What would happen in a property crash? There’s a test for that

Business is booming in Malta’s property sector: the towering cranes dotting the skyline mark the map at every inch gained by the construction industry.

But watchful eyes at the Central Bank are mindful of what would happen if property prices were to drop, and how this would affect Malta’s domestic banking sector.

In their latest Financial Stability Report, Central Bank experts have measured what would happen when property prices fall, dropping the value of collateral that accompanies loans, as well as a corresponding increase in defaulters – or non-performing loans (NPLs).

Two scenarios were considered: a 7.5% shock based on historical deviations, and a worst-case scenario of a 30% drop.

Firstly, the drop in prices would fully translate into lower property-related collateral values. Remember that when ordinary home buyers take out loans, the vast majority of collateral for the banks is the house itself. The CBM’s test actually excludes non-property loans from its exercise.

The “stress test”, as the exercise is called, assumes that when the collateral values decline, the banks will have to set aside more money for an increase in NPLs, as they prepare to take the hit for the money they loaned out on collateral that now has a lower value.

Since property prices are crashing, so then will property owners’ wealth be on the downside, since their asset value is now decreasing. These negative wealth effects are likely to increase non-performing loans, as mortgages now become more relatively expensive to the value of their homes.

Tier 1 capital rules require banks to have a core capital that is substantially higher than the value of assets held by loans: Malta’s core domestic banks have substantial reserves that are 13% over and above these asset values.

According to the Central Bank, under a 7.5% price drop, NPLs would increase by 4%. As banks will have to rely on their capital reserves, this would knock off less than 1% of the banks’ capital reserves.

Under the 30% scenario, NPLs would increase by 18% and banks’ capital would be eroded by some two percentage points.

 “Results show that core domestic banks at the aggregate level would comfortably withstand the assumed shocks, both under the baseline (7.5%) and adverse scenarios (30%),” the Central Bank says in its report.

“During 2016, core domestic banks continued to improve their loss absorption capacity by increasing loan loss provisions as well as improving their capital stance. Given the increase in loan loss provisions, the impact of the test on banks is milder.”

The Central Bank said that Maltese banks’ risk outlook remains similar when compared to the 2015 stress test, where the probability of other scenarios – a deterioration in credit quality, repeated deposit withdrawals – were considered to be low.

“Core domestic banks are in a better position to absorb potential losses following an overall increase in loan loss provisions and strengthening of capital ratios. The stress tests reveal that the banking sector is resilient to the different scenarios.”