The Reserve Bank 2021 Stress Testing Programme

This page contains information on The Reserve Bank 2021 Stress Testing Programme from the May 2021 Financial Stability Report.

Stress testing is used by the Reserve Bank to assess the resilience of institutions and the financial system to hypothetical severe but plausible scenarios. It complements historical indicators of financial stress by providing a forward-looking view of high-impact, low-probability events.

The Reserve Bank also uses stress test insights to inform policy settings and the supervision of individual institutions. Institutions use stress-test results to inform their capital and liquidity strategies and the mitigating actions that can be deployed during times of stress.

A review of the Reserve Bank’s stress testing conducted last year identified a number of initiatives to increase the value derived from stress testing and to improve the capability across the industry. These include:

  • moving to annual industry stress tests for banks;
  • testing a wide range of risks, including the traditional economic downturn, liquidity shocks, cyber and other operational risk events, and climate change;
  • introducing industry stress tests for insurance;
  • developing the Reserve Bank’s internal bank stress-test modelling; and
  • increasing resourcing to support these developments.

The Reserve Bank’s resourcing and revised framework are now more closely aligned to the Basel Committee on Banking Supervision’s stresstesting principles and the practices of overseas regulators (table C.1).

The 2021 programme has been designed around these initiatives and includes four components:

1. Bank industry stress test

The 2021 bank stress test consists of one scenario designed to test banks’ capital adequacy, and two other scenarios with different degrees of severity to test banks’ resilience to a liquidity shock.

The capital adequacy scenario describes a global economic downturn precipitated by an extension to the COVID-19 outbreak combined with a drought event that tests the physical risks from climate change on bank agricultural exposures. Accordingly, the Reserve Bank will provide banks with a series of indicators, including a decline in national output, rising unemployment, significant property price falls, and drought-related shocks to dairy production and working expenses. Banks will use their own models to estimate the impacts of the scenario on their profitability, balance sheet, and capital.

The two liquidity shock scenarios involve a bank-specific event – such as a cyber-attack, IT system disruption or fraud – leading to reputational damage and an outflow of deposits. Banks will model the impacts of the scenario on their net cash position over a six-month timeframe to determine whether they have sufficient liquidity to fund the deposit outflow while continuing to lend. Banks will then identify strategic actions they could take to mitigate the outcomes.

Figure C.1

Stress-testing annual cycle

This year’s stress test marks the move from a one-off project-based approach to an annual repeatable cycle (figure C.1). The forward guidance is designed to allow banks to prepare for these exercises well in advance. The Reserve Bank recognises stress tests are resource intensive and plans to work with industry to optimise the efficiency of the process whilst delivering valuable insights.

2. General insurance industry stress test

This is the first stress test conducted by the Reserve Bank for the insurance sector. It consists of four scenarios to test the resilience of the five largest general insurers to impacts from: an economic downturn; a series of severe weather events involving three large storms; and stress on the insurers’ reinsurance arrangements. Insurers will use their own models to estimate the impacts on profits, balance sheets, and solvency.

3. Reserve Bank stress-test capability improvement

In 2020, the Reserve Bank developed a high-level bank stress-test model to estimate the impacts of the COVID-19 stress-test scenarios on individual banks. The Reserve Bank has a continuous improvement plan to build on this foundation, with the focus this year on improving the credit-risk modelling, which is the key driver of stress-test results for capital outcomes. The 2021 stress-test plan begins our stress-test journey of climate change, with the inclusion of drought conditions in the bank stress-test scenario and the severe weather events in the insurance stress test.

4. Dairy industry stress test

Whilst stress testing has generally been used on financial institutions, similar principles apply to other industries. The Reserve Bank has recently completed a desktop stress test of dairy farms in partnership with the Ministry for Primary Industries. The process simulated a five-year path of a sample of dairy farms’ cashflows and balance sheets under various conditions, especially around milk prices and land prices.

The draft results indicate that while the sector overall has been gradually deleveraging, dairy debt is highly concentrated and pockets of vulnerability to a milk price downturn or drought remain. Simulations suggest that in a scenario with the milk price reduced to $5.50 per kgMS for five years, almost one-third of dairy farms would have negative cashflows and over half of these would require some form of debt restructuring.

Table C.1

Bank stress-testing practices across regulators

Bank stress tests Reserve Bank of New Zealand Federal Reserve Board Bank of England European Central Bank Australian Prudential Regulation Authority
How often are industry stress tests conducted? Annually Annually Annually Annually Every 2-3 years moving to annual
What types of stress scenarios are used? Economic downturn, liquidity shock, operational risk Economic downturn Economic downturn, operational risk Economic downturn, liquidity shock, operational risk Economic downturn, liquidity shock, operational risk
Any plans for an industry climate-change stress test? 2021 explores risks of drought to the agricultural sector Under consideration 2021 climate-change stress test No identified plans 2021 vulnerability assessment
How many banks participate in the stress test? 10 banks with over 95 percent market share 19 large banks 8 banks with 75 percent market share 50 banks with 70 percent European Union market share 8 largest banks with over 80 percent market share
Do published results rely on regulator or bank modelling? Mix of bank and Reserve Bank modelling Federal Reserve modelling Mix of bank and Bank of England modelling Bank modelling Mix of bank and APRA modelling
Are individual banks’ capital results disclosed? Under consideration – currently publish anonymised results Yes Yes Yes No, only system results and a range of outcomes
Are bank actions incorporated into the scenario? 2021 allows for feedback effect from bank actions No No No No
What are the main uses of results? Assurance of financial system resilience and inform risks to participating banks To approve banks’ capital plans including dividends and buybacks To assess the level of banks’ capital Assurance of financial system resilience and inform risks to participating banks Assurance of financial system resilience and inform risks to participating banks
Is it a pass or fail exercise? No Yes Yes No No
Do you run stress tests with other regulators? Yes with APRA, most recently in 2017 No No Yes, across European jurisdictions Yes with RBNZ, most recently in 2017