RBA warns a sharp rise in interest rates could lead to disruptive and lasting market corrections

| 14.04,18. 04:13 AM |

RBA warns a sharp rise in interest rates could lead to disruptive and lasting market corrections

Record low interest rates, accelerating asset prices and a growing appetite for risk could be laying the groundwork for a sharp correction across financial markets, the Reserve Bank has warned.

In its latest Financial Stability Review released on Friday morning, the RBA says strong global economic conditions over the past six months suggests asset prices have surged because investors "see little chance of adverse outcomes".

However, the RBA warns that a sharp rise in interest rates from rising inflation could cause a shock and catch investors by surprise.

"A detrimental shock could lead to a disruptive and lasting correction in a broad range of markets," the RBA says.

"Investors have also taken on more risk in recent years, making them more susceptible to large losses if there were a generalised fall in asset prices.

"This could be triggered by a sharp rise in interest rates in the absence of stronger economic growth arising from, for instance, a jump in realised or expected inflation or a change in investors' risk appetite."

The review cites share market volatility in recent months caused by uncertainty about US Federal Reserve rate rises as an example of how markets can correct quickly.

"The falls in global equity prices in recent months have provided a timely reminder that asset prices can fall quickly with price movements exacerbated by pro-cyclical investor behaviour," the RBA says.

The RBA has also warned that governments are potentially exposed to any correction or shock because of high levels of debt fuelled by record low interest rates.

"The higher debt levels raise concerns about the resilience of a range of borrowers to any adverse shocks, particularly as global monetary policy accommodation starts to be unwound," the RBA says.

Risk of rise in household financial stress

While the review says Australia's financial system remains "resilient" in its ability to withstand shocks, it has raised concerns about high levels of household debt.

"The high level of household indebtedness increases the risk of a rise in household financial stress amplifying a shock to the economy," the RBA warns.

"Most indicators suggest that the incidence of household financial stress is not widespread although some households could be tested were unemployment to increase."

The RBA says some borrowers are in arrears as they transition from interest-only repayments to interest and principal payments after intervention by the Australian Prudential Regulation Authority.

"This partly reflects borrowers taking time to adjust, although for a small share of borrowers this has reflected difficulty in making the higher repayments."

However, the RBA says tougher regulatory measures and a strengthening in lending standards have helped moderate housing market conditions in Australia.

But the RBA says commercial property remains "an area to watch" although a large stock of apartments near completion in Brisbane and other capital cities are being "absorbed with little disruption".

The review briefly touches on the Financial Services Royal Commission and notes the increasing focus on culture at banks and the impact on their businesses.

"International experience has shown that poor culture can have significant adverse effects on banks including their financial importance."

The RBA singled out the Commonwealth Bank which is in a legal battle over allegations that it broke anti-money laundering and anti-terror financing laws on almost 54,000 occasions.


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