The Australian Prudential Regulation Authority’s chairman has reassured the banking fraternity that stress testing has shown the major players in the local banking sector, taken as a group, are likely to withstand a severe downturn in economic conditions.

Speaking at an AB+F Randstad Leaders Lecture luncheon in Brisbane on Thursday 8 November, delivering a presentation titled: the Australian banking system under stress again? the APRA chairman, Dr John Laker, made a number of key points.

He began by pointing out that two years ago, the stress test results were reassuring, and reinforced our confidence in the resilience of the Australian banking system.

This led APRA to revisit the question, against an economy facing a softer growth outlook: Would the Australian banking system cope if the global and domestic economic environment were to turn much gloomier?

The answer can be found in the results of another macroeconomic stress test that APRA has recently completed. And this time the hypothetical was tougher than our 2010 test: it involved a much sharper slowdown in China and a disorderly resolution of eurozone problems leading to a freeze in global funding markets, Laker noted. The results also extended to the New Zealand operations of Australia’s major banks.

As Laker noted, from his point of view, the results of stress tests are used to anchor expectations for the level of capital that an institution should hold in normal times, to provide a sufficient buffer to withstand a challenging environment. The results are also used to inform our risk assessment of institutions and as part of the development of supervisory action plans, he said.

And this is a hypothetical scenario, he was keen to emphasise. 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.

In this latest APRA stress test 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.

So it therefore came as some relief to him and the audience of banking professionals in the room to hear that the results of the macroeconomic stress test conducted by APRA this year for the five advanced banks:

• 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, Laker said. 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.

The weighted average reduction in Total Capital ratios over the three-year stress period was 4.1 percentage points. This took the five advanced banks (who account for around 80 per cent of total banking system assets in Australia), as a group,

marginally below the eight per cent minimum total capital requirement of the Basel II Framework by the end of the stress period.

This result was not unexpected and nor does it raise undue concern on our part, Laker said.

He noted that these banks had been running down their Tier 2 capital levels ahead of finalisation of the Basel III capital standards, which impose stricter eligibility criteria for Tier 2 capital instruments. As APRA has released eligibility criteria in final form, new Basel III Tier 2 compliant instruments can now be developed, and APRA supervisors will be monitoring plans to replenish Tier 2 capital holdings, Laker told the audience.

APRAs recent macroeconomic stress test, together with the IMFs assessment — with further commentary expected soon — provides further confirmation that the Australian banking system has the capital strength to cope not just with the real-world stress test of the crisis, now stretching beyond five years, but with much greater adversity.

However, as Laker warned: nothing stands still. Risk profiles of regulated institutions are dynamic, not static.

To this end, APRA is expanding its commitment to, and resourcing for, stress testing as a core area of frontline supervision. Though there is still much work to be done, we welcome improvements made by institutions to advance their stress-testing programs and their plans for further investment. We also welcome the greater engagement of boards and senior management, Laker concluded.

Q&A follow-up

Following his presentation to an AB+F luncheon in Brisbane, Laker took questions from the audience.

In response to a question on what he saw as best practice here and overseas on improving risk governance, Laker noted that: What works well is a strong risk function and a strong chief risk officer who has the fortitude to stand up to strong management on the sales side of the business. At the Basel Committee meeting we had a presentation from the [US] Office of the Comptroller of the currency about what happened with JP Morgan over its $6bn loss [from uncontrolled derivatives losses].

(AB+F note. this problem first came to light in May amid scrutiny of the actions of one trader, Bruno Michel Iksil, nicknamed the London Whale due to the size of his bets, and highlighted weaknesses in the company’s Chief Investment Office.)

One lesson that Laker said he drew from the presentation was that the risk management function and the CRO were not strong enough to withstand — in personality terms — the head traders and the others who were managing the bank’s position. What boards want to hear is not an enfeebled CRO saying ‘I think it’s OK’, but ‘No, you do this at your peril’, he observed.

That is why we’re happy to lead with the CRO and his team if they’re not cutting through the ambitions of the sales culture of the organisation, he said. Australians are ‘hats in the air’ kind of people, so as soon as things start to look OK, we’ll be exuberant again. That is why we say that if there is any cost cutting going on now, keep away from the risk management area — keep that strong and well resourced, with clear reporting lines to the board.

In response to a suggestion by AB+F that a non-bank lender — such as the recent example of Kyabram’s important local entity, Banksia — could provide a shock that was not on any regulator’s radar, Laker was quick to point out: Banksia’s advertising made it very clear the organisation wasn’t a bank, and the people who lost money didn’t think it was a bank, but was a trusted community operation.

The issue of where the line is between prudential supervision and market based, or disclosure, supervision was really laid down by the Wallis enquiry. If the government of the day wants to change the line, that will be their call, he said.

We won’t be leading the charge in that area because we’re busy patrolling the perimeter and what’s inside the perimeter [in Australia].

But around the globe, there’s considerable and growing concern by policy makers about that perimeter, he noted.

It’s more porous in some countries, and the shadow banking sector is larger in some countries — such as in the US with their money market mutual funds. What the G20 leaders and the Financial Stability Board are doing is focussing on the shadow banking sector and asking ‘who’s minding this store?’ because one of the lessons from the GFC was that no-body was really looking at a sector that had systemic implications, Laker said.

It’s not been a major issue in Australia because of its relatively small size, as the RBA’s numbers have shown. That is, non-bank financial services firms have not encroached on the banks’ market and therefore have not grown strongly, although there has been a noticeable effect on competition — by mortgage originators, for example.

It’s one [risk sector] we’re always alert to. The community always thinks there’s a regulator ‘out there’ somewhere, even though they like to be able to manage their own affairs, and Banksia is a classic example of this. There’s always healthy debate to be had in society of whether people really want to accept the consequences of managing their own risk, Laker concluded.

Note. there will be a further report and commentary on this Leader’s Lecture presentation in the December edition of AB+F magazine.

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