Key takeaways from BoE stress testing update

06 November 2015 / Ben O'Brien
On 21 October 2015, The Bank of England (BoE) published its most important update on the stress testing regime since the original discussion paper was released two years ago.


The BoE hopes that its approach will promote increased resilience in the banking sector, strengthening the wider economy and helping to fulfil its Financial Stability Objectives. Commenting on the latest update, the BoE Governor, Mark Carney, said "The United Kingdom needs banks that can weather shocks without cutting lending to the real economy". 

Transparency

It's clear that the BoE intends to become more transparent. The update offered clarifications on hurdle rate mechanisms and on how the regulator will use information from the stress tests to inform individual institutions’ capital buffers.

The BoE also provided greater detail on the timeline of events to 2018, allowing institutions to plan resource effectively. In addition, the BoE will remain committed to being transparent with systematic capital adequacy and liquidity processes that the relevant financial institutions will need to satisfy, as well as a comprehensive public disclosure of results.

Proportionality

The scope of the concurrent stress testing regime will remain limited to those institutions with £50bn or more of retail deposits – currently the same seven firms that were included in this year’s CST. Annual cyclical stress tests are to be supplemented by more idiosyncratic exploratory scenarios biennially from 2017.

Mark Carney said the focus on the largest banks was intended to ensure the BoE’s resources were focused on lenders that have the biggest effect on the economy. These major banks currently account for 80% of the UK’s lending. It is also clear that the BoE will continue to hold the systemic and globally systemic banks to a higher standard, including the requirement for incremental buffers from 2016.

Smaller lenders may be relieved by the decision not to widen the scope of the annual concurrent stress testing to include a larger number of firms beyond the current seven. However, even smaller players need to conduct stress tests in context of their ICAAP. Indeed, many smaller players aspire towards achieving industry best practice and a more rigorous approach to stress testing in order to satisfy their stakeholders.

Counter-cyclicality scenarios and capital buffers

We also see the introduction of an annual cyclical scenario that will systematically link the severity of the test to the financial cycle.

Every year, the BoE will design and run a scenario intended to assess the risks to the banking system emanating from the financial cycle — the ‘annual cyclical scenario’. This scenario will include domestic, global and market elements. The severity of the cyclical test will be tougher in an upswing, for example when growth in credit is rapid or asset prices appear unsustainably high.

Results of the annual test will be used by the BoE’s Financial Policy Committee and Prudential Regulation Authority to set counter-cyclical capital buffers across all banks, and bespoke capital buffers for individual banks.

Looking forward

The BoE has also set out plans to introduce further exploratory stress tests, potentially targeted at individual banks or a subset of the overall group. These scenarios will be designed to assess the ability of bank balance sheets to withstand specific latent or emerging risks outside of the normal financial cycle, and will be run in alternate years starting from 2017.

It remains the BoE’s objective to improve its own modelling capability to assess systemic risks and amplification mechanisms over and above the scrutiny of individual firms’ submissions. Further information will be published in due course on the BoE’s approach to stress testing beyond 2018. However, the stress testing framework is likely to evolve further to reflect regulatory developments, including structural reform of the banking sector.

Stress testing best practice 

For more information on stress testing please pre-register for our latest stress testing whitepaper ‘Making sense of stress testing’, which will be sent to you hot off the press when it is released at the end of November, please register by emailing [email protected].