil has been timely and fitting, with the RBA providing liquidity support and APRA intensifying its monitor of banks.

The four large banks remain profitable and well capitalised, but the turmoil highlighted their vulnerability to rollover risks arising from short-term wholesale funding. The planned introduction of liquidity guidelines will be helpful to reduce the risk of disruptions arising from loss of access to offshore funding.

The IMF points out that to get a 10% default rate on all housing loans would require “a default on about half of mortgages with loan to value ratios of over 80 percent.”

House loans with an LVR of 80% or more are among the most stretched, but at the moment Australian banks have an arrears rate of 0.2% for impaired assets (including housing) and small banks a rate of 0.50%.

But the IMF says that “using extreme stress test scenarios applied to the large banks suggests that they could suffer a significant fall in profits from an increase in funding costs associated with loss of access to offshore markets for 90 days, but that their capital would remain adequate.”

This scenario is more severe than anything that Australian banks have had to face to date. As a result of the loss of access to offshore markets, banks have to refinance their offshore liabilities due in less than 90 days domestically.

In the most severe case where all wholesale funds (domestic and offshore) due in less than 90 days have to be refinanced at an interest rate that is 500 basis points higher than before the shock, the aggregate capital ratio for the system only falls to 8½ percent.

The worst affected among the four large banks has the capital ratio drop to 7½ percent. Banks’ profitability suffers a more serious hit, which is not surprising, given their heavy reliance on short-term wholesale funding. Nevertheless, it takes a 500 basis points increase in interest rates on liabilities to generate losses for banks.

In other words, if that was to happen now, wholesale interest rates would have to rise to well above 12% (indicating mortgage rates above 15%) for three months for there be any significant damage to bank capital levels and the amount of capital in the financial system as a whole. That assumes the banks can’t get any money from offshore in that period, which hasn’t happened so far.

Even when the stress tests were applied at even more intense levels the IMF team said the results should the resilience of the system.

It’s tests like this and the quality of the assets, provisions and the high levels of capital which have obviously given regulators comfort and the confidence to say, as RBA Governor, Glenn Stevens, did last week, that there was never a question about the solvency of Australian banks.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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