The Bank of England just published the results of its 2016 stress test of Britain’s banks.
Most lenders performed solidly, but Royal Bank of Scotland, Barclays and Standard Chartered came up lacking.
The three banks had to submit plans to the regulator detailing how they would raise capital and boost their resilience to financial shocks.
The test was the third run by the Bank of England, and was used as a measure of how well Britain’s banks would be able to cope should the world suffer a major economic shock in the coming year.
The test is designed to ensure that banks are in possession of right tools — such as sufficient liquidity and relatively strong capital positions — to weather an economic storm.
It’s pretty apocalyptic, setting out major collapses in a whole heap of asset classes and a massive worsening of economic conditions. As the BOE put it when announcing the test scenario in March: “In the Bank’s 2016 stress scenario vulnerabilities across financial markets and the global and UK economies crystallise.”
Here’s what Britain’s banks will have to resist in this year’s stress test:
- Global growth crashes — “The stress scenario incorporates a synchronised global downturn in output growth. Relative to the baseline scenario, growth in China and Hong Kong is particularly adversely affected. GDP growth troughs at -1.9%, as it did during the 2008 global financial crisis.”
- Oil falls to $ 20 per barrel — “Having fallen significantly during 2015, the price of oil troughs at US$ 20 per barrel, reflecting the further slowdown in world demand.”
- Emerging market currencies tank — “There is volatility in financial markets with emerging market currencies depreciating against the US dollar.”
- Property prices drop nearly a third in Britain — “property prices fall globally. Falls in Chinese and Hong Kong property prices are particularly pronounced, following rapid recent growth. In the United Kingdom, residential property prices fall by 31% — this is particularly concentrated in regions which have recently experienced more rapid price increases.” Commercial real estate prices will crater even more, falling 42%.
- UK GDP tanks, and unemployment surges — “The level of UK GDP falls by 4.3%, accompanied by a 4.5 percentage point rise in unemployment. The combined impact of increases in the cost of credit, the contraction in world demand, falls in asset prices and heightened uncertainty have a pronounced impact on domestic growth.”
It’s important to note that the scenario presented in the stress test isn’t supposed to be indicative of what the BOE actually thinks will happen to the British and world economies but rather a total worst case scenario, and is tougher than previous years, reflecting genuine fears about the state of the global economy.
Here’s how the BOE’s economic shocks are presented compared to the last two tests:
Bank of England
And this is how the stress test scenario compared with what actually happened to the global economy during the 2007-2008 financial crisis:
Bank of England
Along with an increase in the severity of the scenario presented to banks, the requirements, in terms of capital levels, were also made tougher by the BOE. In this year’s stress test, the minimum capital levels for the biggest UK banks increased from 4.5% to between 7 and 8%. Here’s the Old Lady of Threadneedle Street’s reason behind the decision, first announced back in March:
The 2016 stress test incorporates a domestic stress which is broadly as severe as the 2014 exercise in terms of its impact on GDP and unemployment. That said, there are significant differences between the UK scenarios incorporated in the two tests. The stress to UK residential property prices is slightly less severe in the 2016 test. Other financial market and asset price shocks such as those to UK equity prices and CRE prices are, however, more severe in the 2016 exercise.
Overall, the stress incorporated in the 2016 test is broader than either of the stresses in the preceding concurrent tests. That reflects the desire of policymakers to use the stress-test framework to help set capital requirements and buffers for all stress-test participants each year.
Stress tests have gained a lot of popularity with central banks since the financial crisis when numerous banks across the globe collapsed or had to be bailed out by governments. Nowhere was that more true than in Britain, where the government, then led by prime minister Gordon Brown, had to pump billions of pounds into both RBS and Lloyds to keep them afloat.
The European Banking Authority, which oversees the eurozone’s financial sector is also a big believer in stress tests. The EBA doesn’t include a pass/fail designation in its test, but this year’s — which dropped in July — showed that Monte dei Paschi di Siena, the stricken Italian lender, would be insolvent in less than three years under an “adverse scenario.” The EBA also highlighted big problems with Deutsche Bank’s capital ratios.
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