Australian banks' asset quality metrics to come under further pressure

But funding profiles continue to improve.

Moody's Investors Service says that Australian banks demonstrated mildly deteriorating asset quality metrics during the six months to 31 September 2016, although they remain well capitalized to withstand an adverse shocks. At the same time, their funding profiles have improved.

"We expect that asset quality will continue to be supported by low interest rates, but that gradual pressure will be exerted by multiple headwinds," says Maadhavi Ramanayake, a Moody's Associate Analyst. "However, the banks are well capitalized to absorb any losses."

"Meanwhile, the banks continued to improve the stability of their funding profiles ahead of the introduction of the Net Stable Funding Ratio (NSFR) requirement in 2018," says Tanya Tang, a Moody's Associate Analyst. "At the same time, slower loan growth has taken some of the pressure off funding requirements".

Moody's conclusions are contained in its just-released reports on the Australian banking industry titled "Asset Quality and Capital Monitor December 2016: Australian Bank Asset Quality and Capital: A Gradual Deterioration in Metrics Buffered by Strong Capital Ratios" and " Banks - Australia: Funding and Liquidity Monitor: Funding Profiles Improve Ahead of NSFR and on Slower Loan Growth".

Here's more from Moody's:

Australian bank asset quality deteriorated mildly due to impairments of commodities-related exposures in the institutional portfolios of the country's four major banks.

Moody's expects asset quality metrics to gradually come under further pressure as a result of multiple headwinds, including stress in resources-related sectors and regions; underemployment and weak wage growth; a worsening outlook for residential property developments; and the cumulative effects of weak milk prices on the dairy sector, notably in their New Zealand subsidiaries.

Housing risks also remain elevated as house prices continued to appreciate in the key Sydney and Melbourne markets, which eroded modest improvements in housing affordability.

However, Australian banks are increasingly well capitalized to absorb any adverse shocks, as evidenced by APRA's implementation of higher residential mortgage credit risk weights for the banks using the Advanced Internal Ratings Based (AIRB) model for capital calculations starting on 1 July 2016.

Moody's expects that the banks will continue to build capital as the Australian Prudential Regulatory Authority (APRA) begins to implement the "Basel IV" regulatory proposals and ensures that bank capital ratios are set at "unquestionably strong" levels, as recommended by the Financial System Inquiry in December 2014.

As for the banks' funding profiles, covered in the second report, they continued to improve the six months to 31 September 2016, ahead of the introduction of the NSFR in 2018. The new regulations incentivise banks to reduce their reliance on less stable sources of funding such as non-operational corporate deposits and short- erm debt funding. The latter has been reducing steadily as a proportion of total funding since 2008.

The banks' diversified funding bases also allowed them to adjust smoothly to changes in US money market regulations in October 2016. At the same time, decreased demand for business loans and investor housing loans reduced pressure on the banks' funding requirements, reversing the growth in the proportion of Australian loans not funded by Australian deposits that was seen over calendar 2015 and into early 2016.