At-risk loans have risen for Australia's four largest banks, indicating an escalation in credit risk due to elevated interest rates.

Aggregate stage 2 loans, classified under the International Financial Reporting Standard 9 (IFRS 9) accounting standards, at Commonwealth Bank of Australia, National Australia Bank Ltd., ANZ Group Holdings Ltd. and Westpac Banking Corp., increased to 17.93% in the 12 months ended Sept. 30, 2023, compared with 15.87% a year earlier. This also marked a significant increase from 12.03% in the year ended September 2019, according to S&P Global Market Intelligence data. Stage 2 loans, as defined by IFRS 9, are loans where credit risk has substantially increased since initial recognition.

The banks' aggregate stage 3 loans also grew to 0.90% in 2023 from 0.83% in 2022, Market Intelligence data revealed. Stage 3 loans are classified as credit-impaired.

Given the economic conditions, including rising interest rates and the impact of inflation, "it would be a fair assumption that analysis would show customers increasing in risks of default since their loans were funded," Liam Te-Wierik, partner for audit and assurance at Grant Thornton Australia, told Market Intelligence in an email. "The Big Four banks are concentrated in residential mortgages, with business lending a close second."

The banks' aggregate reserves for stage 2 loans declined to 17.49% in 2023 from 20.41% in 2022, the data showed. Similarly, reserves for stage 3 loans dropped to 1.85% in 2023 from 1.98% in 2022.

Australian banks have warned of the risks confronting consumers due to increasing living costs and rising interest rates. Commonwealth Bank of Australia CEO Matt Comyn said during the bank's full-year results in August 2023 that customers were facing an "increasingly challenging period" as the cost of living rose. Comyn highlighted the emergence of downside risks as "rising interest rates have a lagged impact on mortgage customers and other cost of living pressures become a financial strain for more Australians."

Westpac CEO Peter King echoed these sentiments during the lender's full-year results in November 2023. King noted that households were squeezed by rising interest rates, although "hardship levels remain at around half the numbers we saw during COVID." But customer delinquencies were not yet significantly increasing.

IFRS 9 was developed in response to the 2008 global financial crisis, addressing concerns of insufficient provisions by banks. Implemented globally in 2018, IFRS 9 aims to enhance transparency regarding a bank's performance and risk exposure by allowing forward-looking provision levels to be set.

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Mortgage cliff, competition

Australian banks are grappling with tougher competition, leading to lower net interest margins. Mortgage lending, their traditional growth driver, stalled in 2023. The value of new housing loan commitments dropped 4.1% in December 2023 compared to November 2023, according to data released Feb. 2 by the Australian Bureau of Statistics. Total new loans for December 2023 amounted to A$26.27 billion, down from A$27.39 billion the previous month. But this was higher than the A$23.51 billion recorded in December 2022.

"One particular focus was the mortgage cliff talked about frequently," Te-Wierik said, suggesting that borrowers who took loans at low rates and had fixed interest rates expiring between 2023 and 2025 might be approaching their repayment capacity. Nonetheless, no adverse effects have materialized yet.

In November 2023, the Reserve Bank of Australia increased its cash rate to 4.35%, marking the 13th rate hike since May 2022 when it stood at 0.1%. The central bank's December 2023 monetary policy review noted a continued decline in inflation, although it is still elevated. Data from the Australian Bureau of Statistics revealed that the consumer price index fell to 4.1% in the October-to-December quarter of 2023, down from 5.4% in the previous three months.

Sharad Jain, an S&P Global Ratings analyst, noted the transition to stage 3 loans from stage 2 remained in line with pre-pandemic levels. "We believe that low unemployment levels, modest economic growth and a change in spending patterns will shield borrowers against the rising interest burden as borrowers shift mortgages from lower fixed rates to higher variable rates, as fixed rate mortgages reach their expiration date," Jain said.

Banks will likely maintain conservative underwriting standards and price risks rationally, Jain added.