Stress Testing New Zealand Banks' Dairy Portfolios

By Hargreaves, David; Williamson, Gina | The Reserve Bank of New Zealand Bulletin, June 2011 | Go to article overview
Save to active project

Stress Testing New Zealand Banks' Dairy Portfolios

Hargreaves, David, Williamson, Gina, The Reserve Bank of New Zealand Bulletin

1 Introduction

Stress testing a portfolio of assets (such as loans) involves evaluating what would happen to the portfolio in the face of various adverse events. Applied across a bank, a stress test can be described as "the evaluation of a bank's financial position under a severe but plausible [economic] scenario." (2) Stress testing is an important risk management tool for banks in evaluating their vulnerability to various types of risk across their balance sheet. The Basel II international capital framework has a specific role for stress testing to help ensure banks have sufficient capital to absorb unanticipated losses in severe economic downturns. (3)

As a central bank with a financial stability function, the Reserve Bank is also interested in stress testing at an aggregate level. Stress testing is particularly useful for assessing financial stability by highlighting the vulnerability of the financial system to certain risks. Stress testing can assist the supervision of individual banks, and help in the formulation of prudential policy.

A stress test may examine the consequences for banks of a full macroeconomic scenario that affects multiple aspects of the banks' business, or concentrate on a downturn in a particular sector. Stress tests can also be classified by the source of the models used for the test. Bottom-up stress testing sees participating institutions use their own models to determine the effects of scenarios determined by the regulator. The regulator then collates results to provide insights into the system-wide impact. This is the type of stress test the Reserve Bank undertook in 2003 (see RBNZ 2004) and again in 2009 in collaboration with the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA). (4)

A top-down stress test involves the regulator collecting data on the whole financial system or a particular part of it and applying a modelling framework themselves. The Reserve Bank has previously done work of this sort to analyse the residential mortgage lending of the banks (see Harrison and Matthew 2008). In this article, we describe a model the Reserve Bank has recently constructed to analyse risk in the dairy farming sector.

The dairy stress testing model presented in this article is a model of credit risk--the risk that a bank will take losses because borrowers do not repay their loans. A credit risk stress testing model involves imposing changes to key macroeconomic variables that affect performance in the sector of interest, relating these changes to borrower default behaviour, and estimating the losses to the lending banks from these defaults and foreclosures.

The purpose of the dairy stress testing model is twofold. First, it may enhance banks' individual stress testing programmes by providing a base model for assessing credit risks in the dairy sector that the banks may wish to customise for internal use. Second, the model provides valuable insights into the vulnerabilities within the dairy sector and potential impacts of stress in this sector on New Zealand banks collectively.

International experts have noted that stress testing prior to the financial crisis often did not identify many of the important risks that had built up prior to the crisis and caused problems during it (see BCBS 2009). For example Geradi et al (2008) note that many analysts looking at the US housing market around 2005 felt nationwide house prices were extremely unlikely to fall substantially, partly as this had not happened in most of the historical datasets used by analysts. As residential loan defaults had also not occurred in great quantity in recent history, a historical analysis such as a regression would have had trouble identifying the risks of substantial loan defaults occurring in the future. Additionally, when large defaults did begin, the regression relationship would be likely to suddenly revise up estimated risks, potentially leading banks to reduce credit supply in order to safeguard their balance sheets.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
Loading One moment ...
Project items
Cite this article

Cited article

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited article

Stress Testing New Zealand Banks' Dairy Portfolios


Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen

matching results for page

Cited passage

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.

Are you sure you want to delete this highlight?