Speech
The Evolution of Household Sector Risks
[*]
Michele Bullock Assistant Governor, Financial System
Ai Group Albury - 10 September 2018
Thank you for the invitation to speak at this Ai Group lunch. It is great to be back in regional
Australia. I am responsible for the area of the Bank that focuses on financial stability. So my remarks
today are going to cover one of the financial risks we have been focusing on over recent years - the
high level of household debt in Australia. Household debt has been rising for a number of decades.
How much of a concern is this? I am going to talk through the evolution of the current debt situation
and how we see the current risks. Given that I am in Albury-Wodonga, I will finish with a few
comments on housing markets and debt in regional Australia.
Household debt in Australia has been rising relative to income for the past 30 years (Graph 1). This
graph shows the total household debt-to-income for Australia from the early 1990s until this year.
Over that time it has risen from around 70 per cent to around 190 per cent. There are three distinct
periods. The first, from the early 1990s until the mid-2000s, saw the debt-to-income ratio more than
double to 160 per cent. Then there was a period from around 2007 to 2013 when the ratio remained
fairly steady at 160 per cent. Finally, since 2013, the debt-to-income ratio has been rising again,
reaching 190 per cent by 2018.
Graph 1
Australia has not been unique in seeing debt-to-income ratios rise. The median debt-to-income ratio
for a range of developed economies has also risen over the past 30 years. But the Australian
debt-toincome ratio has risen more sharply. In fact, Australia has moved from having a debt-to-income ratio
lower than around two thirds of countries in the sample to being in a group of countries that have
debt-to-income ratios in the top quarter of the sample. This suggests that there are both
international and domestic factors at play when it comes to debt-to-income ratios.
There are two key international factors that have tended to increase the ability of households in
developed countries, including Australia, to take on debt over the past few decades. The first is the
structural decline in the level of nominal interest rates over this period, partly reflecting a decline in
inflation but also a decline in bank interest rate margins as a result of financial innovation and
competition. With lower interest payments, borrowers could service a larger loan. The second is
deregulation of the financial sector. Through this period, the constraints on banks' lending were
eased significantly, allowing credit constrained customers to access finance and banks to expand
their provision of credit.
But as noted, in Australia the household debt-to-income ratio has increased more than for many
other countries. The increase in household debt over the past few decades has been largely due to a
rise in mortgage debt. And an important reason for the high level of mortgage debt in Australia is
that the rental stock is mostly owned by households. Australians borrow not only to finance their
own homes but also to invest in housing as an asset. This is different to many other countries where
a significant proportion of the rental stock is owned by corporations or cooperatives (Graph 2). This
graph shows for a number of countries the share of dwellings owned by households on the bottom
axis and the average household debt-to-income ratio on the vertical axis. There is a clear tendency
for countries where more of the housing stock is owned by households to have a higher household
debt-to income-ratio.
Graph 2
Potential vulnerabilities
This high level of household debt relative to income raises two potential vulnerabilities. First, because
mortgage lending is such an important part of bank balance sheets in Australia, any difficulties in the
residential mortgage market could translate to credit quality issues for banks (Graph 3). And since all
of the banks have very similar balance sheet structures, a problem for one is likely a problem for all.
This graph shows the share of banks' domestic credit as a share of total credit over the past couple
of decades. Australian banks have substantially increased their exposure to housing over this period
and housing credit now accounts for over 60 per cent of banks' loans. So the Australian banking
system is potentially very exposed to a decline in credit quality of outstanding mortgages.
Graph 3
The risk that difficulties in the residential real estate market translate into stability issues for the
financial institutions, however, appears to be currently low. The Australian banks are well capitalised
following a substantial strengthening of their capital positions over the past decade. While lending
standards were not bad to begin with, they have nevertheless tightened over the past few years on
two fronts. The Australian Prudential Regulation Authority (APRA) has pushed banks to more strictly
apply their own lending standards. And APRA has also encouraged banks to limit higher risk lending.
Lending at high loan-to-valuation ratios has declined as a share of total loans, providing protection
against a decline in housing prices for both banks and households. And for loans that continue to be
originated at high loan-to-valuation ratios, the use of lenders' mortgage insurance protects financial
institutions from the risk that borrowers are unable to repay their loans. Overall, arrears rates on
housing loans remain very low.
But the second potential vulnerability - from high household indebtedness - is that if there were an
adverse shock to the economy, households could find themselves struggling to meet the repayments
on these high levels of debt. If they have little savings, they might need to reduce consumption in
order to meet loan repayments or, more extreme, sell their houses or default on their loans. This
could have adverse effects on the real economy - for example, in the form of lower economic
growth, higher unemployment and falling house prices - which could, in turn, amplify the negative
shock.
So what do the data tell us about the ability of households to service their debt? This graph shows
the ratio of household mortgage debt to income (a subset of the previous graph on household total
debt) on the left hand panel and various serviceability metrics on the right hand panel (Graph 4).
The mortgage debt-to-income ratio shows the same pattern as total household debt-to-income -
rising up until the mid-2000s then steadying for a few years before increasing again from around
2013. The dashed line represents the total mortgage debt less balances in 'offset' accounts. This
shows that taking into account these 'buffers', the debt-to-income ratio has still risen, although not
by as much. So households in aggregate have some ability to absorb some increase in required
repayments.
Graph 4
In terms of serviceability, interest payments as a share of income rose sharply from the late 1990s
until the mid-2000s reflecting both the rise in debt outstanding as well as increases in interest rates.
Interest payments as a share of disposable income doubled over this period. Since the mid-2000s,
however, interest payments as a share of income have declined as the effect of declines in interest
rates have more than offset the effect of higher levels of debt. Indeed even total scheduled
payments, which includes principal repayments, are lower than they were in the mid-2000s, as the
rise in scheduled principal as a result of larger loans was more than offset by the decline in interest
payments.
The risks nevertheless remain high and it is possible that the aggregate picture is obscuring rising
vulnerabilities for certain types of households. Interest payments have been rising as a share of
income in recent months, reflecting increases in interest rates for some borrowers, particularly those
with investor and interest-only loans. Scheduled principal repayments have also continued to rise
with the shift towards principal-and-interest, rather than interest-only, loans. There are therefore no
doubt some households that are feeling the pressure of high debt levels. But there are a number of
reasons why the situation is not as severe as these numbers suggest.
First, the economy is growing above trend and unemployment is coming down. While incomes are
still growing slowly, good employment prospects will continue to support households meeting their
repayment obligations. Second, as noted earlier, households have taken the opportunity over the
past decade to build prepayments in offset accounts and redraw facilities. In fact, despite the
continuing rise in scheduled repayments, actual repayments relative to income have remained quite
steady as the level of unscheduled repayments of principal has declined and offset the rise in
scheduled repayments. Third, as noted earlier, lending standards have improved over the past few
years, resulting in an improvement in the average quality of both banks' and households' balance
sheets. Much slower growth in investor lending, and declining shares of interest-only and
high-loanto-valuation lending have also helped to reduce the riskiness of new lending. And at the insistence of
the regulator, banks have been tightening their serviceability assessments. In addition, strong
housing price growth in many regions over recent years will have lowered loan-to-valuation ratios for
many borrowers. As noted earlier, arrears rates remain very low.
The discussion above has focussed on the average borrower but what about the marginal borrower?
For example, will the tightening standards result in some households being constrained in the
amount they can borrow with flow-on effects to the housing market and the economy? Our analysis
suggests that while we should remain alert to this possibility, it seems unlikely to result in a
widespread credit crunch. The main reason is that most households do not borrow the maximum
amount anyway so will not be constrained by the tighter standards. While the changes to lending
standards have tended to reduce maximum loan sizes, this has primarily affected the riskiest
borrowers who seek to borrow very close to the maximum loan size and this is a very small group.
Most borrowers will still be able to take out the same sized loan.
It has also been suggested that the expiry of interest-only loan terms will result in financial stress as
households have to refinance into principal-and-interest loans that require higher repayments. Again,
this is worth watching, but borrowers have been transitioning loans from interest-only to
principaland-interest for the past couple of years without signs of widespread stress. Our data suggest that
most borrowers will either be able to meet these higher repayments, refinance their loans with a new
lender, or extend their interest-only terms for long enough to enable to them to resolve their
situation. There appears to be only a relatively small share of borrowers that are finding it hard to
service a principal-and-interest loan, which is to be expected given that over recent years,
serviceability assessments for these loans have been based on the borrower's ability to make
principal-and-interest repayments. So far, the evidence suggests that the transition of loans from
interest-only to principal-and-interest repayments is not having a significant lasting effect on banks'
housing loan arrears rates.
The distribution of household debt
So far, I have focussed on data for the household sector as a whole. But an important aspect of
considering the risks inherent in household debt is the distribution of that debt. If most of the debt is
held by households with lower or less stable income for example, it will be more risky than if a
substantial amount of the debt is held by households with higher or more stable income. In this
respect, the data suggest that we can have some comfort. This graph shows the shares of household
debt held by income quintiles - the bottom 20 per cent of incomes, the next 20 per cent and so on
up to the top 20 per cent of incomes (Graph 5). And it shows how these shares have changed from
the early 2000s until 2015, the latest period for which the data are available. Around 40 per cent of
household debt is held by households that are in the top 20 per cent of the income distribution and
this share has remained fairly steady for the past 20 years. Furthermore, households in the second
highest quintile account for a further 25 per cent of the debt. So in total two-thirds of the debt is
held by households in the top 40 per cent of the income distribution. Nevertheless, around
15 per cent of the debt is held by households in the lowest two income quintiles. Whether or not this
presents risks is not clear. Retirees are typically captured in these lower income brackets and if this
debt is connected with investment property from which they are earning income, it may not be
particularly risky.
Graph 5
Another potential source of risk in the distribution of debt is the age of the head of the household. As
noted, a regular, stable income is important for servicing debt so people in the middle stages of their
careers typically have better capacity to take on and service debt. The next graph shows the shares
of debt for various age groups for owner occupiers, and how they have moved over the past couple
of decades (Graph 6).
Graph 6
Households in which the head is between the ages of 35 and 54 account for around 60 per cent of
the debt. But there does appear over time to be a tendency for a higher share of owner occupier
debt to be held by older age groups. In part, the growing share reflects structural factors like lower
interest rates. More importantly, it is not clear whether the higher share of debt increases the risk
that these households will experience financial stress. On the one hand, it might indicate that in
recent years, people have been unable to pay down their debt by the time they retire. If they
continue to have large amounts of debt at the end of their working life, they might therefore be
vulnerable. On the other hand, people are now remaining in the workforce for longer, possibly a
response to better health and increasing life expectancies. They also hold more assets in
superannuation and have more investment properties. This improves their ability to continue to
service higher debt. And there is no particular indication that older people have higher debt-to-
income or debt servicing ratios than younger workers.
So while the economy wide household debt-to-income ratio is high and rising, the distribution of that
debt suggests that a large proportion of it is held by households that have the ability to service it. It
nevertheless bears watching.
Regional dimensions
I thought I would finish off with some remarks about regional versus metropolitan differences. From
a financial stability perspective, we are mainly focussed on the economy as a whole. But we still
need to be alert to pockets of risk that have the potential to spill over more broadly. These risks may
have important regional dimensions, particularly to the extent that individual regions have less
diversified industrial structures and are thus more vulnerable to idiosyncratic shocks. One recent
example has been the impact of the downturn in the mining sector on economic conditions in
Western Australia, and the subsequent deterioration in the health of household balance sheets and
banks' asset quality. The potential for the drought in eastern Australia to result in household financial
stress is another.
Data limitations make it difficult to drill down too far into particular regions. So I am going to focus
here on a general distinction between metropolitan areas and the rest of Australia. As noted above,
there tends to be a relationship between debt and housing prices. As housing prices rise, people
need to borrow more to purchase a home and with more ability to borrow, people can bid up the
prices of housing. So one place to look for a metro/regional distinction might be housing prices.
While there is clearly a difference in the absolute level of housing prices in cities and regional areas,
over the long sweep, movements in housing prices in the regions have pretty much kept up with
those in capital cities (Graph 7). This graph shows an index of housing prices for each of the states
broken down into capital city and rest of the state. While there are periods where growth in housing
prices diverge, most obviously in NSW and Victoria in recent years, they follow a very similar pattern.
This partly reflects the fact that some cities that are close to the capitals tend to experience similar
movements in house prices as the capitals.
What about housing debt in regional areas? The data suggest that the incidence of household
indebtedness is broadly similar in the capital cities and in the regions (Graph 8). In 2015, the latest
year for which we have data, around 50 per cent of regional households were in debt compared with
around 45 per cent of households in capital cities. But in previous years this was reversed. At a
broad level, the proportion of households in debt seems fairly similar.
Incomes and housing prices tend to be lower on average in regional areas than cities so we might
expect debt to also be lower. But how do debt-to-income ratios compare? This next graph shows
debt-to-income ratios for cities and regional areas at various points over the past 15 years (Graph 9).
In general, average debt-to-income ratios for indebted households in capital cities tend to be a bit
higher than those for indebted households in regional Australia. But it is not a huge difference and it
mostly reflects the fact that people with the highest incomes - and therefore, higher capacity to
manage higher debt-to-income ratios - tend to be more concentrated in cities. In general, it seems
that regional households' appetite for debt is very similar to that of their city counterparts.
Conclusion
Household debt in Australia has risen substantially relative to income over the past few decades and
is now at a high level relative to international peers. This raises potential vulnerabilities in both bank
and household balance sheets. While the risks are high, there are a number of factors that suggest
widespread financial stress among households is not imminent. It is nevertheless an area that we
continue to monitor closely.
Thank you again for the opportunity to talk to you today. I look forward to your questions.
Endnotes