Wednesday, November 30, 2016/12:36 PM /Bank of England
The 2016 stress test incorporated a synchronised UK and global recession with associated shocks to financial market prices, and an independent stress of misconduct costs.
The test, which is the first conducted under the Bank’s new approach to stress testing, examined the resilience of the system to a more severe stress than in 2014 and 2015. It also judged banks against the Bank’s new hurdle rate framework, which held systemic banks to a higher standard reflecting the phasing-in of capital buffers for global systemically important banks.
While the Prudential Regulation Authority (PRA) Board judged that some capital inadequacies were revealed for three banks (The Royal Bank of Scotland Group, Barclays and Standard Chartered), these banks now have plans in place to build further resilience. The Financial Policy Committee (FPC) judged that, as a consequence of the stress test, the banking system is in aggregate capitalised to support the real economy in a severe, broad and synchronised stress scenario.
The PRA Board judged that:
• The test did not reveal capital inadequacies for four out of the seven participating banks, based on their balance sheets at end-2015 (HSBC, Lloyds Banking Group, Nationwide Building Society and Santander UK).
• The Royal Bank of Scotland Group (RBS) did not meet its common equity Tier 1 (CET1) capital or Tier 1 leverage hurdle rates before additional Tier 1 (AT1) conversion in this scenario. After AT1 conversion, it did not meet its CET1 systemic reference point or Tier 1 leverage ratio hurdle rate. Based on RBS’s own assessment of its resilience identified during the stress-testing process, RBS has already updated its capital plan to incorporate further capital strengthening actions and this revised plan has been accepted by the PRA Board. The PRA will continue to monitor RBS’s progress against its revised capital plan.
• Barclays did not meet its CET1 systemic reference point before AT1 conversion in this scenario. In light of the steps that Barclays had already announced to strengthen its capital position, the PRA Board did not require Barclays to submit a revised capital plan. While these steps are being executed, its AT1 capital provides some additional resilience to very severe shocks.
• Standard Chartered met all of its hurdle rates and systemic reference points in this scenario. However, it did not meet its Tier 1 minimum capital requirement (including Pillar 2A). In light of the steps that Standard Chartered is already taking to strengthen its capital position, including the AT1 it has issued during 2016, the PRA Board did not require Standard Chartered to submit a revised capital plan.
The FPC judged that the system should be capitalised to withstand a test of this severity, given the risks it faced. It therefore welcomed the actions by some banks to improve their capital positions. Despite a more severe scenario, the aggregate low points for CET1 capital and Tier 1 leverage ratios were higher than in the 2014 and 2015 tests.
The FPC noted the increased resilience to stress provided by banks’ AT1 capital positions and banks’ stated intention to reduce dividends in stress. It also noted the strong performance of the most domestically focused banks. Given the results, no system-wide macroprudential actions on bank capital were required in response to the 2016 stress test.
The FPC is maintaining the UK countercyclical capital buffer rate at 0% and reaffirms that it expects, absent any material change in the outlook, to maintain this rate until at least June 2017.
This reflects developments since the stress test was launched in March, which suggest greater uncertainty around the UK economic outlook and an increased possibility that material domestic risks could crystallise in the near term.
The FPC was concerned that banks could respond to these developments by hoarding capital and restricting lending. That position has not changed.
Background and stress scenario
In March 2016, the Bank of England launched its third concurrent stress test of the UK banking system. The 2016 stress test covered seven major UK banks and building societies (hereafter referred to as ‘banks’), accounting for around 80% of PRA-regulated banks’ lending to the UK real economy.
Stress tests allow policymakers to assess banks’ ability not just to withstand very severe shocks, but also to maintain the supply of credit to the real economy under stress. They support the FPC in discharging its statutory responsibility to identify, monitor and take action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.
Stress tests also support the PRA in advancing its general objective to promote the safety and soundness of the banks it regulates. The 2016 stress-test scenario was designed under the Bank’s new approach to stress testing.
Under this framework, the stress being tested against will generally be severe and broad, in order to assess the resilience of major UK banks to ‘tail risk’ events. Its precise severity will reflect the risk assessment of the FPC and PRA Board.
As such, the 2016 test was more severe than earlier tests. The severity of the stress in the 2016 scenario is based on the risk assessment the FPC and PRA Board made in March 2016 — that overall risks to global activity associated with credit, financial and other asset markets were elevated, and that risks associated with domestic credit were no longer subdued but were not yet elevated.
The 2016 annual cyclical scenario incorporates a very severe, synchronised UK and global economic recession, a congruent financial market shock and a separate misconduct cost stress.
Annual global GDP growth troughs at -1.9%, as it did during the 2008 global financial crisis. Annual growth in Chinese real GDP is materially weaker than in the financial crisis and troughs at -0.5%.
The level of UK GDP falls by 4.3%, accompanied by a 4.5 percentage point rise in the unemployment rate. Overall, the UK stress is roughly equivalent to that experienced during the financial crisis, albeit with a shallower fall in domestic output, and a more severe rise in unemployment and fall in residential property prices.
The stress test also includes a traded risk scenario that is constructed to be congruent with this macroeconomic stress.
Having fallen significantly during 2015, the price of oil reaches a low of US$20 per barrel, reflecting the slowdown in world demand. Investors’ risk appetite diminishes more generally and financial market participants attempt to de-risk their portfolios, generating volatility.
The VIX index averages 37 during the first year of the stress, which compares to a quarterly average of around 40 between 2008 H2 and 2009 H1.
Interest rates facing some households and businesses increase in the early part of the stress, partly reflecting a rise in term premia on long-term government debt. Credit spreads on corporate bonds rise sharply, with spreads on US investment-grade corporate bonds, for example, rising from around 170 basis points to 500 basis points at the peak of the stress. Meanwhile, policymakers pursue additional monetary stimulus, which starts to reduce long-term interest rates.
Residential property and commercial real estate (CRE) prices also fall. Following rapid recent growth, these falls are particularly pronounced for property markets in China and Hong Kong, with residential property prices falling by around 35% and 50%, respectively.
In the United Kingdom, house prices fall by 31% and average CRE prices fall by 42%. These falls are even greater for prime CRE, reflecting the fact that prices of these properties have risen more robustly since the financial crisis.
The 2016 stress test also incorporates stressed projections, generated by Bank staff, for potential misconduct costs, beyond those paid or provided for by the end of 2015. These stressed misconduct cost projections are not a central forecast of such costs. They are a simultaneous, but unrelated, stress alongside the macroeconomic stress and traded risk scenario incorporated in the 2016 test.
There is a very high degree of uncertainty around any approach to quantifying misconduct cost risks facing UK banks. The stressed projections relate to known past misconduct issues, such as mis-selling of payment protection insurance and misconduct in wholesale markets.
They have been calibrated by Bank staff to have a low likelihood of being exceeded. They are therefore, by design, much larger than the amounts that had already been provided for by banks at end-2015. However, partly because they relate only to known issues, they cannot be considered a ‘worst case’ scenario.
Impact of the stress scenario on the banking system
The stress scenario is estimated to lead to system-wide losses of £44 billion over the first two years of the stress, around five times the net losses incurred by the same banks as a group over 2008–09.
Based on the Bank’s projections, the 2016 stress scenario would reduce the aggregate CET1 capital ratio across the seven participating banks from 12.6% at the end of 2015 to a low point of 8.8% in 2017, after factoring in the impact of management actions and the conversion of AT1 instruments into CET1 capital (Table 1). The aggregate Tier 1 leverage ratio falls from 4.9% at the end of 2015 to a low point of 3.9% in 2017.
Compared to previous tests, the fall in the aggregate CET1 capital ratio from start to stressed low point was larger in the 2016 stress test, reflecting the greater severity of the stress scenario.
Nevertheless, at 8.8% that low point was well above the 7.6% low point reached in 2014 and 2015. This strength of banks’ aggregate capital position in the 2016 stress reflects improvements in banks’ starting capital positions. The aggregate CET1 capital ratio for banks at end-2015 was 12.6%, up by 1.4 percentage points relative to the end of 2014 and up by 2.6 percentage points from the end of 2013.
In part this reflects banks transitioning to previously announced higher capital standards. It is those same standards that are reflected in the Bank’s new hurdle rate framework.
Without any stress (including for misconduct costs)the baseline outlook at the end of 2015 was for participating banks’ aggregate CET1 capital ratio to increase by 1.2 percentage points to 13.8% in 2017, as banks continued to build capital through retained earnings and as their risk-weighted assets contracted slightly.
Relative to the baseline, by the low point at end-2017 the stress reduces the aggregate CET1 capital ratio by 5.0 percentage points and leverage ratio by 1.4 percentage points, reflecting a range of factors (Table 1), including:
• A domestic and global downturn combined with a sharp fall in asset prices, which reduce borrowers’ ability to service debts and diminish the value of collateral held against loans. This contributes to material loan impairment charges amounting to £63 billion over the first two years of the stress, £46 billion higher than projected in the baseline and reducing the aggregate CET1 ratio by 2.4 percentage points
• Sharp movements in market prices and increased counterparty credit risk, which lead to material traded risk losses. These losses are concentrated in 2016, before partially unwinding as asset prices recover. By the end-2017 low point, the traded risk stress, including a shortfall of investment banking revenue net of costs, reduces bank capital by £20 billion relative to the baseline projection, reducing the aggregate CET1 ratio by 1.0 percentage point.
• A slightly weaker net interest income profile, which is around £3.5 billion lower in the stress relative to banks’ aggregate baseline projection over the first two years of the stress, reducing the aggregate CET1 ratio by 0.2 percentage points. This reflects lower loan growth in response to weaker demand for credit, as well as tighter spreads between sterling loans and deposits. These tighter spreads are in part related to the fact that Bank Rate is cut to zero in the stress and, in contrast to the package of monetary policy measures launched in August 2016, no Term Funding Scheme was assumed in the stress scenario.
• Stressed projections for misconduct costs beyond those already provided for at the end of 2015. Around £30 billion of these additional misconduct costs are projected to be realised by the end of 2017, reducing the aggregate CET1 ratio by 1.6 percentage points. This compares to an aggregate of around £40 billion paid and another £18 billion provided for by banks, but not yet used, over the period 2011–15.
The Bank prescribed an aggregate lending path in the stress, in which lending to the UK real economy expanded by 4.5% over the five years of the stress, in line with Bank staff’s projection of the demand for credit over that period, given the stress scenario.
In practice, stress-test participants’ aggregate real-economy lending was projected to grow by 4.75% over the five years of the stress. This is weaker than under the baseline, given lower demand for credit.
Despite weaker lending, higher average risk weights under the stress still mean that risk-weighted assets increase under the stress, driving a 1.6 percentage point reduction in the aggregate CET1 ratio.
On a non risk-weighted basis, banks are projected to reduce their total exposures in the first two years of the stress by around 3%. In the baseline, banks in aggregate increase their exposures by 4% over the same period.
The reduction in the stress pushes up banks’ aggregate Tier 1 leverage ratio by 0.3 percentage points at its low point. Two important factors mitigate the impact of the stress on capital: cuts to ordinary dividends and conversion of AT1 instruments into CET1 capital. Together, these boost aggregate bank capital ratios by 1.2 percentage points. Cuts to ordinary dividends fall into three broad categories applied by the Bank in the following order:
(1) ‘business-as-usual’ actions, cutting dividends in line with banks’ public dividend policies; (2) restrictions on dividend payments resulting from the European Union Capital Requirements Directive (CRD) IV;(1) and (3) ‘strategic’ management actions, which includes departures from banks’ public dividend policies that would be likely to entail significant involvement from banks’ Boards (and hence were only accepted if judged by the Bank to be plausible given the stress).
Under CRD IV, banks failing to maintain a combined capital buffer above their minimum capital requirements are subject to automatic restrictions on discretionary distributions including dividends, variable remuneration and other discretionary coupons.
In aggregate, ordinary dividends for 2015 were around £9 billion (Table 2). During a stress, with a significant fall in banks’ profits, investors should expect a material cut in dividends.
The Bank’s modelling of dividend payments under the 2016 stress scenario is designed to mirror the actions that banks would be expected to take in line with the factors above.
This results in dividends of only £1.6 billion during the first two years of the stress. Relative to banks’ baseline dividend projections, cuts in these payments mitigate the fall in the aggregate CET1 capital ratio by 0.8 percentage points at the low point in 2017.
Lloyds Banking Group and Santander UK cut their ordinary dividends to zero by the low point of the stress, in line with their published payout policies.(1) In reaction to losses made during both the first and second years of the stress, HSBC makes a substantial discretionary cut in ordinary dividend payments in 2016 and then pays no ordinary dividend in 2017, as it makes a loss and becomes subject to CRD IV distribution restrictions.
Meanwhile, Barclays and Standard Chartered are loss-making during the first two years of the stress and cut their ordinary dividend payments to zero as they become subject to CRD IV distribution restrictions. The Royal Bank of Scotland Group does not pay an ordinary dividend in any year of the stress scenario. Nationwide continues to make distributions on its Core Capital Deferred Shares (CCDS).
The test also illustrates how AT1 instruments would convert into CET1 capital if a bank’s CET1 ratio fell below a pre-defined trigger point. The conversion of AT1 instruments provides additional resilience against the impact of the stress on banks’ CET1 capital ratios.
At end-2015, the seven participating banks in aggregate had issued around £23 billion of AT1 capital instruments, for which conversion to CET1 capital would be triggered if their CET1 ratios fell to 7%. The Bank has modelled the conversion of AT1 instruments into CET1 for the three banks whose CET1 ratios fell below this 7% threshold in the stress (Table 3).
These conversions increase the aggregate CET1 ratio at the low point of the stress by 0.4 percentage points. The FPC and PRA Board noted that this was the first stress test in which AT1 had converted. But this was not the first year in which a bank’s CET1 ratio had fallen below 7% in the stress test, so the conversion of AT1 was a positive development in so far as it reflected increased amounts of such loss-absorbing capacity on some banks’ balance sheets. Banks for which AT1 converted in the stress were more resilient, all else equal, than if they had not issued AT1 instruments.
Hurdle rate framework
Performance in the test was assessed against the Bank’s hurdle rate framework, comprising elements expressed both in terms of risk-weighted capital and leverage ratios. Importantly, the results of the test inform judgements by the FPC and PRA Board. There is no automatic link between the results and capital actions required.
The risk-weighted capital ratio hurdle rate framework has two elements. First, a hurdle rate, equal to the sum of the internationally agreed common minimum standard for CET1 (4.5%) and — for the first time in 2016 — any Pillar 2A CET1 uplift set by the PRA, which varies across banks. The weighted average of this hurdle rate was 6.5%. Second, a CET1 ‘systemic reference point’, which holds banks of greater systemic importance to a higher standard.
For banks designated as global systemically important banks (G-SIBs), this adds an additional buffer to the hurdle rate according to the phase-in path of each bank’s G-SIB capital buffer, which has a 2019 end-point of 1%–2% of risk-weighted assets. The weighted average systemic reference point was 7.3% at the low point in 2017.(2) G-SIB capital buffers are designed to be able to be drawn on by banks to absorb the impact of a stress.
Their inclusion in the systemic reference point does not change this. Rather, and reflecting the FPC and PRA Board’s risk tolerance, it acts to reduce the probability that a systemically important bank would be unable to absorb a real stress given that its failure would have a higher impact than that of a non-systemically important bank.
The Tier 1 leverage hurdle rate framework mirrors that of the risk-weighted capital ratio. The hurdle rate is 3%, while a bank’s systemic reference point also includes its G-SIB additional leverage ratio buffer (which is 35% of its corresponding risk-weighted capital buffer).
The FPC judged that as a consequence of the stress test the banking system is, in aggregate, capitalised to support the real economy in a severe, broad and synchronised stress scenario.
The results show that in aggregate the low-point CET1 capital ratio of 8.8% (8.4% before AT1 conversion) was well above the 7.6% low point seen in the 2015 and 2014 tests. This low point is also well above the 6.5% weighted average hurdle rate and 7.3% weighted average systemic reference point.
These results are consistent with UK banks maintaining the supply of lending to the UK real economy: banks’ projections for lending were consistent, in aggregate, with Bank staff’s projection of the demand for credit over the scenario.
The impact of the scenario differs substantially across banks (Table 3). This is due to differences between business models, the types of risks the banks are most exposed to and, in some cases, the extent of their progress through restructuring programmes.
In general, the stress has the greatest impact on those banks with significant international and corporate exposures. The three banks operating principally in domestic markets —Lloyds Banking Group, Nationwide and Santander UK —remain well above their hurdle rates throughout the stress.
This reflects, in part, improvements in the asset quality of banks’ core UK mortgage businesses, through a combination of rising property prices, which have bolstered the value of collateral backing loans, as well as banks adopting more prudent new lending standards (for further details see Box 1).
In determining whether an individual bank’s capital needed to be strengthened further, the PRA Board considered a number of factors, including whether a bank’s CET1 capital ratio or Tier 1 leverage ratio was projected to fall below its individual hurdle rate or, where applicable, its systemic reference point.
For a full table of individual hurdle rates and systemic reference points see Section 2.
Where an individual bank’s CET1 capital or Tier 1 leverage ratios were close to these thresholds, the PRA Board also considered other factors, for example, the bank’s Tier 1 and total capital ratios under stress taking into account their Pillar 1 plus Pillar 2A minima.
Banks in the 2016 stress test were judged against their hurdle rates and systemic reference points based on their capital positions before AT1 conversion. This reflects the PRA Board’s policy that capital buffers should be held in CET1 capital, as opposed to Tier 1 capital.
However, the PRA Board considered the impact of any AT1 conversion on banks’ CET1 capital ratios when deciding the appropriate supervisory response to banks projected to fall below their hurdle rates or systemic reference points, including the acceptable period for building an appropriate level of CET1 in banks’ capital plans.
The PRA Board judged that this test did not reveal capital inadequacies for four out of the seven participating banks, based on their balance sheets at end-2015 (HSBC, Lloyds Banking Group, Nationwide Building Society and Santander UK). While some capital inadequacies were revealed for three banks (The Royal Bank of Scotland Group, Barclays and Standard Chartered), they now have plans in place to build further resilience.
For further details of the actions taken by the FPC and PRA Board in response to the test see Section 5.
An important objective of the concurrent stress-testing framework is to support a continued improvement in banks’ own risk management and capital planning capabilities. On that basis, as in previous concurrent tests, the Bank also undertook a qualitative review of banks’ stress-testing capabilities.
The PRA Board judged that banks in aggregate have made progress this year, but was disappointed that the rate of improvement has been slower and more uneven than expected.
As set out in the Bank of England’s ‘Approach to stress testing the UK banking system’, the qualitative review will be considered in the Bank’s broader assessment of banks’ risk management and governance arrangements for the purpose of setting the PRA buffers and will continue to influence the intensity of supervision of individual banks.
In order to raise standards in model development and management, the Bank plans to publish expectations against which banks’ modelling frameworks will be assessed. The Bank, through the Basel Committee’s Working Group on Stress Testing, is also collaborating with other regulators in the review of bank and supervisory stress-testing programmes and, as needed, will be developing further guidance to enhance these programmes.
Consistent with the approach set out in the Bank of England’s ‘Approach to stress testing the UK banking system’, the 2017 stress test will for the first time include a second — ‘exploratory’ — scenario in addition to the regular ‘cyclical’ scenario. The Bank intends to run a second scenario biennially to examine emerging or latent threats to financial stability.
The seven banks that participated in the 2016 stress test will participate in both scenarios in 2017.
Over time, the Bank’s recent stress tests have tested resilience against a wide range of relevant risks. They remain informative and continue to inform the judgements of the FPC and PRA Board.
The 2014 test considered the resilience of the system to a ‘snap back’ in interest rates and adjustment in UK property markets in the context of high levels of household indebtedness. The 2015 test focused on global risks, including a sharp slowdown in China and emerging markets and a severe euro-area stress.
The 2017 exploratory scenario will supplement these previous tests by considering the impact of weak global supply growth, persistently low interest rates, and a continuation of declines in both world trade relative to GDP and cross-border banking activity. This scenario will not be a more severe test of banks’ capital positions than the annual cyclical scenario.
The focus of the test will be on the implications for banks’ business models, the economic impact of any actions they would take to ensure their viability and the implications for their future resilience. The test will have a seven-year horizon to capture these long-term trends.
Throughout the test horizon, the prudential standards implemented for the UK financial system will be assumed to remain at least as robust as those currently planned.(1) Consistent with the focus on business models rather than detailed financial performance, the data collected from banks will be significantly less detailed than that collected for the annual cyclical scenario. Box 5 provides further details on the 2017 exploratory scenario.
Although the Bank’s concurrent stress tests have, since their inception in 2014, increased in severity (as measured by their impact on the aggregate capital position of the system), there will not be a bias towards more or less severe scenarios in future.
The annual cyclical scenario will evolve systematically over time, increasing in severity in those areas where risks are judged to be building and decreasing in those areas where risks are materialising or abating. It will not vary because of a change in policymakers’ tolerance of risk.
The results of the annual cyclical scenario will help the FPC and PRA Board to set capital buffers that move up and down to match the risk environment for the banking system as a whole, and individual banks within it.
Over time, stress-test participants should become increasingly able to anticipate broad movements in the annual cyclical scenario by monitoring developments in domestic and international credit and financial markets.
As the shape and severity of the scenario becomes more predictable, stress-test participants will be able to adjust their capital and business plans accordingly. In the 2015 Approach Document the Bank set out its plans to develop its capability to model system-wide dynamics.
As a first step towards this goal, the Bank has designed and applied a feedback and amplification model aimed at examining solvency contagion through interbank exposures (see Box 3 for further details).
Bank staffs are developing additional feedback and amplification models, which may interact with the new solvency contagion model to further enhance the Bank’s capability of assessing the resilience of the banking sector.
Timeline for the 2017 stress test
Consistent with previous concurrent stress tests, the balance sheet cut-off date for both the 2017 annual cyclical scenario and exploratory scenario will be end-2016. The Bank will publish the quantitative data associated with these scenarios on its website, along with an explanatory ‘Key Elements’ document around the end of 2017 Q1. The Bank intends to publish the results of the 2017 exercise in 2017 Q4.
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