Answer according to the passage“Key risks to financial systems
1. Financial conditions could tighten further, leading to disorderly declines in asset prices and disruptions to financial system functioning
Financial stability risks would be magnified by a further substantial tightening in global financial conditions. One potential catalyst is that inflation stays high for longer than expected, requiring a larger and more persistent tightening in monetary policy than is currently reflected in financial market pricing. This would exacerbate the risk of a global recession and likely result in a further widening in risk premiums. Large and disorderly declines in financial asset and property prices as a result of higher interest rates and increased risk aversion could disrupt key funding markets and strain the balance sheets of some borrowers and lending institutions. A sharp drop in the demand for and supply of credit would worsen the ensuing downturn and increase the risks to financial stability.

2. As debt-servicing challenges increase, a turn in the credit cycle is likely; a sharp increase in unemployment would magnify these challenges
In aggregate, households and businesses in most jurisdictions have entered the interest rate tightening cycle with strong balance sheets and banks are well capitalised. This is also the case in Australia. However, the combination of higher interest rates and inflation will increase pressure on household budgets and business profitability over the period ahead. This is likely to lead to a turn in the credit cycle, including for lenders in Australia, following a period of very low loan arrears. Debt-servicing challenges will become more difficult still if household incomes are affected by worse-than-expected labour market outcomes.

A small group of borrowers in Australia are particularly vulnerable to repayment difficulties due to rising interest rates and cost-of-living pressures. Many of these households have low liquidity buffers, low incomes and high debt relative to their income. A large decline in housing prices that results in negative equity for households, alongside further shocks to disposable income, would increase the risk that some borrowers default on their loan commitments.

While corporate indebtedness in Australia remains low, many businesses face rising cost pressures, higher interest expenses and slowing revenue growth. Forbearance assisted many firms through the pandemic but is now winding down and insolvencies have started to pick up more recently. There is considerable variation across industries in businesses’ capacity to service debt; those still dealing with pandemic-related disruptions or with energy-intensive cost bases, as well as those with low cash buffers and high levels of debt, are most vulnerable.

Bank balance sheets in Australia are expected to remain resilient to an increase in loan arrears under most plausible scenarios. However, in some economies, a turn in the credit cycle could test the resilience of some lenders (including smaller banks and non-banks) – particularly those with relatively low capital buffers and high leverage, and/or whose lending standards have slipped in recent years.

3. Threats from outside the financial system – including cyber-attacks, geopolitical tensions and climate change – continue to pose risks to financial stability
Cyber-attacks could give rise to systemic risks, a point underscored by the recent attack on Optus. It is probable that a significant financial institution or market infrastructure will be subjected to a successful attack at some point given the increasing sophistication and frequency of cyber-attacks. This could create considerable difficulties for the institution or market concerned and undermine confidence in the broader financial system. The growing risk of cyber-attacks calls for stepped up investment in cyber defence capabilities and increased focus on contingency and recovery plans.

Worsening geopolitical tensions present a growing risk to macroeconomic and financial stability. A deteriorating geopolitical environment has the potential to lead to widespread disruptions to global trade and capital flows. It could also magnify the risk of cyber-attacks on key institutions and infrastructure.

Finally, climate change and extreme weather events have the potential to affect economies and societies on a global scale, and thereby present a systemic challenge for private institutions and policymakers. Both physical and transition risks could result in large losses for financial institutions that are yet to put in place adequate risk controls and resilience strategies.

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What are the main risks facing our financial system today, and explain how these risks might affect our financial system?