essay- australias banking system and the global financial crisis

8/3/2019 Essay- Australias Banking System and the Global Financial Crisis

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The Financial System 25556

Topic 1 Australias banking system and the global financial

crisis

Use the data presented in the RBAs September 2008 Financial Stability Review

to describe the financial position of Australias banking system as at September

2008 and explain the main impacts of the GFC on Australias banking system.

Overview

The past decade has seen the global banking system experience optimal conditions

in the market with high interest rate margins, shrinking equity risk premiums and

rising asset values. However the onset of the global credit crunch in July 2007 has

seen the emergence of challenging conditions where every favourable factor seems

to be simultaneously reversing. Thus the new riskier, falling asset value economy

has had major negative effects on the banking systems worldwide.

As a result the deteriorating economic circumstances have seen Australian banks

underperform in comparison to previous periods, since the onset of the GFC.

Emergence of the GFC

The GFC largely emerged from the market impact of the US sub-prime crisis that

resulted from US banks declining credit standards and reliance on the predicted

increase in housing values. However the banks failed to speculate that what goes up

must eventually come down, which is exactly what happened due to increased loan

defaults causing a surge of excess housing supply on the market and consequently

decreasing housing prices. This trend snowballed, creating toxic loans, as

outstanding loan values became even greater than the falling house values causing

the loan defaults to escalate further.

The losses on the housing loans decreased return on Mortgaged Backed Securities

(MBS) in the market and in turn their prices fell as the required market yield for MBS,

increased due to the increasing risk. This loss to the market and to investors caused

a contraction in the flow of funds in the wholesale credit markets, due to the


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reluctance of banks to lend to each other or to their clients. The total impact was

exacerbated by fear of exposure to the underpriced credit risk.

Financial position of Australias banking system and the Impact of the GFC

The RBA highlights the fact that the Australian banking system is more robust that

many banking systems around the world, because the Australian banks maintained

their high credit rating standard and have had minimal exposure to the US subprime

market.

Despite these factors, the economic downturn, according to the RBA, has still

negatively impacted the Australian banking system due to the capital market

tightening the supply of funds, decrease in asset values, the need for increasedholdings of liquid assets, volatility in the financial markets and the need for the

implementation of tighter lending standards to avoid exposure to a potentially

worsening market. Although the major Australian banks continue to access global

debt markets with their AAA credit rating, the cost of access to funds has increased

due to the wholesale credit market tightening in the wake of the GFC.

The tightening of the capital markets is highlighted by the increased interest rate

spread between BBSW and the OIS, which has risen rapidly from around 10 basis

points in mid 2007 when the GFC emerged, to 80 basis points for short term rates

(see Figure 1 below) and even further for long term rates to around 100 basis points

(see Figure 2). This is indicative of the declining confidence levels of investors and

the decreased willingness of the market to lend. Due to the tightening of funds we

have seen banks become more cautious and implementing tighter lending standards

with higher levels of equity required for loans. (RBA 2008, P.29)

Figure 1 Short-term Interest Rates Figure 2 Long-term Interest Rates

Source: RBA, September 2008, p.29 Source: RBA, September 2008, p.30


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An increased cost of funding emerging from the credit tightening can be seen

through the interest rate margin contraction to 2% (see Figure 3 below). This decline

in the ratio of net interest income to average interest earning assets reflects not only

the increase in funding but also the fact that banks did not initially pass on the higher

wholesale funding costs (RBA 2008, P.22). Not passing on the higher cost of

funding caused pressure on their profitability through margin contraction.

Figure 3: Net Interest Income

Source: RBA, September 2008, p.22

The effect on profitability from the decreased net interest income and banks not

passing on the rise in the cost of funding is reflected in the 5 largest banks profit

after tax for the July-June 08 period reduced by 7% in comparison to previous

periods.

This decline in the recent profit figures has also been influenced by rise in provisional

charges to approximately 0.3% of the banks assets due to the continued instability

in the financial market. Although these charges have increased due to problem loan

levels in Australia, these levels have still remained relatively small compared to the

US.

Even with the decline of 7% net profit it still sits around $10 billion, showing that

although worldwide market conditions are declining Australias banking still remains

strong (RBA 2008, P.21). Although profit margins on loans contracted Australias


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banking sectors still remains relatively strong with a net interest income growth of

10%, this is partly due to the following three factors.

The first being strong growth in deposits from surplus units. These deposits have

grown substantially, by around 20%, since the onset of the GFC (see Figure 4

below) as bank deposits are viewed as one of the safest places to keep money in

this declining economy (RBA 2008, P.32). The increase in funding deposits has

buffered the impact of the tightening wholesale credit.

Figure 4 Bank deposits

Source: RBA, September 2008, p.32

The second factor promoting the relative strong growth is the reduction in

competition for banks due to the impact of funding costs on non ADI mortgage

originators. This section of the market has been dramatically affected because of its

reliance on funding only through the issue of MBS via securitisation vehicles. These

MBS have become relatively illiquid in the market, making it difficult for the mortgage

originators to fund their loans and rollover existing ones.(RBA 2008, P.33)

The third factor working in favour of the Australian banking system has been the

RBA and ARRAs measure to strengthen liquidity management to include the

repurchase in RMBS backed by mortgages.

Banks in the financial market

Banks domestic share prices have come off about 30% since there peak toward the

end of 2007. However this is in line with the volatility and falling prices of the whole

share market which has also come off about 30% (RBA 2008, P.34). The fall in

share prices has lowered the banks P/E ratio and increased its dividend yield;

however these dividends are being increasingly funded by way of diluted dividend

reinvestment.


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Conclusion

The GFC triggered by the US subprime crisis has resulted in a major contraction in

the flow of credit funds. This deteriorating economy has seen Australian banks

underperform in comparison to previous quarters. This is due to the decrease in

asset values and the increased cost of funding. However the banks still remain

strong due to their low exposure to the subprime crisis, increased deposits and

decreased competition.

References

Hunt & Terry, 2008, Financial Institutions and Markets, 5th edition, Cengage

Learning, Melbourne, pp.51-100

Chris Terry, 2009, Notes on the US sub-prime loan crisis

RBA, 2008, The Australian Financial System, Financial System Stability,

September, pp. 21-35

essay- australias banking system and the global financial crisis

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