Banks ‘sailing through’ higher rates despite community financial hardship

Australian banks are sailing through the sharpest interest rate increases in generations, according to APRA chairman John Lonsdale.

APRA chair John Lonsdale. Picture: Chris Pavlich

Australian banks are sailing through the sharpest interest rate increases in generations, and despite an increase in financial hardship in the community and modest increases in overdue payments, banking capital levels are very strong.

That’s the message from the prudential regulator, which on Wednesday told banks to be ready for their annual stress test in the first part of the year. All lenders passed the test last year, which used a severe downturn scenario to test resilience and whether they maintain minimum capital and liquidity requirements. With an economic soft landing now looking more likely, the 2024 exercise should be a relatively easy task.

“We think (the banks’) capital levels, liquidity levels, credit standards, (and) prudentially are very strong,” Australian Prudential Regulation Authority chairman John Lonsdale said he wrote to the banks to outline APRA’s short term priorities.

“There is still financial stress in systems, though. I sit on national debt helpline calls. I listen to two people talk about financial stress, and there is certainly financial stress in the community. But it is not translating into the mortgage book.”

“What we’ve seen in a nutshell, is borrowers have been able to handle that very well.”

APRA has been conducting bank stress tests since 2012 and began doing them annually in 2022.

Mr Lonsdale comments came as inflation data released on Wednesday showed prices are falling more sharply than expected, to an annual 4.1 per cent in the December quarter, down from 5.4 in the three months prior.

Strategists say most of the impact of the 13 interest rate increases by the RBA since May 2022 has now moved through the banking system. And with inflation cooling, the chances of a rate cut in the first half of the year means the banks’ capital provisions could be reversed.

Banks were higher on Wednesday, with Commonwealth Bank shares reaching a new record high, as investors bet on the benefits of lower funding costs, higher credit growth and potentially lower bad debts than expected.

Mr Lonsdale said, however, the regulator had to keep a strong prudential supervision and regulation of the sectors it oversees, which also includes insurance and superannuation.

He highlighted other recent escalating threats, including rising geopolitical risks in Europe and the Middle East, local natural disasters, as well as the growing threat of cyber-attacks.

“The war in Ukraine is ongoing, but now we also have a conflict in the Middle East and threats to the safety of shipping which is already affecting transport costs and prices for goods,” Mr Lonsdale told reporters in a call.

“All of that underscores the need to have a strong, stable financial system with good capital liquidity credit standards, which we have. We need to make sure that where lessons can be learned, we see gaps, we do that.”

In the letter outlining its six-month plan, the regulator said cyber resilience, ensuring lessons from last year’s banking crisis have been learned, and lifting super funds’ game when it comes to unlisted asset valuations and retirement outcomes for members were some of its key priorities.

APRA is consulting on revisions to strengthen liquidity and capital adequacy standards with a new emphasis on “interest rate risk in the banking book” or IRRBB requirements that will help improve reporting and awareness of risks banks carry.

Given the most stringent requirements already apply to big banks, the changes are likely to mostly impact the smaller banks at an uncomfortable time when their costs are soaring from the need to invest on systems to combat scams and cyber attacks, higher inflation and steeper funding costs.

This could have “very serious” implications for the smaller banks, Mr Lonsdale said, adding APRA aimed to be commensurate in the way it regulated the sector.

“We’re always talking to our entities, particularly at the little end of town to hear their concerns, and make sure that what we’re doing is actually proportional,” he said.

“The only caveat I’d add to it is that there are some risks that we don’t think that we can be proportional on,” he said. “Cyber is a really good one... we are saying to all entities, there are basic hygiene issues you’ve got to adhere to.”

Capital and liquidity laws carve outs for the smaller players in the US last year arguably led to the collapse of California-based Silicon Valley Bank and other regional lenders, when depositors suddenly learned that rapid interest rate increases were resulting in losses in the value of the banks’ investments and denting the bank’s capital.

The digital connectedness of a modern banking system meant the ensuing bank runs happened at a much faster speed than regulators and executives were expecting.

“We want to embed the lessons learned from last year’s global banking turmoil through some targeted changes to the prudential framework for banks,” Mr Lonsdale said.

APRA will also formally consult banks on its proposed changes to Additional Tier 1 bonds, commonly known as hybrid instruments, which are capital issued by banks to use in a crisis designed to absorb losses by suspending coupon payments or converting to equity.

But after the instruments featured prominently in the bailout of Credit Suisse last year, the regulator said certain characteristics of bank hybrids, which account for about 2 per cent of the big four’s capital bases, could create “significant challenges, or potentially undermine” their effectiveness in a banking crisis.

To fix this, the regulator spelled out three potential options: making their triggers for conversion to happen earlier when aiming to stabilise a bank in stress, reducing the level of hybrids banks can issue, or restricting who can invest in hybrids.

The must-do list also includes ensuring “all entities meet the standards” on cyber resilience, asking them to answer - voluntarily - a climate risk self-assessment survey, and releasing transitional rules to help banks transition from the existing Banking Executive Accountability Regime (BEAR) to the Financial Accountability Regime (FAR) from March.

It will also keep its ongoing focus on implementing the recommendations from the Financial Regulator Assessment Authority review completed last year, which criticised its “undeveloped” approach to policing the superannuation sector relative to banks, particularly their approach to valuing unlisted assets.

“The issue is we need proper valuation of unlisted assets to make sure that we’ve got investment in the best interests of members, and that’s what we want to ensure,” Mr Lonsdale said.

“Where we see issues with particular entities we will take action. It is a priority and we want to push into the issue.”

In the insurance sector, Mr Lonsdale said it would continue to balance financial sustainability with the need to enhance affordability and availability of insurance.

It will conduct roundtables to brief insurers, banks and funds, on new operational standards that require effective operational controls and strong business continuity plans. “Entities should expect further engagement on operational resilience through 2024 to assist readiness,” the letter said.

“This includes updated finalised guidance supported by meetings with selected entities and webinars to assess and assist readiness.”

The priorities outlined in the letter will be a “bridge” with those to be set by the end of August in its new corporate plan, and are meant to be on top of entity-specific supervisory programs.

“APRA will remain adaptable to changes in the external environment and will adjust these priorities as needed, to ensure the industries it regulates can continue to respond to new and emerging risks,” Mr Lonsdale said.