Australia’s banking system proves to be safe and resilient under APRA’s stress testing regime

The Australian Prudential Regulation Authority

The Australian Prudential Regulation Authority (APRA) is the sole prudential regulator of the financial services industry. It oversees banks, insurance companies, and most members of the superannuation industry. APRA currently supervises financial institutions holding around $9 trillion in assets. To put this figure into context, the combined value of Australia’s 11 million houses in August 2023 was estimated at about $10 trillion.

2023 Banking system stress test

In March 2023 APRA undertook its annual stress test of Australia’s ten largest banks. The theoretical exercise presented banks with a hypothetical scenario featuring a deep and prolonged global economic downturn, accompanied by a sustained period of high inflation and interest rates triggered by a supply shock in global commodities markets that further intensified inflationary pressures, leading to weaker global growth and heightened risk aversion within international capital markets. The APRA test scenario saw inflation peak at 8.6 percent, gross domestic product fall by 4 per cent, unemployment rise to 10 per cent and house prices fall by 35 per cent over three years. Other assumptions included a temporary closure of international funding markets, a three-notch downgrade for bank credit ratings, and intense competition for deposit funding.

Capital raisings were the primary mitigant taken by banks, which collectively raised $37 billion of equity during the theoretical severe downturn. However, this response was theoretical in nature and because there is no precedent, given that Australian banks did not experience significant capital stress during either the Global Financial Crisis or the Covid-19 pandemic.

The results indicated the resilience and overall soundness of Australia’s banking system in the face of a theoretical major economic shock. Unsurprisingly the test also revealed that the risk of contagion from international or domestic events doesn’t stop at banks. The interconnectedness of Australia’s modern financial system means that a crisis in banking would impact superannuation and insurance, and vice versa. Beyond that, the 2023 Optus outage demonstrated how problems in non-financial services industries can spill over into the financial system in that Optus did not provide financial services but was an essential intermediary for those services to be provided. With these findings in mind, APRA has begun planning the first financial system stress test because a system-wide perspective is needed to grasp these linkages and potential impacts.

The interconnectedness of the Australian financial system

Consider the commercial property market as an example of the interconnectedness of Australia’s financial system; banks lend to it, super funds invest in it and insurers underwrite it. Workers don’t want to use it and prefer to work partly or fully from home. Accordingly, a major correction in commercial property valuations would impact all three industries – banking, superannuation and insurance.

Another factor contributing to the need for banks’ stress testing to adopt a system-wide view is the rise and rise of superannuation as an economic force. While the banking industry remains the cornerstone of Australia’s financial system, the value of assets managed by the superannuation sector has grown at almost double the rate of banking – 8.8 per cent a year compared to 4.8 per cent. If this trend continues superannuation assets will exceed the size of the banking sector in time.

Against this background, APRA has decided to conduct its first broader financial system stress test in 2025 with a focus on gaining a deeper understanding of the transmission mechanisms of shocks across the Australian financial system. The process is aimed at identifying possible “blind spots” in APRA’s current supervisory regime.

Implications for investors

A key takeaway for shareholders in Australia’s banks is that as a critical and essential element for the financial security and welfare of Australian households, as well as the functionality of business and government sectors, and the broader economy more generally, Australian banks enjoy a privileged and ‘protected’ status within the financial system and legal framework. One example of this is that bank deposits of up to $250,000 are guaranteed by the Federal government. Being well-capitalised and subjected to strict prudential obligations justifies the confidence of the government in maintaining this guarantee.

Moreover, successive Australian governments have consciously preserved the current status quo of the Australian banking system and have even given a name to it; the four pillars policy! In other countries, the current market structure enjoyed by Australia’s four major banks would be considered anti-competitive. However, the present market structure maintains a robustly sound banking system that withstood the Global Financial Crisis and is sufficiently robust to step through the next financial crisis, if and when that occurs. On the other hand, it also maintains a highly profitable banking system.

Today the Australian economy is faced with high inflation, elevated interest rates, uncertainty in the Chinese property market, and geopolitical risks including escalated fighting in the Middle East. Nevertheless, a safe and resilient banking sector can buffer the domestic economy against adverse external influences and generate superior returns in times of economic prosperity. This is why bank shares should remain a core component of a diversified share portfolio.