The IMF’s recent “stress test”  of the stability of the Australian banking sector provides insights of wider relevance.(Australia Technical Note – Stress Testing the Banking Sector and Systemic Risk Analysis; IMF Country Report 19/51; 2019).  The two big take-aways are that higher capital requirements can strengthen bank resilience to severe financial and economic shocks, and scarcity of government securities can be compensated for to improve  bank liquidity.  

The IMF stress tests the system through simulations that involve three “adverse scenarios”: a fall in trade with China,  turmoil in the global financial system similar to the Global Financial Crisis (GFC), and a collapse in the real estate sector.   
Australia’s financial sector is huge – with assets of about 430 per cent of GDP or more than three times the size of India’s financial system; bank’s dominate the sector with assets of 254 per cent of GDP.  Prima facie, there is a disconcerting array of risks involving very high bank exposure to the real estate sector (about half of bank lending), significant reliance on wholesale funding (about one third) of which the greater part is in foreign currency, and high concentration in that four banks account for 80 per cent of total system assets.  
However, the regulator has acted prudently to raise capital adequacy requirements and ensure that banks have sufficient capital to absorb losses.   The system also has “robust” access to liquidity despite scarcity of government securities (see below). The risks from wholesale funding, a key vulnerability during the GFC, have been reduced by banks extending the duration of funding (and hedging of foreign exchange risks). And, although household debt in Australia is amongst the highest in the world at around 190 per cent of disposable income, households have significant asset levels as a counter.  The entire system is assessed   as “relatively stable”.
While Australia has had uninterrupted growth for 27 years, the IMF assumes a  severely adverse macroeconomic scenario– in which the baseline assumption of 3 per cent GDP growth is slashed to a contraction of the economy of up to 2.5 per cent. Despite this, the banking system remains solvent because of its high profitability and strong equity buffers.
The average regulatory capital is about 14.7 per cent, which is above the regulatory requirement of 8 per cent, and core tier-1 equity - the most loss absorbent capital - is about 10.6 per cent, and while this falls over the simulation period it remains above the minimum regulatory requirement of 4.5 per cent.
Overall, this is consistent with a number of advanced economies in which bank capitalization is almost twice the level recommended by the Basel Committee. The bad news for everyone is that the IMF accords a “High” likelihood to the global financial disruption scenario. However, for Australia, this will result in only a ‘Medium” adverse impact, despite bank exposure to overseas wholesale funding.  High profits and adequate capital provide sufficient loss absorption to avert an economic collapse.
The scenario having the most adverse impact on the economy, that of a meltdown in the real estate sector, is viewed as having only a “Low to Medium” likelihood of being realised.  This will be a relief to the authorities, who will be pleased that average mortgage non performing loans (NPLs) have remained under 1 per cent.  
The likelihood of a slowdown in the world economy, involving a contraction in trade and in the Chinese economy, poses higher risks since the report’s publication. The likelihood of this was assessed last year as “Low to Medium”, and viewed as having “Medium to High” adverse impact because of significant trade with China in both goods and services.
Since fully a third of Australia’s goods exports are to China, this scenario will be troubling, since the risk assessment is based on the IMF’s Global Financial Stability Risk Matrix of July 2018.  The likelihood of the scenario’s  realisation has surely increased since then,  given the recent weakening in global growth and the ongoing “trade war”.  
Australia’s low public debt, which reflects its fiscal framework and commitment to prudent fiscal policies, is rare among advanced economies.   As a result Australian banks have limited access to government securities which represent in the new arrangements of Basel III a preferred form of “High Quality Liquid Assets” (HQLA) that underpin bank liquidity.  
This is something Australia shares with many emerging markets including almost all Islamic finance jurisdictions, with the notable exceptions of Malaysia and Bahrain, which have strong government issuance programmes for liquidity purposes.  
To assist Australia meet the new HQLA requirements the Basel Committee proposed alternative liquidity arrangements during the preparation of the new global liquidity framework, which were also extended to other countries. Thus, with the support of the Basel Committee, the Islamic Financial Services Board (IFSB), the global standard setter for prudential regulations and supervision of Islamic finance, obtained international recognition of liquidity arrangements for Islamic banks comparable to those that were being prepared to assist Australia.
Australia has put in place a Basel-approved Committed Liquidity Facility  (CLF) provided by the central bank, the Reserve Bank of Australia, which is available to meet liquidity shortfalls at banks for a pre-determined fee.  The IFSB’s Council also approved a CLF, suitably adapted to Islamic law, for Islamic finance jurisdictions that have limited HQLA. The other potential use of CLF, although still untested, is that it could allow the central bank to respond to a financial crisis by providing liquidity through this facility, without resorting to Quantitative Easing involving the  expansion of its balance sheet,  which was a feature of the central banks in the GFC economies.  
A key issue raised by the IMF is the relatively informal institutional framework for inter-agency collaboration on financial stability in Australia.   I recall it making the same point to the US authorities in the years just preceding the GFC, and getting responses not dissimilar to those in Australia.  The IMF is right to emphasise the importance of clearly specifying, ex ante, the responsibilities and powers needed to coordinate surveillance as well as crisis management policies.
The issue revolves around what must be done during a crisis against what  should be done before it hits.  The most severe financial crises, in Asia in 1997, and the GFC in 2008, were brought under control, ultimately, despite that crisis management frameworks were poorly designed or in some cases non-existent.  These examples demonstrate that it is political resolve, pragmatism and policy ingenuity that are critical in the midst of a financial crisis.  The authorities must make a commitment to do “whatever it takes”,  in the famous words of Mario Draghi, the President of the European Central Bank,  speaking in 2012 at the height of the Eurozone sovereign debt and financial crisis.  
The de jure transparency and accountability in the financial stability framework that the IMF recommends, however, is something that is achieved over the medium term through the execution of a well planned and robust reform strategy. The critical issue is that having a transparent and accountable framework for financial stability, underpinned by detailed data collection and robust collaborative mechanisms, enhances the ex ante supervision and quality of surveillance of the financial system.  This is still a work in progress in Australia, and much of the world.
It is noteworthy that Australian banks have a relatively low spread between deposit and interest rates  - about 2.9 per cent, or about half of spreads in South Asia – but achieve high profitability (i.e. higher than 10 per cent return on equity).  This is because the system is well capitalized and has negligible NPLs.  This contrasts with South Asia where  the key challenge comes from the poorly capitalised state owned commercial banks (SOCBs) which  have high NPLs.   
This characterizes both India where SOCBs accounts for about 70 per cent of banking sector assets and NPLs are above 10 per cent,  and Bangladesh, with a much smaller SOCB sector.
In Bangladesh NPLs appear to be rising across all bank categories, and have put pressure on profitability, which has been negative at times in the SOCBs. IMF staff reports suggest that interest rate spreads in Bangladesh are not anomalous, and reflect high NPLs and weak profits, but this is a subject that is contentious in Bangladesh.
What is less contentious is the wider applicability, including to South Asia, of the IMF’s recommendations to Australia: greater funding autonomy for its regulators as well as stronger governance and risk management capabilities, and the need for effective stress testing frameworks for solvency, liquidity and contagion risks.  
Ultimately, regulators and policymakers across the world will want to target an expeditious development of a bank resolution framework and the integration of risk and stress testing analysis into the supervisory process. India appears to be making progress on these fronts in recent years, although gaps still remain, as they do also even in Australia.
Finally, in outlining key financial sector vulnerabilities stress tests also illuminate the adequacy – or weaknesses – of bank internal risk management systems and the risk management capabilities of board and management.  The IMF’s revamped stress tests, part of its Financial Sector Assessment Programme (FSAP) is in this sense a grueling, searching exercise best suited for well-prepared jurisdictions.  For others, the key will be to develop “self assessment” capabilities while preparing for the real thing.

The writer is a former Secretary General of the Islamic Financial Services Board