Breaking down the Bank of England’s updated approach to stress testing

The Bank of England (BOE) published its updated approach to stress testing the UK banking system at the end of November 2024.

While the new approach is very similar to the latest practice, the changes that have been made could still mean additional development and restructuring will be required by participants.

We breakdown the notable changes and what actions may need to be taken in response.

What does the updated stress testing structure consist of?

The updated approach has three main components:

• Biennial bank capital stress testing to inform the setting of capital buffers with the participation of the largest and systemic UK banks.
• Other stress test, a desk-based (or targeted), exercise to assess the risks related to the financial cycle.
• Exploratory exercises to assess other risks that are not closely linked to the financial cycle.

Looking back at the previous five years, the BOE cancelled two Capital Stress Testing. The 2020 exercise was cancelled due to COVID. The 2022 one was delayed following the war in Ukraine and merged into the 2023 exercise. Also, three exploratory exercises (liquidity, climate and non-bank financials) were run during the same period. Hence, the changes above are in line with the latest practice.

Biennial bank capital stress testing

The Bank Capital Stress Test is expected to be biennial, starting from 2025 with an expected 11-month cycle. It is used to test risks related to the financial cycle and to inform setting capital buffers for the banking system and individual participants. The biennial approach will create space to assess and address the identified risks.

The reduced frequency could pose operational challenges to firms that currently operate on an annual basis, particularly due to the balances required in response to the variation in capacity between the ‘on’ and ‘off’ years. This could be addressed through having greater automation and high-level documentation in place.

Scenarios

The applied scenarios are expected to reflect policymakers’ assessment of the state of the financial cycle. The scenarios will vary based on that risk assessment, and not because of a change in risk tolerance. That tolerance has not changed with the publication of this updated approach. The risk assessment will be based on a wide range of indicators, consistent with the regular risk assessment published in the FPC Record and Financial Stability Report.

The utilised scenarios are expected to be countercyclical. Being more severe during the period of prosperity and lower after correction. Such an approach would tend to result in banks holding more capital as risks are building up and allows them to draw on capital buffers as the stress unfolds.

The BOE’s intention is to explore a broader range of risks outside the core macroeconomic, such as traded risk scenarios and a separate misconduct stress. This could require new data sources; model suites that are able to predict loss result from new type of risks, and the capability of running multiple scenarios.

Assess capital position

One of the main objectives of the stress testing exercise is to assess if individual banks, and the overall banking system, hold enough capital to absorb possible stress. If the results suggest that the regulatory capital buffer for the banking system is insufficient, the FPC may act to adjust the UK CCyB rate.

From individual bank’s perspective, the PRA buffer can be informed based on a bank’s capital position compared to the hurdle rate (the level of capital that banks are expected to maintain throughout the stress scenario). If stress testing exercises indicate that a bank’s capital ratio would fall below the hurdle rate and it does not have sufficient capital to be able to absorb an increase in its regulatory buffers, it may be required to improve its capital position.

Participation

A certain level of UK coverage is necessary to provide a sufficient level of information to the BOE to support the FPC and PRA in achieving their objectives. Participation rules are expected to be revisited if the participation rate falls materially below 75% of UK balance sheets.

In particular, the BOE would consider including a UK bank or building society in its Bank Capital Stress Test if:

• it accounts for more than 5% of aggregate lending by the banking sector to UK households and businesses,
• it is designated as a UK headquartered ‘global systemically important institution’ (G-SII) or a UK headquartered ‘other systemically important institution’ (O-SII) by the PRA.

Given the BOE’s intention to explore banking system level risks, widening the circle of participants is possible. However, a range of factors would be considered, especially the balance between cost and benefit. If a new firm should be invited, their whole stress testing capability will require significant investment and enhancements.

Other stress test

The years between the Bank Capital Stress Tests is expected to be used to further explore (when appropriate) the resilience of the banking system. This can happen as a desk based-based exercise, when the BOE relies primary on its own estimates of the impact of stress scenarios. Or they could include targeted exercises capturing how specific vulnerabilities could evolve under adverse scenarios.

The design of these exercises will be tailored to the FPC’s and PRC’s assessment of risks. Hence the coverage would depend on the types of risks being assessed and the mix of different business models. The results of these exercises are not likely to be published beyond an aggregate level.

Exploratory exercises:

Exploratory exercises are designed to assess other risks that are not closely linked to the financial cycle such as climate, liquidity events, change in demographic or usage of AI. The timing of such exploratory exercises will be informed by the FPC’s and PRC’s assessment of such risks.

The scope of these exercises will change from time to time. It could mean high demand for analytical resources as atomisation or use of existing solutions may not always be possible.

These kinds of tests could be carried out as a desk-based exercise resulting in limited requirements for institutions. However previous experiences have shown, that it is good practice and benefit can be gained from banks undertaking the exercise themselves.

Given the varying focus and scope of the tests, the choice of which banks participate will vary, depending on the objectives of the exercise, the relevance of banks’ business models to the scenario and risks that are in focus, and whether participation is proportionate for those banks.

The granularity of disclosure of the results may vary, dependent on a range of factors including how novel the risk or vulnerability is, and the uncertainty around the projections. As has been the case to date in such exercises, the results of these exercises are likely to be published at an aggregate level. The results will be used to inform financial stability and supervisory assessment, wider policy, and banks’ risk management.

Next steps

Firms should prepare for the switch to operate the capital stress testing on a biannual basis and build out their capabilities to test their portfolio against other risks beyond core macroeconomic.

4most has a suite of available solutions and extensive industry experience in working with organisations of all sizes and stages of development to address all of these areas.

Get in touch if you are interested in learning more about how we can help your organisation – info@4-most.co.uk.