## _cr09249

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---

### I. THE EFFECTIVENESS OF FISCAL STIMULUS MEASURES

- Context and method
  - GIMF (Global Integrated Monetary and Fiscal Model) two-region version used to estimate aggregate demand impact for Australia and rest of world.
  - GIMF features: overlapping generations, liquidity-constrained households, public capital that complements private capital.

- Fiscal multipliers (Percent Deviation from Baseline for a temporary (one-year), one-percent-of-GDP increase in the fiscal deficit)
  - Public Investment
    - Base Case (No Monetary Accommodation): 1.22
    - Sensitivity Analysis 1/ (No Monetary Accommodation): 1.18
    - Base Case (Monetary Accommodation): 1.32
    - Lowest–Highest sensitivity range: 1.37
  - Public Consumption
    - Base Case: 1.12
    - Sensitivity Analysis 1/: 1.11
    - Base Case (Monetary Accommodation): 1.14
    - Lowest–Highest: 1.32
  - Transfers to Liquidity Constrained Households
    - Base Case: 0.43
    - Sensitivity Analysis 1/: 0.40
    - Base Case (Monetary Accommodation): 0.48
    - Lowest–Highest: 0.54
  - Value Added Taxes
    - Base Case: 0.27
    - Sensitivity Analysis 1/: 0.23
    - Base Case (Monetary Accommodation): 0.31
    - Lowest–Highest: 0.35
  - Transfers to all Households
    - Base Case: 0.14
    - Sensitivity Analysis 1/: 0.09
    - Base Case (Monetary Accommodation): 0.20
    - Lowest–Highest: 0.18
  - Tax on Labor Income
    - Base Case: 0.15
    - Sensitivity Analysis 1/: 0.10
    - Base Case (Monetary Accommodation): 0.20
    - Lowest–Highest: 0.16
  - Tax on Corporate Income
    - Base Case: 0.01
    - Sensitivity Analysis 1/: 0.01
    - Base Case (Monetary Accommodation): 0.03
    - Lowest–Highest: 0.02
  - 1/ Sensitivity analysis varied: complementarity between private and public capital (base-case 0.10; smallest 0.05; largest 0.20), households’ planning horizon (base case 20 years; shortest 10 years), and proportion of liquidity constrained households (base case 30 percent; smallest 20 percent; largest 40 percent).

- Key drivers of multiplier variation
  - Degree of complementarity between private and public capital, proportion of liquidity constrained households, and households’ effective planning horizons have largest impacts on multipliers.
  - Monetary policy response matters: if monetary policy does not respond (monetary accommodation), GDP impact increases.

- Impact of the May 2009 announced discretionary fiscal measures (In Percent of GDP)
  - Transfers: 2008: 0.8; 2009: 1.2; 2010: 0.2; 2011: 0.1; 2012: 0.1; Cumulative: 2.4
  - Public Investment: 2008: 0.0; 2009: 1.2; 2010: 1.7; 2011: 1.2; 2012: 0.4; Cumulative: 4.5
  - Public Spending: 2008: 0.0; 2009: 0.4; 2010: 0.1; 2011: 0.2; 2012: 0.1; Cumulative: 0.8
  - Private Investment: 2008: 0.0; 2009: 0.1; 2010: 0.1; 2011: 0.0; 2012: 0.0; Cumulative: 0.2
  - Total: 2008: 0.8; 2009: 2.9; 2010: 2.1; 2011: 1.5; 2012: 0.6; Cumulative: 7.9
  - 1/ Estimates based on material provided in the May 2009 Commonwealth Government Budget.

- GIMF simulated impact of the announced stimulus on GDP (Percent Deviation from Baseline)
  - Lower Bound Calibration cumulative (2008–2012): 5.26
    - Annual: 2008: 0.06; 2009: 1.85; 2010: 1.79; 2011: 1.27; 2012: 0.29
  - Base Case Calibration cumulative: 6.46
    - Annual: 2008: 0.10; 2009: 2.08; 2010: 2.08; 2011: 1.59; 2012: 0.61
  - Base Case Calibration, Transfers Highly Targeted, Monetary Accommodation cumulative: 9.56
    - Annual: 2008: 0.24; 2009: 3.25; 2010: 3.21; 2011: 2.15; 2012: 0.71
    - Assumption: 60 percent of transfers go to liquidity-constrained households; monetary policy rate does not respond to increased inflation until 2011.
  - Upper Bound Calibration cumulative: 8.83
    - Annual: 2008: 0.15; 2009: 2.58; 2010: 2.68; 2011: 2.21; 2012: 1.21
  - Upper Bound Calibration, Transfers Highly Targeted, Monetary Accommodation cumulative: 12.81
    - Annual: 2008: 0.29; 2009: 4.06; 2010: 4.19; 2011: 2.96; 2012: 1.31
  - Simulation note: in 2008, no one is aware of the 2009 stimulus; from start of 2009 everyone is fully aware of measures over subsequent 4 years.

- Fiscal consolidation and longer-run implications
  - Stimulus financed through increased public borrowing until 2012; beyond 2012 a fiscal consolidation returns public debt/GDP to initial level.
  - During consolidation, GDP level will be lower than if no consolidation were required.

### II. AUSTRALIAN HOUSEHOLD VULNERABILITIES

- Role of household spending
  - Resilience in private consumption will be essential for a milder downturn in Australia.
  - Private consumption growth slowed but less than in United States, United Kingdom, or Canada.

- Housing wealth as key vulnerability
  - House price appreciation was the single largest contributor to growth in Australian household wealth over the last decade.
  - Metrics examined suggest overvaluation in house prices as of March 2009 in the range of 0–20 percent.
  - Factors supporting gradual and orderly adjustment:
    - Significant moderation in house price inflation and apparent stabilization of prices.
    - Significant decline in mortgage interest rates.
    - A government subsidy for first-time home buyers.
    - Continued strong net immigration.
  - Tail risk: a sharp fall in house prices over the next few years remains a tail risk.

- Household saving, debt, and consumption
  - Australian household savings rate: fell over the first half of the last decade, then recovered and returned to positive territory.
  - Household debt: significant increase in household debt relative to disposable income.
  - Debt service costs: moved below 12 percent of disposable income in the first quarter of 2009 following declines in variable mortgage interest rates.
  - Consumption adjustment: households appear to have reduced consumption as a share of disposable income to cover increased debt-service burden, implying consumption may have been closer to a sustainable level entering the downturn.

- Prepared by
  - Ben Hunt (ext. 36361), Khoi Viet Nguyen (ext. 37417), and Patrizia Tumbarello (ext. 34395).

### Household wealth composition and valuation metrics

- Wealth composition and vulnerability
  - Over the last decade Australian households’ net wealth position has risen, with the improvement largely in housing wealth.
  - Financial wealth is a relatively low share of household wealth and has been hit hard by falling equities prices.
  - Housing constitutes a large portion of household wealth in Australia, reflecting concentration of population in large urban centers.
  - Risk implication: With housing such a large share of wealth and house prices having risen significantly, household wealth and spending could be vulnerable to a large decline in house prices.

- Metrics of house-price valuation (methods)
  - Two metrics used:
    - Econometric approach estimating the house-price gap.
    - Ratios of house prices to disposable income and house prices to rents compared to long-run moving averages (10-, 15-, and 20-year).

- Econometric estimates and caveats
  - Econometric estimates (five models, multiple start dates) suggest house-price overvaluation ranges between 5 and 15 percent as of March 2009 depending on specification and starting date.
  - The simple average of the econometric model estimates is 11 percent.
  - Model caveats: potential endogeneity, imperfect capture of theoretical relationships, sensitivity to sample period and specification.
  - Note: low current interest rates help explain current house prices; interest rates are expected to return to a more neutral level.

- Simple ratio metrics (price-to-income and price-to-rent) — Percent deviation from estimated sustainable levels as of March 2009
  - Price-to-Income Ratio: Relative to 10-Year Moving Average -6.1; Relative to 15-Year Moving Average 3.3; Relative to 20-Year Moving Average 7.4
  - Price-to-Rent Ratio: Relative to 10-Year Moving Average 6.7; Relative to 15-Year Moving Average 20.9; Relative to 20-Year Moving Average 30.4

- Assessment (March 2009)
  - Overall assessment: overvaluation in the range of 0 to 20 percent as of March 2009.
  - Rationale: price-to-rent roughly 30 percent above its 20-year moving average but 20-year average may be too long given structural change; 10-year may be too short given expansion duration; 15-year suggests roughly 0–20 percent.
  - Adjustment channels: incomes and rents could grow faster than house prices or fundamentals (e.g., migration) could change—prices need not do all the adjustment and adjustment can be gradual.

- Outlook and factors suggesting orderly adjustment
  - Indicators suggesting orderly adjustment:
    - After declining q/q by 2 percent in 2009 Q1, preliminary data for 2009 Q2 indicate house prices have started to rise again.
    - Variable mortgage interest rates have fallen by almost 400 basis points since the RBA began easing monetary policy in September 2008 and are expected to remain low for an extended period.
    - Government subsidy for first-time home buyers lasts through 2009 and supports housing demand.
    - A gap between population growth and housing starts over the last several years should result in strong demand for housing over the next few years.

### III. BANK-SECTOR IMPLICATIONS AND VULNERABILITIES

- Bank asset quality and capital
  - Past due plus impaired assets rose to around 1 percent of total assets for the four largest banks as of March 2009.
  - Past due plus impaired assets for all banks reached almost 1½ percent of assets in March 2009.
  - For smaller domestic banks past due plus impaired assets reached nearly 3 percent.
  - Aggregate Tier 1 capital of the smaller domestic banks was more than 10 percent as of March 2009.
  - Regulatory requirement for capital: 8 percent of risk-weighted assets.
  - Total capital has increased since 2007 and has remained well above the regulatory requirement of 8 percent while Tier 1 capital rose to 8 percent of risk-weighted assets.
  - Staff estimate: Tangible common equity (TCE) over assets increased to over 4 percent for the four major banks in the last six months.

- Selected banking-sector financial soundness indicators (selected figures)
  - Return on assets (after tax): 1.0 (Dec-05), 0.9 (Dec-06), 0.9 (Dec-07), 0.4 (Sep-08), 0.6 (Dec-08)
  - Regulatory capital to risk-weighted assets: 10.4 (Dec-05), 10.4 (Dec-06), 10.2 (Dec-07), 10.9 (Sep-08), 11.4 (Dec-08), 11.4 (Mar-09)
  - Tier I capital to risk-weighted assets: 7.6 (Dec-05), 7.4 (Dec-06), 7.2 (Dec-07), 7.6 (Sep-08), 8.2 (Dec-08), 8.4 (Mar-09)
  - Gross impaired assets to total assets: 0.2 (Dec-05), 0.2 (Dec-06), 0.2 (Dec-07), 0.5 (Sep-08), 0.8 (Dec-08), 1.0 (Mar-09)
  - Net impaired assets to equity: 1.8 (Dec-05), 1.9 (Dec-06), 1.9 (Dec-07), 6.2 (Sep-08), 8.4 (Dec-08)
  - Four largest banks, selected disclosures: Tier one capital ratio (Basel II) 8.2 (Mar-09), 7.7 (Sep-08); Total capital ratio (Basel II) 11.0 (Mar-09), 11.1 (Sep-08)
  - TCE/total assets (four largest banks): 4.9 (Mar-09), 4.9 (Sep-08), 4.4 (Mar-09 for another date series)

- Funding structure and rollover risk
  - Banks’ wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore.
  - Financial institutions short-term external debt (residual maturity basis) estimated at about $A 400 billion (35 percent of GDP) in March 2009.
  - Australian Banks' Liabilities, Percent of total (Dec 06 / Dec 07 / Dec 08 / Jun 09)
    - Deposits: 41.5 / 39.3 / 42.5 / 45.3
    - Domestic wholesale funding: 23.3 / 26.7 / 24.7 / 21.1
    - Offshore wholesale funding: 29.0 / 28.2 / 28.7 / 30.0
    - Securitization: 6.2 / 5.8 / 4.1 / 3.6
    - Memorandum item: Equity (as a percent of total liabilities): 5.8 / 5.6 / 6.2 / 6.7
    - 1/ Excluding equity.
  - Establishment of deposit and wholesale funding guarantees in October 2008 helped maintain confidence; banks raised about $A 140 billion between December 2008 and early July 2009 and have rolled over short-term debt.
  - Banks have started to increase medium-term funding recognizing liquidity and rollover risks.

- Corporate sector stress and contingent claim analysis (CCA)
  - Nonfinancial corporate sector entered crisis with moderate leverage and strong balance sheets; leverage remained stable and broadly similar to other advanced countries.
  - Market-based indicators suggest corporate solvency risks increased since 2008 but remain manageable.
  - CCA-based findings:
    - Expected corporate default losses could amount to around 2 percent of GDP based on historical recovery rates of around 40 percent.
    - Banks’ losses could amount to about 2 percent of total March 2009 loans.
  - Caveats: equity market volatility could have magnified distance to default and probability of default measures.
  - Private nonfinancial companies raised over $A 18 billion in shares and other equity during Q1 2009, almost twice the amount raised during the same period in 2008.

- International comparison of Australian banks (selected)
  - Using 2008 Bankscope measures for 60 large banks:
    - Australian banks have stronger leverage positions but weaker deposit and liquidity ratios than major Canadian banks.
    - The four Australian banks are in the upper half of the sample in leverage and around the median in deposit and liquidity ratio.
  - Equity/Total Assets, Median (selected)
    - National Australia Bank (AU): 5.7 (2008) / 7.2 (2006)
    - Toronto Dominion Bank (CA): 5.6 (2008) / 5.5 (2006)
    - Australia and New Zealand Banking Group (AU): 5.5 (2008) / 5.7 (2006)
    - Commonwealth Bank of Australia (AU): 5.1 (2008) / 5.5 (2006)
    - Westpac Banking Corporation (AU): 4.5 (2008) / 5.4 (2006)
    - Royal Bank of Canada (CA): 4.0 (2008) / 4.0 (2006)
    - Median of banks in the sample: 4.5 (2008) / 5.1 (2006)
  - Deposits/Total Assets, Median (selected)
    - Commonwealth Bank of Australia (AU): 57.7 (2008) / 50.0 (2006)
    - National Australia Bank (AU): 55.3 (2008) / 51.7 (2006)
    - Median of banks in the sample: 50.9 (2008) / 53.9 (2006)
  - Liquid Assets/Total, Median (selected)
    - Westpac Banking Corporation (AU): 10.0 (2008) / 23.1 (2006)
    - Commonwealth Bank of Australia (AU): 6.2 (2008) / 23.6 (2006)
    - Median of banks in the sample: 8.3 (2008) / 13.1 (2006)
  - Market-based indicators: strong co-movement among the four major Australian banks' equity prices and CDS spreads; similarity to Canadian banks supported by equity indicator correlations.
  - Caution: weak linear correlation observed between end-2006 ratios and share price change (end-2006 - June 2009):
    - Share price change vs Leverage: R^2 = 8E-06
    - Share price change vs Deposit ratio: R^2 = 0.0058
    - Share price change vs Liquidity ratio: R^2 = 0.0187

### IV. ASSET QUALITY SHOCKS — SIMULATIONS AND RESULTS

- Simulation approach
  - Uses Basel II Pillar 3 reports for major banks; loan portfolios organized into risk categories with estimated PD and LGD.
  - APRA prescribed at least 20 percent LGD ratios for mortgages; simulations double LGD floor for mortgages to 40 percent under shocks.
  - PD and LGD data used to calculate likely one-year losses and compare to existing provisions.

- Focus and methodology
  - Focus on residential mortgages and corporate loans; mortgages constitute around half of total credit exposure.
  - Corporate loans shock: shift risk categories up by one category (adjust PDs and LGDs accordingly).
  - Mortgage shock: shift risk categories up by one category and double the LGD floor to 40 percent.
  - Other loans: shift risk categories up by one category; LGD floors for other loans not modified.

- Exposure, LGDs, and PDs (selected aggregates by risk category)
  - Corporate exposures (I - VII): 29,848; 132,248; 204,900; 270,630; 48,307; 8,024; 5,880
  - Residential mortgage exposures (I - VII): 125,240; 313,816; 133,114; 193,393; 34,132; 10,838; 4,407
  - Other exposures (I - VII): 188,191; 80,712; 19,305; 45,389; 16,788; 4,996; 1,261
  - Exposure weighted average LGD (selected)
    - Corporate: 50.8 53.9 47.4 36.6 36.2 45.2 47.7
    - Residential mortgage: 20.0 20.0 20.5 20.9 20.4 20.3 20.6
    - Other: 45.7 52.4 57.0 60.1 65.9 67.6 61.7
  - Average midpoint PD (selected)
    - Corporate: 0.01 0.08 0.31 1.77 6.41 19.46 100.00
    - Residential mortgage: 0.06 0.19 0.41 1.74 5.83 22.19 100.00
    - Other: 0.02 0.11 0.38 1.75 5.84 22.17 100.00

- Losses under Risk-Category Shifting and 40 Percent Mortgage LGD Floor (millions of Australian dollars)
  - Corporate losses by category: 13; 228; 1,707; 5,971; 3,811; 3,630; 2,808
  - Residential mortgage losses by category: 88; 471; 875; 4,764; 3,324; 4,335; 1,763
  - Other losses by category: 79; 134; 188; 1,716; 2,371; 3,377; 778
  - Total losses by category: 181; 833; 2,770; 12,451; 9,506; 11,343; 5,348

- Impact on Capital — Risk-Shifting + 40% Mortgage LGD Floor (millions of Australian dollars and ratios)
  - Total losses: 42,432
    - Mortgage losses: 15,621
    - Corporate losses: 18,167
  - Provisions: 15,942
  - Total losses to capital: 26,490
  - Risk-weighted assets: 1,152,573
  - Loss as percent of risk-weighted assets: 2.3
  - Implied new total capital adequacy ratio (average of four banks): 9.2
  - Implied minimum new total capital adequacy ratio among the four banks: 8.3
  - Implied new tier 1 capital adequacy ratio (average of four banks): 6.1
  - Implied new tangible common equity to tangible asset ratio: 3.2
  - Observation: Even the hardest hit bank’s total capital adequacy ratio remains above the regulatory 8 percent minimum under this shock. Mortgage insurance effects not taken into account.

- Severe PD Increase Scenario — Six-Times PD and 40% Mortgage LGD Floor
  - Adjusted average PDs (selected by asset class/categories)
    - corporate: 0.08 0.50 1.88 10.62 38.44 100.00 100.00
    - residential mortgage: 0.35 1.15 2.45 10.46 35.00 100.00 100.00
    - other: 0.11 0.65 2.25 10.48 35.05 100.00 100.00
  - Expected losses by category (millions of Australian dollars)
    - Corporate: 13; 362; 1,829; 10,561; 6,734; 3,549; 2,808
    - Residential mortgage: 175; 1,444; 1,298; 8,056; 4,726; 4,335; 1,763
    - Other: 99; 284; 259; 2,912; 3,992; 3,377; 778
    - Total losses by category: 287; 2,091; 3,385; 21,529; 15,451; 11,261; 5,348
  - Aggregate results (millions of Australian dollars)
    - Total losses: 59,353
    - Mortgage losses: 21,796
    - Corporate losses: 25,855
    - Provisions: 15,942
    - Total losses to capital: 43,411
  - Loss as percent of risk-weighted assets: 3.8
  - Implied new total capital adequacy ratio (average of four banks): 7.8
  - Implied minimum new total capital adequacy ratio among the four banks: 6.6
  - Implied new tier 1 capital adequacy ratio (average of four banks): 4.6
  - Implied new tangible common equity to tangible asset ratio: 2.5
  - Observation: A six-fold increase in PDs would be needed to reduce the total average capital adequacy ratio below 8 percent; under this scenario two banks’ total capital adequacy ratios would shrink below the 8 percent regulatory minimum.

- Comparison with Contingent Claim Analysis (CCA)
  - Corporate loan losses (In billions of Australian dollars; Percent of Banking Sector Loans)
    - Risk-shifting and LGD floor shock (Table III.10): 18.2; 1.1
    - Six-times PD increase and LGD floor shock (Table III.12): 25.9; 1.6
    - Contingent claim based analysis (Table III.4): 29.1; 1.8
  - Observation: The CCA estimate is close to the corporate loan loss impact of the six-times PD shock.

### V. POLICY IMPLICATIONS AND RECOMMENDATIONS

- Fiscal policy
  - Public investment and public consumption multipliers are the largest among fiscal instruments considered; transfers to liquidity-constrained households have moderate multipliers.
  - Monetary accommodation (no monetary policy response) raises multipliers and increases GDP impact of stimulus.
  - Targeting transfers to liquidity-constrained households increases effectiveness (example calibration: 60 percent targeted yields larger cumulative GDP impacts).

- Banking sector and financial stability
  - Banks appear resilient to illustrative credit shocks in the simulations, with average capital adequacy ratios remaining around or above regulatory minima under the risk-shifting shock.
  - Under the six-times PD scenario, average capital adequacy could fall below 8 percent and two banks could be below the regulatory minimum.
  - Recommendations:
    - APRA should undertake more extreme stress-test scenarios than applied in the past and include Australia’s overseas subsidiaries.
    - Stress tests should include a more protracted and serious macroeconomic downturn than applied in the 2006 Financial Stability Assessment Program.

- Household sector monitoring
  - Monitor household debt-service costs and developments in house prices given housing’s large share of household wealth and vulnerabilities to sharp corrections.
  - Consider policy buffers given tail risk of a sharp fall in house prices.

_italic: Source: _cr09249 - References (IMF staff chapter excerpts)._

### References..............................................................................................................

### _cr09249 - References..............................................................................................................

### I. THE EFFECTIVENESS OF FISCAL STIMULUS MEASURES

- Context and method
  - GIMF (Global Integrated Monetary and Fiscal Model) is used to estimate aggregate demand impact of alternative fiscal measures for Australia and the rest of the world (two-region version).
  - GIMF features: overlapping generations, liquidity-constrained households, public capital that complements private capital.

- Fiscal multipliers (Table I.1: Percent Deviation from Baseline for a temporary (one-year), one-percent-of-GDP increase in the fiscal deficit)
  - Public Investment
    - Base Case (No Monetary Accommodation): 1.22
    - Sensitivity Analysis 1/ (No Monetary Accommodation): 1.18
    - Base Case (Monetary Accommodation): 1.32
    - Lowest–Highest sensitivity range: 1.37
  - Public Consumption
    - Base Case: 1.12
    - Sensitivity Analysis 1/: 1.11
    - Base Case (Monetary Accommodation): 1.14
    - Lowest–Highest: 1.32
  - Transfers to Liquidity Constrained Households
    - Base Case: 0.43
    - Sensitivity Analysis 1/: 0.40
    - Base Case (Monetary Accommodation): 0.48
    - Lowest–Highest: 0.54
  - Value Added Taxes
    - Base Case: 0.27
    - Sensitivity Analysis 1/: 0.23
    - Base Case (Monetary Accommodation): 0.31
    - Lowest–Highest: 0.35
  - Transfers to all Households
    - Base Case: 0.14
    - Sensitivity Analysis 1/: 0.09
    - Base Case (Monetary Accommodation): 0.20
    - Lowest–Highest: 0.18
  - Tax on Labor Income
    - Base Case: 0.15
    - Sensitivity Analysis 1/: 0.10
    - Base Case (Monetary Accommodation): 0.20
    - Lowest–Highest: 0.16
  - Tax on Corporate Income
    - Base Case: 0.01
    - Sensitivity Analysis 1/: 0.01
    - Base Case (Monetary Accommodation): 0.03
    - Lowest–Highest: 0.02
  - 1/ Sensitivity analysis varied: complementarity between private and public capital (base-case 0.10; smallest 0.05; largest 0.20), households’ planning horizon (base case 20 years; shortest 10 years), and proportion of liquidity constrained households (base case 30 percent; smallest 20 percent; largest 40 percent).

- Key drivers of multiplier variation
  - Degree of complementarity between private and public capital, proportion of liquidity constrained households, and households’ effective planning horizons have largest impacts on multipliers.
  - Monetary policy response matters: if monetary policy does not respond (monetary accommodation), GDP impact increases.

- Impact of the May 2009 announced discretionary fiscal measures (Table I.2: In Percent of GDP)
  - Transfers: 2008: 0.8; 2009: 1.2; 2010: 0.2; 2011: 0.1; 2012: 0.1; Cumulative: 2.4
  - Public Investment: 2008: 0.0; 2009: 1.2; 2010: 1.7; 2011: 1.2; 2012: 0.4; Cumulative: 4.5
  - Public Spending: 2008: 0.0; 2009: 0.4; 2010: 0.1; 2011: 0.2; 2012: 0.1; Cumulative: 0.8
  - Private Investment: 2008: 0.0; 2009: 0.1; 2010: 0.1; 2011: 0.0; 2012: 0.0; Cumulative: 0.2
  - Total: 2008: 0.8; 2009: 2.9; 2010: 2.1; 2011: 1.5; 2012: 0.6; Cumulative: 7.9
  - 1/ Estimates based on material provided in the May 2009 Commonwealth Government Budget.

- GIMF simulated impact of the announced stimulus on GDP (Table I.3: Percent Deviation from Baseline)
  - Lower Bound Calibration cumulative (2008–2012): 5.26
    - Annual: 2008: 0.06; 2009: 1.85; 2010: 1.79; 2011: 1.27; 2012: 0.29
  - Base Case Calibration cumulative: 6.46
    - Annual: 2008: 0.10; 2009: 2.08; 2010: 2.08; 2011: 1.59; 2012: 0.61
  - Base Case Calibration, Transfers Highly Targeted, Monetary Accommodation cumulative: 9.56
    - Annual: 2008: 0.24; 2009: 3.25; 2010: 3.21; 2011: 2.15; 2012: 0.71
    - Assumption: 60 percent of transfers go to liquidity-constrained households; monetary policy rate does not respond to increased inflation until 2011.
  - Upper Bound Calibration cumulative: 8.83
    - Annual: 2008: 0.15; 2009: 2.58; 2010: 2.68; 2011: 2.21; 2012: 1.21
  - Upper Bound Calibration, Transfers Highly Targeted, Monetary Accommodation cumulative: 12.81
    - Annual: 2008: 0.29; 2009: 4.06; 2010: 4.19; 2011: 2.96; 2012: 1.31
  - Simulation note: in 2008, no one is aware of the 2009 stimulus; from start of 2009 everyone is fully aware of measures over subsequent 4 years.

- Fiscal consolidation and longer-run implications
  - Stimulus financed through increased public borrowing until 2012; beyond 2012 a fiscal consolidation returns public debt/GDP to initial level.
  - During consolidation, GDP level will be lower than if no consolidation were required.

### II. AUSTRALIAN HOUSEHOLD VULNERABILITIES

- Role of household spending
  - Resilience in private consumption will be essential for a milder downturn in Australia.
  - Private consumption growth slowed but less than in United States, United Kingdom, or Canada (Figure II.1).

- Housing wealth as key vulnerability
  - House price appreciation was the single largest contributor to growth in Australian household wealth over the last decade.
  - Metrics examined suggest overvaluation in house prices as of March 2009 in the range of 0–20 percent.
  - A sharp correction toward the upper end of this range could be disruptive for private consumption, but factors supporting gradual and orderly adjustment include:
    - Significant moderation in house price inflation and apparent stabilization of prices.
    - Significant decline in mortgage interest rates.
    - A government subsidy for first-time home buyers.
    - Continued strong net immigration.
  - Nevertheless, a sharp fall in house prices over the next few years remains a tail risk.

- Household saving, debt, and consumption (Figure II.2 and text)
  - Australian household savings rate:
    - Fell over the first half of the last decade, then recovered and returned to positive territory.
  - Household debt:
    - Significant increase in household debt relative to disposable income.
  - Debt service costs:
    - Rose dramatically in Australia and New Zealand during the earlier period of tight monetary policy.
    - With the decline in variable mortgage interest rates in Australia, debt-service costs moved below 12 percent of disposable income in the first quarter of 2009.
  - Consumption adjustment:
    - Australian households appear to have covered a portion of increased debt-service burden by reducing consumption as a share of disposable income, implying consumption may have been closer to a sustainable level entering the downturn.

- Prepared by
  - Ben Hunt (ext. 36361), Khoi Viet Nguyen (ext. 37417), and Patrizia Tumbarello (ext. 34395).

*Source: _cr09249 - References (IMF staff chapter excerpts).*

### 13.      Despite the run-up in debt, Australian households’ net wealth position has risen

### 13.      Despite the run-up in debt, Australian households’ net wealth position has risen

### Household wealth composition and vulnerability
- Over the last decade Australian households’ net wealth position has risen, with the improvement largely in housing wealth.
- Australian and New Zealand households currently have net wealth positions well above their levels a decade earlier.
- Financial wealth is a relatively low share of household wealth and has been hit hard by falling equities prices.
- Housing constitutes a large portion of household wealth in Australia, reflecting concentration of population in large urban centers (Kohler and Smith (2005)).
- Risk implication: With housing such a large share of wealth and house prices having risen significantly, Australian household wealth and thus spending could be vulnerable to a large decline in house prices.

### Metrics of house-price valuation (methods)
- Two metrics used to assess house-price valuation:
  - Econometric approach estimating the house-price gap (extent to which recent increases cannot be explained by economic factors).
  - Ratios of house prices to disposable income and house prices to rents compared to long-run moving averages (10-, 15-, and 20-year).

- Econometric model specifications (summary):
  - Dependent variable: growth rate of real house prices.
  - Explanatory variables include: growth in per capita real disposable income, changes in working-age population (or lagged net immigration), changes in equity prices and credit, short-term and long-term interest rates (or mortgage rates), and an affordability ratio (lagged ratio of house prices to disposable income). Some specifications include lagged real house price growth.

### Econometric estimates of overvaluation and model caveats
- Model caveats noted: potential endogeneity, imperfect capture of theoretical relationships, sensitivity to sample period and specification.
- Econometric estimates (five models, multiple start dates) suggest house-price overvaluation ranges between 5 and 15 percent as of March 2009 depending on specification and starting date.
- The simple average of the econometric model estimates is 11 percent.
- Note: low current interest rates help explain current house prices; interest rates are expected to return to a more neutral level.

### Simple ratio metrics (price-to-income and price-to-rent)
- Price-to-income and price-to-rent ratios point to some overvaluation.
- Structural factors (permanently lower nominal interest rates, rising incomes, scarcity of land close to main urban centers) can justify higher sustainable ratios.
- Table II.1 — Percent deviation from estimated sustainable levels as of March 2009:
  - Price-to-Income Ratio: Relative to 10-Year Moving Average -6.1; Relative to 15-Year Moving Average 3.3; Relative to 20-Year Moving Average 7.4
  - Price-to-Rent Ratio: Relative to 10-Year Moving Average 6.7; Relative to 15-Year Moving Average 20.9; Relative to 20-Year Moving Average 30.4

### Assessment of potential overvaluation and risks (March 2009)
- Overall assessment: overvaluation in the range of 0 to 20 percent as of March 2009.
  - Rationale: price-to-rent roughly 30 percent above its 20-year moving average but 20-year average may be too long given structural change; 10-year may be too short given expansion duration; 15-year suggests roughly 0–20 percent.
  - This range encompasses the econometric estimates.
- Adjustment channels: sustainable levels can be achieved if incomes and rents grow faster than house prices or if fundamentals (e.g., migration) change—prices need not do all the adjustment and adjustment can be gradual.

### Outlook and factors suggesting orderly adjustment
- Indicators suggesting any required house price adjustment is likely to be orderly:
  - After declining q/q by 2 percent in 2009 Q1, preliminary data for 2009 Q2 indicate house prices have started to rise again.
  - Variable mortgage interest rates have fallen by almost 400 basis points since the RBA began easing monetary policy in September 2008 and are expected to remain low for an extended period.
  - Government subsidy for first-time home buyers lasts through 2009 and supports housing demand.
  - A gap over the last several years between population growth and housing starts should result in strong demand for housing over the next few years.

### Bank-sector implications and vulnerabilities linked to households and corporates
- Contingent claim analysis suggests Australian banks’ potential losses from corporate exposures could amount to as much as 2 percent of total banking sector loans (less than in other countries in the region).
- Analysis shows banks are able to withstand potential losses from sizable shocks to their loan portfolio; results are not rigorous stress tests and should be interpreted with caution.
- Recommendation explicitly stated: APRA has regularly stress tested the banking system but it would be advisable to undertake more extreme stress-test scenarios than applied in the past and include Australia’s overseas subsidiaries.

### Selected banking-sector financial soundness indicators (high-level)
- Regulatory requirement for capital: 8 percent of risk-weighted assets.
- Staff statement: Total capital has increased since 2007 and has remained well above the regulatory requirement of 8 percent of risk-weighted assets while Tier 1 capital rose to 8 percent of risk-weighted assets.
- Staff estimate: Tangible common equity (TCE) over assets increased to over 4 percent for the four major banks in the last six months.
- Additional snapshot indicators reported (selected figures from tables and text; preserved as presented):
  - Return on assets (after tax): 1.0 (Dec-05), 0.9 (Dec-06), 0.9 (Dec-07), 0.4 (Sep-08), 0.6 (Dec-08)
  - Regulatory capital to risk-weighted assets: 10.4 (Dec-05), 10.4 (Dec-06), 10.2 (Dec-07), 10.9 (Sep-08), 11.4 (Dec-08), 11.4 (Mar-09)
  - Tier I capital to risk-weighted assets: 7.6 (Dec-05), 7.4 (Dec-06), 7.2 (Dec-07), 7.6 (Sep-08), 8.2 (Dec-08), 8.4 (Mar-09)
  - Gross impaired assets to total assets: 0.2 (Dec-05), 0.2 (Dec-06), 0.2 (Dec-07), 0.5 (Sep-08), 0.8 (Dec-08), 1.0 (Mar-09)
  - Net impaired assets to equity: 1.8 (Dec-05), 1.9 (Dec-06), 1.9 (Dec-07), 6.2 (Sep-08), 8.4 (Dec-08)
  - From banks’ disclosure statements (four largest banks, selected): Tier one capital ratio (Basel II) 8.2 (Mar-09), 7.7 (Sep-08); Total capital ratio (Basel II) 11.0 (Mar-09), 11.1 (Sep-08)
  - TCE/total assets (four largest banks): 4.9 (Mar-09), 4.9 (Sep-08), 4.4 (Mar-09 for another date series)
- Liquidity and funding notes:
  - Banks’ balance sheets are heavily weighted toward domestic loans, particularly low-risk households.
  - On liabilities, banks remain exposed to rollover risks on short-term wholesale funding and had sizable short-term external debt obligations; access to offshore wholesale markets was disrupted after Lehman Brothers in September 2008.
  - Policy measures (wholesale funding guarantees and deposit guarantees introduced in October 2008) helped ensure liquidity and access to international capital markets.

*Source: IMF staff analysis as presented in the supplied PDF content.*

### 26.      However, a deterioration in banks’ asset quality has been evident since early

### _cr09249 - 26.      However, a deterioration in banks’ asset quality has been evident since early

### Asset quality deterioration
- Past due loans plus impaired assets rose to around 1 percent of total assets for the four largest banks as of March 2009.
- Past due plus impaired assets for all banks reached almost 1½ percent of assets in March 2009.
- For smaller domestic banks past due plus impaired assets reached nearly 3 percent.
- Smaller domestic banks’ deterioration mainly reflects relatively large exposures to lower quality commercial property and a higher share of low-doc lending.
- Aggregate Tier 1 capital of the smaller domestic banks was more than 10 percent as of March 2009.
- Source cited for asset quality data: Reserve Bank of Australia.

### Funding structure and rollover risk
- Banks’ wholesale funding (domestic and offshore) accounts for about 50 percent of total funding, of which about 60 percent is offshore.
- Financial institutions short-term external debt (on a residual maturity basis) is estimated by staff at about $A 400 billion (35 percent of GDP) in March 2009.
- Table III.3 (Australia: Australian Banks' Liabilities, Percent of total) excerpts:
  - Dec 06 / Dec 07 / Dec 08 / Jun 09
  - Deposits: 41.5 / 39.3 / 42.5 / 45.3
  - Domestic wholesale funding: 23.3 / 26.7 / 24.7 / 21.1
  - Offshore wholesale funding: 29.0 / 28.2 / 28.7 / 30.0
  - Securitization: 6.2 / 5.8 / 4.1 / 3.6
  - Total funding liabilities 1/: 100.0 / 100.0 / 100.0 / 100.0
  - Memorandum item: Equity (as a percent of total liabilities): 5.8 / 5.6 / 6.2 / 6.7
  - 1/ Excluding equity.
- Establishment of deposit and wholesale funding guarantees in October 2008 helped maintain confidence; banks were able to raise about $A 140 billion between December 2008 and early July 2009 and have rolled over short-term debt.
- Banks have started to increase medium-term funding recognizing liquidity and rollover risks.

### Corporate sector stress and contingent claim analysis (CCA)
- The nonfinancial corporate sector entered the crisis with moderate leverage and strong balance sheets; leverage (debt to assets and debt to equity) remained stable and broadly similar to other advanced countries.
- Market-based indicators suggest corporate solvency risks increased in Australia since 2008 but remain manageable.
- CCA-based findings:
  - Expected corporate default losses could amount to around 2 percent of GDP based on historical recovery rates of around 40 percent, lower than other advanced countries in Asia.
  - Banks’ losses could amount to about 2 percent of total March 2009 loans.
- Caveats in interpreting CCA results:
  - Equity market volatility in recent months could have magnified distance to default and probability of default measures.
  - Bank lending to the nonfinancial corporate sector slowed significantly in 2009 suggesting leverage has declined since 2008.
  - The nonfinancial corporate sector raised significant equity capital during Q1 2009: private nonfinancial companies raised over $A 18 billion in shares and other equity during Q1 2009, almost twice the amount raised during the same period in 2008.
- Figure III.4 and III.5 summary:
  - Nonfinancial Corporate Sector: Annual Average Expected Losses One Year Ahead (In percent of GDP) — point estimates and confidence intervals (80 percent and 40 percent recovery rates) reported; Australia point estimate around 2 percent of GDP.
  - Banking Sector: Expected Losses from Corporate Sector Distress One Year Ahead (In percent of total banking sector loans) — Australia point estimate around 2 percent of total banking sector loans.
- Table III.4 (Effects of Corporate Sector Distress on the Banking Sector: CCA Results) excerpt (In billions of Australian dollars):
  - Australia: Losses 1 Year Ahead — Bank Loans to Corporate Sector: 5.9; Loan-Loss Provisions: 1,651; Implied Additional Provisions NPL/Losses: 50; NPL/Losses in Percent of Total Bank Loans: 11.7; Provisions (2008): 29.1; 1.8 (row formatting in source; numbers preserved as presented).
  - New Zealand: Losses 1 Year Ahead — Bank Loans to Corporate Sector: 3.5; Loan-Loss Provisions: 280; Implied Additional Provisions NPL/Losses: 12.2; NPL/Losses in Percent of Total Bank Loans: 0.1?; Provisions (2008): 4.3; 1.5 (row formatting in source; numbers preserved as presented).
  - Sources: Based on MKMV-Credit Edge data as of April 29. 2009; and Fund staff calculations.
  - Notes: 1/ Nonfinancial corporate sector. Listed companies only. 2/ Columns B, C, and D report data as of March 2009. 3/ Columns B, C, and D report data as of September 2008. 4/ Columns B, C, D, and E are in New Zealand dollars.

### International comparison of Australian banks
- Using measures of leverage, deposit, and liquidity ratios (mostly 2008 values from Bankscope) for 60 large banks:
  - Australian banks have stronger leverage positions but weaker deposit and liquidity ratios than major Canadian banks.
  - The four Australian banks are in the upper half of the sample in terms of leverage and around the median in terms of deposit and liquidity ratio.
- Table III.5 (Equity/Total Assets, Median of banks in the sample) excerpt — Equity/Total Assets rankings and values for selected banks:
  - National Australia Bank (AU): 5.7 (2008) / 7.2 (2006)
  - Toronto Dominion Bank (CA): 5.6 (2008) / 5.5 (2006)
  - Australia and New Zealand Banking Group (AU): 5.5 (2008) / 5.7 (2006)
  - Commonwealth Bank of Australia (AU): 5.1 (2008) / 5.5 (2006)
  - Westpac Banking Corporation (AU): 4.5 (2008) / 5.4 (2006)
  - Royal Bank of Canada (CA): 4.0 (2008) / 4.0 (2006)
  - Median of banks in the sample: 4.5 (2008) / 5.1 (2006)
- Table III.6 (Deposits/Total Assets, Median of banks in the sample) excerpt — Deposits/Total Assets rankings and values for selected banks:
  - Bank of Nova Scotia (CA): 68.3 (2008) / 69.6 (2006)
  - Toronto Dominion Bank (CA): 66.7 (2008) / 66.4 (2006)
  - Canadian Imperial Bank of Commerce (CA): 65.8 (2008) / 66.7 (2006)
  - Commonwealth Bank of Australia (AU): 57.7 (2008) / 50.0 (2006)
  - National Australia Bank (AU): 55.3 (2008) / 51.7 (2006)
  - Median of banks in the sample: 50.9 (2008) / 53.9 (2006)
- Table III.7 (Liquid Assets/Total, Median of banks in the sample) excerpt — Liquid Assets/Total for selected banks:
  - Royal Bank of Canada (CA): 17.6 (2008) / 28.6 (2006)
  - Banque de Montreal (CA): 16.5 (2008) / 17.0 (2006)
  - Canadian Imperial Bank of Commerce (CA): 10.9 (2008) / 21.2 (2006)
  - Westpac Banking Corporation (AU): 10.0 (2008) / 23.1 (2006)
  - Commonwealth Bank of Australia (AU): 6.2 (2008) / 23.6 (2006)
  - Median of banks in the sample: 8.3 (2008) / 13.1 (2006)
- Market-based indicators:
  - Strong co-movement among the four major Australian banks' equity prices and CDS spreads.
  - Similarity between Australian and Canadian banks supported by strong correlation of equity indicators and divergence from other advanced countries.
- Caution: Liquidity, deposit, and leverage ratios alone may not predict future equity price performance; weak linear correlation observed between these ratios (end-2006) and share price change (end-2006 - June 2009). Reported R^2 values:
  - Share price change vs Leverage: R^2 = 8E-06
  - Share price change vs Deposit ratio: R^2 = 0.0058
  - Share price change vs Liquidity ratio: R^2 = 0.0187

### Comparative financial soundness indicators (2007) and cross-country context
- Table III.8 (Australia and comparator countries, 2007) selected figures:
  - Capital: Assets to Tier 1 capital multiple (Australia): 33.2; Sample Average 1/: 28.8
  - Asset quality: Impaired loans to total loans (Australia): 0.3; comparator values shown (e.g., Canada 0.4, Iceland 0.9).
  - Provisions to impaired loans (Australia): 216.6; comparator sample average: 112.3.
  - Profitability: Return on average assets (Australia): 1.0; Return on average equity (Australia): 17.4; Net interest margin (Australia): 1.8.
  - Composition: Mortgages to total loans (Australia): 53.1; Loans to total assets (Australia): 61.8; Retail deposits to total liabilities (Australia): 41.3; Liquid assets to deposits and ST funding (Australia): 4.1.
  - 1/ Simple (unweighted) average of comparator countries, excluding Australia.
  - 2/ Assets include off-balance sheet items; figures expressed as a multiple, not in percent.

### Asset quality shocks: simulation approach
- Analysis uses Pillar 3 reports under Basel II providing granular asset quality data for the major banks.
- Loan portfolios are organized into several risk categories; in each category probability of default (PD) and loss given default (LGD) is estimated.
- APRA prescribed at least 20 percent LGD ratios for mortgages instead of the general Basel II framework’s 10 percent floor.
- PD and LGD data are used to calculate likely one-year losses and compared to existing general and specific provisions.
- Data collected from Pillar 3 reports for the large four banks (Australia and New Zealand Bank, Commonwealth Bank of Australia, National Australia Bank, and Westpac) and aggregated; loan portfolios consolidated into seven risk categories.

*Source: IMF staff compilation from the provided chapter content.*

### 40.      The analysis focuses on residential mortgages and corporate loans. Mortgages

### _cr09249 - 40.      The analysis focuses on residential mortgages and corporate loans. Mortgages

### Overview
- Analysis focuses on residential mortgages and corporate loans; mortgages constitute around half of total credit exposure.
- Banks consider corporate loans much riskier than mortgages (Figure III.10).

### Methodology and Shock Design
- Corporate loans: shift risk categories up by one category. Adjust PDs and LGDs to the next-higher category to calculate expected losses by category.
- Mortgages: shift risk categories up by one category and double the LGD floor to 40 percent.
- Other loans: shift risk categories up by one category; LGD floors for other loans are not modified.

### Exposure, LGDs, and PDs (as reported)
- Regulatory credit exposure by risk categories (I - VII) (selected aggregates):
  - Corporate: 29,848; 132,248; 204,900; 270,630; 48,307; 8,024; 5,880
  - Residential mortgage: 125,240; 313,816; 133,114; 193,393; 34,132; 10,838; 4,407
  - Other: 188,191; 80,712; 19,305; 45,389; 16,788; 4,996; 1,261
- Exposure weighted average LGD (by asset class across categories):
  - Corporate: 50.8 53.9 47.4 36.6 36.2 45.2 47.7
  - Residential mortgage: 20.0 20.0 20.5 20.9 20.4 20.3 20.6
  - Other: 45.7 52.4 57.0 60.1 65.9 67.6 61.7
- Average midpoint probability of default (by asset class across categories):
  - Corporate: 0.01 0.08 0.31 1.77 6.41 19.46 100.00
  - Residential mortgage: 0.06 0.19 0.41 1.74 5.83 22.19 100.00
  - Other: 0.02 0.11 0.38 1.75 5.84 22.17 100.00

### Losses under Risk-Category Shifting and 40 Percent Mortgage LGD Floor (Table III.9, shock scenario)
- Expected losses by category under adjusted PDs and higher mortgage LGD (selected totals, in millions of Australian dollars):
  - Corporate losses by category: 13; 228; 1,707; 5,971; 3,811; 3,630; 2,808
  - Residential mortgage losses by category: 88; 471; 875; 4,764; 3,324; 4,335; 1,763
  - Other losses by category: 79; 134; 188; 1,716; 2,371; 3,377; 778
  - Total losses by category: 181; 833; 2,770; 12,451; 9,506; 11,343; 5,348

### Impact on Capital — Risk-Shifting + 40% Mortgage LGD Floor (Table III.10)
- Total losses (millions of Australian dollars): 42,432
  - Mortgage losses (millions of Australia dollars): 15,621
  - Corporate losses (millions of Australian dollars): 18,167
- Provisions (millions of Australian dollars): 15,942
- Total losses to capital (millions of Australian dollars): 26,490
- Risk-weighted assets (millions of Australian dollars): 1,152,573
- Loss as percent of risk-weighted assets: 2.3
- Implied new total capital adequacy ratio (average of four banks): 9.2
- Implied minimum new total capital adequacy ratio among the four banks: 8.3
- Implied new tier 1 capital adequacy ratio (average of four banks): 6.1
- Implied new tangible common equity to tangible asset ratio: 3.2
- Observation: Even the hardest hit bank’s total capital adequacy ratio remains above the regulatory 8 percent minimum under this shock. Mortgage insurance effects are not taken into account.

### Severe PD Increase Scenario — Six-Times PD and 40% Mortgage LGD Floor (Tables III.11–III.12)
- Adjusted average PDs used (selected by asset class/categories):
  - corporate: 0.08 0.50 1.88 10.62 38.44 100.00 100.00
  - residential mortgage: 0.35 1.15 2.45 10.46 35.00 100.00 100.00
  - other: 0.11 0.65 2.25 10.48 35.05 100.00 100.00
- Expected losses by category under six-times PD increase and higher mortgage LGD (millions of Australian dollars):
  - Corporate: 13; 362; 1,829; 10,561; 6,734; 3,549; 2,808
  - Residential mortgage: 175; 1,444; 1,298; 8,056; 4,726; 4,335; 1,763
  - Other: 99; 284; 259; 2,912; 3,992; 3,377; 778
  - Total losses by category: 287; 2,091; 3,385; 21,529; 15,451; 11,261; 5,348
- Aggregate results (millions of Australian dollars):
  - Total losses: 59,353
  - Mortgage losses: 21,796
  - Corporate losses: 25,855
  - Provisions: 15,942
  - Total losses to capital: 43,411
- Loss as percent of risk-weighted assets: 3.8
- Implied new total capital adequacy ratio (average of four banks): 7.8
- Implied minimum new total capital adequacy ratio among the four banks: 6.6
- Implied new tier 1 capital adequacy ratio (average of four banks): 4.6
- Implied new tangible common equity to tangible asset ratio: 2.5
- Observation: A six-fold increase in PDs would be needed to reduce the total average capital adequacy ratio below 8 percent; under this scenario two banks’ total capital adequacy ratios would shrink below the 8 percent regulatory minimum.

### Comparison with Contingent Claim Analysis (CCA) (Table III.13)
- Corporate loan losses (In billions of Australian dollars; Percent of Banking Sector Loans):
  - Risk-shifting and LGD floor shock (Table III.10): 18.2; 1.1
  - Six-times PD increase and LGD floor shock (Table III.12): 25.9; 1.6
  - Contingent claim based analysis (Table III.4): 29.1; 1.8
- Observation: The CCA estimate is close to the corporate loan loss impact of the six-times PD shock.

### Policy Implications and Recommendations
- Banks appear resilient to the illustrative shocks, but more complex stress testing is needed.
- Recommend APRA undertake more extreme scenarios than applied in the past and include Australia’s overseas subsidiaries.
- Stress tests should include a more protracted and serious macroeconomic downturn than what was applied in the 2006 Financial Stability Assessment Program.

### Appendix: Contingent Claim Analysis (CCA) Summary
- CCA uses a Black-Scholes-Merton (BSM) option pricing framework to derive one-year-ahead default probabilities and distance-to-default (DtD) from market equity prices and volatilities.
- Distance-to-default (one year) formula provided in text; DtD is adjusted by adding 3 so reported DtD is always positive.
- Banks’ expected losses from corporate sector distress were computed using Moody’s KMV implied CDS (EICDS) spreads, expressing corporate sector expected losses as ratios of corporate sector total liabilities and applying these relative losses to banks’ current performing loans to the corporate sector.

*Sources: Basel II Pillar 3 disclosure statements and Fund staff calculations.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09249.pdf_