NZ banks should undertake "extreme" stress tests, IMF report says

A sharp worsening of asset quality would be needed to reduce New Zealand banks' capital below the regulatory minimum, an IMF report on NZ bank vulnerabilities said. Despite 'weathering the global financial storm', the authors of the paper argue that NZ's banks should be required to undertake "extreme" stress tests and increase capital if needed. The paper's introduction below has a good overview of the paper.

Global events over the past two years have shown the extent to which banks' balance sheet problems can interact with a real recession through several negative feedback loops, with the potential to put an economy on a downward spiral (IMF, 2008 and 2009). To break that spiral, or prevent it from starting, it is crucial to assess the strength of banks' financial position to funding or asset quality shocks. This paper combines different stress scenarios, as well as cross-country evidence, to assess banking system vulnerabilities in the case of New Zealand. New Zealand's banks have weathered the global financial storm relatively well thus far. Banks remain profitable, with low levels of impaired assets, and aggregate capital well above the regulatory minimum. However, they are vulnerable on two fronts. They are heavily exposed to households, whose debt has risen significantly and whose assets have been hit by a slump in house and equity prices. In addition, banks are reliant on short-term wholesale funding from offshore markets that have been disrupted since the collapse of Lehman Brothers in September 2008. The paper finds that a sharp worsening of asset quality would be needed to reduce bank capital below the regulatory minimum. An increase in the default rate from less than 1 percent at present to 6"“8 percent for all loans would be required to reduce bank capital below 8 percent of risk-weighted assets. While such a large increase in defaults is unlikely, the risks of such an outcome have jumped in the past year as the outlook for global and local economies has worsened. Therefore, banks should be required to undertake extreme stress tests and increase their capital if needed. Banks would have access to domestic liquidity from the Reserve Bank of New Zealand (RBNZ) in the event of a disruption to capital inflows, but the balance of payments and exchange rate may come under pressure. The paper notes that use of some official reserves, borrowing from Australian parent banks, and tapping some of the Reserve Bank of New Zealand's swap line with the U.S. Federal Reserve could fill the financing gap if up to two-fifths of external debt in 2009 were not rolled over. The government's wholesale funding guarantee scheme, introduced in November 2008, should help banks roll over their funding and lessen the possibility of a more severe disruption.