Banking system robust to severe dairy stress test

So says a Bulletin article 'Summary of the dairy portfolio stress testing exercise' published today by the Reserve Bank.

Low global milk prices are generating significant financial pressure for dairy farmers, with around one half of the dairy sector currently experiencing a second consecutive season of operating losses.

Five banks that are the largest dairy sector lenders participated in a stress test run by the Reserve Bank in late 2015. Two scenarios were tested, with scenario one assuming that the dairy payout recovers to $5.25/kgMS by the 2017/18 season and a fall in dairy land prices of 20%. Under the second scenario, the dairy payout was assumed to fall to $3/kgMS in 2015/16 and remain below $5/kgMS until the 2019/20 season with a fall in land prices of 40%.

Head of macro financial Bernard Hodgetts says both scenarios assume the dairy payout remains lower for longer than was assumed in the economic projections contained in the Reserve Bank's March Monetary Policy Statement.

"On average, banks reported losses under the two scenarios ranging between 3 to 8% of their total dairy sector exposures," says Hodgetts.

"Bank lending to the dairy sector stands at around $38 billion, which is approximately 10% of the banking system's total lending. We would expect losses of the order seen in the stress scenarios to be absorbed largely through lower bank earnings rather than through an erosion of bank capital."

The test results suggested that in the shorter term, banks would increase their dairy lending in order to support existing borrowers facing negative cash flow, before facing a longer term rise in loan losses if there were a prolonged dairy sector downturn, the article says.

Stress testing is an important part of the Reserve Bank's prudential supervision of banks and has two main objectives:

1. helping the Reserve Bank identify and assess financial system risks, and

2. helping the banks to assess risks and the adequacy of capital buffers.

Senior management of participating banks are currently considering the results of the tests and any actions that they might need to take as a result of insights gleaned from the results. Each bank will also discuss the implications of the tests with supervisors from the Reserve Bank.