Stress test: Banks would stand up to property market crash as big as 47%

House prices have fallen but nowhere near as much as the extreme scenario that the Reserve Bank has been testing out on banks. Photo / Fiona Goodall

New Zealand’s banks would be well-placed to withstand an extreme scenario where house prices fell by 47 per cent and unemployment rose to 9.3 per cent, although it would reduce the level of capital they held as a buffer.

That’s the finding from the Reserve Bank of New Zealand (RBNZ) after its annual stress testing of the sector. The tests covered the five largest banks - ANZ, ASB, BNZ, Westpac and Kiwibank as well as four smaller banks and covered a four-year period from April 1, 2022.

Christian Hawkesby, RBNZ deputy governor, said it tested the banks to help it better understand the implications of risks to bank balance sheets and the overall financial stability.

This time it looked at a situation where property values fell 47 per cent from the peak in November, share prices were down 38 per cent and unemployment rose sharply. The scenario also saw the official cash rate rise to peak at 5.5 per cent and the two-year fixed mortgage rates hit 8.4 per cent.

The scenario also added in a one-in-25-year cyber risk event.

Under those conditions, bank’s common equity tier 1 ratio would fall 3.3 percentage points to 8.9 per cent, which was still well above the 4.5 per cent minimum.

“Although banks’ capital buffers would be reduced in such a scenario, they would still remain well above our regulatory minimum, thanks in part to the build-up of capital since the 2008 Global Financial Crisis, enabling them to continue to support their customers and the economy,” Hawkesby said.

But the RBNZ’s report also noted it would be a very challenging environment for households and businesses with a large number of bank customers unable to repay their loans and experiencing large declines in wealth.

The scenario would potentially result in $20.8 billion in impairment expenses for the banks over four years. That compared to $1.7b in real impairment costs from the Covid-19 pandemic over the last four years.

It would also likely cause banks to make a loss after two years, and the cyber event would lead to costs of $1.3b.

Unemployment was found to be the biggest driver in people defaulting on their mortgages.

“However, mortgage rates became an important driver of defaults as they increased above 6 to 7 per cent, consistent with test rates that large banks have used since 2019 for their affordability assessments of mortgage applications.”

The RBNZ noted it was the first stress test it had done since 2014 involving high interest rates and banks had found difficulty in modeling the impact of higher interest rates due to a lack of historical data.

“This highlighted some limitations for the stress test modeling of new economic risk factors. A number of banks indicated they are investing in their modeling capability and that this stress test proved a useful exercise.”

The stress test was also the first undertaken under the RBNZ’s new capital framework which began in July and required banks to progressively hold more capital.

The RBNZ said the combination of the stress event and rising capital requirements could make it difficult for banks to meet the new capital requirements when fully implemented in 2028.

The scenario was a long way off the current reality, with a low unemployment rate if 3.3 per cent and an official cash rate at 3.5 per cent.

The REINZ House Price Index is down 12.6 per cent since its November peak. But mortgage rates have risen sharply with two year fixed term rates now sitting between 6 per cent and 7 per cent.