Navigating the future: APRA’s roadmap for stress tests and cost of the credit risk

As we embark on the threshold of a new fiscal year, the Australian Prudential Regulation Authority (APRA) is gearing up to unveil its 2024-25 Corporate Plan, set to be disclosed by the end of August.

In anticipation of this pivotal release, APRA has recently communicated its supervision and policy priorities for the upcoming six months to the industry. Among the paramount points delineated is the emphasis on stress testing within the banking sector. Specifically, APRA has articulated intentions to conduct a banking stress test in mid-2024, particularly targeting systemically important banks. The scope of this endeavour will be clarified early this year, with entities duly notified of their involvement.

Bolstering resilience in the banking sector

Reflecting on the trajectory of the banking sector, APRA underscores the imperative for entities to fortify their capacities to navigate periods of profound financial strain and, if necessary, to reconstruct their financial robustness. The turbulence that the international banking landscape witnessed in early 2023 serves as a poignant reminder of the indispensability of readiness to confront adverse scenarios. Accordingly, resilience-building and crisis management tools remain focal points in APRA’s agenda.

The crucial role of stress testing

Stress testing emerges as a pivotal analytical instrument, offering invaluable insights into the core risks and vulnerabilities inherent in specific entities and the broader financial system. Its forward-looking nature equips stakeholders with a proactive stance towards risk mitigation and strategic planning. Forward-looking preparedness of internal processes is a crucial element that should also be gained through stress tests. The ability to apply future expectations on credit risk development on the client level significantly improves risk recognition, stipulating early remedial action to lower future costs.

Reviewing the 2023 stress test: A testament to resilience

The resilience of major banks comes under the spotlight as they emerged unscathed from APRA’s stress tests. The simulated scenario, marked by a 10% unemployment rate, elevated inflation, and a notable decline in house prices, failed to breach the capital or liquidity buffers of major banks. The outcome was exceptionally robust, affirming the banking system’s resilience in navigating the early 2023 stress test cut-off period.

Nevertheless, certain weaknesses were recognised, even in 2023. Upon applying more comprehensive expenditure assumptions, the Reserve Bank of Australia (RBA) discovered that approximately one in eight borrowers were unable to meet their monthly expenses. Moreover, if the cash rate were to rise by half a percentage point to 4.6%, this proportion would increase to 16%, generating concerns within the banking sector.

Assessing the current credit risk landscape

Given the current economic climate, due to the prolonged impact of inflation (currently somewhat tamed) and rising interest rates, it is expected that retail customers may experience increased risks of default since their loans were funded, but certainly Stage 2 IFRS 9 classified loans will increase.

Looking at recent figures, the prevalence of at-risk loans, as classified under the International Financial Reporting Standard 9 (IFRS 9) accounting standards, has witnessed a notable surge.

Stage 2 loans, indicating a substantial increase in credit risk since initial recognition, have surged to 17.93% in the 12 months ended September 30, 2023, according to Australia’s four largest banks, alongside aggregate Stage 3 loans growing to 0.9% this year, underscoring the heightened vulnerabilities within the banking sector.

Australian banks have cautioned about these risks affecting consumers and the financial pressures faced by many Australians. With the potential emergence of downside risks due to rising interest rates, there’s a delayed impact on mortgage customers. However, the levels of hardship experienced are roughly half of those seen during the COVID-19 pandemic. Adequate economic growth, low unemployment rates, and changes in spending habits are expected to shield borrowers from the increasing interest burden as they transition from lower fixed rates to higher variable rates upon the expiration of fixed-rate mortgages.

IFRS 9: Enhancing the detection of significant credit risk increases

In response to the 2008 global financial crisis, the IFRS 9 was conceived to address the inadequacies in provisions by banks. Since its global implementation in 2018, IFRS 9 has been instrumental in augmenting the transparency of a bank’s performance and risk exposure. By enabling forward-looking provision levels, IFRS 9 fosters a more nuanced understanding of risk dynamics, empowering stakeholders to adopt proactive risk management strategies.

The benefits of the analytical IFRS 9 approach are not only recommended but demanded by regulators. The insights from the 2023 APRA Stress Test underscore the critical importance of customer-level considerations within banks’ risk management frameworks. As financial institutions navigate the complexities of the current economic landscape, it’s imperative for them to integrate borrower-level stress expectations seamlessly into their IFRS 9 processes, particularly through the implementation of Significant Increase in Credit Risk (SICR) Stage 2 requirements. This entails a proactive approach towards identifying significant changes in estimated default risk over the remaining expected life of financial instruments. Within the framework of IFRS 9, a Significant Increase event precipitates the calculation of Loss Allowance, set at a level equivalent to Lifetime Expected Credit Losses, instead of the previous estimate based on 12-month Expected Credit Losses.

Banks must anticipate and accommodate potential rises in credit risk, ensuring the inclusion of such customers within Stage 2 assessments. Incorporating customer-specific assumptions into transactional analyses is imperative, making the utilisation of analytical tools essential.

Anticipating the future

As we anticipate the unfolding of the 2024 stress test, the banking sector braces itself for an era characterised by heightened uncertainties and evolving risk landscapes. It is expected that in 2024 stress test banks will, for the most part, remain resilient, but an increase in credit risk will be notable.

Banks will need to consider the potential effects if some level of stress materialises, reinforced with current credit risk status, with this year potentially being characterised by an increase in banks credit risk costs. Banks must be prepared to identify customers with increased risk and create provisions alongside remedial actions to support customers as much as possible to mitigate further risk developments.

The integration of insights collected from stress testing into the IFRS 9, monitoring and collection processes will be crucial for enhancing the resilience of financial institutions, especially when faced with potential adverse scenarios.

With APRA’s steadfast commitment to elevating risk management standards and addressing vulnerabilities proactively, the banking sector is poised to navigate the complexities of the future with resilience and foresight.

By Sanjin Bogdan, Head of IFRS