Orr: stress tests have limitations

RESERVE Bank governor Adrian Orr says stress tests of banks have inherent limitations, suggesting they should not be relied on.

‘‘We emphasise in our public articles that stress testing results should not be read at face value,’’ Mr 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,’’ Mr 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% of banks’ exposures.’’

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

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 continuously and to share those results with the Reserve Bank, although the results are not 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% plunge in house prices, a 40% fall in commercial property prices, unemployment of 11%, and a Fonterra payout to dairy farmers averaging $4.90 per kilo of milk solids for three years, below breakeven for the average farmer.

On top of that, the regulator overlaid an industrywide 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% of their balance sheets, so that latest test covered more than 68% of bank lending, not counting commercial property lending.

The big four banks, ANZ, ASB, BNZ and Westpac, account for about 88% 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.

Mr Orr says that the actual increase will be between 4060%, ‘‘given that current capital levels are above current regulatory requirements.’’

However, when announcing the proposals on December 14, deputy governor Geoff Bascand said that ‘‘we are proposing to almost double the required amount of highquality capital that banks will have to hold.’’

But banks do hold significantly more than the minimum capital required at present.

ANZ Bank, for example, which is New Zealand’s largest, had a tier 1 equity ratio of 11.1% at September 30, much higher than the 6% regulatory minimum.

The Reserve Bank is proposing to lift this to 16% — the smaller banks would have a slightly smaller 15% 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.

Mr 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 writes its flagship Chanticleer column.

Mr 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.

Mr Boyd was clearly suggesting the Reserve Bank proposals are extreme, but Mr 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,’’ he said. — BusinessDesk