Stress testing New Zealand banks’ dairy portfolios

Stress testing a bank loan portfolio by estimating potential losses in a severe economic scenario provides a useful way of evaluating the risks that lenders face. This article describes a model that the Reserve Bank has constructed to analyse the risks facing banks that are lending to New Zealand’s dairy farming sector, which uses detailed information gleaned from bank loan portfolios. Simulations using the model show that simultaneous declines in both the dairy payout and security values have the potential to cause the greatest loan losses for banks. This is to be expected because the reduced earnings tend to increase farm borrowing initially, while falling rural land values erode the banks’ security values, making it more likely that a farm will exceed its borrowing limit. It is hoped that this exercise will assist banks to enhance their individual stress testing programmes and internal risk modelling by providing a base model for assessing credit risks in the dairy sector that can be customised for internal use.