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The Reserve Bank of Australia’s (RBA) macrofinancial bank stress-testing model is a tool to help policymakers better understand the key systemic vulnerabilities in a financial system, given that “the failure of banks can be hugely disruptive for an economy”.
The model enables the RBA to analyse potential financial risks to Australia’s banking sector, such as those arising during the COVID-19 pandemic, which it said worked at the onset of the pandemic.
A stress test typically assumes that if the economy enters a “severe but plausible” downturn (unemployment rises significantly and property prices fall sharply), then the model is used to determine the size of the losses the bank might incur from loan defaults.
As the pandemic was expected to be one of the largest downturns, concerns were raised about “how banks would fare and whether the viability of any would be threatened”, the RBA said.
“There was a significant risk that large numbers of households and businesses would be unable to continue servicing their loans, given the impending drop in income, creating uncertainty about how much bank capital could be subsequently eroded,” the report said.
However, the RBA said “large losses on mortgages only occur when there is both high rates of unemployment and large falls in house prices”, which was consistent with previous research.
In determining the probability of mortgage defaults on residential mortgages, the central bank uses two variables, the unemployment rate and the LVR, usually less than 80.
In addition, it took into account “the benefits to banks of lender mortgage insurance (LMI)” by applying a recovery rate to mortgages that are covered by insurance and “assumed a 20 per cent fall in property prices”.
The scenario also assumed that the bank’s funding costs “remained steady” due to the support available from the RBA’s Term Funding Facility, but accounted for an almost 200-bp drop in capital ratios due to loan loss provisions.
Given, Australia’s employment rate had fallen to its lowest level in almost five decades and the fall in property prices was relatively slow, it said the model was “very helpful” in assuring policymakers that mortgage risks were low.
The report said the “downturn would need to be quite a bit larger” or more prolonged for any banks to come close to breaching their prudential requirements, adding this also reflects the fact that Australian banks earn significant profits and are very well capitalised.
The research paper said by “understanding how likely banks are to fail” can help regulators decide what actions to take.
But it noted, the development of the stress-testing model was “ongoing”.
[Related: Rate hikes could 'lower' repayments: RBA]
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