Is Australia heading for a credit crunch?

Rampant property price inflation has put Australian authorities in a tight spot as they attempt to tighten banks’ lending standards without triggering a credit crunch, argues James McAlevey.

3 minute read

Sydney Opera House

The US Federal Reserve has effectively been exporting extraordinarily loose monetary policy ever since the financial crisis. One of the unintended consequences of that has been to inflate a growing number of asset bubbles around the world, especially in countries where central banks have been forced to run looser monetary policy than they might have wished.

Nowhere is this more apparent than in Australia where the Reserve Bank of Australia (RBA) has arguably kept monetary policy looser than domestic economic conditions warranted to try to cap the Australian dollar’s value. The resulting loose monetary has fuelled an unsustainable boom in house prices, with strong demand from Chinese investors having further inflated the market.

Chart 1: Australia’s booming housing market
Australia’s booming housing market

Given the magnitude of the increase in prices – in Sydney, for example, prices have risen 80 per cent in the past five years – Australia’s housing market has for some time appeared a prime candidate for a sizeable correction. Until now, the prevailing wisdom has been that such a downturn was unlikely without significantly higher interest rates or rising unemployment.

Alleged fraud

However, in recent months a new threat has emerged. The government in February set up a Royal Commission to investigate alleged misconduct in the financial services industry. Having examined potential breaches of responsible lending laws in relation to the sale of home loans, it appears to be taking a more rigorous view of banks’ lending practices.

With allegations of fraudulent activity having led some politicians to clamour for more draconian action – Australian Treasurer Scott Morrison has warned financial sector executives responsible for breaches of corporate law that they could face jail– banks have begun to tighten lending criteria. Notably, in screening mortgage requests they are undertaking greater due diligence to verify applicants’ income and living expenses to assess their ability to service and repay their loans.

With a material tightening of the availability of credit now underway, suddenly there are plausible grounds for concern Australia could be heading for trouble. That could have serious consequences for house prices, the country’s economy, and ironically the banks themselves.

The dangers posed to banks are all the more acute since mortgages account for somewhere between 60-65 per cent of their assets, which is high by international comparisons.2 Furthermore, much of this housing collateral is sitting on banks’ balance sheets at inflated valuations, adding to their vulnerability to a housing downturn.

At the same time, Australian households’ finances have begun to look increasingly stretched. The ratio of total household debt to income is now high by international standards.  According to a recent report from the RBA, it has risen by almost 30 percentage points to close to 190 per cent over the past five years, after being broadly unchanged for close to a decade.3

Household incomes set to be squeezed

Worryingly, many mortgages are on interest-only terms, but are set to revert to capital repayment mortgages in the coming years. According to a recent research note, UBS analysts reckon Australian banks wrote around A$650 billion in interest-only mortgages over the past five years, representing around 40 per cent of total mortgage lending. With the Australian Prudential Regulation Authority (APRA), the country’s financial regulator, having placed a 30 per cent cap on such mortgages, they estimate around A$120 billion of these mortgages will revert to capital repayment loans each year until 2021.4

The UBS analysts estimate repayments on these mortgages will increase by between 30 and 50 per cent, leading to a material squeeze on incomes and forcing many into selling their homes.

In 2017 the APRA, the country’s financial regulator, conducted a stress test of the country’s 13 largest lenders. It found in aggregate, the common equity tier 1 ratio of the industry fell from around 10.5 per cent to a little over seven per cent by year three, and under a worst-case scenario to just below six per cent.

The APRA concluded that although banks would potentially suffer significant losses, its results nevertheless provided a degree of reassurance: “banks remained above regulatory minimum levels in very severe stress scenarios”.5

The regulator has simultaneously been looking to strengthen banks’ ability to withstand a housing downturn by changing the risk-weightings on mortgages and introducing other ‘macroprudential’ measures to limit riskier types of lending. For example, it is looking to tighten lending in Sydney, Melbourne and Perth by encouraging banks to stop lending to developers of high-rise properties – a segment of the market that is suffering from high vacancy rates and has been left badly exposed by the nascent downturn.

The chart below shows that according to UBS, Sydney ranks among the most expensive real estate markets in the world.

Chart 2: UBS Global Real Estate Bubble Index
UBS Global Real Estate Bubble Index

The regulator’s dilemma

It remains to be seen to what extent the steps the regulator has taken will help limit the scale of losses made by banks in the event of a more severe property market downturn. The dilemma it is facing is that by tightening lending standards it runs the risk of causing property prices to fall further, intensifying the problems faced by the banks.

Some of the problems facing Australia are eerily reminiscent of the events seen in the US and western Europe in 2008. While Australian banks may yet avoid the catastrophe that befell financial institutions in the US and Europe, at the very least their profits appear vulnerable and their debt at risk of downgrades, especially given their reliance on wholesale markets for funding.

Given these concerns, we believe the Reserve Bank of Australia will struggle to raise interest rates as fast as many other central banks. For some time now, we have been ‘short’ the Australian dollar, and bank debt via credit default swaps, and ‘long’ short-dated government bonds. Given the danger the Royal Commission will continue to generate adverse headlines for Australia’s banks, and given the bearish outlook for the country’s property market, we have in recent months increased the size of each of these positions.


1 Morrison warns AMP's behaviour can be punished by 'jail time', The Sydney Morning Herald April 18 2018

2 Aviva Investors’ estimates based on company filings

3 Reserve Bank of Australia Financial Stability Review April 2018, p 20

4 Australian Economic Perspectives Credit Crunch? Seven factors to consider, UBS Global Research note published 1 June 2018

5 Preparing for a rainy day, speech by APRA Chairman Wayne Byers 11 July 2018 


Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.