World Economy

UK Banks Face Stress Tests Tuned to Economic Cycle

UK Banks Face Stress Tests Tuned to Economic CycleUK Banks Face Stress Tests Tuned to Economic Cycle

The Bank of England will lay out its approach to stress testing banks next week, bringing in its most recent thinking about the way the financial system interacts with the business cycle and how to smooth peaks and troughs in lending, Bloomberg wrote.

BOE Deputy Governor Jon Cunliffe said in July that the UK central bank was looking at ways of using stress tests to encourage banks to lean against the cycle. Because banks typically boost lending in good times, fueling the expansion and storing up risks to stability, and then slash it in bad times, deepening the slowdown, regulators are seeking ways to reverse this behavior.

“Rather than testing every year against a scenario of constant severity,” Cunliffe said, “the severity of the test, and the resilience banks need to pass it, would be greater in boom times when credit and risk is building up in the financial system and it has further to fall, and then reduced in weaker periods when there is less risk in the system and the economy needs the banking system to maintain lending.”

Regulators seeking to prevent another financial crisis have introduced buffers into lenders’ capital structures, forcing them to hold pools of capital against various classes of risk and in some cases limiting their ability to pay dividends or bonuses if the buffers are used. These include a countercyclical capital buffer, which is accumulated in good times to absorb losses when things are less favorable. The BOE’s Financial Policy Committee sets the level quarterly. It’s currently at zero percent  for UK exposures.

‘External Shock’

In the record of its Sept. 23 meeting, the FPC said it had been briefed on the BOE’s “developing approach to stress testing to 2018, ahead of planned publication of this approach.” One element of the central bank’s approach “could be to establish how stress testing scenarios might be used as an input to inform decisions on the appropriate CCB rate in the future,” the committee said. The approach will be published on Oct. 21.

The FPC recommended in 2013 that UK banks be subjected to regular stress tests to determine the capital adequacy of the financial system. An inaugural test was conducted last year, and the result of the 2015 assessment will be published on Dec. 1.

This year’s test covers seven UK banks and building societies: Barclays Plc, HSBC Holdings Plc, Lloyds Banking Group Plc, Nationwide Building Society, Royal Bank of Scotland Group Plc, Santander UK Plc and Standard Chartered Plc. It sets out a “major external shock” to the banking system, including Chinese growth slowing “materially” and plunging commodity prices.

Banks will be assessed against a 65% drop in the Hang Seng Index and a 34% collapse in Brent crude oil prices. They will also be examined on their ability to weather trading book shocks including a 23% decline in the euro versus the U.S. dollar over one year. To pass the test, lenders must maintain 4.5% common equity tier 1 and a 3% leverage ratio, both measures of financial strength.