It’s clear the banking system has been strained in recent weeks, particularly in the US. It started with the collapse of Silicon Valley Bank, continued with the forced merger of Credit Suisse, the takeover of First Republic Bank by JP Morgan, and more recently (at least, at the time of writing) with speculation over the future of US regional lenders Pacific Western Bank and Western Alliance.
In the UK, while there have been some signs of stress, banks in this country seem to be faring better. While of course positive, concerns remain over contagion and how exposed UK banks may be to the sort of economic and financial shocks already seen, and those we may experience in the future?
In 2020 and 2021, the Bank of England undertook banking system stress-tests which were related to the Covid-19 pandemic. However, in 2022, the BoE returned to its annual cyclical scenario (ACS) testing. A key objective of the BoE’s approach to stress testing is to ensure that banks can continue to support the real economy in the face of severe adverse shocks.
Rather than stressing against a set of events which are expected or likely to occur, the ACS is designed to be both sufficiently broad and severe to provide a sound assessment of the resilience of UK banks to a range of shocks.
The latest iteration will be more severe than the global financial crisis for the UK and the world, incorporating an assessment of banks’ resilience to higher rates both domestically and globally.
In the stress scenario, weaker household real income growth, lower confidence and tighter financial conditions cause more severe domestic and global recessions. The assumptions include UK Bank Rate rising rapidly to 6% in 2023, UK GDP contracting by 5%, world GDP falling 2.5%, UK unemployment rising to 8.5%, UK house prices falling 31%, and UK commercial property and equities both falling by 45%.
The test contains three types of stress:
The test is then calibrated to ensure banks can continue to provide the required level of demand for credit from households and businesses throughout the scenario.
Within the macroeconomic scenario is UK consumer price inflation averaging around 11% for the first three years of the period, peaking at over 17% in early 2023, and only falling back gradually to hit 3.4% by end 2024 and 2% by 2027.
The scenario assumes a 2.5% fall in global GDP, but in terms of the regions UK banks are most exposed to, Euro area GDP is assumed to fall 4.9% in the first year before starting to recover, while US, China and Hong Kong GDP fall by 4.1%, 0.1% and 6.9% respectively over the same period.
For the traded stress, an increase in risk aversion due to worries over weaker corporate profitability cause equity prices to fall and corporate bond spreads to increase. In the UK, tighter financial conditions from higher central bank interest rates increase spreads on investment grade bonds from 171bps to 419bps over risk-free rates and from 541bps to 1953bps for high yield bond spreads.
For the misconduct cost stress, the banks being tested are asked to provide projections of misconduct costs relating to known issues with a low likelihood of being exceeded.
The eight banks included are Barclays, HSBC, Lloyds Banking Group, Nationwide Building Society, NatWest Group, Santander UK, Standard Chartered and Virgin Money UK. Together, these entities make up around 75% of total UK lending.
Each bank will be assessed against ‘hurdle rates’ for their risk-weighted common equity Tier 1 capital and Tier 1 leverage ratios. The hurdle rates are the levels of capital banks are expected to maintain relative to the level of the fall in each ratio under the stress scenario. Any bank identified as falling below its hurdle rate will generally then be required to improve its capital position.
The results from the ACS will be published this summer, which for the first time will include assessing the ring-fenced subgroups on a standalone basis should their position be significantly different to that of the group. These subgroups include Barclays Bank UK, HSBC UK Bank, Lloyds Bank and NatWest Holdings.
For anyone wishing for more details on the tests, links to the Bank of England’s website are provided below.