Today, the 2015 stress testing results of the UK’s seven largest banks and building societies have been revealed. The results show that there has been significant improvement in stress testing processes since the 2014 review, however the results identified considerable variation across banks, and highlighted areas where stress testing and capital planning frameworks need to be strengthened further.
Seven lenders – HSBC, Barclays, Lloyds Banking Group, Standard Chartered, Royal Bank of Scotland (RBS) and Nationwide – were subjected to the Bank of England’s (the Bank) latest round of stress tests. The results revealed that all seven of the UK’s largest banks and building societies passed the stress tests. Although all the banks passed this year’s test without having to raise extra capital, RBS and Standard Charter would have been forced to raise more capital if they had not taken steps during 2015.
The 2015 stress tests demonstrate how much stronger the core of the UK financial system has become. They also show that the UK banking system is on a stronger footing and is better able to support the real economy, even in the face of a major global economic shock.
The purpose of the 2015 stress tests
Stress tests look at how banks would fare in hypothetical situations, with regulators assessing whether the banks would still be able to lend money and remain viable in difficult economic conditions.
The aim of the 2015 stress test was to assess the resilience of the UK banking system to a deterioration in global economic conditions, including a sharp slowdown in China and other emerging markets alongside falling oil prices and a strengthening US dollar. There were particular peculiarities in the scenario like a 0% Base Rate and price deflation which tested the ability of banks to simulate economic conditions not seen in recent years.
Key differences between the 2014 and 2015 stress tests
Last year’s stress test focused on testing the vulnerability of banks’ UK exposures, in contrast to this year’s stress test which focused on exploring risks to UK banks’ businesses outside the UK.
The 2015 test revealed that banks have strengthened their balance sheet since the 2014 test, as most banks started the 2015 stress test in a stronger position than last year's exercise. This is due to banks continuing to improve their capital positions during 2014. This strengthening came about due to improvements in profitability driven in part by reductions in credit impairments.
How can stress testing be strengthened further?
An important objective of the concurrent stress testing framework is to support improvement in banks’ own risk management and capital planning capabilities. By strengthening banks’ own stress testing capabilities, banks’ will be able to better assess potential risks to their business, both as part of the concurrent stress tests and beyond. This should support resilience of individual institutions and the system as a whole.
For the majority of banks, the overall data quality and accuracy of results submitted to the Bank was an improvement compared to 2014. For those banks who performed the best, data submissions contained no material omissions, were accurate and required fewer clarifications.
The Bank also undertook a review of banks’ stress testing model frameworks – having found that they were weak during the 2014 exercise. For some banks their model management standards were found to have improved. But others needed to make considerable improvements – including implementing and embedding model management policies more fully. Some banks lacked formal processes to approve stress testing models and had weak model governance.
While the Bank recognises that improvements take time, banks are expected to continue to invest significantly to implement model development standards, maintain robust model inventories and strengthen their independent model review frameworks.
In 2014, the Bank set expectations that over time, banks’ stress testing processes and frameworks would become more embedded. While progress has been noted, the expectation is that they should continue to improve overtime.
Stress testing in 2016 and beyond
The concurrent stress tests conducted by the Bank in 2014 and 2015 are important steps towards the development of a stress testing framework in the UK.
Under the Bank of England’s plans, next year British banks will be subject to one stress test from the UK regulator and another from the European Banking Authority (EBA). In 2017, the Bank will run both its "cyclical" and "exploratory" tests, followed by just one cyclical test in 2018.
Another important development is the Bank of England has signalled that it will soon want Britain’s banks to hold up to £10bn more capital. It has concluded that the credit cycle has moved to a more ‘normal phase’, which means it will deploy its “countercyclical capital buffer”. This is the amount of extra capital banks must hold ‘in the good times’, to cover them for a rainy day.
The Bank isn’t raising the buffer today – but it is signalling that this could happen in March 2016.
For best practice tips on stress testing, send an email to [email protected] and request a copy of our latest whitepaper ‘Making Sense of Stress Testing’. In this paper we will cover eight key steps to successful stress testing.