Indebtedness weakly correlated with financial stress, RBA finds

Indebtedness is only weakly correlated with financial stress, Reserve Bank researchers have found in the course of stress testing Australian households.

In a paper published yesterday, the researchers said indebted households were not necessarily more likely to be at risk of financial stress than unindebted households.

"This result could be interpreted as evidence that the screening lenders carry out in assessing loan applications is broadly effective," the paper said.

The RBA applied a stress-testing model to data from the Melbourne University's HILDA survey in an attempt to quantify household resilience and the banking system's exposure to households that are more likely to default.

It found that, throughout the 2000s, the household sector remained resilient to scenarios involving asset price, interest rate and unemployment rate shocks. Increases in household loan losses under these stress scenarios were limited.

The background to the research was that lower nominal interest rates and financial deregulation drove an increase in the Australian household sector's aggregate level of indebtedness (debt to income) from abound 40 per cent in the 1980s to around 150 per cent by the mid 2000s.

The distribution of household debt was concentrated among households that were well placed to service it, according to the report. The share of households with some debt rose slightly over the period. However, the distribution of debt did not change much. Higher income and asset-rich households owed about 75 per cent of the debt.

"Aggregate measures of household indebtedness may be misleading indicators of the household sector's financial fragility. Even if aggregate household indebtedness has increased, the household sector could still be highly resilient to macroeconomic shocks," it said.

Based on a number of financial stress indicators, such as households reporting that they were unable to make mortgage or bill payments, the financial health of households increased over the 2000s.

The share of households with negative financial margins (a measure based on the difference between a household's income and estimated minimum expenses) was 12 per cent in 2002, ten per cent in 2006 and eight per cent in 2010.

"A negative financial margin does not mean a household will default. Households often have assets they can draw on in a stress situation," the report said.

The researchers found that the effect on expected household loan losses of a relatively severe stress scenario, under which unemployment rises, asset prices fall and interest rates are unchanged, increased over the 2000s, suggesting that the household sector's vulnerability to macroeconomic shocks may have increased a little.

However, in a scenario where interest rates are lower, expected losses are lower compared with Australia's experience during the financial crisis.

"This is due to the offsetting effect of lower interest rates, highlighting the potential for expansionary monetary policy to offset the effect of negative macroeconomic shocks on household loan losses," the report said.

A one percentage point rise in interest rates causes the share of households with negative financial margins to increase by 50 basis points and debt at risk by ten bps.

A one percentage point increase in the unemployment rate raises the share of households with negative financial margins by 30 bps. There is little impact on debt at risk because of the limited debt and good collateral position of the households most likely to become unemployed.

A ten per cent fall in all asset process causes debt at risk to rise by 40 bps.