housingJames Eyers – smh.com.au
The low-risk nature of Australian housing portfolios ‘has traditionally provided ballast for Australian banks … But that does not mean that will always be the case.’ Photo: Nic Walker

Australian banks are well enough capitalised to withstand a severe shock to the economy, but poorly prepared to recover from a financial crisis, the banking regulator has warned.

In a major speech in Sydney at lunchtime on Friday, Australian Prudential Regulatory Authority chairman Wayne Byres revealed the results of the regulator’s industry-wide stress test of Australian banks’ mortgage books conducted over recent months.

“If we draw one conclusion from the stress test this year, it’s that there remains more to do to be able to confidently deliver strength in adversity,” Mr Byres said.

With surging house prices in Sydney and Melbourne putting an unprecedented level of attention on the risks inside bank home loan books, Mr Byres said the low-risk nature of Australian housing portfolios “has traditionally provided ballast for Australian banks … But that does not mean that will always be the case.”

With the Financial System Inquiry considering whether to call for banks to hold more common equity tier 1 capital (CET1) to add a further buffer between shareholders and taxpayers in the event of a bank collapse, APRA found that under a highly stressed economic scenario – which saw house prices crash 40 per cent and unemployment rise to 13 per cent – every one of the 13 banks tested remained above the minimum CET1 capital requirement of 4.5 per cent.

During the recent full-year reporting season the big banks pointed to their own stress-testing of mortgages as illustrating their resilience to a crisis. Mr Byers said this reflected the strengthening in capital ratios at an industry level over the past five years, “but nor should it lead to complacency”.

Under economic shock, almost all banks projected that they would fall well into the capital conservation buffer range and would therefore be severely constrained on paying dividends and bonuses under two scenarios modelled by APRA. “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.

He also revealed several shortcomings with the way in which banks are conducting their own stress tests. Bank data, modelling and development of scenarios required improvement and there was a varying level of sophistication between institutions, he said. (APRA is prevented from discussing the stress-test results as they apply to any particular institution.)

During the tests, which involved APRA teams working alongside senior bank executives in the 13 banks around the country, the banks were forced to respond to two scenarios: Scenario A involved a housing market double-dip prompted by a sharp slowdown in China; 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 involved a higher interest rate scenario.

Banks also conducted their own stress tests but for some banks, “there is not a great deal of innovation in the design of scenarios, which are not always customised to the institution’s particular risk profile and most importantly not always pushing to the boundary of adversity,” he said.

APRA will therefore from next year provide banks with a common scenario to be used in their own internal stress tests “to ensure an appropriate degree of severity is considered as part of banks’ capital planning processes, and enables APRA to compare and aggregate results to gain an industry perspective on an annual basis”.

Mr Byres also said banks needed to be more cautious about using historical data in Australia given the absence of major housing crises. “Let me be clear: that lack of experience is a good thing, but we shouldn’t be blind to the risks that nevertheless exist,” he said.

One of the key shortcomings with the way in which Australian banks are developing stress tests is the lack of management attention on mitigating actions envisaged to respond to the stress and rebuild confidence in the banking system. “This was an area of the stress test that was not completed, in our view, with entirely convincing answers,” Mr Byres told the audience at the Australian Banking & Finance event hosted by King & Wood Mallesons. “In many cases, there was clear evidence of optimism in banks’ estimates of the beneficial impact of some mitigating actions, including for example on cost-cutting or the implications of repricing loans.

“If the system doesn’t have sufficient resilience to quickly bounce back from shocks, it risks compounding the shocks being experienced. Our conclusion is, therefore, that there is scope to further improve the resilience of the system.”

With the Financial Stability Board preparing to release information on the calculation of risk-weighted assets ahead of the meeting next week of G20 leaders in Brisbane, My Byres also questioned whether the Australian banking system is actually more risky than CET1 levels suggest due to the way in which Australian banks risk weight housing loans for being lower risk.

For the big banks, who use their own models to determine how much capital to carry against mortgages, very small amounts of capital are carried against housing books. But the ratio of risk-weighted assets to total (unweighted) assets has fallen quite noticeably – from 65 per cent before the GFC to around 45 per cent today. “Put simply, much of the strengthening of capital ratios relative to a decade ago is less the product of substantial growth in capital and more the product of the increasing proportion of housing loans within loan portfolios. In short, banks have de-risked rather than deleveraged,” he said.
The Financial System Inquiry is considering imposing a floor on mortgage risk weights to force the big banks to carry more capital against loans.

APRA said it was concerned that the banks typically projected little differentiation in borrower default rates between the two scenarios, despite the very different paths of interest rates and implied borrowing costs. “This raises the question whether banks could be underestimating the potential losses that could stem from sharply rising interest rates in the scenario. In the current low-interest-rate environment, this is a key area in which banks need to further develop their analytical capabilities.”

Mr Byres also sided with the financial inquiry’s interim report on the highly contentious issue of whether Australian banks are more strongly capitalised then their global peers. The banks suggested to the Financial System Inquiry that they fall into the top quartile of capitalisation compared to global peers, but Mr Byres questioned this, saying the largest Australian banks “appear to be in the upper half of their global peers in terms of their capital strength”. This was the same finding as the interim report and has been used to build the case for CET1 levels to be increased.

Mr Byres said APRA was wary about stress testing results becoming the primary assessment of capital adequacy, given the results can be quite scenario-specific but saw them as “helpfully informing our supervisory assessment of capital”.

Thanks: smh.com.au