The 2017 Bank Stress Test – introducing the BES
28 March 2017 by Eoin Walsh
The Bank of England released its assumptions for the 2017 annual stress test yesterday (key elements of the 2017 stress tests), the results of which will be published in Q4 2017. Yet again, the banks will be tested against an onerous set of scenarios, with the UK stresses being fairly similar to the 2016 version, although global stresses are more severe.
To summarise, some of the headline assumptions are, UK GDP falls by 4.7% (vs 4.3% in 2016), unemployment rises to 9.5% (same as 2016) and global GDP falls by 2.4% (vs 1.9% in 2016). UK residential property is assumed to fall by 33% vs 31% in 2016, while commercial property is assumed to fall by 40%, vs 42% in 2016. As regards widening in bond spreads, the real tightening seen in 2016 has been taken into account, so this year US Corporate bond spreads have been stressed to a widening scenario of 1,150bps, which is 100bps more than the 2016 version.
A further fall in the value of £ vs $ is also envisioned, with the rate hitting a trough at $0.85/£1, while base rates peak at 4% in the adverse scenario, compared to a cut to zero in 2016 – reflecting the trade-off between growth and inflation.
The aim of the stresses are to determine how the UK banking system would react to another severe downturn, with the hurdle rates being similar to 2016, and all banks being expected to meet minimum CET1 requirements and globally systemic banks being held to a higher standard.
The Bank of England has also introduced a Biennial Exploratory Scenario (BES) to “examine bank’s strategic responses to a structurally more challenging operating environment”. This is not a test on capital, but will focus on how “banks would meet regulatory requirements and build sustainable business models in the face of these headwinds”, i.e. can the banks remain profitable in an ongoing stressed environment? This is intended to help various committees to “understand and anticipate any potential changes in the financial system should the drivers of low profitability persist”, although it’s not clear if there are specific repercussions to failing this particular test.
The BES introduces various further scenarios, such as global trade volumes falling by a further 30%, with world trade to GDP falling to the lowest level since 2003. In addition, lower productivity halves global GDP growth to 1.9%, with Chinese productivity growth falling to 3.5% from 5.8%. UK base rates are cut to zero in year 1 and stay there for 10 years, while 10 year gilts yields are 1.25% by the end of the 10 year horizon.
Overall, the addition of the BES is a tough addition to the tests and the profitability of the UK banks in this scenario will be severely tested. The main test, as mentioned, is similar to 2016, with tough assumptions on growth rates and base rates, probably more akin to what we would expect from an emerging market economy, than the UK economy we have today. However, most banks should pass comfortably, as they did in 2016, although the tougher assumptions on global factors, particularly in Asia, could impact the results from HSBC and Standard Chartered.
Ultimately, banks will continue to be a conductor for global volatility, but for us, these tests should continue to show that stronger capital bases have increased the resilience of the main UK banks to global shocks, and for fixed income investors this increased confidence against default risk is all important. We now await the results of these new tests and the impact they will have on the individual lenders.
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