Housing downturn would wipe out major bank capital

APRA has revealed that the capital backing the home loans of the big four banks would not survive a substantial housing market correction.

The revelation was made by the Australian Financial Review over the weekend after it pressed the prudential regulator for greater clarification of its stress tests of 13 lenders.

The four majors were only able to pass APRA's stress tests after drawing on extra capital allocated to other areas of their business and through profits generated in some years of the test, the AFR reported.

The majors currently use an internal ratings-based (IRB) approach to credit risk, while the non-majors use a standardised approach.

The disparity has been widely contested by the smaller banks through various submissions to the Financial System Inquiry.

In a footnote to his 7 November speech, APRA chairman Wayne Byres notes that, as an aside, the stress test results can also provide a perspective on the relative levels of capital required by different regulatory approaches.

“The loss rates on residential mortgages in the scenarios did demonstrate that banks using the IRB approach tended to generate, on average, lower loss rates than banks using the standardised approach,” Mr Byres said.

“However, regulatory capital for housing held by standardised banks was (just) sufficient to cover the losses incurred during the stress period; that was not the case for IRB banks (although strict comparison between these specific stress scenarios and regulatory capital requirements needs a degree of caution, given differences in time periods and modelling methodology between the stress test and the capital framework).”

Mr Byres recently expressed his disappointment at the Australian banks’ recovery plans in the event of a property market crash.

“Disappointingly, there was a only a very light linkage between the mitigating actions proposed by banks in the stress test and their recovery plans (or 'living wills'), with loose references rather than comprehensive use,” Mr Byres said.

“Recovery plans should have provided banks with ready-made responses with which to answer this aspect of the stress test,” he said.

“APRA will be engaging with banks following the stress test to review and improve this area of crisis preparedness.”

The 2014 stress test involved 13 large, locally incorporated banks, which together account for around 90 per cent of total industry assets. Participating banks were provided with two stress scenarios, which were developed in collaboration with the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ).

Central to both scenarios was a severe downturn in the housing market.

One scenario was a housing market double-dip, prompted by a sharp slowdown in China. In this scenario, Australian GDP growth declines to -4 per cent and then struggles to return to positive territory for a couple of years, unemployment increases to over 13 per cent and house prices fall by almost 40 per cent.

Mr Byres stressed that the scenario was by no means the regulator’s forecast.

However, a new housing market sentiment survey by RP Data released this week found 68 per cent of Australians feel the property market could suffer a significant price correction.

This is the highest reading RP Data has ever received for this question.

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