Australian banks vulnerable to 'second order effects' from the housing market

Mortgages already account for 63% of banks' loan books.

Banks in Australia are increasingly sensitive to adverse economic developments that could result if house prices were to slump, following a more than 16-year surge, Moody's Investors Service said in a report.

"Between 2000 and 2016, house prices rose by 113% in Australia. At the same time, household indebtedness has risen sharply, and mortgages now account for 63% of the banking systems' total loan books in the country."

Moody's said house prices will continue to climb in Australia, albeit at a slower pace over the next 12 to 18 months. If there were a house price correction in the country, the combination of protective features built into their mortgage markets, banks' underwriting practices and full recourse loans would limit mortgage losses.

Louise Lundberg, a Vice President and Senior Credit Officer at Moody's said banks are exposed to second order effects. "Namely, a material economic slowdown that would likely accompany a substantial house price correction would lead to higher losses on consumer loans, commercial real estate loans, and loans to consumer-exposed corporates."

"In most scenarios, Moody's expect banks to be able to absorb any loan losses through their earnings. Any impact on their capital levels, which we currently assess as strong to adequate, would likely be limited. Assuming unchanged earnings (although these would likely be negatively impacted in a stressed scenario), loan losses could increaseto 1.8% in Australia from 0.2% before eating into capital," Moody's said.