A European stress test for Australia's banks

So, Australian Prudential Regulation Authority chairman John Laker believes Australian banks could survive ‘'a period of months'' without access to global markets if global funding markets freeze as a result of the turmoil in Europe. That's not exactly reassuring.

In fact the major banks themselves believe they are holding sufficient liquidity, have termed out their wholesale borrowings sufficiently and have displaced sufficient wholesale debt with customer deposits to survive quite a lot longer than that.

Laker's comments during his regular appearance before the Senate Economics committee, however, do point to renewed concern within the banking regulator about the potential for another flashpoint in the ongoing instability within the global financial system since the initial crisis erupted in 2007, what Laker described as a ‘'roller coaster ride'' in financial markets, which was again on a downwards swing after the Greek and French elections and the banking crisis emerging within Spain.

Laker's checklist for the Australian bank's prudential health has a number of ticks.

They are solidly profitable; they are holding historically high (indeed very high) levels of (high quality) capital; the major banks have only ‘'very limited'' exposures to the euro area countries under the most strain; the larger banks have lengthened the maturities of their wholesale funding and they are holding a lot of liquidity. The majors have also established a market for covered bonds and retain significant headroom to issue more and have access to repo transactions with the Reserve Bank if necessary.

Despite all that, Laker believes that any break-up of the euro area or a European sovereign or banking default would create market turmoil and would impact on the major banks because of their continuing, albeit reduced, exposure to global funding markets.

He's less concerned about domestic threats, saying the prospect was for near-trend growth in the Australian economy in 2012 and 2013, the terms of trade remained high, inflation and unemployment low and the fiscal position strong.

That's true of the economy overall, although the recent spate of company collapses, significant and continuing job losses, the depth of the anxiety and risk-aversion among consumers and sliding house prices might be emerging issues of concern.

The majors showed in 2008 that, with some assistance from the federal government in the form of the funding guarantees (which they paid for), they were able to weather that storm. Today they are in far stronger shape to cope with a reprise of that seizure in global markets after the Lehman Bros collapse.

The Australian corporate sector generally, with some exceptions, is also in better shape. It has less debt, particularly short-term debt, and more liquidity. Historically the biggest threat to the banks has been their commercial property exposures, but they have reduced their lending to that sector, which has itself reduced its gearing.

If house prices were to continue to slide and unemployment were to escalate as the non-resource economies continue to splutter, however, that might cause the banks some issues, although it would take very large spikes in both to create a material threat.

Earlier this year an IMF working paper looked at the Australian majors through a novel lens, asking what would happen if the Irish experience of an unemployment rate of 13.6 per cent and a near halving of house prices from their pre-crisis peaks were to occur here. They concluded that the majors' tier one capital ratios would fall by only 1.5 percentage points and remain above the regulatory minimum.

The only scenario where the majors would need to raise new capital would be if their peak corporate loan loss experience of the original crisis –about six per cent of their corporate loan books – were to be repeated in tandem with that surge in unemployment and crash in house prices.

Earlier this month an IMF team arrived in Australia to undertake a rather more formal stress-testing of the majors, so there'll be another check on the battle-readiness of the system.

Laker did point to another potential source of risk. With minimal growth in demand for credit and the deposit wars maintaining pressure on their margins, the banks' earnings growth has flattened and their returns on equity are subsiding. There is some potential that a bank or banks might succumb to pressure from the market to chase higher earnings by taking on more risk.

The way Laker put it was that ‘'in this environment strategic ambitions will be crucial in determining how ADIs (authorised deposit-taking institutions) maintain their financial strength and profitability in a durable way and these discussions are a key topic in APRA's regular discussion with boards and senior management.''

APRA is known to have, among other issues, let the banks know it would be concerned if, for instance, they were to relax their loan-to-valuation ratios to try to drive more housing loan volumes.

It showed itself to be a vigilant and proactive banking regulator ahead of and during the financial crisis. One assumes it wants to maintain that reputation which, along with the actual resilience of the banks, may yet be tested again if the European authorities can't devise or agree on a formula for stabilising the eurozone and averting the threat of a destructive fracturing of the eurozone, with banking and sovereign debt defaults, that would give the global financial system an even bigger shake than it experienced in 2008.