Draconian scenarios look pretty frightening as Bank of England outlines annual stress tests
The Bank of England has outlined that banks are to be tested on their readiness for a range of worst case economic scenarios, including a 17% inflation rate and a doubling of UK unemployment.
Tuesday 27 September 2022 20:06, UK
It seems somehow appropriate that, with sterling and gilts (UK government bonds) in free-fall, the Bank of England should have fleshed out what this year's annual stress tests on the banking sector will involve.
Stress tests were introduced by the Bank in the wake of the global financial crisis and specifically look to assess the capital adequacy of the UK's banking system.
They were held annually until the pandemic forced the cancellation of the 2020 stress test as the Bank - and the institutions it stress tests - focused on supporting the economy and customers through the crisis.
The 2021 stress test subsequently focused on the banking sector's resilience to COVID-19 while a test due to be launched in March this year was postponed in the wake of Vladimir Putin's attack on Ukraine.
So it seems appropriate that, with economies slowing across the globe as central banks raise interest rates in response to the inflation Putin has unleashed, the Bank is now to test what it described as "the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, large falls in asset prices and higher global interest rates".
There will also be a separate stress test of misconduct costs - perhaps a nod to the fact that, more than a decade on from the global financial crisis, some banks are still being fined heavily by regulators around the world for various misdemeanours.
The lenders participating - Barclays, HSBC, Lloyds Banking Group, Nationwide building society, NatWest Group, Santander UK, Standard Chartered and Virgin Money UK - will be tested on how they would cope with a 5% drop in UK GDP over the next year and a 2.5% drop in global GDP in that period, a more-than-doubling of UK unemployment to 8.5%, a 31% drop in house prices (why, in passing, has the Bank selected a 31% drop in house prices, as opposed to a 30% drop or a 32% drop?) and a 45% drop in commercial property prices from peak to trough.
The Bank's 'what if?' scenarios
The scenario sketched out in this year's stress test also sees UK inflation peaking at 17% next year and averaging 11% over the next three years, Bank Rate hitting a peak of 6% early next year, and interest rates hitting 4.7% in the eurozone and 6.5% in the US by the beginning of next year.
It is vital to stress that these are not scenarios the Bank expects to happen - merely theoretical worst case scenarios against which the Bank wishes to test the resilience of the UK banking sector. They are very much what can be called "what if?" scenarios.
Interestingly, the 2022 exercise will also see tests carried out on the ring-fenced entities of the participating banks - Barclays Bank UK, HSBC UK Bank, Lloyds Bank and NatWest Holdings.
Ring-fencing, which was introduced at the beginning of 2019, was another change introduced following the global financial crisis. The aim was to separate UK retail banks from the so-called "casino banking" arms of their parent organisations to ensure that banks with more than £25bn worth of deposits were "ring-fenced" from shocks originating either elsewhere in the group or in financial markets.
The lenders participating in the stress test have until 11 January next year in which to submit responses to data requests issued by Threadneedle Street in January this year. The theoretical scenarios set out in the exercise cover a five-year period that began on 30 June this year.
The Bank will then crunch the responses and come up with a response by summer next year.
Read more:
How the failing pound affects you
'Significant' interest rate rise to come
Why the Bank's tests matter
These tests are important for a number of reasons.
The first and most obvious is that they are aimed at providing reassurance to taxpayers that the balance sheets of banks are more resilient than they were when, for example, the global financial crisis struck. They should reassure all stakeholders in the banking sector that, should a worst case scenario unfold, UK taxpayers will not be required to step in and supports lenders like HBOS and Royal Bank of Scotland in the way they were during the crisis.
Secondly, though, they help the Bank remedy any problems that may emerge during the stress testing exercise and get ahead of potential difficulties.
As the Bank noted: "The stress-test results, and other relevant information - including any developments in the macroeconomy since the launch of the test - are used by the Financial Policy Committee and Prudential regulation Committee to co-ordinate their policy responses to ensure the banking system as a whole, and individual banks within it, maintain sufficient capital to absorb losses and continue to supply credit to households and businesses even in a stress."
That is done by adjusting capital buffers - the reserves that banks must set aside to absorb potential loan losses. These are both set on a system-wide basis, with what is known as the countercyclical capital buffer, as well as specific buffers for individual lenders set out by the Bank.
Scenarios set out by the Bank in stress tests in recent years have tended to concentrate heavily on the impact of climate change and COVID-19.
In some ways, it is bracing to see the banks being tested on a good old-fashioned recession, even if the Draconian scenarios set out in this year's exercise do look pretty frightening.