Australian bank stress tests
History shows that bank failures can be extremely disruptive to an economy. Consequently, financial
regulators and those responsible for ensuring financial stability devote considerable resources to monitoring
the health of banks.
A tool often used to do this is the stress test. In a stress test, it is usually assumed that the economy
enters a ‘severe but plausible’ recession in which unemployment rises significantly and property prices fall
clearly. A model is then used to determine the extent of the losses that banks could incur due to payment defaults in this
scenario, and whether these are significant enough to render them unviable. Understand the probability that banks are
failing in a major downturn in the economy can help regulators decide what action to take.
This document describes how the Reserve Bank of Australia (RBA) banking stress test model works. It also shows
how the model was useful in a real crisis, at the start of the COVID-19 pandemic.
How does the model work?
The core of the stress test model is to map a scenario for GDP, unemployment rate and
house prices to changes in banks’ capital ratios. This is done by estimating the answer of three
1. Bank profits – which are particularly influenced by increasing credit losses as the economy deteriorates.
2. The amount of profits that is retained as capital rather than paid out as dividends.
3. The change in their (risk-weighted) assets as the riskiness of their loan portfolio changes due to the
changing economic situation.
These three variables allow the model to update its estimates of bank capital ratios each quarter, and
show how close each bank is to violating its prudential capital requirement.
The importance of capturing interaction effects.
The RBA model includes Australia’s nine largest banks. An important feature of the model is that it
includes various mechanisms to capture how the behaviors and results of one bank affect all others. The
global financial (and other) crisis has shown that such “contagion” effects can greatly amplify the effect of
an economic slowdown on bank capital. We consider three forms of contagion within the model, which
1. Funding costs: When a bank is in difficulty, funding costs increase for all banks.
2. Fire sales: To meet liquidity needs, a bank may start selling its securities, which may drive prices down
of these securities and force the other banks to depreciate their value.
3. Economic feedback: If banks restrict lending to households and businesses, the economy may
deteriorate more sharply and lead to higher loan losses for all banks.
Actual usage during COVID-19
The RBA stress test model has been particularly valuable as an analytical tool during the COVID-19 pandemic
hit Australia in March 2020. At that time, the economy was set to enter one of its biggest
slowdowns. This raised significant concerns about how the banks would fare and whether the viability of any
would be threatened.
The model was very useful in assuring decision-makers that this was unlikely and that the slowdown
needs to be a little bigger or longer for banks to be about to violate their prudential rules
terms. This mainly reflects the fact that Australian banks are making significant profits and are very well
In capital letters.
Originally published by Nicholas Garvin, Samuel Kurian, Mike Major and David Norman, RBA