Banks warned to maintain lending standards. The Reserve Bank has warned banks to “resist the pressure to ease lending standards to gain market share.

Household conservatism encouraged.Ongoing consolidation of household balance sheets would be desirable from a financial stability perspective”.

The RBA has provided special sections in the report dealing with the funding composition of banks and households mortgage repayment buffers.

What does it all mean?

The Financial Stability Review usually is a straight-forward document with few controversial issues raised. But in the latest report the Reserve Bank has been uncharacteristically forthright, warning banks against the temptation of easing lending standards too far. The RBA notes that profit growth has slowed, credit growth is lower and there are higher funding costs. In this environment a financial intermediary may be tempted to ease lending standards to boost lending and profit growth. The RBA notes that there will be challenges in the months ahead to resist the temptation to ease lending standards too far “in the pursuit of unrealistic profit expectations.

A number of businesses will be disappointed by the RBA warning to banks. Small businesses, and especially borrowers in the real estate segment, believe that banks are being too conservative in lending practices. The challenge for banks is to achieve an appropriate balance between risk and return that pleases the regulators and the general public.

And any thoughts that the RBA is concerned with the extent of consumer conservatism have been dispelled. The RBA notes that the “consolidation of household balance sheets” remains a positive development from a big picture perspective. Again, sections of the business community will be disappointed, especially retailers.

There is plenty of comfort in the report as well with the RBA noting that 15 per cent of borrowers are ahead in repayments by two years or more. Further, in terms of bank funding, dependence on domestic deposits is now similar to other advanced economies.

In addition the central bank also noted the pickup in appetite for debt by the corporate sector - which has grown by 6½ per cent in annualised terms over the six months to July after declining for much of the previous three years. No doubt the sharp fall in fixed and variable rates is enticing businesses to once again look at funding to accelerate investment plans.

What does the report say?

Risks from Euro area.Along with the weaker near-term outlook for global growth, the euro area problems will continue to pose heightened risks to global financial stability in the period ahead.

Asian banking system watched also.…vulnerabilities may have built up during recent credit expansions, which could be revealed in the event of a significant decline in asset prices or economic activity. As some banking systems in Asia are now quite large, there is a greater chance that problems in them could have adverse international spillovers.

Australian banks are strong.The Australian banking system has remained in a relatively strong position.” Further, “The Australian banking system remains well placed to cope with shocks from abroad, such as those that may emanate from the ongoing problems in Europe.

More exposure to domestic deposits.Around half of the banks’ funding now comes from customer deposits, which is a broadly similar share to a number of other comparable countries’ banking systems.

Profit growth at banks has slowed. Warning on lending standards.While this has prompted a renewed focus by banks on cost containment, at this stage, it has not spurred inappropriate risk-taking. With demand for credit likely to remain moderate, a challenge for firms in a competitive banking environment will be to resist the pressure to ease lending standards to gain market share in the pursuit of unrealistic profit expectations.

Further warning on banks.The challenge for the industry in this environment will be to avoid taking on unnecessary risk or cutting costs indiscriminately in a bid to sustain unrealistic profit expectations, as this could ultimately sow the seeds of future problems.

Pressure on bank funding costs.The strong competition for deposits has widened their spreads relative to benchmark rates, contributing to an increase in banks’ funding costs relative to the cash rate.

Household conservatism encouraged.Although there are some isolated pockets of weakness, aggregate measures of financial stress remain low. Ongoing consolidation of household balance sheets would be desirable from a financial stability perspective, as it would make indebted households better able to cope with any future income shock or fall in housing prices.

Business borrowing cautiously.After a period of deleveraging, there has recently been a pick-up in business borrowing, though businesses’ overall recourse to external funding remains below average. While the uneven conditions in the business sector have been contributing to the weaker performance in banks’ loan portfolios in recent years, business balance sheets are in good shape overall.

Financial system strong.Australia has this year undergone an IMF Financial Sector Assessment Program review. The results, which are due to be published later this year, confirm that Australia has a stable financial system, with robust financial regulatory, supervisory and crisis management frameworks.

Mortgage borrowers ahead of schedule.In aggregate, indebted households’ mortgage prepayment buffers are estimated to be equivalent to around 1½ years of scheduled repayments (principal plus interest) based on current interest rates. While this average figure is boosted by a group of borrowers that are significantly ahead of schedule – liaison with the major banks suggests that around 15 per cent of borrowers are ahead by two years or more – many borrowers still have sizeable buffers.

Household sectorThe household sector’s more prudent financial behaviour has continued in 2012. The saving ratio has averaged around 9½ per cent of disposable income for the past few years, well above its level of five to ten years ago”.

“Households’ more circumspect financial behaviour is also related to a decrease in their appetite for risk and riskier assets. For example, on top of the effect of declining equity prices, households have actively reduced their equity holdings. As a result, the share of households’ financial assets held directly in equities (i.e. outside superannuation) has roughly halved, from 18 per cent in 2007 to 8½ per cent in March 2012”.

Healthy balance sheetsGiven the large share of households with mortgage prepayment buffers, along with relatively low unemployment and moderate income growth, most households appear well placed to meet their debt obligations”.

Business Sector Small businesses continue to report more subdued conditions; this partly reflects that they are concentrated in industries such as construction that have been under pressure”.

Following a period of significant deleveraging over recent years, there are signs that businesses’ appetite for debt may be starting to recover. Business credit grew by 6½ per cent in annualised terms over the six months to July after declining for much of the previous three years

What is the importance of the economic data?

The Financial Stability Review is published by the Reserve Bank every six months. The report is basically a health check on the financial sector but it also assesses the state of household and business balance sheets.

What are the implications for interest rates and investors?

The Reserve Bank doesn’t want banks to ease lending standards to give a boost to economic growth. The RBA is effectively saying that if there is an easing to be done, it is by us. The door certainly remains open to a further rate cut. We favour a move in November but can’t rule out some stimulus being delivered next week.

The document also highlighted the super-conservative financial practices by consumers and businesses and the ongoing deleveraging that is taking place.

Interestingly the cautious nature of Aussie households has not only resulted in paying down debt at a faster pace, but also a shift away from riskier asset classes.

In fact the report details the share of households’ financial assets held directly in equities (outside superannuation) has roughly halved, from 18 per cent in 2007 to 8½ per cent in March 2012.