Source: Reserve Bank of New Zealand
The Reserve Bank’s – Te Pūtea Matua – latest stress test of New Zealand’s banks illustrates the benefit and necessity of shoring up bank capital in the good times to provide resilience. The COVID-19 pandemic has demonstrated that large shocks can occur with very little warning.
“The onset of the COVID-19 pandemic provides a stark reminder to us all of the importance of being prepared for the unexpected, especially when you are a systemically important bank at the core of New Zealand’s financial system. The more capital a bank holds, the better it can weather economic storms and meet customer needs during tough times like now.” Deputy Governor Geoff Bascand says.
“Our stress test assess the impact of significant, hypothetical, economic downturns on the profitability and capital of the largest banks in New Zealand. The results show us that banks can, and should, draw on their capital buffers to continue meeting customers’ needs during very challenging economic times.
“Our base case stress test scenario assumes that the unemployment rate rises to 13% and the level of New Zealand’s annual GDP falls by 12%. The scenario also assumes a significant negative impact on property prices, the largest lending destination for banks.
“Given the strong, regulated, starting point of bank capital, banks are able to continue their lending activity in this scenario. This best ensures they will play an important part of the economic recovery in New Zealand, rather than be a further source of concern by unnecessarily restricting access to credit.
“We also test a more severe economic scenario, which assumes unemployment rises to around 18%, and we experience an 18% decline in the level of GDP. Under this scenario, banks come under considerable strain, and would need to access additional capital to remain above their regulatory minimums”, Mr Bascand says.
“Even though these scenarios are severe, they are not unprecedented internationally, and the economic costs of such bank failures are significant.
“There is a limit to the comfort these stress tests provide, given that they are only simulated. In particular, the user knows how the stress ends and can act rationally. This is not the case in real time. The more bank capital there is, the less the banks and the New Zealand economy are exposed to the risks of decision making under uncertainty” Mr Bascand says.
- The Reserve Bank has been running industry stress tests periodically since the global financial crisis (GFC). This stress test was unique, in that it was being conducted during an economic shock.
- The scenarios were set at different levels of severity, taking elements of the scenarios developed by Treasury in April combined with different degrees of global economic stress.
- The pessimistic baseline scenario (PBS) can be characterised as a 1 in 50 to 1 in 75 year event with the unemployment rate rising to 13.4 percent and a peak-to-trough fall in house prices of 37 percent.
- GDP and unemployment in the PBS are comparable to Treasury’s ‘scenario 5’ for the first two years which assumed borders are closed for the first 12 months and New Zealand spends two months at alert levels 3 and 4.
- The very severe scenario (VSS) is more like a 1 in 200 year event with the unemployment rate rising to 17.7 percent and a peak-to-trough fall in property prices of 50 percent. Although the VSS is more severe than previous stress tests, it was seen as plausible at the time these scenarios were developed, and is comparable to the experience of Ireland in the GFC.