Stress testing of ANZ NZ, ASB, BNZ and Westpac NZ shows the fours' combined pre-tax profit would tumble by $32 billion over five years to $4 billion, but they would not breach their minimum capital requirements.
These are among the conclusions of Reserve Bank and Australian Prudential Regulation Authority (APRA) stress testing of the big four NZ banks, as detailed by the Reserve Bank. The test was based on data and regulatory requirements as at March 2017, and ran for five years to March 2022.
The testing done last year included the assessment of two scenarios. In the first, a downturn in the Chinese economy spreads through trade channels to other emerging markets, with flow-on effects to other parts of the global economy, including Europe and Japan. A collapse in demand for commodity exports and negative investor sentiment towards the Australian and New Zealand economies triggers domestic recessions and a six month closure of offshore funding markets for banks. New Zealand’s unemployment rate quickly rises to peak at 11%, house prices fall 35%, and the Fonterra dairy payout remains below $5/kgMS for three years. The scenario assumes that macroeconomic conditions begin to improve by the fourth year, though property prices do not recover. Banks receive a two notch credit rating downgrade, and face elevated funding costs in both wholesale and retail deposit markets.
In the second scenario, the macroeconomic conditions described above were overlaid with an operational risk scenario, exploring the implications of an industry-wide misconduct event related to residential mortgages. The Reserve Bank says the monetary response to the downturn sees the Official Cash Rate cut to just 0.25%, but banks' higher funding spreads mean the decline isn't fully passed through to customers' interest rates.
"Consistent with previous tests, results suggest that strong underlying profitability from repricing actions to maintain their net interest margins would allow these banks as a group to absorb significant losses through the stress scenario without breaching their minimum capital requirements. While the test demonstrates these banks’ resilience, there remains uncertainty as to how such scenarios would unfold in reality," the Reserve Bank says.
"Cumulative pre-tax profit over the five years declined from $36 billion in a baseline projection, which assumes no stresses occur, to $4 billion in the stress scenario. The aggregate return on assets turned negative in years two and three, before recovering as credit losses abated," the Reserve Bank says.
The banks began with an aggregate Common Equity Tier 1 (CET1) capital ratio of 10.3%, and an aggregate buffer ratio of 5.4%. The aggregate CET1 ratio dropped to a low of 6.9% in the third year, with individual banks' CET1 ratios falling to between 6.4% and 7.4%. Buffer ratios fell to between 1.2% and 1.4% at their low points, placing the banks in the middle of the capital conservation buffer. Most of the banks moved out of the buffer by the fifth year thanks to accumulated earnings. All four banks met their core funding ratio and mismatch ratio requirements during the test.
14% of loans default
The banks reported about 14% of their total credit exposures would default over the five years of the test. Total loan impairment expenses of $21 billion gives a cumulative loss rate of 4.3% of their total credit exposure. Credit losses were naturally spread across banks’ lending portfolios. Residential mortgage lending losses were $5.1 billion or 24% of total losses, farm lending was $4.4 billion or 21%, and general corporate lending was $4.4 billion or 20% of losses. Commercial property lending, and credit cards and other consumer lending, both accounted for 11% of losses.
The banks were asked to model scenarios involving industry-wide conduct risk and/or mis-selling in residential mortgage origination, with this having a material impact on their solvency and leading to a further credit rating downgrade.
"Submissions explored the consequences of systematic errors in automated property valuations, government-imposed moratoria on mortgage foreclosures, and flaws in origination practices, such as systematic miscalculations of loan affordability and inappropriate sales practices. The scenarios led to CET1 ratios falling a further 0.4 to 2.4 percentage points in year three of the test, compared to the macroeconomic scenario."
Outcomes sensitive to modelling assumptions
The Reserve Bank separately developed a standardised event involving a class action lawsuit for breaches of standards for loan origination, and prescribed a redress calculation methodology. The total cost to the four banks of this was $2.2 billion, there was a further notch credit rating downgrade, and five basis points reduction to net interest margins for all five years. However, the regulator notes it's challenging to calibrate the impact of an industry-wide misconduct event for NZ banks, given the limited number of relevant precedents.
It also notes there are uncertainties around the magnitude of losses banks could face in a real downturn, and the extent to which banks could restore net interest margins. Thus outcomes are sensitive to modelling assumptions used in the testing.
"Recent stress tests have shown that strong underlying earnings are an important buffer for the large New Zealand banks. The combination of low cost-to-income ratios, generally short repricing profiles, and resulting stable net interest margins, suggests that these banks would be able to internally generate capital in the form of retained earnings to offset significant credit losses in a stress scenario," the Reserve Bank says.
"Overall, these outcomes suggest that, as a group, the large New Zealand banks could absorb material losses in a downturn event while remaining solvent. The test shows that the strong underlying profitability that the banks are presumed to maintain through the scenario acts as a significant buffer, offsetting their credit losses and allowing them to generate sufficient capital to stay above their minimum requirements in each year of the test."
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