Australia: Did APRA assume a bailout in its stress test?

Houses and Holes at Macrobusiness.com.au makes an important point regarding the Australian mortgage insurance sector towards the end of this article:

John Laker, head of APRA, is out today with a speech in which he announced the results of a recent APRA stress test of Australian banks. Here is the scenario and the results:

The ‘what if’ scenario was built around a further deterioration of global economic conditions, with a disorderly resolution of the fiscal problems in Europe triggering a dislocation in global debt markets and a sharp downturn in the North Atlantic economies. China is assumed to be unable to fully offset the decline in its exports with domestic spending and, as a result, the rate of growth of the Chinese economy slows sharply. The implied reduction in Chinese demand for minerals lowers commodity prices significantly, with a consequent deterioration in the exchange rate for the Australian dollar. Domestically, households and businesses respond to the external shock by reducing consumption and investment expenditure. As a result, GDP falls and unemployment rises substantially, which feeds back into rising defaults and sharp falls in house prices and commercial property prices.

In this scenario, the key macroeconomic parameters for Australia used as the basis for the stress test were:

• a sharp (5 per cent) contraction in real GDP in the first year;
• a rapid rise in the unemployment rate to a peak of 12 per cent;
• a peak-to-trough fall in house prices of 35 per cent; and
• a fall in commercial property prices of 40 per cent.

This is a tougher stress test than the one APRA undertook in 2010. The projected economic contraction is deeper and more prolonged, with a weaker recovery and a longer period before return to growth. The rise in unemployment is higher and the impact on the housing market therefore more pronounced; there is a greater peak-to-trough fall in house prices. This time, the stress test also addressed liquidity consequences. The dislocation in global debt markets results in the largest banks being unable to access global funding markets for six months. The consequence is more intense competition for deposit funding and an increase in funding costs, weighing on lending margins and acting as a drag on revenues.

Remember, this is a hypothetical. It is in no way a forecast or a central expectation for the course of the Australian economy. Rather, the stress test was intended to test the boundaries of ‘severe but plausible’, especially given the current relatively strong position of the Australian economy. Benchmarked against recent industry-wide stress tests in other countries, the severity is confirmed by the fact that the GDP shock is more than four standard deviations based on the annual volatility of GDP in Australia since 1960; the shock was one-to-three standard deviations in other major tests. As a test of plausibility, the macroeconomic scenario would be comparable with the actual experience of the United Kingdom, United States and some European countries during the global financial crisis.

Although the macroeconomic scenario was tougher than in the 2010 exercise, the actual mechanics of the stress test were largely the same. The advanced banks were asked to apply the macroeconomic scenario in their own models and provide their assessment, in quite granular detail, of the impact on the ratings migration of assets, default behaviour, profitability and capital. After analysing this information, APRA then determined a common set of portfolio-specific risk measures that were applied to the banks’ loan portfolios.

Reflecting the severity of the scenario, the advanced banks all reported significant losses, driven by much higher bad debt expenses. Credit loss rates in aggregate were comparable with the experience in the early 1990s, although not quite as high as the peaks then reached. As expected, total losses were larger than in the 2010 exercise.

Despite the deterioration in labour market conditions and the projected stress on the housing market, residential mortgages, which account for nearly half of the advanced banks’ credit exposures, contributed only a fifth of total losses. The mortgage portfolio alone was not the principal driver of losses, a reflection of the structure of the domestic mortgage market as well as the general tightening in lending standards following the crisis. Losses were realised across a range of loan portfolios, particularly corporate, SME and commercial property portfolios. Losses on these business portfolios were more front loaded, materialising earlier in the scenario than losses on residential mortgage portfolios, which tended to lag the increase in unemployment.

The main results of the stress test for the five advanced banks, taken as a group, are as follows:

• none of the banks would have failed under the downturn macroecnomic scenario;
• none of the banks would have breached the four per cent minimum Tier 1 capital requirement of the Basel II Framework in any year of the stress test;
• and the weighted average reduction in Tier 1 capital ratios over the three-year stress period was 3.8 percentage points.

This is a very positive result. It reflects the efforts of the advanced banks to strengthen their Tier 1 capital positions since the crisis began through ordinary equity issues and profit retention. It leaves these banks well positioned to transition to the new Basel III capital regime.

Well…bonza! But just one question. What did the stress test assume about the Lenders Mortgage Insurance sector (LMIs)? They are those hapless gents sitting on wafer thin capital buffers but carrying the risk of all the banks’ riskiest mortgages.

If the APRA stress test assumed a smooth and uninterrupted flow of payouts for losses from the LMIs to the banks then it also assumed their defacto nationalisation. In reality, under extreme stress, there is a very serious risk is that the LMIs will be wiped out and their relationships with the banks will descend into legal chaos as the two parties aim to survive at the cost of one another. You may recall that the biggest losers on Wall St in the GFC were insurers (think AIG), not banks.

In short, in the kind of scenario painted by APRA, it is quite possible that the government would have to step in and the post-nationalised LMIs would continue to pump a river of public cash into the banks via a backdoor bailout (ala AIG in the US).

So, if we are to take this excellent stress test result seriously, we really need to know what APRA assumed about the LMIs. Hmm?

Reproduced with thanks to Houses and Holes at Macrobusiness.com.au