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2022 Bank Solvency Stress Test: Assessing the resilience of banks to a stagflation scenario

Thomas West, Ken Nicholls, Tyler Smith

Executive summary

Banking stress tests assess how banks can cope with severe but plausible scenarios. The scenarios modelled are not the most likely outcomes. We use the tests to look at banks’ resilience, making sure they have enough capital to withstand severe shocks while being able to continue supporting the economy. This stress test focused on bank capital and did not attempt to cover a liquidity stress such as a severe outflow of bank deposits.

The 2022 Bank Solvency Stress Test consisted of a stagflation scenario that shares elements of the current economic environment. It featured a global slowdown in economic activity as central banks raise interest rates in the face of high inflation and the lingering impacts from the pandemic. The results of the stress test showed that the New Zealand banking sector is well placed to withstand a stagflation scenario of high inflation and low or negative economic growth. This resilience has been partly due to the build-up of capital since the Global Financial Crisis.

The aggregate Common Equity Tier 1 ratio in the stress test fell 3.3 percentage points to a minimum of 8.9% before mitigants, as shown in Figure 1, well above the 4.5% regulatory minimum. The results before mitigating actions leave sufficient capital for banks to continue lending while maintaining capital ratios above the regulatory minima. That said, this would be a challenging macroeconomic environment for households and businesses with a large number of bank customers unable to repay their loans and experiencing large declines in wealth.

Figure 1 - Aggregate capital ratios

Download the aggregate ratio capitals chart (jpg, 34KB)

In the scenario, which begins on 1 April 2022, the New Zealand economy experiences:

  • Falling house prices of 42% (47% from the peak in November 2021)
  • Equity prices falling 38% (42% since December 2021)
  • The unemployment rate rising to 9.3%
  • Gross Domestic Product contracting by 5%
  • The OCR peaking at 5.5% and the 2-year mortgage rate at 8.4%; and
  • In addition to the economic scenario, banks are impacted by and required to model a 1-in-25-year cyber risk event.

The scenario causes aggregate impairment expenses of $20.8 billion over 4 years, compared to the $1.7 billion real impairment cost of the COVID-19 pandemic over the past 4 years. Bank profits are negative in year 2 of the stress test. The combination of negative economic growth, rising interest rates and increasing unemployment lead to high levels of defaults whilst falling asset prices reduce the collateral banks hold to minimise losses in the event of a default. The cyber event leads to aggregate costs of $1.3 billion.

The stress test results and sensitivity analysis we requested banks to carry out suggests unemployment was the main factor driving higher residential mortgage customer defaults. However, mortgage rates became an important driver of defaults as they increased above 6% to 7%, consistent with test rates that large banks have used since 2019 for their affordability assessments of mortgage applications.

It is our first stress test since 2014 involving high interest rates. Banks noted the difficulty in modelling the impact of higher interest rates, given the lack of historical data. This highlighted some limitations for the stress test modelling of new economic risk factors. A number of banks indicated they are investing in their modelling capability and that this stress test proved a useful exercise.

This was the first stress test conducted under the new capital framework that requires banks to hold more capital in the future. The combination of this stress event and rising capital requirements could make it difficult for banks to meet the new capital requirements when they are fully implemented in 2028. Our annual stress test will continue to be used to monitor this transition risk.

The stress test results feed into our supervisory process for monitoring, managing and assessing risks of regulated banks. We would like to thank all participants for their open engagement in the 2022 solvency stress test.