Insights from the 2017 bank stress test

This page contains insights from the 2017 bank stress test from the November 2017 Financial Stability Report.

The Reserve Bank has directed several stress tests of major banks in recent years. They are an important tool to understand the resilience of the financial system and individual banks, and to improve banks’ capabilities to conduct stress tests for risk management purposes.

The four largest New Zealand banks have recently completed the 2017 stress testing exercise, which featured two scenarios.1 In the first scenario, a sharp slowdown in New Zealand’s major trading partner economies triggered a downturn in the domestic economy. The scenario featured a 35 percent fall in house prices, a 40 percent fall in commercial and rural property prices, an 11 percent peak in the unemployment rate, and a Fonterra payout averaging $4.90 per kgMS. Banks were required to grow their lending book in line with prescribed assumptions, and also faced funding cost pressures associated with a temporary closure of offshore funding markets and a two notch reduction in their credit rating.

The second scenario examined the effects of an operational risk event overlaid on the macroeconomic scenario. An initial exploration of this risk required banks to quantify the impact of what they considered to be the ‘least implausible’ industry-wide operational risk event related to residential mortgage lending conduct. The final results incorporated a scenario where customers bring a successful legal case against banks for failures to comply with verification, documentation and lending practices set out in the Responsible Lending Code. Other identified risks included a government or regulator-imposed moratorium on mortgage foreclosures and systematic errors in property valuations.

Banks currently have significant buffers of common equity Tier 1 capital above minimum requirements (‘buffer ratios’). The buffer ratio of the median bank falls to 205 basis points during the macroeconomic scenario, and to 125 basis points during the operational risk scenario (figure B1). Falling within the 250 basis point capital conservation buffer (CCB) results in restrictions on dividend payments for all banks. In an attempt to increase capital ratios, banks reported that they would cut costs, re-price funding and lending rates to increase margins, and tighten origination standards. These mitigating actions were expected to increase the average buffer ratio to above the CCB during the macroeconomic scenario. However, the efficacy of mitigating actions during a live stress event is uncertain, and some actions have the potential to worsen the depth of an economic downturn.

Figure B1 Median stressed buffer ratio

Box B Figure B1 FSR November 2017

Source: RBNZ

Figure B2 Contributions to peak-to-trough decline in system CET1 ratio (before mitigating actions)

Box B Figure B2 FSR November 2017

Source: RBNZ

Note: Other includes non-credit losses arising from operational, market and counterparty risk incorporated in the macroeconomic scenario.

Figure B2 shows the contributions to the peak decline in the system capital ratio. The main drivers were:

Credit losses: Due to the deteriorating macroeconomic environment in the scenario, cumulative credit losses associated with defaulting loans were around 5.5 percent of gross loans. Losses were spread across most portfolios, with residential mortgages and farm lending together accounting for 50 percent of total losses. Credit losses reduced CET1 ratios by 600 basis points.

RWA growth: The key driver of RWA outcomes were (i) risk weights increasing in line with deterioration in the average credit quality of nondefaulted customers and (ii) the requirement that banks’ lending grows on average by 6 percent over the course of the scenario. RWA growth reduced CET1 ratios by approximately 160 basis points.

Underlying profit: The banking system’s net interest margin declined by approximately 50 basis points per annum in the scenario. Banks only gradually passed on higher funding costs to customers, reflecting a desire to maintain long-term customer relationships and that some customers are on fixed rates. Underlying profits remained sufficient to provide a substantial buffer of earnings that accumulate to around 550 basis points of additional capital for the average bank.

Operational risk event: Banks were assumed to pay compensation on a proportion of new loans written since the Responsible Lending Code came into effect, and were also subject to a further one notch credit rating downgrade. These costs reduced the system CET1 ratio by approximately 70 basis points.

Like previous stress tests, this exercise suggests the major New Zealand banks can, as a group, absorb large losses in a downturn while remaining solvent. However, it is important to note that there is significant uncertainty around the impact of a severe downturn on the banking system. Stressed capital impacts are highly sensitive to assumed loss rates, and loss rates in some severe downturns in other advanced economies have significantly exceeded the losses in the 2017 test.

System-wide stress tests also cannot test individual banks against all possible risks that they could face and have capital to mitigate. For example, an individual bank could have substantially worse outcomes if they had higher funding costs during the downturn than their peers, leading to erosion in their net interest margin. For these reasons, the Reserve Bank does not use stress test results as a mechanical indicator of individual or industry capital adequacy. The Reserve Bank intends to publish further analysis of the lessons from its recent stress tests, including their implications for systemic resilience.

1 The stress test used balance sheet data and regulatory requirements applying on the most recent half year balance date as at March 2017. This box focuses on phase 2 of the test, where the Reserve Bank required banks to impose additional assumptions on common factors, such as portfolio loss rates and product margins, to provide a more consistent view across banks.