APRA Stress Testing in Plain English

Key takeaways

• Stress tests are scenario analysis, not forecasts.
• Typical scenarios combine a property price fall with rising unemployment.
• Results influence capital requirements and credit policy.
• The 3.0 percentage point serviceability buffer is stress testing applied to you.

What is a stress test?

A hypothetical severe scenario, applied consistently across institutions, to see what happens to capital. APRA specifies the scenario, banks model losses under it, and APRA reviews the results and the modelling behind them.

The scenario is deliberately severe. That is the point: a test the system passes easily tells the supervisor nothing. It is not a forecast, and a bank reporting a large modelled loss is not predicting that loss.

Scenarios have typically featured a large fall in residential and commercial property prices, a material rise in unemployment, a contraction in economic activity, and in some exercises an offshore shock or a period of higher rates on top.

How do the results reach a borrower?

Through three channels, none of which are announced as "because of a stress test".

The most direct link is the serviceability buffer. APRA requires lenders to assess a borrower's ability to repay at an interest rate at least 3.0 percentage points above the loan product rate - so with rates where they are, borrowers are commonly being assessed near 9.25% to 9.5%. That is a household-level stress test using exactly the same logic.

What are the limitations?

Worth understanding, because stress tests are sometimes treated as proof of safety.

• The scenario is chosen. A test cannot capture a shock nobody wrote into the scenario.
• Models are calibrated on history - relationships that held in past downturns may not hold in the next one.
• Second-round effects are hard to model - banks tightening simultaneously amplifies the downturn itself.
• Behavioural assumptions matter enormously, particularly around how borrowers use offset balances and prepayment buffers under stress.

Their real value is comparative and diagnostic: they show which portfolios are most sensitive to which shocks, and they force institutions to build the data capability to answer the question at all.

Frequently asked questions

What scenarios does APRA use in stress tests?

Severe but plausible downturns, typically combining a large fall in property prices, a material rise in unemployment and a contraction in activity, sometimes with an additional offshore or rate shock. The specific scenario varies with each exercise.

Is a stress test a prediction?

No. It is scenario analysis designed to reveal vulnerabilities. A bank modelling large losses under a stress scenario is not forecasting those losses, and the scenario is chosen to be severe by design.

How does stress testing affect my borrowing capacity?

Directly, through the serviceability buffer. APRA requires lenders to assess repayment ability at a rate at least 3.0 percentage points above the actual product rate, which reduces the maximum loan your income supports.

Why does APRA keep the buffer at 3 percentage points?

APRA has held the buffer at 3.0 points on the basis that household debt levels and uncertainty about the rate outlook justify maintaining it. It reviews the setting periodically and has adjusted it before.

Related reading

• Why APRA Will Not Drop the 3% Serviceability Buffer
• Stress-Testing Your Own Budget at +3%
• Basel Risk Weights and Your Mortgage

Sources

• Prudential Practice Guide APG 223 Residential Mortgage Lending — APRA
• Financial Stability Review — Reserve Bank of Australia