Five of UK's eight major banks pass Bank of England's first 'stress tests'

Out-Law News | 22 Dec 2014 | 4:16 pm | 2 min. read

Five of the UK's eight major banks and building societies are well enough capitalised to respond to the effects of a "very severe housing market shock" along with a sharp rise or fall in interest rates, according to the first 'stress tests' carried out by the Bank of England in its role as banking regulator.

The Prudential Regulation Authority (PRA) said that there was "substantial variation" across the individual firms in terms of the impact of its fictional stress scenario on their balance sheets. As of the end of 2013, Co-operative Bank, Lloyds Banking Group and Royal Bank of Scotland would have failed the tests. However, only Co-operative Bank will be required to submit a revised capital plan to the regulator "given continuing improvements to banks' resilience over the course of 2014 and concrete plans to build capital further going forward", it said.

A second part of the test, conducted by macro-economic financial stability regulator the Financial Policy Committee (FPC) found that the UK banking system as a whole would be able to carry on its core functions in the event of a stress scenario. Of the eight banks, only the Co-operative Bank fell below a 4.5% capital ratio at the most stressed point of the scenario, while the resilience of the system overall had "improved significantly" since a similar exercise carried out in 2013, it said.

Bank of England governor Mark Carney said that the stress test was a "major component" of the UK's financial regulation regimes both on a macro- and micro-prudential level.

"This was a demanding test," he said. "The results show that the core of the banking system is significantly more resilient, that it has the strength to continue to serve the real economy even in a severe stress, and that the growing confidence in the system is merited."

The stress testing exercise will be repeated next year, featuring a different stress scenario and potential changes to the methodology once the Bank has reviewed the 2014 exercise. Next year's tests are likely to include banks' leverage ratios as well as their capital ratios. The leverage ratio refers to the minimum level of capital banks will have to hold as a proportion of their total assets without weighting for risk, and is considered less vulnerable to manipulation than traditional measures of the loans and other assets on banks' books.

The UK's first stress tests come shortly after similar tests were carried out on 130 EU-regulated banks by the European Central Bank (ECB) and European Banking Authority (EBA). Four UK banks also participated in, and passed, the EBA's tests: Royal Bank of Scotland, HSBC, Lloyds Banking Group and Barclays.

The fictional stress scenario put forward by the Bank of England for use in the tests (42-page / 862KB PDF) involved a 2.5% drop in GDP from its level at the end of 2013, a 6.6% increase in the consumer price index (CPI) measure of inflation, a 12% increase in unemployment, sterling falling in value by 30% and a 35% fall in house prices. Banks were not allowed to reduce their lending to the economy over the three years covered by the scenario, but were allowed to cut staff costs, dividends and include changing lending patterns.

The Bank of England said that its scenario was "not a forecast or expectation" but rather "a coherent, severe 'tail risk' scenario" that was "designed specifically to assess the resilience of UK banks".

In its latest Financial Stability Report, the FPC noted that the global economic outlook overall had "weakened" since its last report in June.

"These developments could affect the outlook for financial stability in the United Kingdom if concerns about persistent low growth lead to a sudden reappraisal of underlying vulnerabilities in highly indebted economies, or if a shift in global risk appetite triggers sharp adjustments in financial markets and undermines business and household confidence," it said in its report.

"The recent sharp fall in the oil price should support global and UK growth, but it also entails some risk to financial stability," it said.