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Bank stress tests – the devil is in the detail

Bank stress tests – the devil is in the detail

Richard Conway Weekly bulletin December 2018
UK banks have done enough to weather the worst of Brexit. That was the message from the BoE’s latest financial stability report and annual stress tests released last week. Surely cause for a pat on the back.

Results had been brought forward to allow MPs time to consider the outcome – good or bad – before parliament got a chance to vote on the latest deal. They are due to debate it over the course of this week.

Nicky Morgan’s Treasury Committee’s key concern is the Bank’s ability to manage monetary and financial stability in a ‘no deal, no transition scenario’.

A clean bill of health

All lenders passed for just the second time since the Bank began its annual exercise in 2014.

“The test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis” according to the report. Banks tested were even able to service projected fines for misconduct, “well beyond current provisions”. All-in-all, the UK financial system is “ready for Brexit whatever form it takes” according to the governor.

No one would deny that the scenarios considered were extreme; a disorderly Brexit where the Bank Rate rises to 5.5%; consumer and business lending rates rise by 250bps; a reversion to WTO terms till 2023; sharp contractions in output at home and abroad; and a pronounced increase in risk premiums on sterling assets.

But the devil is in the detail

The tests themselves were largely unchanged from 2017 but this time around carried slightly higher pass rates. So far, so good. However, there was one significant concession for the lenders, and it could mean the difference between passing and failing.

UK banks are currently in the process of moving to a new set of accounting standards, known as IFRS9. Under these, banks would be forced to recognise expected losses on loans today, not just book provisions once a default has occurred or a payment been missed. Turns out this has a pretty significant impact.

Were the new standards to come into full force today, Barclays and Lloyds would fail the test on the first run. Convertible debt (AT1), designed to bail in bondholders and bolster capital, would bring them back to compliance but there’s no doubt that it paints less of a rosy picture.

Breathing room, but work to do

Now, for the time being it’s unlikely that this would be required. UK lenders are subject to a transition period stretching out to 2023 which provides some degree of breathing room. But it does highlight that there may be issues down the road.

It also ties in with results of EU-wide bank stress tests, conducted earlier this month, which pointed to potential issues in both institutions. Indeed, they were among the worst performers of the 48 tested, although both still made the passing mark.

Is there a conflict of interest?

Perhaps a more interesting question is who is best placed to run these stress tests. The BoE, through its Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) is no doubt the front runner. They’ve definitely done a good job to date, with the UK bank stress tests held as standard bearers for the practice worldwide.

However, with the Bank’s own objective of financial stability indirectly judged by performance in these tests, it does call into question the arrangement. With some commentators raising concerns over the tests and the results, you can’t help but think “is the tail wagging the dog?”

Upcoming economic data
PMIs will provide an update on economic growth at the start of the week, with most due by Wednesday. It is unlikely that these figures will move the dial in a meaningful way as far as policy is concerned, however we can imagine they will get some additional scrutiny given growth concerns at home and abroad. Indeed, the ECB, on the back of less than ideal unemployment and inflation numbers last week is walking a fine line on plans to tighten – so the more data the better.

Australian GDP numbers due Wednesday are expected to show a softening of growth, with risks to the downside given several recent surveys. Q3 Eurozone GDP and US nonfarm payrolls should round off the week on Friday. The former is expected to be unchanged on latest estimates (1.7% YoY and 0.25 QoQ) while the latter is expected to have softened from 250k to 205k in November.

For more information, please contact Richard Conway, Associate Director at Chatham, at rconway1@chathamfinancial.com.


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