More than 10 major Australian financial institutions have proven their resilience after the prudential regulator tested them against hypothetical “stormy economic weather” situations.
Speaking at an event, APRA chairman Wayne Byres revealed the results of an “industry stress test” that 13 of Australia’s largest banks underwent in 2017.
“The aim of the stress test was not to set capital levels, and consistent with past practice it was not run as a pass or fail exercise,” Mr Byres explained.
“Rather, APRA utilises stress tests to examine the resilience of the largest banks, individually and collectively, and to explore the potential impacts of grim and challenging periods of stormy economic weather.”
The stress test scenario the banks had to tackle was a “severe economic stress in Australia and New Zealand” – triggered by a downturn in China and lowered demand for commodities – with a “significant downturn in the housing market at the epicentre”.
Sovereign and bank debt ratings would be downgraded, which would result in “temporary closure of offshore funding markets, a sell-off in the Australian dollar and widening in credit spreads”.
In this scenario, the Australian GDP would drop by 4 per cent, unemployment would double to 11 per cent and house prices would fall by 35 per cent across three years.
Stress test – Real GDP Growth
The scenario also added a “twist” in which banks needed to factor in an “operational risk loss event involving misconduct and mis-selling in the origination of residential mortgages” which would serve to amplify stress and add extra shock to bank balance sheets.
“As you would expect given the severity of the macroeconomic scenario, banks incurred significant losses, producing a substantial reduction in capital,” Mr Byres said.
Banks predicted credit losses of approximately $40 million on their residential mortgage books as well as a drop of more than 3 per cent in the industry’s common equity tier 1 ratio (CET1).
“Adding in the operational risk event, the aggregate CET1 ratio fell further to just below 6 per cent, driven by additional costs from customer compensation, redress, legal fees and fines,” Mr Byres said.
“Despite significant losses, these results nevertheless provide a degree of reassurance: banks remained above regulatory minimum levels in very severe stress scenarios.”
Furthermore, the APRA chairman added that the results of this hypothetical exercise had not factored in management actions, such as equity raisings, repricing and cost cutting, all of which would happen in a real scenario.
“Once we take into account expected (and plausible) management actions, the banks remain above the top of the capital conservation buffer throughout, and rebuild back towards unquestionably strong levels by the end of the recovery periods.”
Under the stress test, the banks also maintained their funding and liquidity positions. Even the banks whose liquidity coverage ratios dropped below 100 per cent had been able to implement strategies to bounce back.
More ‘fire drills’ needed
However, Mr Byres warned that more needed to be done in order to further minimise losses in such an event.
“Like weather forecasting, stress testing is an inexact science,” he said. “Given these challenges, stress testing needs to continue to evolve, and no one scenario can be relied upon for a definitive answer.
“These ‘fire drills’ are, however, still too rare, and this brought into question the level of engagement of senior management in contingency planning while it is still, fortunately, a theoretical exercise.
“In addition, scenario analysis was limited at some banks, which in turn limited visibility on which actions would be effective in which conditions, and which would potentially be ruled out.
“We expect that plans will continue to evolve to address these issues, and we will be looking at the next editions in the year ahead,” Mr Byres concluded.
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