Bank of England publish annual stress testing results

All of the uk’s largest banks passed the stress test but a newly announced increase in the uk’s countercyclical capital buffer means that some may still need to strengthen their capital positions

Author: Ivelina Nilsson

Date: 17 December 2019

Yesterday, the Bank of England (BoE) published the results of its annual stress testing exercise with the UK’s seven largest lenders. The stress tests are based on a severe recession scenario, which is worse than the 2008-2009 financial crisis. In the scenario, UK GDP contracts by 4.7%, house prices fall by 33% and unemployment rises to 9.2%. The stress is a test to the resilience of the UK financial system. Each participating bank is expected to show it has sufficient capital to withstand this severe economic shock.

On the face of it, the results are as expected. Despite a deterioration in asset quality for corporate exposures, all banks show that their capital remains at adequate levels in stress. Banks that passed the test with relatively narrower margins last year appear to have improved their resilience.

However, a closer look raises some interesting points.

Dividends and contingent capital The largest UK lenders pass the test but this is only after they take material actions during a stress scenario. These include cuts in dividends, coupon payments and variable remuneration. Lloyds and Barclays would also need to convert contingent capital, AT1, into equity if new IFRS 9 accounting rules are fully applied. (These new rules are currently being phased in until 2023.)

Perfect foresight Should a stress of this magnitude and duration occur, the impact could be more severe than indicated in the stress testing results. This is because the BoE requires banks to assume ‘perfect foresight’, i.e. that they can accurately predict what will happen to the economy and their portfolios from day one of the stress. In reality, market participants would not have a perfect foresight – they would not know with certainty how deep or how long the recession would be. At the peak of the 2008-2009 recession for example, forecasts were more pessimistic than the actual outcome, and many banks reported overly conservative losses.

The countercyclical capital buffer

Yesterday the BoE also published a proposal to raise the level of the UK countercyclical capital buffer (CCYB) from 1% to 2%, which will come into effect this time next year.

The CCYB requires banks to hold additional capital in times of credit boom. It was activated for the first time in the UK in 2017 and currently stands at 1%. The increase in the CCYB from 1% to 2% will ensure that banks have more capital to absorb losses in stress without cutting their lending. It will also enable the BoE to implement a gradual approach to raising the CCYB rate when the economy shows signs of overheating.

During 2020, the BoE will consult on a proposal to simultaneously reduce the requirements for Pillar 2a capital. For the UK’s largest banks, the proposal is to offset half of the CCYB increase through a Pillar 2a reduction. For the UK’s smaller banks, the offset is proposed to be 100%.

The burden of the extra CCYB requirement will be shifted towards larger banks. However, some smaller banks may be adversely affected if they do not have sufficient Pillar 2A capital to benefit from the proposed reduction or are constrained by another capital requirement, the leveraged ratio.

The BoE also stated that it is considering options for incorporating the new IFRS 9 accounting standard into stress tests and capital requirements on a more enduring basis. This is to ensure that the new accounting standard, which is being phased in until 2023, should not result in an unwarranted increase in capital requirements.

For further information on our stress testing services, please get in touch with Ivelina at ivelina.nilsson@4-most.co.uk