Orr: Don't rely on bank stress test outcomes alone

Monday 14th January 2019

Reserve Bank governor Adrian Orr says stress tests of banks have inherent limitations, suggesting they shouldn’t be relied on.

“We emphasise in our public articles that stress testing results should not be read at face value,” Orr says in a letter.

“Both the significant modelling uncertainties, and the fact that the banks know how/when the stress situation ends, limits the value of stress tests,” Orr says.

“Further, passing a stress test covering only dairy portfolios is not a meaningful indication of overall capital strength, given it is only approximately 10 percent of banks’ exposures.”

Orr was responding to a BusinessDesk story questioning whether the central bank’s proposed new capital requirements for the major banks amount to gold-plating.

The Reserve Bank has published the results of a number of stress tests, including one that looked solely at dairy portfolios, but it has also conducted more general tests.

The major banks are also required to conduct their own stress tests on a continuous basis and to share those results with the Reserve Bank, although the results aren’t made public.

But the last time the central bank conducted such a test itself was in 2017 when it looked at the big four banks in conjunction with the Australian Prudential Regulation Authority - APRA. The banks passed with flying colours, as they have in all such tests.

The scenario for that test was far broader than just the dairy industry – it included a 35 percent plunge in house prices, a 40 percent fall in commercial property prices, unemployment of 11 percent and a Fonterra payout to dairy farmers averaging $4.90 per kilo of milk solids for three years, below break-even for the average farmer.

On top of that, the regulator overlaid an industry-wide scandal relating to bad behaviour in mortgage lending, such as customers successfully suing the banks for poor lending practices and failure to abide by the Responsible Lending Code.

This scenario includes far more severe conditions than the last actual test of banks’ financial resilience, the global financial crisis, but the New Zealand registered banks have come through all such tests, real and simulated, with their balance sheets intact and capital capacity to spare.

According to the Reserve Bank’s new Bank Financial Strength Dashboard, the big four banks’ mortgage books account for another 58 percent of their balance sheets, so that latest test covered more than 68 percent of bank lending, not counting commercial property lending.

The big four banks, ANZ, ASB, BNZ and Westpac, account for about 88 percent of New Zealand’s banking system.

The Reserve Bank is proposing that the big four banks will have to effectively double their minimum tier 1 equity during the next five years.

Orr says that the actual increase will be between 40-60 percent, “given that current capital levels are above current regulatory requirements.”

However, when announcing the proposals on Dec. 14, deputy governor Geoff Bascand said that "we are proposing to almost double the required amount of high-quality capital that banks will have to hold."

But banks do hold significantly more than the minimum capital required currently. ANZ Bank, for example, which is New Zealand’s largest, had a tier 1 equity ratio of 11.1 percent at September 30, much higher than the 6 percent regulatory minimum.

The Reserve Bank is proposing to lift this to 16 percent – the smaller banks would have a slightly smaller 15 percent minimum.

Given banks’ current practice of comfortably exceeding statutory minimum capital requirements – their prized banking licences depend on such compliance – it would be unreasonable to expect they will hug minimum requirements in future.

Orr also dismissed criticism from Australian Financial Review journalist Tony Boyd who has written for that paper on banking issues for more than 35 years and currently writes its flagship Chanticleer column.

Boyd had suggested that the Australian banking regulator, the Australian Prudential Regulation Authority, has more stringent capital requirements than most Western countries – but not nearly as stringent as the Reserve Bank is now proposing – and that no Australian depositor has lost money.

All four of New Zealand’s big four banks are owned by Australia’s big four banks and Boyd was clearly suggesting the Reserve Bank proposals are extreme, but Orr dismisses his views.

“Group capital requirements are not relevant for New Zealand creditors and/or taxpayers. Only capital in the New Zealand subsidiary can be relied on,” Orr says.

The Reserve Bank has long insisted that the New Zealand arms of the major Australian banks have registered subsidiaries with their own capital adequacy requirements distinct from their parents.

It famously won a long battle with Westpac in late 2004 when that bank finally agreed to incorporate a local subsidiary, a process finally completed two years later – Orr was Westpac’s chief economist between 2000 and 2003.

“No Australian bank depositor has lost money because a) the Financial Claims Scheme has been in place since 2008 and b) institutions that failed in the early 1990s period of stress were rescued by state governments,” he says.

BusinessDesk also highlighted international ratings agency Fitch’s view of the Reserve Bank’s proposed changes as “radical.”

It also considered them “highly conservative relative to international peers” and would go "well beyond the international norm.”

But Orr argues that “the Fitch article also said the proposal ‘sets a global standard’ and is ‘positive for banks’ credit profiles, although we do not expect any immediate rating changes.”

There’s no question the proposals would make New Zealand banks much stronger but there is a question as to whether they amount to unnecessary goldplating.

Orr also dismisses the suggestion that the Reserve Bank might have failed to consult APRA on its proposed changes.

“We are in constant dialogue with our Australian colleagues at APRA. On this particular topic, we have shared many conversations, papers and briefings over a period of many months,” he says.

“Our APRA colleagues are always pleased to be briefed and we jointly recognise each other’s sovereignty with respect to the issues.”

Orr says the Reserve Bank will shortly release all the background material that supports the consultation document released on Dec. 14. The consultation period ends on March 29.

(BusinessDesk)

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