APRA chair John Lonsdale
The Australian Prudential Regulation Authority will expand its stress testing regime with the introduction of a financial system stress test, reflecting what it sees as the growing interconnectedness of risks across industry sectors.
The regulator is working on the design of a new system-wide stress test and plans to conduct the first one next year.
APRA chair John Lonsdale said: “The intention behind the new test is to sharpen APRA’s response to systemic risks by deepening our understanding of the transmission mechanisms of shocks across the financial system. We hope to gain insight into the impacts os spillover and amplification risks between industries and identify potential blind spots in our supervisory regime.”
Speaking at the AFR Banking Summit yesterday, Lonsdale said the types of system-wide risks APRA is concerned about include major technology and telecommunications outages, a collapse in the commercial property market or climate change impacts.
Such events would impact all three industries APRA regulates – banking, superannuation and insurance – with possible contagion between sectors.
The new stress test will complement APRA’s current ADI stress testing program. Lonsdale provided some details from the 2023 test.
The stress test scenario featured a deep and prolonged global economic downturn, sustained high inflation and sustained high interest rates. The downturn was triggered by a supply shock in global commodity markets.
In Australia, inflation peaked at 8.6 per cent, a 4 per cent fall in GDP, unemployment of 10 per cent and a 35 per cent house price fall over three years. International funding markets were closed temporarily and bank debt ratings were downgraded by three notches.
Of the 11 banks chosen for the stress test, all had sufficient capital to withstand the downturn and support an economic recovery. Common equity tier 1 capital ratios fell by an average of 3.3 percentage points, eating into capital buffers. Banks were given permission to release their counter-cyclical capital buffers.
Credit losses were “significant” and both profits and dividends were cut. The average liquidity coverage ratio fell by 36 percentage points.
Lonsdale said one lesson from the 2023 stress test was that banks need to improve their internal stress testing capabilities.
“We want to see a wide range of stakeholders across the banks, including the lines of business, the risk teams, senior management and the board, working together and really challenging each other to understand what their stress test results mean,” he said.
“We saw some approaches to modelling that either did not highlight their limitations, were too optimistic in their assumptions or used models that didn’t differentiate between key sources of risk within banks’ portfolios.”