‘Solvency phase’: RBA’s Jonathan Kearns warns of new bank tests

The liquidity phase of the COVID-19 crisis has mostly passed but will be replaced by a solvency test for the nation’s banks.

The RBA says Australian banks have done well to cushion the economic blow from COVID. Picture: iStock

The Reserve Bank has warned that the banking system faces a new test around “solvency” of businesses now that the liquidity phase of the COVID-19 crisis has mostly passed.

Even as the economy has started on a path to recovery with the coronavirus contained for now, RBA head of stability Jonathan Kearns said the resilience of the system up until now didn’t mean that the risks had passed.

“We’ve had the largest contraction in global output since the Great Depression,” Mr Kearns said in speech to the Australasian Finance and Banking Conference on Tuesday.

“And as that impairs some households’ and businesses’ ability to repay their loans, the liquidity phase of the crisis is giving way to a solvency phase.”

The comments underscore growing concern among regulators of a potential hit to the economy when fiscal support programs such as JobKeeper end in March. At the same time more than $87bn of loans have been deferred with banks expected to push customers for repayments in the March quarter.

The economic shock, Mr Kearns said, was much larger than it was in the global financial crisis, and for many decades before then.

However, the nation’s banks were in a much better position than in the lead-up to the GFC, with strong capital ratios and elevated liquid asset holdings which held them in good stead earlier this year.

In addition, they had large capital buffers which were there to be used, not preserved, and would enable them to continue lending and supporting their customers.

In contrast to COVID-19, Mr Kearns said the GFC was initially a relatively small shock originating from within the financial system which was amplified by the system and caused significant economic loss.

This time there was a large shock external to the system - big enough to have exposed any weaknesses.

“Yet banks have performed well so far through the pandemic, cushioning rather than amplifying the shock by continuing to lend and supporting households and businesses,” he said.

“Notably, in at least 55 jurisdictions banks have been able to defer loan repayments for borrowers affected by the pandemic.

“How the banking system has been affected by, and responded to, the early stages of the crisis has been very different this time.”

On the future of banking in the COVID-19 era, Mr Kearns said both the magnitude and quality of bank capital had increased since the GFC.

Holdings of liquid assets had also increased, with the ratio of liquid assets to total assets rising by one-quarter since 2007, and Australian banks were also profitable.

In 2019 the combined profits of the banking system were $34bn and their return on equity, at 11 per cent, exceeded their cost of equity.

Most of the major banks’ big increase in capital in recent years had been internally generated.

While loan deferrals had avoided unnecessary household and business defaults, and fire sales of assets, Mr Kearns said it was important they were temporary and not used to hide problem loans.

Stress-testing showed that the banks were resilient to sharp downturns, with the RBA’s baseline scenario showing that GDP would be about four per cent below its peak by December 2020, the unemployment rate close to eight per cent, and housing prices two per cent below their peak.

Bank common equity tier one ratios would fall by about 60 basis points. This compared to management capital buffers of at least 300 basis points held by the major banks.

Bank profitability was also suffering from a period of ultra-low interest rates, according to Mr Kearns.

“Overall very low interest rates may well reduce Australian banks’ profits, but possibly by less than for banks in other jurisdictions,” he said. “Australian banks haven’t faced very low rates for an extended period, but estimates for Australia by the Reserve Bank find that a 100 basis point downward shift in the yield curve lowers the return on assets by about 5 basis points after one year.

“These estimates are around the lower end of the range of estimates internationally, consistent with the intuition that the impact may be smaller.”