Banks not prepared for housing downturn

Speaking at the AB+F Randstad Leaders Lecture Series in Sydney on Friday, the regulator delivered the results of APRA’s 2014 stress test on Australia’s largest banks.

“Disappointingly, there was a only a very light linkage between the mitigating actions proposed by banks in the stress test and their recovery plans (or 'living wills'), with loose references rather than comprehensive use,” Mr Byres said.

“Recovery plans should have provided banks with ready-made responses with which to answer this aspect of the stress test,” he said.

“APRA will be engaging with banks following the stress test to review and improve this area of crisis preparedness.”

The 2014 stress test involved 13 large, locally-incorporated banks, which together account for around 90 per cent of total industry assets. Participating banks were provided with two stress scenarios, which were developed in collaboration with the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ).

Central to both scenarios was a severe downturn in the housing market.

Scenario A was a housing market double-dip, prompted by a sharp slowdown in China. In this scenario, Australian GDP growth declines to -4 per cent and then struggles to return to positive territory for a couple of years, unemployment increases to over 13 per cent and house prices fall by almost 40 per cent.

Scenario B was a higher interest rate scenario. In the face of strong growth and emerging inflation, the RBA lifts the cash rate significantly. However, global growth subsequently weakens and a sharp drop in commodity prices leads to increased uncertainty and volatility in financial markets. In Australia, higher unemployment and higher borrowing costs drive a significant fall in house prices.

“Let me stress (with no pun intended) that these are not APRA’s official forecasts!” Mr Byres said.

“Nor would we even say they are the most likely scenarios to emerge,” he said. “But they are very deliberately designed, specifically targeting key vulnerabilities currently front of mind for prudential supervisors.”

The results of the stress test were generated in two phases. In the first phase, results are based on bank’s own modelling, within the confines of the common scenarios and certain instructions.

The second phase replaces the banks’ individual estimates of loss impacts with APRA’s own estimates, developed using a combination of models, internal research and external benchmarks.

“In the first phase, banks projected a significant impact on profitability and marked declines in capital ratios in both scenarios, consistent with the deterioration in economic conditions,” Mr Byres said.

“The stress impact on capital was driven by three principal forces: an increase in banks’ funding costs which reduced net interest income, growth in risk-weighted assets as credit quality deteriorated, and of course, a substantial increase in credit losses as borrowers defaulted,” he said.

In aggregate, the level of credit losses projected by banks was comparable with the early 1990s recession in Australia, but unlike that experience, there were material losses on residential mortgages.

This reflects the housing market epicentre of the scenarios, and also the increasing concentration of bank loan books on that single asset class, Mr Byres said.

“In each scenario, losses on residential mortgages totalled around $45 billion over a five-year period, and accounted for a little under one-third of total credit losses,” he said.

“By international standards, this would be broadly in line with the three per cent loss rate for mortgages experienced in the UK in the early 1990s, but lower than in Ireland (five per cent) and the United States (seven per cent) in recent years.

“In other words, banks’ modelling predicts housing losses would certainly be material, but not of the scale seen overseas.”

The results in the second phase of the stress test, based on APRA estimates of stress loss, produced a similar message on overall capital loss – although the distribution across banks differed from Phase 1 as more consistent loss estimates were applied.

Aggregate losses over the five years totalled around $170 billion under each scenario.

Housing losses under Scenario A were $49 billion; they were $57 billion under Scenario B.

These aggregate losses produced a material decline in the capital ratio of the banking system.

At an individual bank level, there was a degree of variation in the peak-to-trough fall in capital ratios, but all remained above the minimum CET1 capital requirement of 4.5 per cent.

“This broad set of results should not really be a surprise,” Mr Byres said.

“It reflects the strengthening in capital ratios at an industry level over the past five years,” he said. “But nor should it lead to complacency.”

For some banks, the conversion of Additional Tier 1 instruments would have been triggered as losses mounted.

More generally, and even though CET1 requirements were not breached, it is unlikely that Australia would have the fully functioning banking system it would like in such an environment, Mr Byres said.

“Banks with substantially reduced capital ratios would be severely constrained in their ability to raise funding (both in availability and pricing), and hence in their ability to advance credit,” he said.

“In short, we would have survived the stress, but the aftermath might not be entirely comfortable.”