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Stress Test – Bank of England 2017

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The Stress Test Report has been published annually since 2014. The report consists of taking certain variables such as unemployment, inflation, growth, among others, and evaluating what would happen to the banking system in case the greatest risks for the British economy were to materialise. Based on this report, the Financial Policy Committee (FPC) of the Bank of England is able to take the necessary measures to try to reduce or eliminate the risks to which commercial banks are exposed.

For the first time since the Bank of England issued and analysed the stress tests in 2014, no bank needs to strengthen its capital position as a result of the test. The 2017 simulation showed that banks are resistant to deep and simultaneous recessions in the UK, and to the global economy and a fall in asset prices. The economic scenario that was taken as the basis for the stress test was more severe than that witnessed by the markets in the 2008 financial crisis.

In the test, the banks’ losses would be close to £50 billion in the first two years after the economic crises happened. That scale of losses, relative to their assets, would have wiped out the common equity capital base of the UK banking system if the scenario were ten years ago. The stress test shows that these losses can now be absorbed within the capital reserves that banks have over their minimum requirements.

Capital positions have strengthened in the last decade which has given the central bank peace of mind. During the test, the bank started with a Tier 1 Leverage ratio of 5.4% and a Tier 1 capital ratio of 16% in aggregate. The aggregate common equity Tier 1 (CET1) ratio was 13.4%, which is three times stronger than a decade ago.

These capital ratios measure the financial health of banks. It puts in relation the funds with which it has to face an immediately possible crisis in the financial system of any country, with the risk assumed by the banks through the assets that they have in the balance. That is, they have taken it into account to demonstrate the solvency of capital in relation to risk assets. If these rates are very low in relation to what the regulators decide, banks will have to reinforce the quality of their capital, either by increasing it or improving it.

Even after severe losses during the test, banks would have a sufficient leverage ratio in the aggregate to continue giving credit to consumers and investors, which would boost the real economy. The bank’s main conclusion was that the financial system had continued to strengthen capital during 2017 and all banks had sufficient capital to meet the standard established by the test.

The FPC increased the system-wide UK countercyclical capital buffer rate (CCyB) from 0.5% to 1%. This measure was taken by the committee due to the losses of the banks, that they had in their assets for some credits that were not recovered. In addition, during 2017 there was a very rapid growth of rates of credit so that during the next three years the rate of loss of consumer credit could be 20% if the stress test scenario occurs.

The establishment of the system-wide UK countercyclical capital buffer rate did not require banks to strengthen their capital positions, but they were required to incorporate part of the capital they currently have in excess of their regulatory requirements in their regulatory capital reserves.

The conditions of the stress test considered a risk in the local credits at historical average levels, the global gross domestic product fell 2.4%, the product of the United Kingdom fell 4.7%, the unemployment of the UK went up to 9.5%, the real estate market down to 40% and residential property dropped by 33%, in addition to a depreciation of the pound sterling in its index up to 27%.

A domestic crisis coupled with a global economic crisis, with a fall in global assets and a depreciation of the pound would make it more difficult for consumers and investors to meet their obligations to the banks, which would decrease the value of the assets that support the balance of the bank.

Compared to stress tests from previous years, the aggregate capital ratio CET1 is lower in the 2017 test, but this is because the conditions evaluated were much more extreme. It is also important to mention that the results are different for all banks and this is due to different segments and market models, the type of risk to which they are exposed, and in some cases the degree of progress of restructuring programs.

There are two special cases which did not meet the reference levels of the capital ratio CET1 in 2016: Barclays and RBS. But by 2017 the capital structure had already improved, so after the stress test, the banks passed the quality test of their capital. Thanks to these banks improving their results, the bank committee in charge of regulating the financial system decided that no bank needed to take measures to improve the capital position for the first time since the stress tests were carried out.

In the following graphs you can see how the CET1 ratios projected in the stress scenario were, showing that the banks have solid profiles in their capital and how the evolution of the CET1 capital ratio improved between 2016 and 2017 respectively.

 

Graph 51. Projected CET1 capital ratios in the stress scenario. Retrieved the 3rd of February 2018, From https://www.bankofengland.co.uk/-/media/boe/files/stress-testing/2017/stress-testing-the-uk-banking-system-2017-results.pdf?la=en&hash=ACE1E2FB54482F5DC3412864C6907928B622044A

Graph 52 Evolution of CET1 capital ratios in the 2016 and 2017 tests. Retrieved the 3rd of February 2018, From https://www.bankofengland.co.uk/-/media/boe/files/stress-testing/2017/stress-testing-the-uk-banking-system-2017-results.pdf?la=en&hash=ACE1E2FB54482F5DC3412864C6907928B622044A

The quality of consumer credit portfolios is a very important determinant to analyse the ability of banks to withstand low economic cycles. This is due to the fact that non-compliance with loans increases in economic recessions and it is on these occasions that banks must test the quality of capital they have in order to continue lending, and thus support economic growth.

Defaults in consumer debt have decreased in recent years, and cancellation rates decreased from 5% to 2% between 2011 and 2016. This is a reflection of how credit quality has improved in recent years since the financial crisis. It is also evidence of a change in the distribution of consumer loans to borrowers with less risk of default.

But not only this can be attributed to a better distribution in the loans, it is also true that banks have enjoyed a better economic situation with a better rate of job creation, low-interest rates by the Bank of England, as well as new financial innovations. The Prudential Regulation Committee (PRC) concluded that some banks have underestimated the risks exposed in the stress test because they think that the best credit quality is due to policies implemented by them and not by the economic conditions, which may be risky if the exposed risks materialise.

In the test scenario, the effects of an increase in the Bank’s interest rate on the economy were evaluated. Although the increase in the rates does not directly influence the depth of the crisis, some effects that the rate hike could generate were observed. Higher rates would put more pressure on borrowers, which could lead to higher loan default rates of up to £10 million.

The prevalence of short-term mortgages shows that households are particularly exposed to the volatility of the interest rate. Nearly three-quarters of the mortgages were fixed in short-term contracts, or with variable rates which could have a negative effect on other markets such as real estate. In addition, in a pessimistic scenario, the crisis could deepen if it combines higher unemployment rates with higher values of mortgages, which would put borrowers under greater pressure.

In conclusion, stress test report carried out by the Bank of England shows the strength of the British financial system, given that all the banks analysed in the area could withstand very adverse situations in the economy, being able to continue lending to the money market which could be important for an economic recovery if the economy is in a recession. Banks are expected to see 26% deterioration rates on credit cards, 14% on personal loans and 17% on unsecured loans such as cars and overdrafts, among others. It is important that the Prudential Regulation Committee has reached the conclusion that the financial system is robust given the multiple risks that the British economy faces, so it is necessary that the system is prepared by the multiple paths that Brexit can take.

©Forex.Academy

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