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Gareth Vaughan outlines why he takes Reserve Bank stress testing of New Zealand banks with a dollop of salt

Banking / opinion
Gareth Vaughan outlines why he takes Reserve Bank stress testing of New Zealand banks with a dollop of salt
dollop of salt
Source: 123rf.com Copyright: bowonpat

By Gareth Vaughan

More than a hundred years ago a ship named the Titanic was launched. It was said to be unsinkable.

The reason we've all heard of this ship today is because it wasn't unsinkable. In fact the Titanic sank on its maiden voyage in 1912 after hitting an iceberg in the North Atlantic Ocean.

It even turned out the ship was poorly prepared for such a scenario, not having enough lifeboats. More than 1,500 people died. "Titanic" thus became a byword for disaster, tragedy and hubris.

I thought of the ill-fated ship this week after reading details of the Reserve Bank's latest bank stress testing. This is not because I think or want New Zealand banks to suffer a similar fate to the Titanic. I don't. Rather it's because the Reserve Bank makes it sound as if the banks are unsinkable.

In this year's solvency stress test the Reserve Bank modelled a four-year scenario where house prices fell 47% from the very elevated November 2021 peak, share markets dropped 42% from December 2021, the unemployment rate - currently 3.3% - rose to 9.3%, Gross Domestic Product contracted 5%, the Official Cash Rate (OCR) peaked at 5.5% and the two-year mortgage rate at 8.4%, and banks were hit by a "one-in-25 year" cyber-risk event.

The Reserve Bank says this scenario caused loan impairments of $20.8 billion over four years, saw banks post losses during year two, and cop aggregate costs of $1.3 billion from the cyber-attack(s).

This stagflation and cyber-attack combination certainly packs a punch. But not only did NZ banks survive, even before mitigating actions they still had enough capital to both continue lending and maintain capital ratios above their minimum regulatory requirements.

The Reserve Bank did note, however, this would be a "challenging macroeconomic environment for households and businesses," I.E. people, with a significant number of bank customers unable to repay their loans and watching their wealth erode.

The Reserve Bank also suggests most banks would need to initiate mitigating actions such as issuing capital, restricting dividends (poor shareholders), and cutting costs in order to replenish their capital buffers, and to meet rising regulatory capital requirements being phased in over the years to 2028. More likely, in my view, the Reserve Bank would just kick the can down the road on the deadlines for the increased capital requirements again as it did when Covid-19 hit.

Clearly NZ banks are strong. This is good. And certainly with the big four oligopoly it's what you would expect. After all the four - ANZ, ASB, BNZ and Westpac - hold a combined 87%, or $447.829 billion, of NZ's $512.719 billion of total bank loans. As ANZ's recent annual profit of $2.3 billion highlights, they're also very profitable.

A beef

My beef with the stress tests is not that the Reserve Bank does them. Given the central bank's financial stability mandate it needs to do something of this ilk. It's rather that I believe the stress tests should be taken with a large grain of salt. They're a good academic exercise for central bank boffins to undertake. And they can map out a vast range of potential catastrophic scenarios. But no one knows exactly what combination of events will cause the next crisis and/or be experienced during it.

This year's solvency stress test asked banks to consider how a cyber-attack would impact their business for the first time. Banks were required to base this on a one-in-25 year cyber risk event/s, whatever that means, which affects the general banking system.

According to the Reserve Bank, banks modelled the impacts of scenarios including various distributed denial of service attacks, attacks locking banks out of critical infrastructure, kill chain malware and ransomware events with all attacks modelled to extend over one to two months.

It's not clear whether any of these scenarios included state sponsored attacks. But it's certainly good banks are modelling cyber-attacks given they're constantly facing them. Ross McEwan, CEO of BNZ's parent National Australia Bank, recently said his bank faces more than 50 million attacks on its digital channels every month.

Alarming revelation

The latest stress testing also incorporated high interest rates, for the first time since 2014. Alarmingly here the Reserve Bank says banks noted the difficulty in modelling the impact of higher interest rates, given a lack of historical data. This seems surprising given the rise in interest rates as recently as the lead up to the Global Financial Crisis (GFC) when the OCR peaked at 8.25% between July 2007 and July 2008.

"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," the Reserve Bank says.

I'm old enough to remember when unemployment topped 11% in 1991 and some mortgage interest rates hit double digits in 2008. And I'm younger than some of the people working in our banks. So in our world of rising interest rates it's concerning banks are apparently struggling with their modelling.

Another thing that's interesting to consider is that NZ's major banks emerged from the latest crisis stronger than when they went into it. In major part this is due to the mitigation measures the Government and Reserve Bank put in place.

When Covid-19 hit the wage subsidy and mortgage deferral scheme gave people the confidence to continue borrowing and spending. The Reserve Bank dropping the OCR to just 0.25%, keeping it there from March 2020 until October 2021, and removing loan-to-value ratio restrictions, helped give them the means to do so.

Thus NZ banks topped $6 billion in annual profits for the first time in the September 2021 year as they realised almost all the loan provisioning taken at the onset of Covid-19 wouldn't be needed.

When the GFC kicked in banks were also supported. The Reserve Bank slashed the OCR from 8.25% in July 2008 to 2.50% in April 2009, making 150 basis point cuts in both December 2008 and January 2009. The Government also introduced the Crown retail deposit guarantee scheme, and Crown wholesale funding guarantee scheme covering overseas bank borrowing that was used by ANZ, BNZ, Westpac and Kiwibank.

Pandemics, foot & mouth and more

In May 2020 the then-Reserve Bank Deputy Governor Geoff Bascand acknowledged the Reserve Bank's stress testing of banks hadn't run a fully fledged pandemic scenario. It had, however, tested an outbreak of foot and mouth disease.

The very real risk of foot and mouth (FMD) remains, with the Reserve Bank's Financial Stability Report this week noting the recent outbreak in Indonesia.

"In New Zealand, the probability of an outbreak remains low owing to effective border controls and the lack of direct flights from Indonesia currently. However, an outbreak would have a large adverse impact on the sector if it occurred, as it would be likely to trigger a swift suspension of all FMD susceptible animal-based exports. We are working with other parts of government to monitor the current Indonesian outbreak and risks to New Zealand," the Reserve Bank says.  

Another scenario I would think worth modelling, given the ownership of our major banks, is a banking crisis in Australia spilling into NZ. But it's good to see from the Financial Stability Report that the Reserve Bank is keeping a watchful eye on China, our key trade partner, with a section on the implications of a slowdown in Chinese growth.

It's great that NZ banks come through Reserve Bank stress tests so well. But this doesn't mean nothing could ever go wrong. You never know what the exact nature of the next crisis will be thus it's impossible to prepare for everything. What happened to the Titanic reminds us you just don't know exactly what's out there, and where human error and greed might lead.

Another point is, if a worst case scenario happens with runs on NZ banks and/or bank(s) flirting with the possibility of failure, does anyone believe the Government will just stand back and watch? History suggests that's very unlikely. At the end of the day bank customers are voters and governments can pretty much bail anything out if they really want to.

In conclusion and to answer the question posed in my headline, no bank stress tests aren't bunkum. But they should be taken with a grain or two of salt.

*The chart above comes from the Reserve Bank's Financial Stability Report.

*This article was first published in our email for paying subscribers early on Friday morning. See here for more details and how to subscribe.

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36 Comments

Good article and timely. I think it’s very possible that house price fall will be hit. The testing may well be tested in the near future!

I hope we don’t see a convergence of all of those events, but given we’ve seen a war in Europe and global pandemic in the last few years, who knows..

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Dont worry everyone. Interest Rates will stay Low for a Very Long Time.

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I heard that interest rates are going to go negative soon.

Adrian Orr has been asking the banks to prepare for negative rates.    He has been in all the newspapers talking about how negative rates will be here soon.

Oh, wait... that was 11 months ago 🙃

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Yeah I agree, I think most of those scenarios in that test will be hit in the next 12 to 18 months. Good luck everyone!

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There is nothing to do but wait

Cheap money has hard consequences

Interesting to note that when the world wants to write about it they don’t pull in Tony the comb or Bernie as the experts

They use an academic who is impartial 

https://www.theguardian.com/world/2022/nov/05/new-zealand-the-kiwi-in-t…

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Yes TA/Bern/AC.......no mater how badly impeding or what future property busting drops are most likely.   TA/Bern/AC will reliably say  "I see green shoots of property market revival,  buy now, please, please."  "Its not dire and the property market is the best place to be,  load up on debt,  as much as you can,  buy now, please"

They are akin to a current Russian tank group commander saying,  "its been a good missions day today,  our squad only lost 10x out of our 30x operational tanks to enemy fire,  on todays retreating moves".   
"I inform Moscow command that we will only lose 25% tanks tomorrow,  a much improved result"  "I tell the my tank boys to take heart,  as Moscow send us 3x new latest Gen tanks, to bolster ranks  (2002 models) and to stay happy and fight on positively,   Our win is assured"

Tony/Bern/AC,  the happy Russian tank group commanders,  giving us,  the unwitting peasants,  the true propaganda that we must believe, otherwise we will be in bad financial perils.......

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The world is paying a lot of attention to what is happening here – because we are the most cockeyed, you’d think we would be the first to fall over.”

this expert must have missed grant robertson telling us all is good and orr blaming it all on ukraine.

As if we could have screwed it all up worse than anyone else..just coz we dropped our rates the most, imported more unskilled people than anyone else and hiked our house prices the most (amongst other mind boggling govt/rbnz decisions). 

What do impartial experts know.

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Guardian - impartial don't make me laugh they are as left as jacinda.

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It's great that NZ banks come through Reserve Bank stress tests so well. But this doesn't mean nothing could ever go wrong. You never know what the exact nature of the next crisis will be thus it's impossible to prepare for everything.

IMF reveals no safeguards, no audits, no prevention of thieving in the present Ukrainian government. http://johnhelmer.net/thieves-paradise-in-kiev-imf-admits-it-doesnt-know-how-much-ukraine-has-received-of-35-billion-in-promised-foreign-cash-or-where-the-money-was-spent/

Link

What's NZ's liabilty as a contributor to IMF funding?

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Well we've all agreed that the super fund is a government asset now, so we should be ok.

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Can't answer the NZs liability but the link confirms what I've suspected/perceived all along. Before Zelensky became President/PM Ukraine was massively corrupt. Probably on a par with Russia. After he took over I suspect corruption was reduced somewhat but still a cess pit. I also wouldn't be surprised if some of the non financial military aid found its way to Russia for a price. If it wasn't far off a basket case before the invasion, it will be for years to come. A huge millstone around Europe's neck.

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Watched a program on Aljazeera about Ukraine it was no different to Russia, it had the usual suspects with Billions of dollars. Think it was a huge glass chandelier in a entrance way that was silver and they didn't like it so sent it away to get gold plated that struck me the most. 

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Al Jazeera based in US vassal state:  Al Udeid Air Force Base in Doha, Qatar

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you're showing your bias Audaxes.

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Probably the most unbiased new service there is, even then its obviously pro Palestinian whenever it reports on Israel. Ukraine was basically Russia, it had all the same traits and the West should have just left it alone.

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Yea man frankly if there's not much else going on a Sunday I try to squeeze in rationalising some genocide here and there, just to pass the time. After all, it's not the fault of the guys leaving people in mass graves, is it? They're not really doing anything wrong at all.

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Zelensky has to have inherited a significant can of worms when he was voted in. He was only the second generation away from a Russian patsy and the traces of corruption that filtered through their government and business community was clearly significant. Some of it only came to light after Russia invaded and they found people feeding Russia information. It takes time to clean all that up, and the west should understand only too well how hard it would be to clean up banking laws. Even without the invasion, I would have expected it to take quite some time for Ukraine to clean up  their system.

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Testing at a house price drop of 47% seems very conservative given prices rose by about that much in just two years. Surely there a good chance we’ll overshoot that, at least in some parts of the country. 

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47% up then 47% down leads to a real drop of 22% against the original value 

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An ocean of salt

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Yep. There are all sorts of potential scenarios.

eg War. Where men (and presumably women these days) get conscripted and can't pay their mortgages any more. Unless the army/ navy pays well?

A massive EQ in Wn or Ak.

However these days you can just print money can't you. Because most other countries do that.

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I laugh...one in 25 year cyber event....major breaches happen here weekly in Oz. Its only a matter of time that after telcos, govt departments and insurers....banks are next...and prize prey for hackers and cyber warriors

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Bernard Hickey Highlights below points, all pointing towards  more downside to come and if Mr Orr feels that bank can tolerate 47% fall in house prices, is preparing the people for his action in coming months, specially 23rd Nov announcement.

  • Aotearoa kept growing jobs and real incomes at faster-than-expected rates in the September quarter;

  • Reserve Bank stress tests found banks were so profitable and well stocked with spare capital they could handle a 47% fall in house prices;

  • the US Federal Reserve and the Bank of England both hiked their key interest rates by 75 basis points, setting the scene for the Reserve Bank to do the same on Nov 23; and,

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Adrian Orr this week was shilling "mortgage holidays" and other "relief" for borrowers.

He is pushing them to borrowers like a drug dealer pushes meth.

We ought to all take a step back and ask ourselves WHY.   

Why is he pushing mortgage holidays if the banks are strong?    He has no mandate or responsibility to do such things.     He is either pushing them because:

1) the banks aren't all that strong, and there are financial stability risks, and/or

2) he is once again putting his fingers where they don't belong (fiddling with house prices, which he has no mandate to do).

My money is on both 1) and 2). 

We all know what a disaster the individual mortgage stress tests were.   Many borrowers are already facing rates that are higher than they were stress tested for.   

I'd bet that the bank resilience tests will prove to be just as inaccurate and useless.     Our RBNZ is hopeless at assessing risk and managing risk.

 

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yeah, nah.   A mortgage holiday is for the benefit of the borrower not the lender.  It just gives the borrower some breathing space, which the bank itself should be happy to permit, if it increases the possibility of the loan to remain performing.  RBNZ is just trying to be Tane Mahuta and be kind by making caring statements on behalf of the struggling borrowers which they and the banks helped them into this mess.

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True...

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Prior to covid,  widespread mortgage holidays were unheard of.

They have proven to be highly distortionary in the housing market.

They have contributed to systemic risk for our economy.     

The Reserve Bank governor should not be promoting them.

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Perhaps he's just got that generational belief that house prices going up is a good thing, that the "wealth effect" is real and positive (as opposed to just loading massive debt on following generations so as to feel rich now). Hard thing to shake.

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It's hard to believe that the banks do not know how to model higher interest rate settings in terms of impact on credit quality of their asset base.  That sounds like B-S that the RBNZ so easily swallows.  More likely is that the modelling shows things they don't want the RBNZ to know.

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What RBNZ won't do, the accounting standards around impairment will. 

If Orr is right, impairment levels will stay the same and provisions for impairment won't blow it. If they start ticking up then it's clear what the banks say internally vs. the brave face they're putting on (lest the $2b+ a year extraction-fest be stopped in its tracks) doesn't line up anymore. 

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The question is whether we should tolerate a financial system so complex, that the risks of failure are essentially impossible to determine, regardless of , or even in the absence of predictable shocks? Let alone black swan events. 

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Complex financial system… we mainly have RE lending with a bit of Ag thrown in!

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Good one Gareth. Thanks

Happy to read that RBNZ is doing some preparation. But I don't really trust their battle against inflation.

Some 'threatening event' like the pension funds in UK may occur here ( mortgages or Kiwisaver etc) and RBNZ and govt will wear the superhero capes and save the people again , obviously by easing policy and spending . NZ$ will be hit , I guess NZ$ must have reached its low anyways

The debt and leverage has been well spread - so many people start complaining

 

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Alarmingly here the Reserve Bank says banks noted the difficulty in modelling the impact of higher interest rates, given a lack of historical data. 

Seriously, Banks don't have the historical data?

Banks are the ones charging the loan interest, the information is in their systems.

I call the banks out on that one as BS. Go back and have another go banker...

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I assume banks have two sets of data. The one that describes the very real impairment risks they are well aware of, that they keep to themselves, and the very watered down neverland dataset compiled for the compliance requirement. Keep an eye on insider sellers.

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Banks should not be allowed to 'risk-weight' their assets. Why? Let me quote from The End of Alchemy, by Lord King.

"Risk weights derived from statistical studies of the past moreover, proved highly misleading in the crisis, for example, past data had suggested that mortgages were a relatively safe asset for banks to own, and yet in the crisis they turned out to be the source of large losses".

"It is better to be roughly right than precisely wrong, and to use a simple but robust measure of required capital. Heuristics are better than so-called optimising solutions that assume the wrong model. In the case of bank regulation, it is better to use a measure of leverage than a ratio of capital to risk-weighted assets".

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