Ben O’ Brien, Consulting Risk Practice Director. Jaywing

The recent PRA announcement, which detailed the eight largest UK bank’s results under the new stress testing regime, gave an interesting insight to the individual banks involved and the considerations for next year’s exercise. We know how each of them fared, who needs to improve and why a new stress testing framework was needed. But some questions remain, such as why banks routinely passed stress tests and then failed in the banking crisis? Should we be encouraged by the results of this stress test or concerned that stress testing as a concept is inherently flawed? Has the interconnectedness of the banks, cited as a major driving factor behind the last banking crisis, been sufficiently understood and the risks to the banking sector and the wider UK economy mitigated?

Six years on from the fall of Lehman Brothers and the new stress test regime, introduced by The Bank of England (BoE) post-banking crisis, has delivered its first set of results. This new, concurrent, forward looking, common stress testing regime is designed to assess the stability of the banking system as a whole and consider the impact the inter connectedness in the banking sector had on wider stability. There is no doubt that the new process represents a step forward in stress testing, in particular because of its promise to understand the wider banking system, but has it delivered on its promises?

The new stress testing regime and its results

The new regime has the following key principles:

• Institutions all perform the stress test at the same time, from April to June to ensure concurrency.
• Institutions all use the same scenarios, base and stress.
• Data is shared with the BoE to allow sector-level understanding and modelling.
• Results are made public for purposes of transparency.
• The FPC and the PRA work together and use the data across firms to model resilience at a banking sector level.

The paper, Stress testing the UK banking system: 2014 results, quoted: “The Financial Policy Committee judged that no system-wide, macro prudential actions were needed in response to the stress test”.

The actual stress event that was applied to each of the firms’ balance sheets at the end of 2013 was a variant on the stress scenario applied to the European banks by the EBA. The principal difference to the EBA stress was to add a house price fall of 35% (48% in London), reflecting long articulated risks about London house prices and sharply increasing base rates. The fact that most of the firms passed such a severe scenario (much more severe than what actually happened in 2009 and 2010) was taken as a good sign for the banking industry.

But the news from the results announcement was not all good. Co-operative Bank was revealed to hold insufficient capital to absorb its credit losses at the peak of the stress. The BoE have accepted a plan from Co-operative Bank to build its capital reserves but recognised that they were not sufficiently capitalised to survive another crisis as things stood at the end of 2013. The announcement also made reference to the slim margin by which RBS and Lloyds Bank had passed the minimum core equity tier 1 ratio (CET1) ratio threshold of 4.5% that the BoE imposed. It made the point that the partially state-owned banks only avoided having to re-submit capital plans because they took measures to bolster capital reserves during 2014.

The fact that the stress testing process showed some frailties in the banking system was inevitable and demonstrates the validity of the exercise. The first round of the new stress testing regime can be considered a success, increasing confidence in the sector. Clearly, there remain legitimate concerns over interest rate increases and housing market shocks with recent stamp duty changes, not to mention the increasing economic uncertainty overseas in recent months which pose genuine risks to UK banks that are by no means isolated from such international developments. Full disclosure by the banks is also good to see. The analysis was set out in public to provide greater transparency and reduced the uncertainty over the capital standards the banks are held to. The BoE was satisfied that banks increased their capital reserves in 2014 and clearly link this to their new financial stability policies, describing the stress testing as:“…a forward-looking assessment of capital adequacy, demonstrating the substantial improvement in resilience of participating banks collectively in recent years.”

What does the future hold for the UK’s banking sector?

Whilst the next round won’t include more organisations, there were hints that the bar will be set higher in 2015. The net is expected to be cast wider in 2016 to pickup smaller or challenger banks, rather than just the eight largest, to give a truly holistic view of the sector. The top eight banks will be focusing on improving their modelling capabilities in 2015 whilst the next tier down, have been granted a stay of execution, will need to prepare themselves to support the regulators financial stability objectives in 2016. The paper quoted: “Next year, the Bank is planning to publish a document setting out its intended path towards the medium-term stress-testing framework.”

The new regime will undoubtedly deliver a more robust process but after the incongruity between major banks all passing stress tests in the early 2000 s and the failures of the banking system in 2008 and 2009 the UK tax payer is right to demand accountability not just from the banks but from the financial regulators too. The improved process will take time to deliver fully on its financial stability objectives but, for now, the transparency that the banks were held to has not yet translated into greater transparency from the Bank of England themselves. There was little information made public on the PRA work on sector wide modelling, the impact of the inter connectedness of the banks or the “feed backs and amplifications mechanisms” discussed at length in the original stress testing paper from October 2013.

It will be a key test of success to see what progress has made in this regard. It may be that we will have to wait a while longer: valuable data will have been collected, which will allow that question to be better answered in the future. But these insights are largely missing from the first major instalment in the financial stability programme. It was always going to be unlikely that after one round of tests there would be a full answer to the stability of the UK banking system but unless the 2015 exercise adds significantly to answering wider banking stability questions it may not fully deliver on its stated ambition. But clearly this is just the beginning of the new regime and an ongoing process, which has started well and is bound to be refined and developed over time.