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Bank of England to test UK banks' resilience against 'major external shock' as part of 2015 stress test

Out-Law News | 31 Mar 2015 | 4:57 pm | 3 min. read

The Bank of England plans to test the major UK banks' ability to withstand global economic shocks including a collapse in China's economic growth and deflation in the eurozone as part of its 'stress scenario' for 2015, it has announced.

The UK's largest banks and building societies will have to be able to demonstrate their ability to meet certain criteria throughout a fictional five-year scenario in order to pass the test. The firms that will be tested are Barclays, HSBC, Lloyds, Royal Bank of Scotland, Santander, Standard Chartered and Nationwide. The Co-operative Bank, which failed similar tests in 2014, will not be tested this year as it is now too small to "have a material impact on the resiliences of the financial system", according to the announcement.

Bank of England governor Mark Carney said that the results of the 2014 tests, in which UK GDP fell by 2.5% and house prices by 35%, "demonstrated how much stronger the core of the UK financial system has become since the financial crisis".

"This year's test will have a different focus and is equally important," he said. "By assessing the resilience of the UK banking system against a major external shock, we will improve further our ability to identify vulnerabilities and we will ensure that banks have plans in place to address a wider range of possible stresses."

"As a forward-looking regulator our job is never complete. Our focus is clear. To promote the good of the people of the United Kingdom, we are committed to ensuring that our major banks are resilient, that they can weather shocks without calling on taxpayer support, and that they can continue to lend even in adverse conditions. This year's stress tests will build on last year's work and advance our medium-term stress-testing framework," he said.

As in 2014, banks must be able to maintain a 4.5% core capital ratio, which is the main measure of bank solvency on a risk-weighted basis, after being exposed to the stress scenario in order to pass the tests. This year, they will also have to meet a 3% leverage ratio, while ensuring that lending to the real economy grows by 10% over the five-year period. The leverage ratio refers to the minimum level of capital banks have to hold as a proportion of their total assets without weighting for risk, and is considered less vulnerable to manipulation than traditional measures.

If a firm's capital ratio is projected to fall below the 4.5% core capital threshold during the test, the Prudential Regulation Authority (PRA) would generally require the firm to take action to strengthen its capital position, as Lloyds and RBS were required to do last year. There is a "strong presumption" that firms would be required to do the same if they fall below the leverage threshold. The PRA may also require specific firms to take action even if the thresholds are met, depending on internal governance and other factors.

The 2015 stress scenario incorporates three elements: a synchronised global downturn particularly felt in Asia and the eurozone, with a knock-on effect on global inflation; severe financial market stress with a reduction in global risk appetite and market liquidity and some counterparty defaults, particularly in indebted economies; and UK market slowdown driven by the downturn in its trading partners, requiring additional monetary stimulus.

"Whilst it may be considered unlikely that all events identified in the proposed test would occur in unison, the potential for one or more to take place is clearly something the Bank of England has identified as at least a possibility," said financial regulation expert Michael Ruck of Pinsent Masons, the law firm behind Out-Law.com. "Banks will no doubt take note of this focus and carefully consider how they would react to these various events."

"The UK banking industry will be seeking a clean bill of health but, as we have recently seen in the US, there is no guarantee all banks will pass the test with flying colours," he said.

The UK's stress testing regime is designed to ensure that the UK banking system can absorb, rather than amplify, shocks while continuing to provide financial services to businesses and consumers. Stress testing makes up one of the three 'pillars' of the Bank of England's capital adequacy monitoring tools, alongside ongoing risk-weighted capital requirements and a leverage requirement. It is used by the PRA to assess the capital adequacy of individual firms, and by the Financial Policy Committee to assess the resilience of the banking system as a whole.

The Bank of England will publish the results of the 2015 tests alongside its annual Financial Stability Report in December.

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