Bank of England Stress Tests

Monday 07 December 2015   Category: Banking By David Green

The Bank of England released the results of its latest stress tests on the seven largest UK banks and building societies on 1st December.   Tests were conducted on Barclays, HSBC Holdings Group, Lloyds Banking Group, RBS Group, Santander UK, Standard Chartered and Nationwide Building Society.

The headline news was that Royal Bank of Scotland and Standard Chartered Bank were the weakest performers, but the true story lies somewhat deeper.

2014 Stress Tests

In its previous stress tests a year earlier, the Bank of England had subjected eight UK financial institutions (the seven institutions, above, and the Co-operative Bank) to a stressed scenario based on a severe economic downturn in the UK, where house prices had fallen, Sterling had depreciated, inflation had risen and therefore interest rates were sharply higher. Co-op Bank failed the test, while Royal Bank of Scotland and Lloyds Banking Group were judged to have passed narrowly, with all three needing to raise additional capital.

2015 Stress Tests

This year's test scenario was quite different, based on a global economic shock adversely affecting banks’ overseas businesses. It included global GDP falling by 7%, stubbornly low inflation and interest rates remaining unusually low. In particular, a 15% corporate default rate in China and Hong Kong was assumed, much worse than actual losses in two most recent Asian crises. The stress tests were based on banks’ most recent year-end balance sheets (April 2015 for Nationwide and December 2014 for the remainder), and looked five years into the future rather than the three years of last year's test. Cooperative Bank, which was the weakest last year, was not tested this time around.

The test also assumed further misconduct charges of £40 billion across the seven banks, roughly the amount already paid out by the banks since 2009. The Bank of England believes it unlikely but not impossible that new fines and compensation claims will exceed this level.

Thresholds

There were two key thresholds to be met in the test. Core equity tier one (CET1) capital, which comprises ordinary shareholders' equity, was to remain above 4.5% of risk-weighted assets. Total tier one capital, which is CET1 plus additional tier one (AT1) capital such as contingent convertible bonds, was to remain above 3.0% of total assets (with no risk-weighting); this measure is known as the leverage ratio.

Banks were assessed at every projected year-end from 2015 to 2019 according to the stressed scenario, with the resulting capital levels published. Mitigation was then allowed for any reasonably likely management action, such as the conversion of AT1 bonds into CET1 capital, non-payment of staff bonuses and other cost cutting measures.

The Bank of England retained the right to require individual banks to meet more stringent capital levels, and to require them to raise additional capital quickly, should they judge stressed levels of capital to be inadequate, even if the key stress test thresholds were met.

2015 Results

Nationwide and Santander UK were the least affected, due to their almost exclusive focus on the UK housing market. HSBC, RBS and Standard Chartered were most affected. At HSBC and Standard Chartered this reflected their exposures to China and Hong Kong, while for RBS it reflected the challenges remaining in its corporate lending business and the forthcoming disposal of Williams and Glyn.

Despite all banks meeting the thresholds, the regulator announced that neither RBS nor Standard Chartered met their individually agreed CET1 ratios in the tested scenario. However, it does not require either bank to submit revised capital plans, since both firms have already improved their ratios since December. Standard Chartered is also in the middle of a fully underwritten rights issue that will raise additional CET1 capital before year-end 2015.

Shortcomings

This statement reveals one of the main shortcomings of the stress test - by the time the results are published, they are 11 months out of date for most banks. Using latest published results and interim management statements as at September 2015, all banks are now better capitalised than during the test. The second drawback, for our clients at least, is that the test results only measure whether there would be a bail-in under the stress scenario, not which investors would be bailed in.  Most banks issue junior debt and/or holding company debt that would be bailed in before senior unsecured bond holders and wholesale depositors

Arlingclose’s Analysis

The relevant ratio to determine whether there would be a bail-in of senior investors, such as clients’ deposits, is the "total loss absorbing capacity" (TLAC) or "minimum requirement for eligible liabilities" (MREL). Final rules for calculating these ratios have yet to be published, but Arlingclose has estimated current and stressed values using the Bank of England results and bank’s own published accounts. We believe that there would be no bail-in of senior creditors until this measure falls below 8% of risk-weighted assets.

None of the named banks failed to meet our expected 8% threshold, below which there could be a bail-in of senior unsecured creditors.

HSBC fares the worst on this measure, although it should be noted that the Bank of England tested HSBC Holdings plc and its global subsidiaries whereas Arlingclose’s normal bail-in analysis is based on the UK operating entity HSBC Bank plc and its European subsidiaries.

Standard Chartered, Santander UK and Barclays are the next lowest scorers, reflecting in part the same limitations in their balance sheets.

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