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Stress Test – Bank of England 2017

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.

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Report of the Financial Policy Committee June-November 2017

The Financial Policy Committee (FPC) was established in 1998 and amended in 2012. The main objective of the committee is to ensure the financial stability of the United Kingdom, which is one of the fundamental pillars of the Bank of England. In addition to supervising the health of the financial system, it must also aim at the good development of the economy by supporting other committees and the objectives of the Crown that are based on growth and employment. The responsibilities of the committee are mainly to identify, monitor and take necessary actions to remove or reduce the systematic risks of the financial system of the United Kingdom.

The Financial Policy Committee (FPC) has the objective of ensuring that the financial system of the United Kingdom is resistant to the various risks and situations that they may face over time. The FPC evaluates internal and international risks and is always monitoring variables such as credits, mortgages and others so that they are within an acceptable range for the committee.

In recent years in the UK, consumer credit has grown rapidly. The conditions for access to a mortgage have become more accessible so it is easy to think that there are negative incentives for bankers who often prioritise their economic benefits and profits of the banks before the security of the financial system.

Another concern of the committee is Brexit. This event has generated much uncertainty in international markets and is still unclear on what will be the conditions of the departure of the United Kingdom from the European Union. This is a concern because it is clear that the financial system will be affected when Brexit is completed.

On the other hand, in the June report, the Committee observed that many of the global risks had not materialised which was a relief to the financial system and the economy of the UK, but they continued to observe vulnerabilities in the Chinese financial system, so they were still analysing the situation in China. For the FPC, market volatility measures and the valuation of some assets such as corporate bonds and UK real estate did not seem to show signs that investors had these global negative projections within their valuation models, in addition to very low interest rates which affected long-term assets.

To maintain the soundness of the financial system and avoid possible future risks, the bank decided to increase the UK countercyclical capital buffer (CCyB) rate to 0.5% from 0% Also, the FPC expected to increase the rate to 1% at its November meeting. The countercyclical capital buffer (CCyB) is a tool that enables the FPC to adjust the resilience of the banking system. The FPC increases the CCyB when they consider that risks are building up. The bank forces commercial banks to have more capital reserves to face possible economic or financial shocks, absorbing the losses which makes a stronger financial system and prevents bank failures.

The bank performs multiple stress tests of the economy, taking different scenarios to analyse what the response of banks and the financial system would be in general, to study what possible measures can be taken to reduce the risks to which the system is exposed. The bank’s annual stress test assesses the banks’ resistance to consumer credit risks. Due to the rapid growth of consumer credit in the last year, the FPC began to perform stress tests analysing what the possible losses of the banks could be if a problem was found in the local economy.

Credit card debt and personal loans were the main variables that increased rapidly. But the committee noted that the losses in consumer loans were low and the loan environment was good so there was a large number of loan offerings. The downside is that the maturity of the loans was very short, so the quality of the loans could go down drastically and very quickly.

The Brexit negotiations had already begun before the June meeting and the bank had very broad expectations about the possible paths that the negotiation could take, so there was no clarity about the possible steps to follow. To be prepared, the FPC had a contingency plan to reduce the financial risks derived from Brexit as much as possible.

Spreads on sovereign bonds in the Eurozone had declined due to the resolution of some political uncertainties. In China, the outflow of capital had stabilised but the economic growth of the country was still based on a very rapid expansion of credits, which made it a risky scenario due to possible problems in the financial system. In the UK, yields on 10-year government bonds were close to -2% and in general, in the G7, long-term interest rates were low, which was evidence of negative growth expectations in addition to the uncertainty of the investors. The above can be seen in the following graph.

 

Graph 48. International ten-year real government bond yields. Retrieved 27th January 2018, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

It is evident in the FPC reports that the main local concern is Brexit. This is because there are many companies and banks that could leave and stop operating in the UK because of the regulation changes after the negotiations, there could be changes in the rules which would affect the margins of the companies, make contracts again or relocate resources which could be costly. The withdrawal of the United Kingdom from the European Union has the potential to affect the economy through the supply, demand and exchange rate channels.

In global financial markets, the uncertainty measures implicit in the prices of the options were low. In June, the VIX measure of implied capital volatility derived from the prices of the S&P 500 stock index options had reached its lowest level since 1993. The Committee noted that, often in periods of low volatility, the risk increases, and then they become evident.

As previously mentioned, long-term risk-free interest rates in advanced economies remained low, which is consistent with pessimistic growth scenarios and a great uncertainty of the global situation is perceived. As for short-term expectations, they improved in the last period despite the fact that world average growth was lower compared to the pre-crisis period.

The committee argued that the prices of global assets were vulnerable due to possible increases in long-term interest rates or adjustments in growth expectations. Regarding the exposure of the UK banks to the real estate market, positive signs were found because the exposure to this market was reduced to half of the figures seen before 2008, making the financial system more robust, at least in this aspect.

The UK banking system continued to strengthen its capital positions due to the valuation of different metrics in addition to the results of the stress tests, so the committee concluded that the system was well capitalised, with good liquidity and good financing coverage.

The June report concluded that the recovery capacity of the UK financial system had strengthened significantly since the crisis and is capable of absorbing shocks to the real economy. The future of the economy was expected to be full of risks due to events such as, risks in China, negative expectations and mainly due to uncertainty about the completion of the Brexit talks, but the FPC promised to carry out all the possible studies to have greater clarity about what awaited the UK after leaving the European Union, and taking the necessary measures to maintain a robust financial system and good growth rates.

The following graph shows the comparison of the main debt metrics, market conditions and the balance sheet of the bank. As it is observed, the values up to the June meeting did not show high risks being within the values seen historically.

Graph 49. Core indicator set for the countercyclical capital buffer. Retrieved 27th January 2018, from https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

At the November meeting, the FPC raised the UK countercyclical capital buffer rate from 0.5% to 1%. This measure was taken by the bank due to the results obtained in the stress test where some risks were observed, so it was decided to raise the rate as a precaution.

In November, the FPC continued to observe Brexit as a major risk, some risks in the domestic economy and global risks were due to some erroneous asset valuations. But despite these risks, after the stress test of the financial system, the FPC concluded that the system was robust and could support the economy in case of a disorderly Brexit that would lead some variables to show negative trends such as employment, the real estate market and even an aversion to UK assets. If the worst-case scenario were to occur for the British economy, the financial system would have the strength to support economic recovery and not collapse.

The conjuncture that could generate a crisis in the banking system would be a messy Brexit and a severe global recession. In this scenario, it would be possible to generate a credit restriction for new loans because the capital of the banks would be threatened, so the financial system would not be able to support the economy.

Regarding local conditions, it was observed that the main variables were within normal parameters without any excessive risk, although the committee must continue to monitor the system, especially due to the high level of indebtedness in the economy. The credit growth rate was above the nominal GDP growth, but there was no evidence of excessive risk at the moment. The following graph shows that consumer credit was not at alarming levels.

 

Graph 50. Outstanding consumer credit to income. Retrieved 27th January 2017, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/november-2017.pdf?la=en&hash=8CB2A5526478872DE14D531254B948BB6FD47793#page=9

As already mentioned, if after Brexit, investors stop acquiring British assets, this could affect the financial system which would reduce the number of loans granted to people, which would have an impact on the economy and could affect the economic growth of the country in the short term.

Regarding external factors, the committee explained that the current account of the UK has been in deficit persistently since 1999 and has increased since 2012 reaching 4.6% of GDP in the second quarter of 2017. It has been increased mainly by lower profits from foreign direct investment.

Long-term global interest rates have remained near historically lower levels. This has been evidence of structural factors such as demographic changes and expectations of low inflation despite solid but moderate growth. As in June, the committee observed worldwide investors have placed an excessive weight and optimism in current economic conditions, and have not correctly assessed the medium-term risks which have created a risk in the global financial markets, which in future may come to affect the British financial system.

In the corporate bond market, spreads were at levels seen before the financial crisis with a more compressed high yield, compared to historical levels. This has come along with greater leverage of companies in the United States. In the UK, there is a high risk that economic growth will be weak, so the UK’s risk-free rates have been falling since mid-2016 compared to other economies.

Short-term expectations have improved in terms of global economic growth with better prospects for the IMF by the end of 2017. The better prospects were given by better behaviour in the Eurozone, Japan, China, Russia and emerging Europe. Despite these better prospects, the FPC observed some vulnerabilities in some financial systems and markets due to a significant increase in the debt of non-financial sector companies as part of the GDP at previous levels of the 2008 crisis, especially in China where the debt has grown about 60% in the last 5 years. Finally, on the international scene, the government confirmed its intentions that by the 29th of March 2019 the United Kingdom must have completed its negotiations to leave the European Union and establish trade negotiations after it no longer belongs to the economic union.

In conclusion, the Financial Policy Committee is very explicit about which risks will be faced by the financial system and how the committee is prepared to face them by taking the respective measures. In the last two reports, the committee focused on the same risks at the local and international level, taking the Brexit negotiations as the main risk for the United Kingdom, which could lead the financial system to limit its offer, which could affect British growth. They also emphasise that the interest rates of developed countries have remained low due to not so optimistic expectations of the countries, in addition to the fact that inflation has remained low. This is a recurring theme in the reports of the central banks of the United States and England because they have not seen entirely positive behaviour in inflation and in growth, so when they have been making monetary policy decisions they have been very cautious.

Based on the FPC report it is also evident that there is an optimism among investors worldwide that has prioritised current conditions but has not valued the global economic risks such as excessive Chinese companies’ debt and some geopolitical conflicts, whereby markets and financial systems are exposed to a risk given the overvaluation. This represents a threat to global economic growth and especially to the United States where the large rise in stock market shares has generated households with greater wealth. This has encouraged consumption and in turn, this has boosted economic growth, but the overvaluation of assets could affect the economic growth since it affects the main engine of the economy.

China also represents a global risk because it is the second-largest economy, so if a crisis occurs in the financial system, domestic consumption would decrease drastically and exports around the world would be affected. It is perhaps the most latent risk internationally for developed countries that could trigger other risks such as falls in stock market indices and contagion in global financial systems.