THE IMPACT OF STRESS TESTING ON THE INDUSTRY AND ECONOMY

Ben O’Brien, Risk Practice Director, Jaywing

Earlier this year, the Bank of England outlined the new scenario under its stress testing regime, which focuses on different economic stresses to last year, including economic stagnation and greater stresses on corporate entities. This new scenario is based on an unlikely, though plausible, slowdown in the growth of the Chinese economy that has underpinned recent global growth.

The 2015 tests have an emphasis on market liquidity and risks associated with trading operations. This has moved stress testing forward in terms of the breadth and depth of its coverage. What will be interesting is how the move from a UK housing market crash scenario to a more global threat will create different winners and losers this time round.

Not only were the 2014 housing scenarios extremely unlikely, they penalised those with large residential mortgage portfolios. For the likes of Nationwide and Lloyds Banking Group, this may have resulted in artificially low rankings, associated as much with their exposure to the mortgage market than wider financial stability. The 2015 scenarios continue to be plausible in, as now more than ever, economists are increasingly concerned about the slow-down in China’s growth.

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Besides a lull in global economic growth, the 2015 stress tests will consider the effects of a reduction in spending on bank profitability, a scenario that feels more plausible than the 2014 scenario that projected a 48% drop in London property prices.

One real merit of the stress testing programme is the ranking and disclosure element that creates greater transparency of how the sector is performing and identifies ways in which it can improve. The ability for consumers to see that the top eight are accountable for their actions is a big step and encourages honesty between the industry and consumers.

Considering more genuine risks, such as recessions and a stunt in global economic growth, provides the opportunity to mix it up and test the banks on different elements. This in turn will help the Bank of England develop a more rounded perspective of how the financial sector may respond if affected by national or international vulnerabilities, and how susceptible they are to risk during such changes. Both Standard Chartered and HSBC performed well in the 2014 round of stress testing when tested against UK property risks as their portfolios are less dominated by the UK mortgage market than others that were tested. However, the 2015 scenarios will redistribute the weight towards global exposures and is likely to result in a very different rank ordering of vulnerability.

Looking ahead to the results expected from the 2015 regime, I anticipate that both Lloyds and Nationwide’s rank will improve as the focus of the exercises shifts away from UK property risks, to more global economic risks. The ranking produced from the results is one of the merits of the stress testing regime as it reveals which organisations have the ability to respond well to changes but it should not be taken as a wider measure of vulnerability until several of these stress scenarios have been evaluated.

Overall, the 2015 exercise will show how banks are positioned to respond to plausible global concerns and a wider variety of stresses, something the 2014 results could not highlight. As each round of stress tests is carried out, more data is being collected on different risks. This data will be incredibly beneficial as it will provide knowledge and insight into how the banks will deal with stresses in the future. With each round of tests, the deeper our knowledge becomes and the more able we are to determine the impact of different risks, both short and long term, and the potential effect these risks will have across the sector.

By the end of 2015, the top eight will have undergone two stress testing exercises. Going forward, it would be beneficial for the Bank of England to open the tests to more organisations across the financial sector, so a more informed prediction of the impact of economic difficulty can be assessed across the whole of the banking industry.

More importantly, particularly for the general public, is the fact that the Bank of England is once again asking the banking sector to prepare for the worst by simulating severe yet plausible economic scenarios and understanding what the impacts might be. Indeed, we will all be a little bit wiser for finding out.

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