Australian banks are too exposed to mortgages, but what if the world was flat?

Greater asset diversification would help Australian banks lock in a buffer for future downturns. Joel Carrett/Flickr

One of the issues currently being considered by Australia’s Financial System Inquiry is the heavy exposure of Australian banks to the residential mortgage market.

The exposure to domestic mortgages, which account for around 60% of all bank lending, and to small and medium enterprise loans, could be a key impediment to the resilience of our financial system, raising the question of how to mitigate this risk.

The global financial crisis showed how disastrous a real estate correction can be, with loss rates in bank mortgage portfolios exceeding bank capital set aside to cover such losses. The Australian Prudential Regulation Authority recently issued a draft prudential practice guide on residential mortgage lending to limit some of the risks.

Also of concern to regulators is the exposure of investors and superannuation fund members to the performance of banks, because of the high dependence on bank deposits and the concentration of superannuation savings on Australian equities, with a heavy allocation to banks.

But other national economies are exposed to similar issues, opening up the possibility that global risk transfer mechanisms could be used by banks to share risks across countries with differing business cycles, concentrations and risk appetites.

Merits of international financial integration

Generally speaking, asset portfolio performances move in tandem with the economy. The chart below compares GDP growth rates - as a proxy for the macro economy - for Australia and and an equally-weighted average over Australia and the US.

Real GDP growth rate - Australia versus equally-weighted Australia/US average. Organisation for Economic Co-operation and Development.

The variation of the GDP growth rate (solid lines) follow different business cycles. Australia experienced the lowest GDP growth in 1983 and the US during the recent financial crisis in 2009.

This suggests that internationally diversified bank asset portfolios (for example, with diversification over Australian and US assets) could allow a reduction in loss rate variation – in particular, lower loss rates during severe economic downturns. For example, the lowest GDP growth rate for an equally-weighted portfolio in Australia and the US (dashed blue line) is 47% lower than for Australia only.

This would allow greater propensity for capital requirements and capital buffers to be sufficient to cover future losses than would be the case with nationally concentrated asset portfolios and hence a greater resilience of Australian banks. A second result would be better risk-return outcomes for financial institutions and their investors and, as a result, a greater efficiency of Australian banks.

Diversification works in both ways. Losses during economic downturns may be lower and in economic upturns higher. During the recent global financial crisis (GFC), a bank portfolio balanced over Australian and US assets would have had a lower performance than one concentrated on Australian assets.

It’s sometimes argued that financially literate investors, rather than the banks they invest in, may choose such diversification strategies. But this is limited in the real world, specifically with regard to retail deposit and superannuation investments.

Further international asset diversification of Australian banks, in particular across countries with relatively low commercial but high financial integration (such as the US and Europe) would be beneficial. Other benefits may include a mitigation of existing foreign exchange exposures resulting from overseas bank funding.

The role of asset securitisation

One obvious way forward may be asset securitisation. Securitisation markets allow financial institutions to transfer existing assets and their risks to third parties, including overseas investors and to obtain exposure to alternative asset classes.

The Financial System Inquiry acknowledges that residential mortgage-backed securitisation markets are in parts constrained after the GFC.

The chart below compares the total assets of authorised deposit-taking institutions (ADIs) and securitisation vehicles. Australian securitisation consists mainly of residential mortgage-backed securities issued by ADIs and non-ADIs. Securitisation volumes have declined after the GFC, while total ADI assets have increased further.

Total assets of securitisation vehicles and ADIs. Reserve Bank of Australia

The numbers suggest that less than 4% of total ADI assets are currently securitised. The fraction of assets transferred to overseas investors is likely to be much smaller.

A second issue is that securitisation is often seen as a source of funding, as financial institutions effectively sell loan portfolios and use the proceeds to fund the origination of new Australian loans. So, securitisation may not change the concentration of Australian banks on domestic assets, as investment volumes are reallocated to the same domestic asset classes.

To diversify asset portfolios internationally, securitised bank assets could be replaced with investments that are exposed to assets with low correlation to the remaining asset portfolios for diversification to work. For example, banks that issue domestic residential mortgage-backed securities could invest in overseas securities.

Another alternative outside securitisation could be a straightforward swap of a significant fraction of bank assets between a major Australian and a major overseas financial institution.

Making it a reality to avoid future crises

Australian banks have largely avoided international asset diversification in the past - what would change the status quo?

Change may require reducing potential impediments such as transaction costs and information asymmetries. Banks know their own mortgage customers well, but information asymmetries exist if local lenders have a better understanding of transferred risks than overseas investors who will demand premium for uncertainties, and vice versa.

Incentives may be required to encourage banks to internationalise asset portfolios, and re-invigorate securitisation markets - this would make sense given both would greatly support the resilience of the Australian financial system.

The Financial System Inquiry recently closed its second round of submissions and is now working towards its final report to the Australian government. The terms of reference have a strong focus on the reduction of costs and other inefficiencies. The outcome of this inquiry could lay the foundation to make international asset diversification a reality.