The fourth of the Bank of England’s annual stress tests for the UK’s key banking institutions has been the most demanding, incorporating two scenarios, the first of which is the annual cyclical scenario (‘ACS’) of a severe and synchronised domestic and global downturn set against a background of an increase in Bank Rate which results a sharp fall in asset prices, weakens borrowers’ ability to service debt, results in higher impairments and diminishes the value of collateral held against loans.
All seven key institutions assessed this year – Barclays, HSBC, Lloyds Banking Group, RBS Group, Standard Chartered, Santander UK and Nationwide – passed the tests and for the first time in four years none was required to strengthen its capital position as a result. This is crucial as these banks account for around 80% of bank lending to the UK real economy. In addition, Barclays, HSBC, RBS and Standard Chartered which are designated as G-SIBs - global systemically important banks – are required to and hold an additional capital buffer to reflect the higher ensuing impact of any failure.
The economic scenario tested was more severe than that witnessed during the financial crisis, with UK house prices falling by one-third and commercial property by 40%, GDP falling 4.7%, unemployment doubling to 9.5%, sterling falling by nearly 30% and, at the same time, Bank Rate rising and peaking at 4%. [The 2016 tests, in contrast, were assessed against Bank Rate being cut to zero.] You might say that the chances of this apocalyptic scenario are extremely slim, but you might have ascribed a similar probability in 2005 of the perfect storm of banks collapsing globally three years later. The current stress tests see the banks incurring losses of around £50 billion in the first two years, but their now vastly improved capital positions allow them to absorb the losses and remain resilient enough to keep lending to consumers and businesses. Ten years ago it would have, quite simply, wiped out the common equity capital base of the UK banking system.
Legacy misconduct issues linger as a millstone, the potential for costs beyond those already paid or provided for remain a latent burden. Another strand to the Bank’s stress tests is the ‘exploratory scenario’ which is a longer-term outlook of depressed global growth, stagnant trade, persistently low interest rates and competition from smaller institutions. This test concentrates on the banks’ actions rather than their capital positions – it explores not whether, but how, banks would meet the regulatory requirements of regulators and the return on equity their investors demand whilst building sustainable business models. Its motivation is to get banks to think about and act to address their strategic challenges.
Does this mean banks can be complacent? The outcome of the stress tests may for now imply a clean bill of health, validating their efforts over the past several years to increase their capital and be more operationally efficient. However, the risks from global debt levels and the pace of consumer credit growth, misconduct costs and the consequences of a disorderly Brexit are real and ongoing threats, ones which the banks cannot be sanguine about.