The Reserve Bank says the Australian banking system is about to be tested like it hasn’t been tested for some time.

But this test will come at a time when the banks are among the strongest, best capitalised, and most profitable banks in the world.

In the RBA’s first of two financial stability reports for 2009, it says in spite of all the current positives, the country’s banking system is “facing a more difficult environment than it has for some years.”

And this morning a senior bank executive has said it’s unlikely Australia will suffer a US-style subprime mortgage crisis in housing, like that still damaging the US economy.

The RBA singled out unemployment as the main “downside risk for the banks, but even there, the problems of corporate loans going sour has been a greater concern in the past.”

Looking ahead, the main downside risk to the performance of banks’ housing portfolios is from a rise in unemployment as the economy slows, with the recent declines in interest rates having helped to alleviate debt-servicing pressures. Notwithstanding this, in previous credit cycles it has typically been business and commercial property loans that have posed the greater risk to asset quality. The RBA stated:

While the overall level of profitability is high, it has declined recently and problem loans have increased from the very low levels of recent years.

Notwithstanding weaker wealth management income, the recent decline in bank profits has been mainly due to a rise in provisioning charges. The five largest banks reported charges for bad and doubtful debts of $5.3 billion over the latest half year, compared to $1.4 billion in the same period a year earlier.

Banks’ trading updates and analysts’ expectations suggest that the charges for bad and doubtful debts are likely to rise further, to be equivalent to around 0.5 per cent of their assets for the 2009 financial year. This is up from the unusually low charges over recent years — when both specific and general provisions fell to very low levels — but well below the expense for bad and doubtful debts incurred in the early 1990s.

Provisioning expenses have also increased at the regional banks, with these banks reporting a $360 million rise in provisioning charges over the past year. These higher charges are likely to see the banking system’s aggregate post-tax profits decline in the near term, with analysts generally anticipating that aggregate profits for the largest banks will be around 10 per cent lower in the 2009 financial year than in 2008.

If this were to occur, the post-tax return on equity would be around 14 per cent which, while lower than the average return over the past decade, would still be higher than that being earned in many other banking systems around the world.

Banks’ lending growth has also slowed recently, although banks generally continue to make credit available to good quality borrowers, albeit on less accommodating terms than in the recent past.

The RBA said:

The Australian financial system has weathered the current challenges better than many other financial systems. Unlike in a number of other countries, the Australian banking sector continues to report solid profits, has little exposure to high-risk securities, and the largest banks have maintained their high credit ratings.

The system is soundly capitalised and the banks have been able to raise additional equity from the private sector at only modest discounts to prevailing prices.

The introduction of the Australian Government Guarantee Scheme for Wholesale Funding and Large Deposits has also helped shore up banks’ access to funding, and banks have recently taken the opportunity to lengthen the maturity profile of their liabilities.

Housing holding strong: And in a separate speech to a Sydney housing conference today, the RBA’s head of economic analysis, Tony Jackson, said the Australian housing market is in better condition than many people think.

The 4% cut in the official cash rate has played a big part in making homes more affordable and he said ”It is quite clear that purchase affordability has recently improved very significantly in Australia,” Dr Richards told the fourth annual Housing Congress in Sydney on Thursday.

”The recent sharp improvement in housing affordability clearly mostly reflects the sharp fall in mortgage rates over the past half year.” He did warn that “some of the loans being written now will turn sour. However, overall, I suspect that the risk of non-performing loans increasing to the extent seen in the U.S. is low”.

He said potential buyers “need to carefully consider their own circumstances, including whether they would be able to continue to service their loans if mortgage rates were at some point to begin to return to more normal levels.” But that comment can apply to all buyers.

“The recent weakness seen in Australian housing prices has been mainly at the higher end of the market. Property prices in more expensive suburbs, which had risen more over the prior few years, have recently fallen noticeably,” Mr Richards told a housing conference in Sydney.

“The modest fall in Australian housing prices in 2008 was much smaller than the double-digit falls seen (with some variations across measures) in US and UK house prices. Similarly, the falls in housing approvals and in broader measures of economic activity in Australia have been smaller than the declines seen in many other countries.”