Last Thursday, the Australian Prudential Regulation Authority (APRA) released the results of its latest stress tests of Australian banks. The results were very good with none of the banks breaching the minimum Basel II capital requirements or requiring extraordinary liquidity support by the RBA – even under very severe conditions.
Background
APRA has a long history of conducting stress tests on the financial system and ADIs. Results are used to manage risk and as a base to set minimum financial requirements. It has been augured that such tests and APRA’s conservative application of rules have been a driving factor in the resilience of the Australian financial system.
The scenario
During this last round of testing, APRA adopted a stricter set of macroeconomic assumptions than it did in its most recent stress test in 2010. It also included for the first time an assessment of the liquidity consequences of a freeze in the global funding markets in addition to a capital adequacy test.
The test modeled the impact of the following on the top five banks (the ‘Big 4” and Macquarie):
- A 5% fall in GDP
- A more than doubling of unemployment to 12%
- A fall in house prices of 35% and commercial property of 40%
- A freeze in funding markets
When comparing APRA’s tests to those conducted in other jurisdictions, they are very favorable. APRA’s tests were broader and more severe than other nations. For example, the stress test assumption of a 5% GDP drop implies a four standard-deviation shock, compared with Europe and the US, where the regulators’ macroeconomic stresses were within one to three standard deviations.
Results
- None of the five banks tested would have failed and none would have breached the current Basel II minimum Tier 1 capital requirements
- APRA estimated a 3.8 percentage point decline in the banks’ Tier 1 capital ratios which is well within their current capital cushions
- Importantly, APRA found that the housing sector, often seen as a significant source of risk for the Australian banking system, is not the main driver of aggregate losses. Although residential mortgages account for more than half of the banks’ assets, they only account for about 20% of the overall losses in the stress test
- APRA also stressed liquidity with a six month freeze in funding markets and found banks can still meet their maturing obligations without relying on central bank liquidity support beyond current repo arrangements - largely through growth in deposits and collateral inflows as a result of a drop in the Australian dollar
Conclusion
The results are obviously very good and demonstrate the strength in the Australian financial system. However the very strict scenario analysis is an indicator of the growing concerns about the possibility of future asset quality issues. The liquidity test also assumes the Australian dollar will fall in a similar fashion to previous shocks – this may not be the case and it is unclear what impact this may have.