Warnings to Australian banks

Australian Banks Given One Week To Prepare For European "Meltdown"

Zero Hedge,

15 Cecember, 2011

Whereas previously we had heard extensive horror stories about banks being told to prepare for the end of the world in case the European summit (the latest and greatest one from last Friday which was supposed to find a cure for cancer among other things) failed, and even went so far as to read about preparations for trading in the drachma on a when issued basis, once the summit passed (and it was clear that media posturing would do nothing to fix what has already been a failure and it would be best to remove the threats of "reality" from the public's attention) all such "end of the world" speculation promptly disappeared - after all why remind people that things are now worse than ever.  

Until today.

According to the Australian Finance Review, (original article below) banks down under "have been given 1 week by regulators to stress test how they would handle a spike in joblessness, plunge in home prices spurred by EU debt crisis." Aka a European "Meltdown." And since we don't have immediate access to the article, we leave it to Bloomberg First Word to describe for us what the article says:

• Australian Prudential Regulation Authority envision worst-case scenario of 12% unemployment, 30% drop in house prices, 40% fall in commercial property values, AFR says

• Banks will assume that write-offs, other mitigation measures are unavailable; later stress tests might allow for such steps, AFR says

• Australia’s banks have A$87.2b of exposure to Europe, or 2.7% of assets, with A$74.6b of it mostly tied to bank borrowers in France, Germany, Netherlands, AFR says, citing RBA statistics

Why is this notable?

Because unlike before, when media reports were really a propaganda ploy to get European politicians to collaborate (what has now proven to be an impossible task), and nothing but a rhetorical device, this time around, the warning is for real. And, more importantly, we have a sense of urgency, courtesy of the 1 week deadline: the question then is is it really that bad, and does Europe truly have a little over a week for global banks to prepare for the inevitable fall out?

Lastly, how long until our own prudent leaders decide it may be time to push the Stress Test scheduled for next year forward, just in case the "unthinkable" does happen, and US banks end up getting stampeded even as the rest of the world is already prepared for a worst case scenario?

We are confident Tim Geithner will get right back to us asap on all of these open items.

Banks told to prepare for the worst

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JONATHAN SHAPIRO AND ANDREW?CORNELL

Australian Financial review,

16 December, 2011

Australian banks have been ordered to urgently stress test their ability to withstand a sharp rise in unemployment, a collapse in the property market and economic recession amid rising anxiety over the European debt crisis.

The Australian Prudential Regulation Authority has told banks to model what would happen if the European meltdown spread to Australia through a series of stress tests designed to ensure the strength of the local banking system.

The regulator has given the banks just one week to model the impact of a worst-case scenario resulting in contraction in gross domestic product, an unemployment rate of 12 per cent, as well as a 30 per cent decline in house prices and a 40 per cent drop in commercial property values.

Bank executives told The Australian Financial Review the worst case scenario was extreme and difficult to?model given the short weekend deadline. “We think that’s probably part of the test,” said one senior banker. “If you can’t do this modelling or say you’re not sure of the impact, APRA will be onto it.”

The stress test has been prompted by an escalation of the European sovereign debt crisis that could lead to a global recession and a hard landing in China.

It comes in the same week that the Reserve Bank of Australia’s deputy governor, Ric Battellino, warned that Australia’s indirect exposure to Europe “through the effect on some of our important trading partners, could be significant”.

The European Banking Authority was created in January this year to stress test troubled banks in the region. The EBA released its latest quarterly stress test results earlier this month revising the capital shortfall to €114.7 billion ($151 billion).

The short notice and time frame allowed by APRA, particularly in light of negative comments from the RBA, indicates the regulator is preparing for a difficult 2012.

Bank sources say there is no suggestion APRA is concerned about existing credit quality and assessment. Rather, the authority is seeking to understand the impact of a severe external shock. The APRA missive has had bank treasurers and risk officers scrambling in a week in which three of the big banks held annual meetings.

Australia’s banks have limited exposure to Europe, totalling $87.2?billion, or 2.7 per cent of assets, according to the RBA. Of that amount, $74.6 billion is exposed to borrowers in core nations – France Germany and the Netherlands – mostly to banks.

APRA, which declined to comment, has conducted stress tests on Australia’s banks in the past, as have international agencies and credit raters.

In 2003, the regulator tested the banks’ resilience to a sharp fall in house prices. It concluded that while Australia’s banks could withstand a sharp fall in property values, mortgage insurance providers would struggle to withstand claims.

APRA again tested the banks in 2005 and 2006 to determine their ability to withstand a three-year stressed scenario where unemployment rose to 8.75 per cent as house prices fell by 30 per cent.

While profits would decline as bad debts and funding costs increased, the banks would not lose money and could withstand a short, sharp downturn because of their larger weighting to mortgages.

APRA did not discuss or make the findings public until long after the tests were conducted.

In recent months, independent stress tests have been conducted on the Australian banks in response to overseas investors’ concerns that Australia’s high property prices and elevated levels of indebtedness left the nation’s lenders exposed to a bursting of the housing bubble.

In January this year, Fitch Ratings conducted an independent stress test on Australia’s big four banks.

Fitch concluded that, in the event of a severe property downturn, the banks would be hit with cumulative losses of $6 billion and a 25 per cent decline in operating profit over three years.

Credit analysts at investment bank Deutsche Bank also conducted an impact study on the major banks whereby mortgage defaults rose by 9?per cent and housing prices fell by 30 per cent.

Deutsche Bank concluded the banks were unlikely to experience losses of more than $8 billion.

Both tests showed that low loan-to-value ratios, or the high level of equity within mortgages, provided a buffer in the event of house prices falling sharply.

APRA’s latest test is clearly based on a worst-case scenario because it does not allow the banks to assume any management mitigation.

Bankers believe the regulator will request modelling of a second and even third scenario.

“For example, the first round assumes no write-offs of bad debts, which means you can’t realise any tax losses, leaving you with a deferred balance sheet asset but no capital relief,” one risk officer said.

“That’s not realistic and it guarantees them a bad outcome, but then we would expect APRA to work backwards to see what impact mitigation measures by management might have. This first wave though is a pretty raw, theoretical piece of work.”