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Why Australian banks are standing strong

By Saul Eslake - posted Wednesday, 8 October 2008

There are four main reasons why Australia’s major banks continue to perform strongly amid the growing financial crisis.

The first is that Australian banks haven't engaged in anything like the extent of imprudent mortgage lending as their counterparts in the United States and some European countries. “Sub-prime” mortgages represent less than 1 per cent of all Australian mortgages (compared with over 15 per cent in the United States), and most of the subprime mortgages that have been written in Australia have been originated by non-traditional lenders, not by the banks. And banks have generally avoided writing mortgages at extremely high loan-to-valuation ratios.

The greater prudence of Australian banks partly reflects better judgment on the part of their managements than some of their overseas counterparts, partly better supervision by Australian regulators than their overseas counterparts, and partly differences in laws establishing the rights and obligations of parties to a mortgage as between Australia and the United States.


It also, importantly, reflects the fact that Australia's Reserve Bank was one of the very few in the world not to have made the mistake of keeping interest rates too low for too long in the early years of this decade, notwithstanding the intense criticism and pressure which accompanied every one of the increases in interest rates which the RBA implemented during this period.

Had the RBA succumbed to this pressure, and kept rates as low as the US Federal Reserve (or for as long), many more Australians might have been tempted into taking out mortgages that they would have been unable to service at more “normal” interest rates than was actually the case.

Second, Australian banks haven't bought armfuls of securities based on dodgy American mortgages, as did many of their European counterparts. Nor did they seek to compete directly in the American mortgage market. Hence they have not had to take the massive write-downs which many other banks have been obliged to do.

Third, Australia's economy has grown more strongly than most other Western economies. Recessions always result in loan losses for banks, no matter how prudent their judgment may have been when the loans were originally made. The fact that Australia's unemployment rate has remained at close to three-decade lows has meant that Australian home borrowers have been able to continue servicing their mortgages - albeit in many cases while having to make significant cutbacks elsewhere in their budgets - which has in turn contributed to keeping Australian banks' mortgage delinquency and default rates low by both historical and international standards.

Australia's legal system, which gives lenders more rights in the event of default than America's (which in effect makes it rational for borrowers whose property values fall below that of their outstanding principal to walk away from their obligations), has also contributed to this outcome.

And fourth, Australia has very few “pure” investment banks like Bear Stearns or Lehman Brothers. The closest parallel in Australia is Macquarie, but Macquarie has been less highly geared and has a broader spread of assets than many of the US investment banks (although that hasn't stopped it from being targeted by hedge funds). Nor are many of Australia's financial institutions as wholly dependent on mortgages for the lending side of their business as are many American retail banks (such as Washington Mutual).


Australia's banking system does have one point of vulnerability, however, and that is the relatively heavy reliance of the Australian banks on "wholesale funding". That is, borrowing in the domestic or overseas wholesale money markets in order to make up the difference between what Australians choose to save in the form of bank deposits and what they want to borrow by way of loans.

This "wholesale funding requirement" is, in effect, the mirror image of Australia's current account deficit, which reflects the fact that as a nation we spend more than we earn. Australia has the world's fourth largest current account deficit (in absolute dollar terms), and we finance it almost exclusively through the overseas borrowings of the banks -- unlike the United States, which finances almost two-thirds of its current account deficit via foreign central bank purchases of US dollars (as a by-product of their exchange rate management policies); Spain, which has the second-largest current account deficit in the world but which as a member of the euro area in effect finances it out of Germany's surplus; or the United Kingdom, which finances a good deal of the world's third largest current account deficit via government borrowings to finance its budget deficit.

The Australian banks' relatively high reliance on "wholesale funding" means that their overall "cost of funds" is more sensitive to movements in the premium which they pay for those funds, relative to the official cash rate, than banks in many other countries where dependence on wholesale funding is less.

The ability of Australia's banks to continue financing Australia's current account deficit is a key element in the Australian economy's ability to maintain a positive growth rate (since we couldn't finance our present growth rate out of our own saving).

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First published by Crikey on October 3, 2008.

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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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