Stress tests and bank capital

Just before Christmas the Reserve Bank released a consultative document on the Governor’s idiosyncratic proposal to increase required bank capital ratios to levels unknown anywhere else in the world.    I will have some fairly extensive commentary on aspects of that (unconvincing) document over the next few weeks, but today I wanted to focus in on stress tests –  something the Reserve Bank would prefer you paid little or no attention to in thinking about the appropriateness of their proposal.

Over the last decade or so, bank stress tests have come to play an important role in assessments of the soundness of banks, and banking systems, in many countries.   Devise a sufficiently demanding shock (or set of shocks) and then require banks to test their individual loan portfolios on those assumptions and see what losses would be thrown up.     Sometimes there has been a sense of the system being gamed – the shocks and associated assumptions deliberately set in such a way that banks the supervisors want to protect don’t emerge too badly.  There were suspicions of such issues in the US in 2009, and in the euro-area stress tests more recently (I heard a nice story about the clever way one set of tests were set up to minimise the adverse results for some Greek banks).    When you are in the middle of a crisis, that sort of thing is always a bit of risk: supervisors and their political masters have rather mixed motivations in those circumstances.

But there haven’t any credible suspicions of this sort of “rigging the game” in the stress tests conducted in New Zealand (and Australia) this decade.  That is no real surprise.  Our banking systems have appeared to be in good shape, and it wasn’t obvious that there was anything the supervisors and regulators would want to hide.  If anything, with both APRA and the RBNZ champing at the bit to interfere more in banks’ choices (especially around housing finance), the incentives ran the other way (if you could show more vulnerability, your case for intervention was stronger).  I was still at the Reserve Bank when the first results came in for the stress tests published in late 2014, and I vividly call a seminar in which various sceptics (me included) pushed and prodded, unconvinced that the results could possibly be as good as they appeared to be.  But, various iterations later, the broad picture of the results stood up to scrutiny.

There have been several stress test results published in the last few years (nota bene, however, that unlike the Bank of England, the Reserve Bank has not published results for individual banks.  The Bank of England approach should be adopted here –  publishing individual bank results should be a key component of disclosure and transparency.)  One of those was a dairy-specific stress test, about which I’m not going to say anything more  here (I had a few sceptical comments here).

The other two stress tests  are more useful in thinking about the overall soundness resilience of the banking system, in the face of severe adverse shocks.

The first set was published in late 2014.   This is how they described the main scenario

In scenario A, a sharp slowdown in economic growth in China triggers a severe double-dip recession. Real GDP declines by around 4 percent, and unemployment peaks at just over 13 percent. House prices decline by 40 percent nationally, with a more marked fall in Auckland. The agricultural sector is also impacted by a combination of a 40 percent fall in land prices and a 33 percent fall in commodity prices. The decline in commodity prices results in Fonterra payouts of just over $5 per kilogram of milk solids (kg/MS) throughout the scenario.

Auckland house prices were assumed to fall by 50 or 55 per cent (as large as the biggest falls seen anywhere).   In a 2015 commentary on these stress tests I pointed out just how demanding this stress test was, especially as regards the increase in the unemployment rate (around 8 percentage points).

My point is simply to highlight that the Reserve Bank’s stress tests were very stringent, using an increase in the unemployment rate larger than any seen in any floating exchange rate country in at least 30 years.  It is right that stress tests are stringent (the point is to test whether the system is robust to pretty extreme shocks)  but these ones certainly were.  And yet not a single one of big banks lost money in a single year.  That might seem a bit optimistic –  it did to me when I first saw the results –  but they are the Reserve Bank’s own numbers.

No bank lost money in a single year, and –  this is the Bank’s own chart –  none of them even had to raise any new capital (none would otherwise have fallen below minimum required capital ratios).


This should have been a bit of a problem for the Reserve Bank, as they published these results –  sold at the time as an indication of a sound and resilient system – just a few months before the then-Governor launched a new wave of LVR controls on housing lending.  I wrote various commentaries on this point back in 2015, and occasionally the Governor and his deputy seemed to squirm a little (one example here), but not ones to let rigorously done stress tests get in a way of a favoured intervention, they went on their merry way.   Ever since then, they’ve been trying to convince us that their interventions further reduced the risks associated with the New Zealand financial system.

In 2017, the results of another set of stress tests were published.     Here was how they described the main scenario in that set of stress tests.

The four largest New Zealand banks have recently completed the 2017 stress testing exercise, which featured two scenarios.1 In the first scenario, a sharp slowdown in New Zealand’s major trading partner economies triggered a downturn in the domestic economy. The scenario featured a 35 percent fall in house prices, a 40 percent fall in commercial and rural property prices, an 11 percent peak in the unemployment rate, and a Fonterra payout averaging $4.90 per kgMS. Banks were required to grow their lending book in line with prescribed assumptions, and also faced funding cost pressures associated with a temporary closure of offshore funding markets and a two notch reduction in their credit rating.

(By then, the unemployment rate was starting from a slightly lower level).

If this test was less demanding regarding the fall in house prices, it not only explicitly assumes huge losses in asset values across the full range of types of collateral banks take in their lending, but also imposed material increasses in funding costs (rather than allowing any such pressures to emerge endogenously), and required banks to keep on growing their lending through a savage recession (in which demand for credit is in any case likely to be very subdued).   If there are one or two areas where this stress test could have been made a bit more demanding, overall the test is likely to materially overstate the potential loan losses in an economic downturn of this sort, because large dairy losses and large housing/commercial losses are highly unlikely to occur at the same time.  In any serious adverse economic shock, both the OCR and the New Zealand exchange rate are likely to fall –  typically a long way.   A fall in the exchange rate acts as a huge buffer to the dairy payout, even if global dairy prices fall a long way in an international recession.   These are details –  perhaps important ones –  but they go to the point that overall the 2017 stress test was a pretty demanding one (which is what one wants –  there is no value in soft tests, especially in good times).

And again, no bank made losses, and no bank fell below the minimum capital requirements. Here is some of the Bank’s text.

Credit losses: Due to the deteriorating macroeconomic environment in the scenario, cumulative credit losses associated with defaulting loans were around 5.5 percent of gross loans. Losses were spread across most portfolios, with residential mortgages and farm lending together accounting for 50 percent of total losses. Credit losses reduced CET1 ratios by 600 basis points.

RWA growth: The key driver of RWA outcomes were (i) risk weights increasing in line with deterioration in the average credit quality of nondefaulted customers and (ii) the requirement that banks’ lending grows on average by 6 percent over the course of the scenario. RWA growth reduced CET1 ratios by approximately 160 basis points.

Underlying profit: The banking system’s net interest margin declined by approximately 50 basis points per annum in the scenario. Banks only gradually passed on higher funding costs to customers, reflecting a desire to maintain long-term customer relationships and that some customers are on fixed rates. Underlying profits remained sufficient to provide a substantial buffer of earnings that accumulate to around 550 basis points of additional capital for the average bank.

The banking system survived, quite comfortably, the very demanding test thrown at it, based on bank loan books as they stood in early 2017.  As the Bank goes on to note, the results are sensitive to the assumptions used, but the Reserve Bank had no incentive whatever to understate the potential scale of the losses –  after all, these stress test results were released when they already had their capital review project underway.

Of course, we had one more “stress test”; the actual events of 2008/09.   Going into that recession, the Reserve Bank had been becoming increasingly uneasy about bank balance sheets.  There had been several years of rapid growth in housing lending, but there had also been very rapid growth in commercial property and other business lending, and in farm lending, and a sense that not all of this lending had been done with anything like the discipline that might have been prudent.    The 2008/09 recession was pretty severe, and quite a bit of poor-quality lending was revealed (especially in the dairy sector).  And yet, of course, the banking system came through that shock substantially unscathed.   One could argue that the test really wasn’t that demanding, since asset prices didn’t stay down for long, but in a sense that was the point: even with a severe international recession, and lending standards that did seem to have become quite relaxed, we experienced nothing like the sort of asset price or unemployment adjustments that the stress tests assume.   Capital ratios then were lower than they are now –  the latter now regarded by the Bank as totally inadequate.    Really severe adverse events don’t arise out of the blue, they are typically a reflection (as in Ireland or Iceland) of severe misallocations and reckless lending in the years leading up to the reckoning.   This latter point is one that seems lost on the Reserve Bank.

You’d have thought the Reserve Bank couldn’t have it both ways.  Sure, the most recent stress test results are now two years old, but they’ve spent the last few years telling us that they are pretty comfortable with lending standards (especially after imposing their LVR controls).  What used to be a focus of particular concern –  Auckland housing –  has largely gone sideways since then, and overall credit growth has been pretty subdued.  There is no credible story they can tell (and they haven’t even tried) as to how robust balance sheets in 2017 are now such as to make it imperative –  using the coercive power of the state –  for banks to have much higher capital ratios again.

Stress tests do get a (brief) mention in the capital consultation document.  They acknowledge the results

64. Recent stress tests have found that the banking system can maintain significant capital buffers above current minimum requirements during a severe downturn. During the 2017 stress test, the capital ratios of major banks fell to around 125 basis points above minimum requirements, while earlier tests had a trough buffer ratio of around 200 basis points. However, stress test results are sensitive to assumptions on the scale and timing of credit losses, and on the ability of banks to generate underlying profit under stress.

To which one might reasonably respond with “well, sure, but that is the sort of things you are supposed to test”.

But where they get rather desperate is in the next paragraph.

stress test from consultative doc

And here we have come full circle, back to rather strained reliance on the US, Spain, and Ireland in the 2008/09 crisis.

This chart attempts to imply that there is something wrong with the stress test results, rather than drawing the more obvious conclusion that they say something good about the health of the New Zealand and Australian banking systems, and about the macro environments within which those systems are operating.

Take the first panel of experiences, those from the late 1980s and early 1990s.  All five countries had newly liberalised their financial systems.  Neither banks nor borrowers nor supervisors (to the extent that the latter even existed) new much about lending or borrowing in a market economy.  In New Zealand and Australia there was wild corporate exuberance.  And in the three countries where there were systemic banking crises, all that was compounded by fixed exchange rate regimes –  that misallocated resources during the boom phase and then compounded the adjustment difficulties in the bust.

And what of the second panel?   In both Spain and Ireland there was a fixed exchange rate (membership of a common currency, but it amounted to much the same thing for practical purposes), and in the United States there was a deeply government-distorted housing finance market.   None of those cases bear any resemblance whatever to the situation of the New Zealand economy (and banks) in 2019.   We haven’t had the reckless lending, and although a future severe recession will involve losses, there is no reason to think that the 2017 stress test results materially misrepresent the health of the system.  (As the Bank has noted in the past, research suggests that in most serious banking crisis it isn’t residential lending that is the problem, but corporate and property development lending. The Bank has also previously been on record highlighting the importance of the floating exchange rate in providing a buffer in severe shocks, but now they seem to wilfully downplay or ignore that.)

The consultative document is now out for….consultation (although I think few believe the Governor is serious about taking on board other perspectives, and being open to changing his view).    But a story out the other day suggests they aren’t content to wait calmly for submissions to come in, and that the Governor has returned to the fray already in a letter to a single media outlet

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

(I’ve asked them for a copy of this letter –  clearly already in the public domain –  but even though the Official Information Act requires them to respond as soon as reasonably practicable, I’m still waiting).

And what does the Governor have to say?

Reserve Bank governor Adrian Orr says stress tests of banks have inherent limitations, suggesting they shouldn’t be relied on.

“We emphasise in our public articles that stress testing results should not be read at face value,” 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,” 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 percent of banks’ exposures.”

As Newsroom notes, the final point is simply irrelevant –  the Governor attempting to play distraction –  when as the Governor and anyone else interested knows the Bank has done economywide stress tests, across the entire loan books of the banks (see above).

And of course stress tests have inherent limitations.   That is one of the reasons to have as much transparency as possible about the tests so that users can evaluate for themselves just how demanding the Reserve Bank has been.   And while the Governor seems to want to imply that the limitation he highlights could understate the potential loan losses etc, there are alternative perspectives.  For example, knowing at the start of the stress test just how severe and lengthy the eventual shakeout (asset price falls, high and enduring unemployment) will prove to be may lead to more loans being called in earlier, perhaps at larger losses.    One thing we saw in the US in 2007/08 was that banks were able to raise fresh capital early on, at a time when few appreciated just how bad things were going to get.

I don’t, for example, recall anyone suggesting (for example) that the stress test results should result in a reduction in minimum capital ratios (despite the ample margins).  They are one input, but they should be something the Governor engages with a great deal more seriously, particularly when he proposes to go out on a limb and adopt capital requirements out of step with those anywhere else in the world.   And if he wants to run these arguments, it might be better form to do so in the published consultative document, than in knee-jerk responses to individual people casting doubt on his preferred option.  I can think of one or two half-decent counter arguments –  and I’ll come back to them in a later post –  but they aren’t ones the Bank has ever advanced.

Reality is that in thinking about the consultative document, on the one hand we have detailed and specific results from repeated stress tests (and the aftermath of a period of rapid lending growth and loose lending standards not many years ago), using the specifics of banks’ loan books as they stand.   A stake in the ground as it were.   And on the other hand, we have numbers that –  despite pages and pages of the document –  are really just plucked out of the air –  both the proposed requirements themselves, and the economic and financial consequences if those whims eventually form policy.

But more on some of those issues over the next few weeks.





Stress tests and credit availability

It is 3 January, a public holiday, the heart of summer (notionally at least –  it is actually cool and wet in Wellington), and something of a low ebb in local news and analysis.  But bright and early this morning, I did a radio interview on the Reserve Bank’s stress tests of the major banks.

The request was apparently prompted by a Stuff article, itself prompted by a recent new Reserve Bank animated video explaining stress tests.    The article, rightly, pointed out that following a very severe recession and significant credit losses for banks it was likely that banks’ lending standards would be somewhat tighter than they would have been in the previous boom.  That might even affect some of those hoping to take advantage of lower asset prices.

The stress tests themselves aren’t new.  They were done in late 2015, and were written up in the Reserve Bank’s Financial Stability Report last May.   I wrote about those results at the time.  In that stress test the Reserve Bank, quite appropriately, looked at how banks would cope if they were faced with a very severe recession and a very sharp fall in asset prices.  Stress tests are useless unless they use very demanding shocks.   These were. In the stress test, the unemployment rate rose to around 13 per cent and stayed there for some time.  For housing loan books it is the combination of unemployment and falling house prices that creates the scope for large loan losses –  either strand alone isn’t enough.  In fact, the increase in the unemployment rate was larger than anything experienced in any advanced economy with its own monetary policy in the 70 years since the end of World War Two.  And house prices were assumed to fall by 40 per cent generally, and by 55 per cent in Auckland –  about as large as any falls anywhere.

The banks emerged from these very demanding stress tests intact.  It wasn’t even a close run thing.  Capital ratios dropped, but mostly because the risk weights applied to banks’ outstanding loans increased  (a 50 per cent initial LVR loan looks riskier after house prices fall by 40 per cent).  The actual loan losses weren’t large enough to offset bank’s other operational earnings, so that the actual dollar value of banking system capital was not reduced.  This is the Reserve Bank’s chart of losses.


Total losses, over four years, were around 4 per cent of assets.  As the Bank observed

The cumulative hit to profits averaged around 4 percent of initial assets (figure C1), which is a similar outcome to phase 2 of the full regulator-led exercise conducted in late 2014. About 30 percent of total losses were related to mortgage lending, with half of this due to the Auckland property market. SME and rural lending accounted for most of the remainder of financial system losses. Loss rates for mortgage lending were around 2 percent, significantly lower than the 5 percent loss rate observed for most other sectors.

Faced with such very demanding economic circumstances, banks could be expected to become more cautious about lending.  That is what generally happens in economic downturns.    Banks –  like others in the economy –  find that things hadn’t turned out as they expected, and aren’t sure what will happen next, or how long the downturn will last for.  Central banks don’t know either.

In this sort of climate banks are typically keen to conserve capital –  it isn’t necessarily easy to raise more capital, and shareholders are a bit uneasy.  On the other hand, banks stay in business by lending and borrowing, and being known to be reasonably willing to extend credit.    As I noted in my earlier post, lower asset prices (houses and farms) tend to result in a lower stock of credit over time just through the normal process of turnover.  What was a million dollar house might now be a half million dollar house, and a new purchaser will typically need a lot less credit to facilitate the transaction than the previous million dollar purchaser would have.  That process takes time, but it is fairly inexorable.  Combine it with the lower turnover that is typical during recessions and there is likely to be a lot less new credit going out the door, even without credit standards tightening.  Business credit demand also tends to fall away sharply during recessions –  demand for new investment projects dries up, and that is particularly marked in sectors like commercial property (where empirical evidence suggests banks are particularly prone to taking losses).

But I’m sceptical of the notion that even in the sort of recession dealt with in the Reserve Bank’s stress tests credit conditions for home buyers would tighten much.  There are really three reasons for that.  The first  –  unique to current circumstances –  is that credit conditions for home buyers are already quite (inappropriately) tight as a result of the Reserve Bank’s successive waves of LVR controls.  That is a very different climate than existed in previous booms (here or abroad).  Those controls would typically be expected to be lifted in any downturn.  The second reason is that, as the Bank’s results above show, even in a scenario of this sort loan losses on the housing loan books are not large –  not trivial by any means, by not of the sort of scale that is likely to take banks by surprise if such a shakeout ever occurs.   Servicing capacity remains a vitally important factor and any young couple with a secure income would be unlikely to find it that difficult to secure a 70 or 80 per cent LVR loan to purchase a first home.  Banks, after all, will often be keen to replace extremely highly indebted borrowers (eg investment property borrowers with negative equity) with less indebted owner occupiers with decades of home ownership in front of them.

The third reason is history.  Take, for example, the banking crisis of the late 1980s and early 1990s, which was much more damaging that the stress test results in the recent Reserve Bank exercise.  Several major banks were severely adversely affected, and the BNZ would have failed were it not for the government bailout.  And yet through that period-  late 80s and early 90s –  banks’ housing credit stock grew quite rapidly.  Even though the unemployment rate was high and rising –  not to 13 per cent –  and interest rates were still quite high, banks recognised that housing loans were generally relatively lower risk exposures.  To be sure, the stock of housing credit was much lower then than it is now –  and there was still some reintermediation (from non-banks to banks) going on, so I wouldn’t expect a repeat, but it is a reason not to be too worried about the availability of credit to house purchasers with reasonable deposits even in the aftermath of a very nasty recession and a sharp fall in house prices.  Even good projects advanced by property developers would probably struggle to get credit  –  as happened after 2007/08 –  but existing suburban houses are likely to be a very different proposition than new commercial developments, or even new fringe residential subdivisions.   (One caveat to that might be if governments were to intervene, in response to a sharp fall in house prices, and impair the value or certainty of banks’ security interests in residential mortgages –  but that isn’t an element in the Reserve Bank stress test.)

As a reminder, the stress test scenarios are very demanding.  The Reserve Bank likes to suggest that the scenarios don’t fully account for the second round effects of tighter credit conditions after the initial shakeout, but the scenario is so severe –  more so, say, than the US experience in 2008/09 – that we can largely set that concern to one side.     Based on the lending standards our banks were adopting in 2015 –  when the stress tests were done –  our banks look to be able to withstand all but the very worst imaginable economic shocks, and to be able to emerge still providing finance to reasonable projects, perhaps especially mortgages on existing residential properties.  Indeed, credit conditions for potential mortgage borrowers might be little or no worse than they are now, given the direct interference in that market through the waves of LVR restrictions.

The Stuff article appeared to be driven by the idea that those hoping to take advantage of a future fall in house prices might be out of luck, as the credit might not be available to do so.    For the potential first home buyer considering waiting for a future shakeout that seems a misplaced concern (although it might not be for someone wanting to buy say 20 properties at once).

The bigger question, of course, is what might trigger a really sharp fall in New Zealand real and nominal house prices.  I don’t think there is any evidence that what has happened here is, primarily, some sort of speculative bubble.  Mostly it is a consequence of the land use restrictions, exacerbated by the rapid immigration-policy fuelled population growth.  As we saw in 2008/09, recessions and reversals in immigration numbers can prompt a temporary fall in nominal house prices.  But without far-reaching reforms in land use regulation, perhaps supported by permanent material changes in target immigration levels, it is difficult to be optimistic that the sustained halving in house prices, that might re-establish more reasonable levels of affordability, is in prospect.

Stress tests really should reassure us…for now

Last year, in the course of the Reserve Bank’s faux consultations on its proposed investor finance LVR restrictions, I devoted several posts to the results of the Reserve Bank’s stress-testing exercise.  Those tests –  2014 ones –  appeared to show that, even if faced with a very severe adverse shock to (in particular) house prices and unemployment, the New Zealand banking and financial system would come through substantially unscathed.  “Substantially unscathed” here meant some significant loan losses, not typically enough to wipe out even a full year’s profit, and a decline in capital ratios –  the latter simply because in the models as house prices fell the assigned risk weight on each still-performing loan would rise (eg a loan that might have had a 60 per cent LVR at origination becomes a 90 per cent  LVR loan if house prices fall by a third).   But there was nothing that suggested a threat to the soundness of any of the banks, or the banking system as a whole.   That result should not have been too surprising.  Bank shareholders have considerable amounts of  their own money at stake and credit allocation in New Zealand is not distorted by large scale government interventions (unlike pre-crisis US, or Ireland).  Housing loan books typically don’t see huge losses even in really severe crises –  and there hasn’t been a mad rush of highly risky corporate or property development lending in recent years.  But if the  banks came through such tough stress tests in relatively good shape, what possible basis could there be for yet more rounds of direct regulatory controls, which inevitably impair to some extent the efficiency of the financial system?

The Reserve Bank was never really satisfactorily able to respond to this point, even when some media and MPs started asking the questions.  The Governor went ahead and regulated anyway.

And now he seems to want to do so again.

This year, the Reserve Bank has been back with some more stress test results.  I wrote about their 2014 dairy stress test results here.  That scenario, and the results, didn’t look sufficiently severe, and there are already signs of worse outcomes than those indicated by the stress tests.

And then in last month’s FSR, we had the results of another set of stress tests on banks’ entire loan portfolios.

In late 2015, the four largest banks in New Zealand participated in a common scenario ICAAP test. This test was a hybrid between an internal test (conducted regularly with each institution choosing their own scenarios) and a regulator-led stress test (occurring every 2-3 years with common scenarios and assumptions). Due to the use of a common scenario across banks, the results of the test provided insights for the financial system as a whole. However, the test featured less standardisation of methodology than a full regulator-led exercise. For example, there was no ‘phase 2’ where loss rates were standardised.

Like the 2014 regulator-led stress tests, the scenario used in this exercise was severe

As with previous regulator-led tests, the stress scenario was a severe macroeconomic downturn. Over a three-year period, real GDP fell by 6 percent, unemployment rose to 13 percent, and dairy incomes remained at low levels. Residential property prices fell by 40 percent (with a more severe fall of 55 percent assumed for Auckland); and both commercial and rural property values fell by 40 percent. Finally, the 90-day interest rate fell by about 3 percentage points due to monetary policy easing,

These are very demanding scenarios.  In particular, for the unemployment rate to rise to 13 per cent, it would have to increase by more than 7 percentage points from the current quite-elevated level.  Even in the severe recession in the early 1990s, associated both with a financial crisis, disinflation and considerable fiscal consolidation, and a period of substantial structural change, New Zealand’s unemployment rate did not get above about 11 per cent.  No other floating exchange rate country has experienced an increase in its unemployment rate of that magnitude in modern times –  not even, for example, the US following 2007.

To be clear, I’m not objecting to the scenario.  Stress tests are really only useful if they use quite severe scenarios –  anyone can pass easy tests –  but this scenario looks to have quite a few buffers built in.  Similarly, a 55 per cent fall in Auckland house prices would be one of the larger falls ever seen anywhere –  again, not totally implausible, especially as New Zealand is prone to population shocks –  but about as large as the biggest falls ever experienced in an advanced country major city.   On the other hand, the last sentence of that scenario is worth noting: the ability to cut policy interest rates provides a substantial buffer (to economies and banking systems) in difficult times.  But with the OCR at 2.25 per cent, it would now be quite a stretch –  to the outer limits of conventional monetary policy –  for the 90 day bill rate to fall by three percentage points.  The Bank may need to take explicit account of that limitation in future stress tests.

In this stress test, the overall losses were quite substantial

The cumulative hit to profits averaged around 4 percent of initial assets (figure C1), which is a similar outcome to phase 2 of the full regulator-led exercise conducted in late 2014

Nonetheless, underlying operating margins were largely maintained, so that

underlying earnings during the scenario were of a similar magnitude to reported credit losses, so that return on assets averaged around zero.

In a very severe adverse scenario, banks did not make losses.  They simply did not make any profits.

But risk-weighted capital ratios still fell.

Although projected credit losses were largely absorbed with underlying profitability, capital ratios were expected to decline throughout the scenario. This reflected an increase in the average risk weight from around 50 to 70 percent, due to negative ratings migrations (rising probability of borrower defaults) and falling collateral values (rising losses given default).

In fact, although risk-weighted capital ratios fell during the scenario, simple leverage ratios, of total capital to total assets, (while not reported) are likely to have increased.  The dollar value of capital did not fall (no overall losses) while in estimating how the Reserve Bank’s severe shock would affect them and their businesses, banks generated results which implied a decline in credit exposures by 11 per cent. The Reserve Bank does not like leverage ratios, but most other regulators and analysts see a useful place for them –  the OECD, for example, used to regularly urge New Zealand to adopt them.

And here, for completeness, is that Reserve Bank’s chart of how the capital ratios behaved.

C2: Capital ratios relative to respective minimum requirements (% of risk-weighted assets)

Figure C2 Capital ratios relative to respective minimum requirements (% of riskweighted assets)

The regulatory minimum is zero on this chart, so banks were well away from that, even after this severe adverse shock –  and, of course, regulatory minima have been increased since before the 2008/09 downturn.  The grey area is the so-called “conservation buffer” and as the Reserve Bank notes

the average bank reported falling into the upper end of the capital conservation buffer in the final year of the test, which would trigger restrictions on dividend payments to shareholders (figure C2).

Since none of the big banks in New Zealand is listed, the temporary limitation on the ability to pay a dividend is unlikely to be too troubling.    Banks don’t want to be in the conservation buffer, and will seek to get out of it again.  But carry the scenario forward a year or two and on the basis of normal earnings they would probably get back there fairly quickly.  What each bank might actually do might, of course, depend on the health of its parent –  if the parents were experiencing a similar adverse scenario in Australia, the market and management pressures on the New Zealand subsidiary to quickly restore capital buffers would be materially greater.

Despite all this essentially “good news” story –  savage recession, huge unemployment, severe falls in leveraged asset prices, and yet the banking system is still in pretty good shape –  the Reserve Bank has never really been happy with the story.   That is implicit in the FSR and, from what I hear, also the story they tell people who come to visit them.

I think there is a variety of reasons for that, including innate regulator/central banker caution.  Some of that attitude is a good thing, provided it is conditioned by a good understanding of how systemic banking crises in other places/times have actually developed.  Here it doesn’t seem to be.

They also seem uneasy because their scenarios do not consciously take account of any second-round effects of the reduction in credit exposures the banks would effect as part of the response to the extreme adverse scenario.   As noted above, banks estimated that their credit exposures would fall by 11 per cent.  The Reserve Bank has long worried that such a reduction in the stock of credit would act as an additional factor amplifying the economic downturn and the fall in asset prices, such that the initial macro scenario they set out for the banks was no longer sufficiently demanding.

In principle, it is a fair point.  In practice, I think it is misplaced for two main reasons.

The first is that in developing their severe economic scenario they will have benchmarked it against other really nasty downturns in other times/places.  But any additional impact of forced bank deleveraging –  over and above the initial shock that triggered the downturn –  will already be included in the GDP/unemployment and asset price numbers we see.  The 1991 downturn in New Zealand included any additional impact from the BNZ and DFC failures, the post 2007 US recession included any deleveraging impacts from all the financial institution failure and additional lender caution, and so on.  It would be double-counting to take as extreme a scenario as the Reserve Bank is using, and then add a whole new downturn on top of that, as banks pulled in their lending horns.

The second reason is that it doesn’t look as though the Reserve Bank has given anything like adequate weight to the way in which the size of a mortgage book is driven primarily by house prices and housing turnover.    In the FSR discussion, they do note that the reduction in credit exposures “could reflect a reduction in customer demand” –  there is less investment etc in recessions for example – this seems a very weak statement of what would be likely to occur with bank mortgage books in particular.

A while ago, I ran a chart illustrating the way in which a simple initial shock to house prices goes on raising household debt to income ratios for years afterwards, even if there is no subsequent further increase in house prices.  That occurs just because the housing stock turns over relatively slowly, and so after prices move to a new high level it takes years for all purchases to have taken place at the new higher price (and associated higher need for credit).

This was that chart.  Price double in year 1, are unchanged thereafter, and borrower LVRs are the same after the initial shock as they were before.

scenario debt to income

In fact, in housing booms typically involve borrowers and lenders becoming less risk-averse and housing turnover increasing.

scenarios 2

You can see the difference higher initial LVRs and slower repayments make –  it still takes years for debt to income ratios to reach a new steady-state level, and the process will happen more or less automatically, unless banks actively stand in the way. Turnover and prices drive mortgage books.  When both increase, banks’ credit exposure will increase without them really trying.

But the same process can happen in reverse.

Recall that in the Reserve Bank’s scenario house prices fall by 40 per cent (and 55 per cent in Auckland.)  I’m assuming that the 40 per cent applies to the rest of the country, so lets say nationwide house prices fall by 45 per cent.  Each new house being purchased, even if the initial LVRs stay the same, now takes 45 per cent smaller mortgages than was required before house prices fell.

But in downturns, it isn’t only prices that fall.  In fact, turnover often falls first.  Sellers are reluctant to sell below purchase price, and many people are just genuinely uncertain. Economic downturns leave potential buyers more cautious too.  The drops in turnover can be very substantial.   Even in New Zealand, house sales per capita over 2008 to 2011 were only around half the rate seen at the peak of the boom in 2003.  Housing mortgage  approvals data only start at the end of 2003, but the same sort of fall is evident in approvals –  and this is a recession much less severe than the one in the Reserve Bank’s stress test scenario, and in which house prices fell by only around 10 to 15 per cent.

So what happens to the volume of housing credit outstanding if we assume:

  • house prices nationwide fall by 45 per cent, and stay at that low level thereafter
  • housing turnover (and new mortgages) fall by 50 per cent and stay at that low level for five years, before reverting to normal.

In the base scenario (the first chart above), we assumed prices double in year 1.    That produced a stock of debt which rose substantially in the first few years, and then kept rising slowly thereafter for many years.  Lets assume the severe adverse shock happens in year 10.  This is what happens to the stock of housing mortgage debt in the two scenarios.

scenarios 3

The differences are really large, without the banks even trying.   The housing market does it for them.  Within five years of the severe adverse shock, the stock of household mortgage debt is 10 per cent lower than it was just before the shock hit, and 20 per cent lower than it would be in the base scenario (where continuing turnover at the higher initial house prices carried household debt continually higher).  Even when turnover returns to normal, the stock of credit keeps dropping, just because new purchases are at the new much lower prices.

These scenarios are only illustrative, but they illustrate a key point: turnover and house prices drive the size of mortgage books, independently of any active choices banks make.  It seems quite plausible that bank balance sheets would shrink quite materially in the years following a shock like the stress test scenario, without the banks having to do very much active at all. Between lower turnover and low prices on both the housing and dairy books on the one hand and lower investment demand on account of the weaker economy on the other, there would be big savings in required capital simply from these customer choices.

Of course, in severe downturns, borrowers tend to be more cautious about how much they are willing to borrow –  and so it is quite plausible that borrower LVRs would shrink in the course of a shakeout like this, even without action by the banks.  That would further reduce the stock of debt.

And, of course, in a savage downturn of this sort one would have to expect banks to alter their lending standards –  pull in their horns.  This is something the Reserve Bank has never seemed comfortable with.   Way back in April 2008, just as the 2008/09 recession was beginning to become apparent, the then Governor was saying openly

Banks should avoid overreacting to the economic downturn, Reserve Bank Governor Alan Bollard told the Marlborough Chamber of Commerce today. “The New Zealand economy remains fundamentally sound and creditworthy,” he said.

“Banks, businesses and households alike need to recognise the new external environment and adopt a cautious approach – but don’t go into hibernation, the underlying economy remains robust,” he said.

In fact, the only sensible reaction of both banks and businesses, going into what proved to be a severe recession, from which in some respects the economy has still not fully recovered, was to pull in their horns.  That was especially so as the economy had quite severely overheated during the previous boom, and in some areas –  property development and dairy in particular –  credit standards had deterioriated very sharply during the boom.  The recession would prove that some of the critical assumptions –  by borrowers and lenders –  made during the boom were misplaced.  In the middle of the downturn no one knows what the correct “new normal” actually is, and considerably greater caution –  by lenders and borrowers –  was quite appropriate.  The only prudent step was to stop and reassess.

So it would be in a downturn –  a savage downturn –  of the sort in the stress test scenario.  Central bankers might win political brownie points by urging banks to keep lending.  But it isn’t obvious that it would be good business –  no Governor knows the future, any more than bankers and borrowers do.  Things no doubt do return to some sort of normal eventually, but as we’ve seen –  even in non-crisis in New Zealand –  quite when and how is a very open question.   And as I noted earlier, all those severe downturns that the Reserve Bank used to benchmark its stress test scenarios already included any pulling in of horns by banks (and borrowers).

This has become rather too long a post, so I will stop here.  Bank supervisors should never on their laurels.  Bank, and borrower, behavior can change quite quickly and the quality of loan books can deteriorate quite alarmingly quickly  –  and often does in the few years just before crises.  But on the stress tests the Reserve Bank has presented, and the supporting analysis the Bank has provided, there is little sign of anything other than a reasonably cautious prudent banking system, with robust capital buffers to cope with even seriously adverse shocks.  If the Reserve Bank wants to keep on imposing more and more controls, the onus really should be on it to show us what is wrong with its own published analysis and stress test results.