As with any APRA stress test, we need to devise a hypothetical scenario for participants to model, with the goal being to propose events and conditions that are “severe but plausible”. Sadly, as we look at the external operating environment there are any number of potential events that would not only be extremely severe but also seem highly plausible. In terms of market shocks, these include the escalation of existing wars, as well as heightened tensions in the Asia-Pacific; the risk of trade wars or sanctions; while the challenges facing the economies of several of our main trading partners have implications for export income and jobs and investment. Operational risks are also rising, as the reliance of businesses and consumers on technology creates vulnerabilities to errors of the kind that sparked July’s global Crowdstrike outage, as well as deliberate sabotage by criminals or state-sponsored groups.

Although geographically isolated, Australia’s economy and financial system are deeply dependent on overseas links. A country famously “built on the sheep’s back”, exports still account for around a quarter of Australia’s GDP¹ and three million jobs² while our financial system relies on access to international markets for access to capital, funding, reinsurance and investment opportunities. The digitalisation of the economy, meanwhile, means many financial institutions rely heavily on internationally based third-party service providers to deliver essential services to the community.

These vulnerabilities are not unique to Australia, and around the world financial regulators are becoming increasingly attuned to the potential impacts of geopolitical volatility on financial stability. APRA is also stepping up its focus on geopolitical risk to ensure both we, and the entities we supervise, are equipped to deal with the impact of such shocks. What I’d like to do today is describe some of the ways APRA, with its mandate for protecting the safety and stability of the financial system, is doing this in a volatile and uncertain operating environment – by improving our understanding of where crises may arise, how they might play out and where the transmission risks reside; and building and retaining financial and operational resilience into the system that we can fall back on in times of need.

Reconnaissance

Despite Russia only scraping into the number 38 spot in the list of Australia’s main export markets, Moscow’s invasion of its western neighbour in early 2022 still had a sizeable economic impact here. In pushing up the global cost of oil and other commodities, in combination with supply chain issues related to COVID-19 and pandemic demand stimulus, the war contributed to sharply higher inflation, which resulted in the Reserve Bank lifting interest rates to bring inflation back into its target range.³ The combination of higher inflation and interest rates has pushed the rate of non-performing loans slowly upwards, increasing bank credit risk. We’ve separately had feedback from our regulated entities about the challenges of complying at short notice with new Australian and international sanctions on Russian interests.

The episode provides a contemporary case-study of how geopolitical risks emanating from outside the financial system can impact Australian banks, insurers and superannuation trustees, as well as the community. This isn’t a new phenomenon, however, several trends have pushed geopolitical risk up global risk registers to a point where it was cited by respondents to the Bank of England’s most recent Systemic Risk Survey as the number one risk to the financial system.⁴ And closer to home, when the Reserve Bank of New Zealand asked 13 local banks to simulate the most plausible scenario that might cause them to breach their capital requirements, geopolitical risk was most commonly identified as the biggest threat.⁵

The first contributing trend is the increased interconnection and complexity of the global financial system: our banks rely on international markets for funding and capital; our insurers depend on a handful of global reinsurance giants; and our superannuation funds heavily invest billions of dollars of members’ money in overseas assets. The second is the ever-growing reliance of financial entities and their customers on digital technologies. Aside from creating supply chain vulnerabilities, this technological dependence creates operational risks such as cyber-attacks or outages that impact the availability of critical functions or services.

Third is the current period of heightened geopolitical volatility, with wars in Europe and the Middle East, and great power competition and territorial disputes in the Asia-Pacific. Less visible, but no less important, is acceleration in the fragmentation of the international order into different regional and political blocs. In the years since the global financial crisis, support for globalisation has waned, the number of free trade agreements globally has stalled at the same time as the volume of trade restrictions including tariffs and sanctions has risen sharply.⁶

Against this backdrop, financial regulators globally are sharpening their understanding of how geopolitical shocks may spill over into the financial system and increase awareness, adaptability and resilience to these risks. The European Central Bank in September nominated strengthening resilience to geopolitical shocks as a key priority for its banking supervision activities, warning of a “prolonged period of sustained geopolitical tensions, marked by high uncertainty and increased volatility”.⁷ Still in Europe, Germany’s primary financial regulator BaFin has begun assessing the exposure of banks, insurers and reinsurers to regions, industries or companies affected by difficult geopolitical circumstances.⁸ In North America, the Canadian Government last year expanded the mandate of its chief financial regulator to cover the threats of foreign interference. Canada’s Office of the Superintendent of Financial Institutions (OSFI) published its first guidance to industry on combatting these threats in January this year⁹ with a focus on integrity – both for individuals and organisations – and improving security measures.

APRA is also stepping up its focus on the risks associated with geopolitical events. Working closely with our fellow agencies on the Council of Financial Regulators (CFR), we are developing a keener understanding of how risks arising from international events could impact banks, insurers and superannuation funds, as well as the broader domestic financial system. APRA recently created its first specialist geopolitical risk team, which is collaborating with CFR agencies to examine potential channels of transmission through which global shocks may reach Australia and how they may impact our financial system. This includes economic impacts in areas such as supply chains, commodity prices and trade restrictions; financial impacts including access to capital and reinsurance, as well as credit, liquidity and interest rate risks; operational risks such as cyber-attacks that impact the availability of critical functions or services; and community impacts including civil unrest or a loss of confidence in the banking system.

With regards to operational risk, APRA has been supporting our financial institutions to build their resilience to risks inherent in a highly connected, digital environment for several years. Our prudential standard on information security has been in place since 2019, while our new prudential standard on operational risk management comes into force next year. The new CPS 230 Operational Risk Management will put our regulated entities in a stronger position to prevent and, where necessary, respond to severe disruptions to business continuity. Additionally, APRA will soon begin a comprehensive review of our governance prudential framework. Our goal is to create a single cross-industry standard that strengthens our expectations on directors’ skills and integrity to ensure boards are better positioned to respond to uncertainty and shocks in the operating environment.

Just as we are further building up our understanding of geopolitical risk as a prudential regulator tasked with maintaining the safety and stability of the financial system, so too are many APRA-regulated entities. This is a trend that supports the CFR’s focus in this area and which we strongly encourage. We note that geopolitical risk carries the potential for multiple disruptive events to occur simultaneously. For example, a cyberattack may occur at the same time as a geopolitical shock, which may both be happening during instances of bank runs, all converging to compound the financial risks already occurring. We recommend that organisations should start to include these more severe “multi-event” scenarios in their overall risk management approach.

As with other areas in our prudential framework, proportionality here is key. While boards, senior leaders and risk functions need to be aware of their operating environment and how overseas events may impact their operations, we recognise that not every entity has the size, resources or international exposure to necessitate its own specialist teams. We would expect entities of greater systemic significance, however, to be dialling up their focus on understanding how international events could impact their businesses.

Joint exercises

Although not specifically a response to heightened global volatility, APRA’s new system risk stress test is another tool that is designed to increase our understanding of transmission risks across a financial system that has grown ever larger and more complex in recent years. It’s also recognition of the growing systemic importance of superannuation, as well as the emergence of new financial sectors: private credit, crypto, alternative payment platforms and digital wallets.

For this first test, we have decided to focus on links between the two giants of the Australian financial system: a banking industry holding more than $6 trillion in total assets and a superannuation industry with almost $4 trillion in funds under management. Specifically, we intend to explore the extent to which the superannuation system may dampen or amplify stress across the financial system. The four potential risk transmission channels we are most interested in are:

• the impact of a crisis on superannuation fund liquidity and how trustees might respond to any shortfalls;
• the impact on banks’ liquidity due to large outflows from institutional counterparties;
• banks’ ability to rely on superannuation as a source of capital in time of stress; and
• the impact of asset markets from banks’ and superannuation trustees’ synchronised responses to the stress.

We remain in consultation with industry on the design of the test and the scenario we model. We anticipate that it will involve a major financial market shock of some sort, a series of secondary shocks that erode bank capital and superannuation member contributions, compounded by an operational risk component that disrupts entities’ ability to respond to the financial challenges.

Fortifying our defences

While we continue looking for information we can use to reinforce the resilience of the banking, insurance and superannuation industries, it’s important to note that Australia’s financial system is already in a strong position to deal with a crisis. That strength has been built up over many years in alignment with international best practice and lessons from real life events.

In the aftermath of the global financial crisis, our banks have “unquestionably strong” capital levels, above minimum regulatory requirements. Our life, general and private health insurers hold capital between 1.8 and two and a half times their minimum regulatory requirements in addition to their reinsurance provisions. Our superannuation system is amongst the world’s largest and its performance has only been sharpened by APRA’s efforts to weed out underperforming funds, scrutinise questionable expenditure and improve asset valuation practices.

This position of financial strength not only enables financial institutions to absorb heavy losses in the event of a crisis; it also enables the system to act as a shock absorber, supporting households and businesses when they need it most. We saw this during the pandemic as banks allowed home and business borrowers to defer payments on more than 832,000 loans, or a total loan value of roughly $266 billion. Some 3.5 million Australians drew down a portion of their superannuation to see them through financial difficulty, while business interruption insurance was a lifeline for many companies unable to trade through the prolonged lockdowns, social gathering limits and travel restrictions.

Speaking in London only a few weeks ago, the Deputy Governor of the PRA, APRA’s UK equivalent, noted that the GFC had been the “biggest growth-destroying event in recent economic history” and avoiding any repeat was the most important contribution the Prudential Regulation Authority could make to promoting growth.¹⁰So to return to the thrust of my speech to the Australian Banking Association Conference in June, a safe and stable financial system is not an impediment to economic growth – it’s a precondition. 

Something in reserve

That’s something worth reflecting on as we consider APRA’s macroprudential policies, which also play a role in building additional reserves/buffers into the system that can be drawn on during more difficult times.

Earlier today, APRA announced that we are keeping those settings steady. It’s a decision we came to after careful consideration of factors including household debt levels, credit growth, labour market conditions, as well as instability in the geopolitical environment.

The counter-cyclical capital buffer remains at its default rate of 1 per cent of risk-weighted assets. While it’s never been deployed in Australia, the release of the full one per cent buffer by all Australian banks would free up roughly $22 billion to support continued lending to households and businesses in a significant downturn.

The mortgage serviceability buffer also stays at 3 percentage points above the loan rate. Despite the scrutiny it’s been subjected to over recent months, the purpose of this buffer isn’t always well understood in the community. It’s often described as purely a measure to ensure borrowers can meet repayments should interest rates rise another 3 percent. However, that is far from the full picture.

At an individual level, it’s a contingency for any type of deterioration in a borrower’s financial position, whether a loss of income, falling ill and being unable to work or an unexpected rise in expenditure. At a system-level, it is a contingency against economy-wide risks factors, such as a rise in unemployment or the impact of an international trade war. In short, it’s a buffer for uncertainty – something there is no shortage of in the current geopolitical environment.

When it comes to home lending, that built-in safeguard is especially important given that mortgages are by far the largest asset class held by Australian banks. Residential mortgages make up two-third of all bank loans in Australia, compared to 30 per cent in Europe¹¹ and only 10 per cent in the United States.¹²Australians also have one of the highest levels of household debt relative to income in the world. Our banking system is therefore particularly vulnerable to any scenario that results in large numbers of borrowers being unable to make their mortgage repayments. Should bank losses begin to mount due to borrower defaults and homes sold for a loss, we would likely see banks withhold dividends to investors and curtail lending as their capital positions came under threat. This would further weaken the domestic economy and amplify the impact of the crisis.

At the moment, about 1 per cent of home loans are classified as non-performing to the value of $23 billion. That’s around 35,000 households in deep financial difficulty and facing immense financial and emotional stress.¹³ That level of mortgage stress is relatively normal in historical terms but it’s double the proportion we saw in 2016 and it’s trending up.

With the IMF recently predicting low economic growth and higher unemployment in Australia over the coming year,¹⁴ APRA believes the current macroprudential settings remain appropriate. That said, the settings remain under constant review and should APRA believe that changes would strike a better balance between risk and reward in the financial system, then we will do so.

Prepared for uncertainty

The world has always been an uncertain and sometimes dangerous place, and interconnection brings risks as well as opportunities.

But just as Australia’s national prosperity has been built over the past two centuries on international trade, so does our financial system rely on access to global markets. Isolation is not an option. 

We can, however, prepare for the impact of global events by building up our understanding of where risks lie, how they might flow through to our institutions or the broader Australian financial system and what mitigating actions we might take. Just as importantly, we can ensure our banks, insurers and superannuation trustees have the financial and operational resilience to keep supporting their customers and the economy in the event of a crisis. We might not be able to prevent uncertainty, but we can be certain of the strength of our financial system to deal with it.

Footnotes

¹ Australia Trade Statistics | WITS

²  Exporters drive Australian jobs and economy | Minister for Trade and Tourism

³  In its May 2022 statement on monetary policy, following the first upward move in the official cash rate since 2010, the Reserve Bank stated that “the recent increase in inflation largely reflects the increase in energy, food and other commodity prices associated with the Russian invasion of Ukraine, but inflation pressures are broad based.”

⁴  Systemic Risk Survey Results - 2024 H2 | Bank of England

⁵  Financial Stability Report Nov 2024

⁶  Global trade has nearly flatlined. Populism is taking a toll on growth

⁷  Global rifts and financial shifts: supervising banks in an era of geopolitical instability

⁸  BaFin - Foreword by the President - 3. Geopolitical turmoil

⁹  Integrity and Security - Guideline - Office of the Superintendent of Financial Institutions

¹⁰  Competing for growth − speech by Sam Woods | Bank of England

¹¹  Real estate markets in an environment of high financing costs

¹²  Federal Reserve Board - Assets and Liabilities of Commercial Banks in the United States - H.8 - October 25, 2024

¹³  Data on the number of households affected by non-performing home loans is not available, and so this represents an approximation based on 1 per cent of households that have a mortgage on their home.

¹⁴  Australia economy: IMF warns of more economic trouble ahead