December 20, 2023

The financial system has significantly reduced its fragility since the Global Financial Crisis. Central banks all around the world, including the Reserve Bank of Australia (RBA), have increased capital requirements and improved banks’ leverage ratios. Last week, the Australian Prudential Regulation Authority (APRA) updated requirements for banks to better manage the impact of interest rate changes on their financial position. There is no doubt that APRA and the RBA have been doing whatever possible to strengthen financial stability in Australia. Consequently, Australia has a resilient, well-capitalised and profitable banking system. 

Notwithstanding, macroprudential policy (as it is usually known banking regulation policy) has not yet explained its impact on economic activity. They have been targeting financial stability so deeply, that they have not examined its impact on economic performance. In other words, are there trade-offs between financial stability and economic growth? Does financial regulation condition how banks lend money to the market? Does banking regulation encourage banks to lend more real estate loans than business loans? Could macroprudential policies constraint economic growth? A recent work by Fernandez-Gallardo et al (2023), presented at the US Federal Reserve Bank of Dallas last month, shows that macroprudential policies strengthen the financial stability at the cost of reducing economic growth. 

Exploring Australian data, we find that for each dollar of lending, 62 cents go to the housing market. The same figure was 54 cents per dollar twenty-one years ago. Considering that the housing market involves asset-back securities as collaterals, the data tells us that the proportion of total credit backed with collaterals has increased, making the Australian financial system considerably stronger. On the other hand, the same data shows that bank loans to business have decreased from 30 cents to 28 cents per dollar lent to the economy between 2002 and 2023.

Source: Australian Prudential Regulation Authority (APRA) 

It is well-known the predominance of the four big banks in the Australian banking system. Bank balance sheet data shows that these banks have increased the amount of credit towards less risky markets (housing market). Why is it important? Banks provide loans to the economy, and they contribute to the capital stock of the economy, which has long-term impact on economic productivity. The higher productivity is, the higher real wages and standards of living are.

Source: Australian Prudential Regulation Authority (APRA) 

To sum up, macroprudential policies have strengthen financial stability significantly in Australia.  In addition to targeting financial stability, it is important that regulators also take into account how their rules encourage banks to build their asset portfolios and lend money to the economy, which is what ultimately impacts capital formation and economic growth.