Serviceability buffers to cushion banks from credit losses 

S&P Global Ratings has revised its credit outlook for Australian banks, projecting that credit losses will remain low over the next two years, at approximately 0.15 per cent of total loans.

This level is expected to be similar to pre-pandemic figures, even as interest rate hikes impact the debt serviceability of highly leveraged borrowers.

With the Reserve Bank of Australia (RBA) raising the cash rate by another 25 bps on 6 June, taking the cash rate to 4.1 per cent, mortgage stress is predicted to exceed 1.4 million households, according to recent data by Roy Morgan.

As household debt increases, the combination of high household debt, rising interest rates, and uncertain economic conditions poses risks to borrowers’ ability to service their debts, thus exposing Australian banks to potential credit losses.

In fact, S&P Global Ratings’ quarterly market overview for March 2023 revealed a gradual increase in mortgage arrears in Australia as borrowers face mounting financial challenges, with prime mortgage arrears reaching 0.95 per cent.

However, credit analyst Nico de Lange warned that a sharp decline in property prices, a significant economic downturn accompanied by rising unemployment, or financial market disruptions could trigger a surge in credit losses.

Nevertheless, he noted that the risk of a severe property price fall has diminished.

Mr de Lange anticipates that house prices will continue to decline in an orderly manner over the next one to two years.

“Higher borrowing costs and the roll-off of lower fixed-rate mortgages to higher variable-rate mortgages over the next two years should keep house prices under check,” Mr de Lange said.

As of December 2022, fixed-rate mortgages accounted for approximately one-third of housing credit. However, a large portion of these super-low fixed-rate loans will expire in the coming weeks, resulting in a substantial increase in rates for hundreds of thousands of borrowers, more than doubling their previous rates.

Despite these factors, the report highlighted that most borrowers should be able to absorb the anticipated interest rate hikes, as the 3 per cent serviceability buffer imposed by the Australian Prudential Regulation Authority (APRA) provides a necessary cushion.

Mr de Lange added that banks have strengthened their serviceability tests over the years, partly due to increased regulatory scrutiny and industry benchmarking.

Additionally, indicators such as loan-to-value ratios for new loans have improved in the past two years.

“But there would be a segment of borrowers that will be adversely affected by rising interest rates, in our view,” Mr de Lange said.

“At the pointy end it would be those who lose their job or income and who borrowed at high leverage when prices were rising (house price nationally peaked in May 2022).

“We consider that segment to be small at the overall system level as well as the individual bank level for most banks.”

S&P Global Ratings anticipates below-trend consumption between 2023 and 2026 as mortgage payments rise, weakening the overall economic outlook.

[Related: Mortgage arrears lift amid tightening serviceability]