Tag: Fitch Ratings

China Bank Reform Positive But Too Soon for Mass Upgrades

Fitch Ratings says that China’s tightened regulatory stance has slowed the build-up in financial-sector risks and should help improve the financial system’s overall stability. However, Fitch Ratings does not believe these measures have reduced risks meaningfully enough to warrant the type of sector-wide bank rating upgrades recently made by Moody’s. The authorities have also not been tested in their resolve to tackle financial risks if economic growth slowed beyond tolerance levels.

The result of Moody’s approach is rating compression between policy banks and large state banks (and mid-tier banks to some extent), which creates potential for higher rating volatility. Fitch has adopted a ‘through-the-cycle’ approach and differentiates more between institutions that we believe are likely to receive a high level of state support and those for which support is less certain.

Regulatory tightening has slowed credit growth over the last year, particularly shadow-bank activities although they have not declined. Interconnectedness in the financial system has also fallen, as shown by a drop in interbank wealth-management-product investment in 2017 and lower sequential growth in bank claims on non-bank financial institutions since 2H17. The credit-to-GDP growth gap has narrowed, but we still expect our Fitch-Adjusted Total Social Financing to reach around 273% of GDP by end-2018F (269% at end-2017). A change in the outlook on China’s operating environment, currently ‘bb+’/negative, would hinge on continued deceleration in credit growth, with deleveraging reducing contagion risks and improving transparency and governance.

The largest state banks are likely to be less affected by tighter regulation (which could increase asset impairments), given their stronger capital positions and loss-absorption buffers, as well as superior liquidity (and geographical diversification for BOC). These factors underpinned our decision last month to upgrade the Viability Ratings of BOC, CCB and ICBC to ‘bb+’ from ‘bb’.

However, mid-tier banks are more exposed, due to weaker funding and liquidity profiles, larger off-balance-sheet activities, and lower loss-absorption capacity. Moody’s upgraded almost all banks in its ratings portfolio, including some mid-sized ones, noting that they are “managing the transition well by virtue of their capital strength, liability franchise and/or relatively modest involvement in shadow banking activities”. Fitch disagrees with Moody’s view that the mid-sized banks’ involvement in shadow activities is “modest”. We also view their capital as overstated if taking into account off-balance-sheet exposures. Any upgrades to bank Viability Ratings would likely require sustainable improvements in capital buffers commensurate with risk appetite.

Our approach to support ratings for Chinese banks also differs. Fitch does not, for example, factor institutional support into the ratings of Ping An Bank or China Guangfa Bank (both BB+/Stable/b), as their largest shareholders are insurers that are subject to sector-specific regulation and would be similarly affected as the banks in a stress scenario, given the nature of their investments. These two banks represent over half of their largest shareholders’ assets, which raises doubts over their parents’ ability to provide support.

Fitch believes the state’s propensity to support different tiers of banks will vary under a stress scenario, with mid-tier banks unlikely to receive the same level of sovereign support as larger banks. Moody’s gives a three-notch uplift for many mid-tier banks, which is equivalent to the uplift that it gives for BOC, CCB and ICBC. Moody’s also now equalises its ratings of almost all state banks with the policy banks and the sovereign, which means it gives a higher support uplift, of four notches, to ABC and BOCOM than to the largest state banks.

Fitch will continue to focus on differentiating the potential for support in its rating analysis and research. In addition, Fitch’s ‘through-the-cycle’ approach aims to minimise ratings volatility.

Global Growth Robust, But US Inflation Risks Rising

Near-term global growth prospects remain robust despite rising trade tensions and political risks, but US inflation risks are rising, says Fitch Ratings in its new Global Economic Outlook (GEO).

Accelerating private investment, tightening labour markets, pro-cyclical US fiscal easing and accommodative monetary policy are all supporting above-trend growth in advanced economies. In emerging markets (EMs), China’s growth rate is holding up better than expected so far this year in the face of slowing credit growth; Russia and Brazil continue to recover, albeit slowly; and the rise in commodity prices is supporting incomes in EM commodity producers.

“Global trade tensions have risen significantly this year, but at this stage the scale of tariffs imposed remains too small to materially affect the global growth outlook. A major escalation that entailed blanket across-the-board geographical tariffs on all trade flows between several major countries would be much more damaging,” says Brian Coulton, Fitch’s Chief Economist.

Populist political forces continue to create policy risk and increase the threat of rising tensions within the eurozone that could adversely affect the outlook for investment, a key driver of growth last year. At this stage, we have made only a modest downward revision to our eurozone investment forecast for this year (to 3.3% from 3.9% in March), but a further escalation in uncertainty represents an important downside risk.

A much sharper-than-anticipated pick-up in US inflation remains a key risk to the global outlook. The decline in US unemployment – to 3.8% in May – is becoming more important to watch, and we forecast the rate to hit a 66-year low of 3.4% in 2019. A wide array of indicators of US labour market tightness suggest it is now only a matter of time before sharper upward pressures on US wage growth start to be seen.

“An inflation shock in the US could bring forward adjustments in US and global bond yields and sharply increase volatility, harming risk appetite. In particular, it could lead to a rapid decompression of the term premium, which remains negative for US 10-year bond yields. In combination with a likely aggressive Fed response, this would be disruptive for global growth,” adds Coulton.

Global growth forecasts remain unchanged since our March GEO, at 3.3% for 2018 and 3.2% for 2019. Nevertheless, 2018 growth forecasts have been revised down for 10 of the 20 economies that make up the GEO, with the eurozone seeing a 0.2pp downward revision, the UK a 0.1pp downward revision and Japan a 0.3pp downward revision. Brazil and South Africa have seen sizeable markdowns, and our Russia and Indonesia forecasts have also been lowered. These have been offset by 0.1pp upward revisions to the US and China and a stronger outlook for Poland and India in 2018.

For 2019, there have been fewer forecast changes, with the notable exception of Turkey, where recent currency turmoil and interest rate hikes are set to take a heavy toll on domestic demand. The US 2019 growth forecast has been raised by 0.1pp, and China’s 2019 outlook has been upgraded by 0.2pp following better-than-expected recent momentum.

Fitch still forecasts a total of four Fed rate hikes in 2018, followed by three more next year. Recent pronouncements from ECB officials suggest that the Asset Purchase Programme (APP) will be phased out in 2018, but also appear to imply that purchases will be scaled down between September and the end of the year rather than stopping abruptly after September. This is significant for the likely timing of the first ECB rate hike in 2019. ECB forward guidance has stated that rate hikes will not take place until “well after” the end of asset purchases, which the bank has clarified to mean quarters rather than years. A December 2018 end-date for the APP would imply rate hikes in 3Q19 or 4Q19. On this basis, we have revised our forecast of ECB rate hikes to just one increase in 2019, from two hikes before.

Global monetary policy normalisation and upward pressures on the US dollar have likely been contributing to the rise in financial market volatility witnessed so far this year. Both these global trends look set to stay.

Global Growth Robust, But US Inflation Risks Rising

Near-term global growth prospects remain robust despite rising trade tensions and political risks, but US inflation risks are rising, says Fitch Ratings in its new Global Economic Outlook (GEO).

Accelerating private investment, tightening labour markets, pro-cyclical US fiscal easing and accommodative monetary policy are all supporting above-trend growth in advanced economies. In emerging markets (EMs), China’s growth rate is holding up better than expected so far this year in the face of slowing credit growth; Russia and Brazil continue to recover, albeit slowly; and the rise in commodity prices is supporting incomes in EM commodity producers.

“Global trade tensions have risen significantly this year, but at this stage the scale of tariffs imposed remains too small to materially affect the global growth outlook. A major escalation that entailed blanket across-the-board geographical tariffs on all trade flows between several major countries would be much more damaging,” says Brian Coulton, Fitch’s Chief Economist.

Populist political forces continue to create policy risk and increase the threat of rising tensions within the eurozone that could adversely affect the outlook for investment, a key driver of growth last year. At this stage, we have made only a modest downward revision to our eurozone investment forecast for this year (to 3.3% from 3.9% in March), but a further escalation in uncertainty represents an important downside risk.

A much sharper-than-anticipated pick-up in US inflation remains a key risk to the global outlook. The decline in US unemployment – to 3.8% in May – is becoming more important to watch, and we forecast the rate to hit a 66-year low of 3.4% in 2019. A wide array of indicators of US labour market tightness suggest it is now only a matter of time before sharper upward pressures on US wage growth start to be seen.

“An inflation shock in the US could bring forward adjustments in US and global bond yields and sharply increase volatility, harming risk appetite. In particular, it could lead to a rapid decompression of the term premium, which remains negative for US 10-year bond yields. In combination with a likely aggressive Fed response, this would be disruptive for global growth,” adds Coulton.

Global growth forecasts remain unchanged since our March GEO, at 3.3% for 2018 and 3.2% for 2019. Nevertheless, 2018 growth forecasts have been revised down for 10 of the 20 economies that make up the GEO, with the eurozone seeing a 0.2pp downward revision, the UK a 0.1pp downward revision and Japan a 0.3pp downward revision. Brazil and South Africa have seen sizeable markdowns, and our Russia and Indonesia forecasts have also been lowered. These have been offset by 0.1pp upward revisions to the US and China and a stronger outlook for Poland and India in 2018.

For 2019, there have been fewer forecast changes, with the notable exception of Turkey, where recent currency turmoil and interest rate hikes are set to take a heavy toll on domestic demand. The US 2019 growth forecast has been raised by 0.1pp, and China’s 2019 outlook has been upgraded by 0.2pp following better-than-expected recent momentum.

Fitch still forecasts a total of four Fed rate hikes in 2018, followed by three more next year. Recent pronouncements from ECB officials suggest that the Asset Purchase Programme (APP) will be phased out in 2018, but also appear to imply that purchases will be scaled down between September and the end of the year rather than stopping abruptly after September. This is significant for the likely timing of the first ECB rate hike in 2019. ECB forward guidance has stated that rate hikes will not take place until “well after” the end of asset purchases, which the bank has clarified to mean quarters rather than years. A December 2018 end-date for the APP would imply rate hikes in 3Q19 or 4Q19. On this basis, we have revised our forecast of ECB rate hikes to just one increase in 2019, from two hikes before.

Global monetary policy normalisation and upward pressures on the US dollar have likely been contributing to the rise in financial market volatility witnessed so far this year. Both these global trends look set to stay.

Bail-in May Become More Complex For Mid-Sized EU Banks

Proposed amendments to the EU Bank Recovery and Resolution Directive (BRRD) regarding minimum levels of bail-inable subordinated debt may make it harder to effect a bail-in resolution on mid-sized banks that run into trouble, Fitch Ratings says.

Minimum subordinated debt requirements may only apply to global systemically important banks (G-SIBs) and “top-tier” banks with assets above EUR100 billion, according to a draft paper to be discussed at a European Council meeting on Friday.

This EUR100 billion threshold to designate a top-tier bank would be at the top of the range previously proposed, and could make it more difficult to apply bail-in to mid-sized banks under the EU’s bail-in framework. This may be because of legal challenges from bondholders that are bailed in if equally ranking creditors (eg junior depositors) are not or because of financial stability risks of bailing in equally ranking retail bondholders and junior depositors alongside institutional bondholders.

The EUR100 billion cut-off is particularly relevant to markets with less concentrated banking systems, for example Italy and Spain, and to smaller EU countries. For banks below the threshold, it could be challenging and costly to issue large amounts of subordinated debt, particularly for smaller banks with a more limited footprint in the debt capital markets. Consequently, mid-sized bank senior creditors may miss out on the protection the subordinated buffers would have provided.

How widely minimum subordination requirements should apply has been a matter of contention. Some northern EU member states want a broader scope covering at least all of the “other systemically important institutions” (O-SIIs), to minimise contagion risk. Others, mainly southern EU member states, want to limit the application to avoid forcing any but the largest banks to build subordinated debt buffers. An amendment originally proposed by Belgian delegates provides resolution authorities with the option to request subordinated minimum required eligible liabilities and own funds (MREL) for banks deemed systemic – but this is not automatic, as it is for the top-tier banks and GSIBs.

The European Council’s draft BRRD paper also proposes capping for most banks the requirement for subordinated MREL at 8% of a bank’s total liabilities and own funds. This would limit the associated costs for banks, but would leave their senior creditors less well protected in the event of outsized losses.

Friday’s discussions will also seek to agree a timescale for banks to meet the new requirements. The draft proposes G-SIBs and top-tier banks will have until January 2022. Other banks subject to the requirements will be given until 1 January 2024, but some EU member states are seeking longer timescales as some banks may struggle to build buffers, particularly if they are deposit-funded and have not issued subordinated debt previously.

Dodd-Frank Easing May Be Long-Term Negative for US Banks

Congressional passage of financial reform legislation easing the Dodd-Frank Act (DFA) for smaller and custodial banks is not likely to be a near-term ratings issue but could be negative for some banks’ credit profiles over the long term, if it results in significantly reduced capital levels, Fitch Ratings says.

The congressional legislation, which is widely expected to be signed into law by the president as early as this week, eases the capital and regulatory requirements for smaller institutions and custody banks. Fitch views robust regulation and capital as supportive of bank creditworthiness.

Key attributes of the legislation raise the systemic threshold to $250 billion from $50 billion for enhanced prudential standards (EPS), reduce stress testing requirements and modify applicability of proprietary trading rules (the Volcker Rule). The legislation reduces regulations for U.S. small to mid-size banks in particular, while only providing de-minimis regulatory relief to the largest U.S. banks. The change to the systemic threshold reduces the number of banks subject to heightened regulatory oversight to 12 from 38. Regulators will still have discretion to apply EPS to banks with $100 billion-$250 billion in assets. Banks above $250 billion in assets would not see much benefit from the legislation.

The biggest potential change to regulatory and capital requirements is for banks under $100 billion in assets, exempting them from DFA stress test requirements. From Fitch’s perspective, stress testing has provided discipline for banks and is an important risk governance practice that is considered in its rating analysis. The elimination or meaningful reduction of stress testing would likely have negative ratings implications.

Technically, the Fed’s CCAR process is not considered EPS and therefore the lower $50 billion proposed threshold isn’t applicable to CCAR, which applies to banks over $50 billion in assets. However, exempting banks with under $100 billion in assets from stress testing requirements makes it likely the Fed would align its CCAR testing requirements with Congress’ new thresholds. Banks with over $250 billion in assets would still be required to run CCAR; however, banks between $100 billion and $250 billion in assets would be subject to periodic rather than annual stress testing requirements.

Trust and custody banks would benefit from the potential carve out of central bank deposits to their supplementary leverage ratios, allowing for increased leverage. However, the joint banking regulators’ notice of proposed rulemaking (NPR) on the enhanced supplementary leverage ratio (eSLR) noted the proposed recalibration of the eSLR was contingent on the capital rules’ current definitions of tier 1 capital and total leverage exposure, which is being significantly altered by this legislation. The NPR specifically stated: “Significant changes to either of these components would likely necessitate reconsideration of the proposed recalibration as the proposal is not intended to materially change the aggregate amount of capital in the banking system.” The regulators’ response to this definition change only for the custody banks remains unclear. Ultimately, how much custody banks increase their leverage will also dictate ratings implications.

Banks with less than $10 billion in assets would be exempt from Volcker Rule restrictions on speculative trading, and banks originating less than 500 mortgages annually would be exempt from some of the record-keeping requirements of the Home Mortgage Disclosure Act. The Volcker Rule exemption would not aid large banks that must still demonstrate compliance with the rule. The legislation would also require U.S. regulators to consider certain investment-grade municipal securities as high-quality liquid assets for liquidity coverage calculations.

Cryptocurrency Derivatives to Test Clearinghouses, Banks

Centrally cleared cryptocurrency derivatives could be a real-world test of clearinghouses’ margining and default procedures, particularly if derivative notional volumes increase and cryptocurrencies exhibit heightened price volatility, says Fitch Ratings.

Although they have largely avoided direct exposure to cryptocurrencies, banks’ role as clearing members creates a secondary channel for cryptocurrency risk. This could indirectly affect banks under more extreme stress scenarios, such as if margining and clearinghouse capital contributions prove insufficient to absorb counterparty defaults.

A dramatic increase in financial institutions’ exposure to cryptocurrency derivatives could challenge clearinghouses and large financial institution clearing members in ways beyond those typically associated with the introduction of new market products. Cryptocurrencies are prone to extreme price volatility, which has been exacerbated by a nascent, unregulated underlying market with a limited price history and without generally accepted fundamental valuation principles. These factors complicate margin calculations, particularly related to short positions, for which losses cannot be capped. Inadequate margins may lead to use of clearinghouses’ collective funds to mitigate losses, thus calling upon the resources of non-defaulting clearing members, including many of the world’s largest banks and other financial institutions.

Bitcoin futures are cash-settled derivatives (i.e. without delivery of the base asset) that allow investors to assume long and short exposures to bitcoin prices without directly facing the cryptocurrency itself. In December 2017, CME Group and CBOE introduced the trading of bitcoin futures under the tickers BTC and XBT, respectively. BTC contracts are cleared through CME Clearing, while XBT contracts are cleared through Options Clearing Corporation (OCC).

As of May 9, 2018, open interests in XBT and BTC were modest at 6,287 and 2,479 contracts, respectively, worth approximately $59 million and $116 million, respectively. However, if challenges associated with trading the cryptocurrency are addressed, including uncertainty over regulatory, tax and legal frameworks, cryptocurrency derivative volumes could grow.

Clearinghouses have imposed high initial margin requirements, as well as price and position size limitations, suggesting a cautious approach thus far to trading cryptocurrency derivatives. As of May 9, 2018, initial (maintenance) margin requirements at CME were 43% of the associated notional amount, while at OCC the percentage was 44%, up from around 30% at the derivatives’ introduction in December 2017. Position limits at both exchanges are limited to 5,000 contracts in total or 1,000 in spot/expiring contracts. Consistent with price limitations for equity indexes, the maximum price limits at CME and CBOE are set at 20% above or below the previous day’s closing price, and trading is not permitted outside this band. There are also special price fluctuation limits set at 7% and 13%, which lead to temporary trading suspension.

The CME and OCC have not yet established separate legal entities or default funds for cryptocurrency derivatives, instead allocating exposure to the same default funds as equity indexes. This is understandable given the cost inefficiencies of establishing entities and default funds for what is currently a relatively low volume business. Nevertheless, a member default from losses on cryptocurrency derivatives may cause disruptions in other cleared products. Should centrally-cleared cryptocurrency derivatives materially grow, Fitch would expect clearinghouses at a minimum to establish separate default funds in an effort to isolate and mitigate associated risks.

Weakening UK Household Finances Pose Risks

The UK household sector’s worsening financial health reduces consumer resilience to income or interest rate shocks and presents risks for UK consumer loan portfolios, Fitch Ratings says in a new report. Consumer credit has been a key driver of rising household debt.

UK households’ swing into an aggregate net financial deficit position over the last year is almost unprecedented, having only previously occurred briefly during the late 1980s. Greater residential investment is a factor, but the household saving ratio has declined steadily since the mid-1990s to an historical low of 4.9% last year. This has been partly due to lower private pensions saving relative to income.

More recently, the UK household debt to income ratio has risen, retracing more than a third of its post-global financial crisis decline (in contrast with the US), and is likely to keep rising given the sector’s financial deficit. This has been largely driven by growing consumer credit, notably car loans.

Low interest rates mean the rise has yet to increase the debt service burden. We calculate that the effective interest rate on all UK household debt fell to 3.3% last year. The fall in the effective interest rate has saved household borrowers GBP20 billion-25 billion in interest payments since 2009.

But weaker household finances reduce the resilience of consumer spending – by far the largest demand component of UK GDP – to shocks. A major interest rate shock appears unlikely (we forecast the UK base rate to rise gradually, to 1.25% by end-2019), but a more immediate shock could come from tightening credit supply. The impact of the Brexit referendum on real wages may be fading, but Brexit uncertainty creates risks of a bigger shock to growth and employment.

Any performance deterioration in UK consumer loans would be from a very strong level. The charge-off rate on bank-financed consumer credit hit a record low of 1.7% in 4Q17. We forecast a modest rise in UK unemployment this year, to 4.7%, implying that charge-offs, which are closely correlated with changes in unemployment, will head back up to 2%-3%.

Fitch-rated consumer ABS deals have substantial headroom to absorb any performance deterioration. For example, the lowest long-term charge-off assumption we currently apply to any prime UK credit card trust is 5%, following the sharp increase in competition in credit card lending since 2013.

UK auto ABS deals have also performed strongly and benefit from structural credit protection, although if unemployment rose and consumer demand fell, both credit risk and residual value risk, which has become more prominent with the rise of the personal contract purchase (PCP) product, could increase.

UK banks are highly exposed to UK households, but mostly through mortgages, with consumer credit accounting for just 10% of banks’ lending to the sector. Recent stress testing by the Bank of England highlighted strong capital buffers against severe consumer credit losses. Nevertheless, high household debt is a constraint in our assessment of UK banks’ operating environment, and currently caps UK domestic banks’ Viability Ratings in the ‘a’ range, all else being equal.

Non-bank financial institutions are more exposed, although their specialist nature means any impact from deteriorating performance would vary across the industry.

Housing Downturn Could Pressure Australian Bank Ratings

As a result of Fitch’s latest mortgage stress tests, they argue on one hand that in a mild down turn the banks will not be seriously impacted, but then talk about scenarios where unemployment or interest rates rise, in which case, things turn more serious. CBA and Westpac would be worst hit. Nicely sitting in the fence?

A stress test published by Fitch Ratings shows that the mortgage portfolios of Australia’s four major banks could withstand a significant housing market downturn without experiencing losses that – in isolation – threaten the banks’ viability. However, ratings would be likely to come under pressure in severe scenarios where banks also suffer from large second-order economic effects, including a fall in consumer spending and higher losses from banks’ business loan portfolios.

We examined the capital impact of a point-in-time stress across a range of scenarios, with house-price declines of 20%-60% and default rates of 10%-20%. The Irish housing market collapse that began in 2007 was used as a reference point; this which involved house-price declines of 43% and a peak default rate of 13%. Even the moderate scenarios in our stress test are severe relative to Australia’s most recent recession in the late-1980s and early-1990s, when default rates peaked at 3%.

The tests showed that the banks’ ratings would be resilient to the moderate scenarios, reflecting adequate capital buffers and strong profitability. The severe scenarios would involve a negative shift in Fitch’s view of the operating environment for Australian banks, as well as our assessment of asset quality, capitalisation, profitability and, potentially, funding. These factors combined would be more likely to lead to downgrades.

CBA and Westpac have experienced the largest losses, reflecting their higher exposure to Australian mortgages. However, the proportionally larger commercial exposures of ANZ and NAB would render them vulnerable in a broader stress event.

The stress test was undertaken as risks within the household sector have continued to grow; and Australian banks, including the four majors, have large exposures to residential mortgages.

Our central scenario is not a sharp or substantial correction in Australia’s housing market, and we believe the outlook for economic growth and unemployment is relatively benign. House-price growth should moderate further through 2018, as banks continue to tighten underwriting standards for mortgages; interest-only loans convert to amortising repayments; and additional housing supply comes on to the market. A rapid rise in the unemployment rate remains the most likely driver of a significant housing market correction, although sharply higher interest rates would also pressure some borrowers – given the high household debt.

Fitch Gives Australia AAA

All is well. Fitch have reconfirmed Australia at ‘AAA’; Outlook Stable! This despite the high debt to GDP, and high household debt, and cooling house prices, and the ongoing impact of the Royal Commission.

Fitch forecasts a modest acceleration in GDP growth from 2.3% in 2017 to 2.7% in both 2018 and 2019, above the ‘AAA’ median. Growth will be supported by higher non-mining private investment and public infrastructure investment, particularly as the drag from the substantial multi-year decline in mining investment fades. Exports will be supported by strong global demand and higher liquefied natural gas (LNG) exports as more production capacity comes online. Consumption growth has been steady, but is likely to remain subdued given sluggish wage growth, high household debt, and a savings rate which is already low.

Monetary policy is likely to remain accommodative and supportive of growth over the next two years in the absence of significant wage growth or inflationary pressures. Fitch expects the Reserve Bank of Australia (RBA) to lag the U.S. Federal Reserve in tightening policy rates, only beginning to gradually lift rates with two 25bp hikes in 2019. Australia’s flexible exchange rate provides the RBA with a buffer against tightening global financial conditions. The RBA would be likely to tolerate some depreciation of the Australian dollar, which has been broadly stable against the US dollar to date despite a growing interest-rate differential with the Fed. Macroprudential policies have given the RBA scope to maintain lower rates without substantially contributing to a further build-up in financial-sector risks.

Australia’s net external debt-to-GDP ratio is the highest within the ‘AAA’ category, at 56.1%. The heavy reliance on external funding leaves Australia exposed to sustained shifts in capital flows and higher external financing costs, particularly in the context of tightening global financial conditions which would weigh on growth and financial stability. Most external liabilities are denominated in local currency or hedged to reduce currency and maturity mismatches, helping to mitigate risks. Australia is a net foreign-currency creditor, after adjusting for foreign-currency hedges.

High household debt, at 188.6% of disposable income in 4Q17, poses a potential downside risk for the economic outlook and financial stability. An interest-rate or employment shock could impair households’ ability to service their debt, particularly in the current low-wage-growth environment, thereby pressuring consumption growth. Many households maintain large mortgage offset accounts, which can be drawn down to service debt and smooth consumption, but newer borrowers and more financially weaker households would remain vulnerable.

Housing-price growth has continued to cool on the back of tighter credit standards, prudential regulation, and higher supply. A sharp correction in the housing market could flow through to both consumers and the financial sector. However, a severe downturn is not Fitch’s base case. We expect Australian house prices to remain relatively stable, with modest price rises nationally in 2018.

Australia’s banking system scores ‘aa’ on Fitch’s Banking System Indicator (BSI), the joint highest of any sovereign, and is well positioned to manage potential shocks. Sound prudential regulation has improved the resiliency of bank balance sheets by strengthening underwriting standards and limiting exposure to riskier mortgage products. Recent limits on growth rates for investor and interest-only loans have slowed the growth in these products, which Fitch considers riskier than traditional amortising mortgages. Furthermore, the strong capital position of Australian banks provides substantial loss-absorbing capacity in the event of a shock. The ongoing Royal Banking Commission is likely to have an impact on the public’s confidence in the banking sector, but has not affected the underlying soundness to date

APAC Banks’ Property Risks are Mounting

Banks in Asia-Pacific (APAC) will face heightened property risks over the medium term, given their relatively high exposure to the sector and the susceptibility of heavily indebted household sectors to a rise in interest rates or unemployment, says Fitch Ratings.

Residential property risks are highest for Australian and New Zealand banks, and may remain elevated in the short term as low interest rates and high house prices continue to drive mortgage growth, albeit it a slower rate. Residential property loans accounted for 43% of Australian bank assets in December 2017, up from 39% five years earlier, while in New Zealand the share rose to 46% from 43%. Australian and New Zealand households also have some of the region’s highest debt burdens.

Hong Kong banks’ property risks are increasing, with the territory being one of the few markets where property lending has accelerated over the past year, while intense competition continued to pressure margins. Mortgages account for a relatively low proportion of system assets, but a sharp housing market downturn could hurt sentiment and expose vulnerabilities, as rising prices have boosted private-sector wealth, banks’ reserves and collateral valuations. Banks’ rising exposure to mainland Chinese property is driving real-estate lending growth.

Korea’s high household debt would make its economy less resilient to shocks, including a housing market downturn. Household debt ratios are unlikely to decline over the medium term. However, household assets are also relatively high and banks’ property exposure is healthy overall, with low delinquencies and moderate LTV ratios. The same is also broadly true for Singapore, where we expect a more buoyant property market to support bank lending in 2018.

APAC regulators have actively tightened macro-prudential measures in an effort to strengthen banking-sector resilience to potential property risks. These measures have helped cool property markets in Singapore and Taiwan, while the tight stance has generally bolstered loss-absorption buffers and supported lending standards. Nevertheless, continued rapid lending and a further rise in risk appetite could increase the prospects of negative ratings action in the medium term, particularly in the absence of commensurate reinforcement to buffers.

Household leverage has started to decline in the emerging markets where it is highest – Malaysia and Thailand. We expect some fallout from over-supply in Malaysia, but risks to banks should be manageable as their exposure to the more vulnerable segments has remained small. Strong commercial real-estate lending growth by Thai banks in 2017 reflected an improving operating environment and followed sluggish growth in previous years, although there are still risks associated with consumer lending. Real-estate lending growth has also remained high in the Philippines.

Chinese banks shifted toward retail banking and mortgage lending in 2017, amid pressures in the corporate and financial sectors. However, increases in household leverage have been from a low base and have not reached the levels of most developed economies, suggesting that any near-term risks from China’s household debt burden remain moderate. Bigger risks would emerge if household lending was left unchecked over the medium term.

The risk across APAC of a residential property market downturn that significantly undermines banks’ asset quality is unlikely in 2018, given that economic conditions are likely to remain benign. However, rapid mortgage lending growth, incrementally higher risk-taking and relaxed mortgage pricing amid competitive pressures are likely to have created vulnerabilities that could be tested by a change in economic conditions. Rising interest rates are a potential trigger, despite our view that monetary tightening will be much slower in APAC than in the US.