Released today, the Financial System Inquiry interim report has called for further information about what measures can be taken to mitigate the effects of developments in the housing market on the financial system and the economy.
“Since the Wallis Inquiry, the increase in households’ mortgage indebtedness has been accompanied by banks allocating a greater proportion of their loan book to mortgages; the share of loans for housing has increased from 47 per cent in 1997 to its current share of 66 per cent,” the report said.
“A large enough disruption to the housing market could have significant implications for household balance sheets, financial stability, economic growth, and the speed of recovery in household spending and broader economic activity following a shock,” it said.
While the inquiry acknowledges that recent results from official stress tests have found Australian banks are likely to be relatively resilient to most shocks, the likelihood of this happening in Australia “is difficult to quantify”.
“Historically, banks have mainly realised losses on their commercial property loan portfolios,” the report said.
“However, the exposure of the financial system to the housing market has clearly increased over time and, in the opinion of the inquiry, the systemic risk associated with this trend should be further considered,” it said.
The FSI Secretariat conducted an analysis of a number of scenarios, one of which considered the effect of a shock that resulted in a sharp and prolonged fall in house prices.
“In this scenario, household wealth would contract and there would be broader and, potentially, long-lasting effects on the economy and financial system,” the report found.
“A sharp fall in house prices could push some households into negative equity and would amplify financial distress associated with any broader economic downturn.
“Deleveraging, combined with lower consumer confidence, would weigh on household consumption and broader economic growth.
“The extent of the damage to households’ balance sheets would determine, to a large degree, the speed of recovery of household consumption."
The report found an extreme shock would also affect the quality of banks’ balance sheets and their capacity to extend new credit.
“This would include business lending, particularly for small businesses – which tend to use housing as collateral.
“Offshore wholesale funding would be likely to become more expensive and some banks might find it more difficult to raise funds, which would exacerbate pressures on the cost and availability of bank credit."
Overall, the report found the deterioration in bank balance sheets would compromise the speed of a subsequent recovery in economic activity.