Speech
Financial Stability Through the Lens of Business
[*]
Michele Bullock Assistant Governor (Financial System)
Address to the Toowoomba Chamber of Commerce
Toowoomba - 8 August 2019
Thank you to the Toowoomba Chamber of Commerce for inviting me to speak with you today. It is a
pleasure to be here.
I have spoken about financial stability from a number of perspectives in the past - resilience of the
banking sector, developments in the property sector and developments in the household sector.
Today I want to talk about financial stability from the perspective of the business sector. In our
regular Financial Stability Review, we always discuss the corporate sector balance sheet and its
resilience. Today I want to draw out some of the issues we have been focusing on in recent months.
But, first of all, what is financial stability and why is it important? As I have said in the past, there is
no universal definition. But basically, it is when the financial sector is doing its job of facilitating a
smooth flow of funds in the economy to support economic growth. The opposite, financial instability,
is probably easier to picture though. This is where the financial sector is experiencing disruptions so
that it harms the economy. The global financial crisis, or GFC, was a very vivid demonstration of
what can happen when the financial system is unstable - credit supply dries up, investment and
consumption fall and unemployment rises. So there is a very human cost to financial instability.
While we at the Reserve Bank do not have responsibility for the supervision of financial institutions,
we do have an important role in monitoring the financial system as a whole and the economy for
financial imbalances that could lead to instability. We typically look at such things as developments in
financial markets, and, in particular, evidence of excessive risk-taking behaviour, the balance sheets
of financial institutions and their resilience to changes in economic circumstances, and household
and business balance sheets. Part of our role is to draw attention to potential risks that might be
building and have an impact on the stability of the financial system.
Why are developments in the business sector relevant for financial stability? One obvious link is that
if businesses are struggling to meet their obligations, they impact on the real economy and this could
have flow-on effects to bank balance sheets through increasing non-performing loans and defaults.
But poorly performing businesses in one sector could also feed through to employment and
businesses in other sectors, amplifying the effect. For example, poorly performing retail businesses
might impact workers as well as owners and developers of shopping centres. Farm businesses that
are affected by the drought will reduce their expenditure on capital and labour as well as their
expenditure on discretionary consumption, impacting a range of businesses in their communities.
And these impacts in turn will be reflected in banks' asset quality if households and businesses find it
more difficult to service their loans. Furthermore, while specific shocks to a particular business sector
may not have immediate financial stability implications, they can mean that businesses in that sector
are, for some time, more vulnerable to broader macroeconomic shocks. So it is important for us to
understand and assess the impact of idiosyncratic shocks on balance sheet health.
In addition, some developments can be quite specific to business conditions in particular regions,
and to those financial institutions that have extended credit to businesses and households in those
regions. The end of the mining investment boom, for example, had significant implications for the
economy and businesses in mining intensive regions, such as Western Australia and parts of
Queensland. This in turn has seen large falls in housing prices and increases in arrears in these
regions. However, banks appear to be managing this, and the increase in arrears does not currently
pose a risk to financial stability. Nonetheless, it does illustrate that in assessing the financial stability
implications of business conditions, it is important to give some consideration to sectors, regions, and
even the size of the firms.
In the rest of my speech, I will discuss some aspects of business conditions that are relevant to
thinking about financial stability. I will start with some information on businesses in aggregate. I will
then talk a little about some individual sectors and I will finish up with a focus on the small business
sector.
Conditions in the business sector
There are a number of metrics we use to look at the financial health of firms.
Profitability or return on equity give an indication of the general health of the business. Firms with
low profitability are more likely to cease operations due to poor performance and, in the process,
potentially default on their debts.
Gearing looks at how much debt relative to equity there is in the business. Firms with high
gearing are more vulnerable to asset price falls and losses from their operations as they have a
relatively small equity buffer. This makes them more likely to go bankrupt and default. So, if
gearing is high, the firm is likely to be viewed as riskier.
Debt-servicing ratios measure the ratio of interest expenses on any debt to the profits of the
business. This gives an indication of firms' capacity to repay their loans. The higher this is, the
more at risk firms are if interest rates rise or profits fall.
Liquidity measures the ratio of cash to a firm's current liabilities. This measures the firm's ability to
repay its current liabilities as they become due. If this is very low, firms are at risk of being unable
to meet their short-term financial obligations.
The most current data we have on the financial position of businesses is from listed corporations.
Companies listed on the stock exchange tend to be large, and have to report regular information to
the market. This provides a useful source of timely information on companies' financial health. In
contrast, small businesses are unlisted and so information about their financial health is less readily
available and comes with a longer lag. Because they account for the majority of borrowing, large
businesses pose a greater risk to financial stability. That's not to say small businesses aren't
important, and I will come back to discuss them later.
On the basis of listed companies reporting, conditions in the business sector in 2018 were positive
overall, supported by continued economic growth and low interest rates.
In aggregate, profits of listed non-financial corporations have looked healthy over recent years. The
aggregate return on equity (before interest, tax and depreciation) of these firms was around
25 per cent in 2018, a little higher than it has been on average since the GFC (Graph 1). Gearing and
debt-servicing ratios have trended lower in recent years and liquidity has increased further. This
means that, in aggregate, firms have a larger equity buffer in their business, are less vulnerable to
unexpected decreases in cash flows and are better placed to repay their short-term financial
obligations. This is good from the perspective of financial stability as firms seem to be less vulnerable
to negative economic shocks.
Graph 1
But the aggregates can disguise substantial differences across firms. It is therefore important to look
at the distribution of the various financial metrics. For this purpose we typically look at the median
and the risky 'tails' of the distribution. The median is the value of the metric which is in the middle of
the group - half the group have values above the median and half have values below. There are a
number of ways to define the risky tail of the distribution. Today, I am defining it as either the top or
bottom 25 per cent depending on the relationship between the financial metric and firm riskiness.
For example, higher gearing and debt-servicing ratios make a firm more vulnerable to negative
shocks. So we examine more carefully those firms for whom gearing and debt-servicing burden fall in
the top 25 per cent of the group. On the other hand, low profitability and liquidity tend to make firms
more vulnerable. Consequently, we look at developments in the group of firms with ratios in the
bottom 25 per cent of the distribution.
Looking at the distributions of the financial metrics, the financial position of the most vulnerable
firms generally improved over the past few years (Graph 2). While the least profitable 25 per cent of
companies are making losses, returns on equity for this group have risen slightly over the past few
years. These companies, however, tend to have very little debt overall so there is little potential for
flow-on effects to the financial sector. Gearing ratios for firms in the top 25 per cent of the group are
quite a bit lower than they were a decade ago. In line with low gearing and the low interest rate
environment, the debt-servicing ratios for companies in the top 25 per cent of the distribution are
also at low levels, having fallen sharply over the past decade. Lastly, the liquidity position of
companies in the bottom 25 per cent has been reasonably stable over the past few years at higher
levels than seen in the years leading up to the financial crisis. In general, it would seem that the
financial stability risks from these vulnerable firms are not increasing.
Graph 2
Sectoral differences
Another perspective on financial stability risks comes from looking at sectors facing changes in their
environment that could make them more vulnerable. The two I am going to focus on here are
domestic retailing and mining because they provide some interesting contrasts.
Domestic retailing, particularly bricks-and-mortar retailing for discretionary goods, has been
experiencing challenging conditions in recent years. Competition from both large international and
online retailers has been intense; consumer spending is growing slowly and consumer preferences
are changing.
Some colleagues of mine undertook some work on the potential financial stability risks associated
[1]
with the retailing sector in the second half of last year. Broadly, they concluded that, although
retailers and investors face a number of risks, there is currently no strong evidence of widespread
vulnerability, or that risks to banks are high.
They found that while listed discretionary goods retailers appear to be in good financial health
overall, there were some signs of financial difficulties in some unlisted and smaller retailers. The next
two graphs, drawn from their work, show some key financial ratios for listed and unlisted retailers
respectively. There is a lot of information here so I want to draw your attention to just a few points.
Starting with the listed sector, the financial position of discretionary retailers generally appear sound
(Graph 3). Profitability as measured by return on equity has remained broadly stable at reasonably
high levels across the distribution. Similarly, liquidity ratios are also at reasonably high levels so
companies appear well positioned to meet their short-term liabilities. Turning to the bottom panels of
the graph, gearing has been broadly unchanged at low levels across the distribution. In line with
this, and also reflecting declining interest rates, debt-servicing ratios have trended downwards to be
fairly low.
Graph 3
Unlisted retailers, on the other hand, are not so well positioned in terms of gearing and liquidity
(Graph 4). Over one quarter of unlisted retailers are highly indebted, with gearing ratios above
100 per cent. This implies that their debt is larger than their equity and, as a result, they are more
vulnerable to asset devaluations or losses. In addition, liquidity ratios declined in recent years and
remain at low levels. This in turn has increased the risk that they will not be able to meet their short-
term liabilities without selling assets. Another negative development in this sector is that the share of
loss-making retailers has increased over the past few years. However, these retailers are, on
average, smaller, accounting for around 10 per cent of total retail sector debt.
Similarly, they found that, looking across listed and unlisted companies, small retailers are more
[2]
likely to be identified as vulnerable than large retailers. This classification is based on whether at
least two out of the four financial ratios fall in the most vulnerable 25 per cent of their distributions.
Basing this classification on at least two ratios is important because looking at one financial metric
alone may not give us a true sense of the firm's financial health. For example, a firm may have a
relatively high gearing ratio but may be able to safely sustain this due to strong profitability. Taken
together, smaller retailers appear to be facing more difficult conditions in both the listed and unlisted
sector. Having said that, there is no current evidence of widespread vulnerability and difficulties in
the sector appear unlikely to pose a significant risk to the banking sector.
Graph 4
However, the challenges faced by brick-and-mortar retailers have spilled over into the demand for
retail floor space. Conditions are weakest in mid-sized shopping centres, where vacancy rates have
increased to around 5 per cent, up from around 3 per cent a few years ago (Graph 5). Vacancy rates
have also drifted a little higher in large shopping centres. Rents have been flat over the past few
years, and landlords have attempted to avoid vacancies by increasing incentives and changing
tenancy mixes. And retail valuations have been rising much slower than other commercial property
valuations. At the same time, there has been a considerable increase in retail development activity in
recent years, both in terms of refurbishments and the building of new centres. It is possible that
some of this might just be keeping pace with population growth. But there is also a risk that new and
improved shopping centres simply cannibalise business from some other centres, eventually resulting
in excess supply, particularly in light of weak household spending of late. This would weigh on rents
and valuations. And, to the extent that owners of these centres hold debt, difficulties in servicing
repayments could result in further sales and price declines.
Graph 5
Ultimately, the implication for financial stability of these vulnerabilities depends on the exposures of
the financial institutions to retail businesses and developers. So the third issue addressed by my
colleagues was banks' exposures to retail commercial property development. Given the increase in
retail property development over the past decade, it is perhaps not surprising to see that banks'
exposures have also risen (Graph 6). Indeed, in terms of commercial property, banks are most
exposed to office and retail, and exposures to both these sectors have increased sharply over the
past decade. Nevertheless, at less than $60 billion, the exposure represents less than 3 per cent of
major banks' assets. And despite the difficult conditions in this sector, this has not translated into a
deterioration in loan performance with non-performing loans to the retail sector remaining
unchanged at low levels. So, while there may be vulnerabilities in the retail sector, these do not
currently seem to pose a significant risk to the financial sector.
Graph 6
The second sector I want to focus on is the mining sector. In contrast to the retail sector, mining
firms in aggregate have experienced improved conditions recently, driven by increased commodity
prices. Accordingly, profitability has increased to be at its highest level in the past ten years
(Graph 7). Liquidity is also at a very high level. At the same time, debt and gearing ratios are at the
lower end of the ranges seen over the past couple of decades. In fact, they are also relatively low
when compared to firms outside of the resources sector. As a result, mining firms' balance sheets
appear well placed to absorb shocks, perhaps more than has been the case for some time. So, while
risks related to market conditions have abated somewhat, this has occurred alongside ongoing
improvements in mining firms' balance sheet positions. Specifically, firms in the sector have reported
a strong focus on reducing costs, realising efficiencies and paying down debt, particularly amid
earlier expectations of commodity price declines (as global supply increased and demand was seen
to be moderating). And while banks' direct exposures to the mining sector tend to be very low at
around one per cent, the mining sector accounts for around 20 per cent of Australia's business
investment. As such, there are important spillover channels to the rest of the economy, which mean
that the improved position of mining firms reduces risks to firms in other parts of the economy.
Graph 7
Small business
The final issue I want to briefly cover is conditions for small business more generally and risks that
[3]
could arise from this source. Small businesses are a substantial part of the Australian economy.
They account for 70 per cent of employment and 40 per cent of production in the private non-
financial sector. Difficult conditions in small business could therefore have flow-on effects to the
economy through decreasing employment and lower income for unincorporated enterprises, and
hence to the health of households' balance sheets more broadly. And these effects are often
particularly felt in regional areas where small businesses are part of the lifeblood of the community.
Furthermore, there could be impacts on banks' asset quality if non-performing loans rise.
Small businesses have been facing tighter credit conditions over the past year or so from a level that
was already tight. Over the past couple of years, lending to small businesses (which includes
businesses with annual turnover of less than $50 million) has hardly grown at all, unlike lending to
large businesses, which has grown by around five per cent per year on average (Graph 8).
Graph 8
[4]
There are a number of reasons why small businesses are facing tighter credit conditions. First,
there is a more of a blurring in the line between lending to small business and personal credit. The
obligations placed on financial institutions for lending to consumers (under responsible lending
obligations) are stricter than the requirements for lending to small business, and these have
tightened over the past couple of years. But lenders are increasingly treating small businesses as
household borrowers, imposing the stricter conditions on small business lending. Furthermore,
property is a common form of security for small business lending - around 50 per cent of loans to
small business are secured by residential property. The decline in housing prices over the past couple
of years has therefore likely to have reduced the amount of money that small businesses can
borrow.
Having said that, some colleagues of mine have done some work looking at the characteristics of
[5]
firms that are likely to receive credit. They showed that, while the size of the business is an
important consideration in the lender's decision to extend credit, other factors are also important
once you control for size and other characteristics. These other factors include profitability, debt-
servicing ratios and credit history. For example, more profitable firms are more likely to receive credit
after controlling for the influence of other characteristics.
Nonetheless, tighter credit conditions make it more difficult for small businesses to fund themselves
or to refinance existing debt. It is likely to be particularly challenging in regional areas impacted by
the drought, where many businesses are already experiencing difficulties.
It is possible that these tighter credit conditions might push small businesses into failure and default
on their loans. But any impact from this channel on the financial system at this stage is still quite
small. Non-performing loans in the private unincorporated business sector have risen a bit over the
past year or so but they remain at relatively low levels (Graph 9). And lending to this sector accounts
for a small share of banks' assets.
Graph 9
Conclusion
Today I have outlined a view of the stability of the Australian financial system through the lens of the
business sector. In general, the financial health of businesses looks sound. And while some individual
sectors and regions do face challenges, these do not currently pose a threat to financial stability.
Financial institutions are resilient and their exposures to these areas remain low. It is nevertheless
important to keep an eye on developments in the business sector and remain alert to possible risks
to financial stability from this source.
Endnotes
[*] I am grateful to Gabriela Araujo and Cathie Close for assistance with this speech.
[1] Araujo G and T De Atholia (2018), 'Financial Stability Risks and Retailing', RBA Bulletin, September.
[2] They define small businesses as those with less than $10 million in assets, medium-sized businesses as those with
more than $10 million but less than $100 million in assets, and large businesses as those with $100 million or more
in assets.
[3] There are a variety of definitions of small business. The definition here is businesses with annual turnover less than
$50 million.
[4]
Connolly E and J Bank (2018), 'Access to Small Business Finance', RBA Bulletin, September.
[5]
Araujo G and J Hambur (2018), 'Which Firms Get Credit? Evidence from Firm-level Data', RBA Bulletin, December.
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