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Not Stressed About Stress Tests

27 November 2017 by Mark Holman

Tomorrow the Bank of England will publish its annual stress tests results for the UK banking system. Naturally, we will be scrutinising the report, although we are not expecting the results to change our minds on the credit worthiness of the UK financial system. The stress tests tend to be headline grabbing because of the significant capital erosion that the banks could experience as a consequence of the doomsday scenarios that the PRA sets for them.

The most important thing I would say about these stress tests is that they are not a forecast of what is realistically going to happen. The PRA are testing the banks’ resilience to sets of circumstances that are even more punitive than during the global financial crisis; and they expect the banks to not only survive them but also to continue lending to the economy.

Banks that do not fare well in the tests will be asked to submit plans to improve their creditworthiness. This is a good thing, although shareholders may not think so as their capital can be diluted as the banks further strengthen their buffers. From a creditor or customer standpoint though, the tests just make the banking system safer. We can say unambiguously that our banking system is the safest it has been in the modern era, and tomorrow’s stress test results should be welcomed by the investor community.

By comparison, there would be a large number of well-rated corporates that would struggle, and possibly even default, as a consequence of facing a 5-year period that the current bank test envisages. The scenario includes a period whereby, for example:  peak to trough global GDP declines by 2.4% and UK GDP falls by 4.7%; UK residential property prices fall by 33% and UK commercial real estate declines by 40%; STG declines to just $0.85; US High Yield bonds spreads widen by 1150 basis points; and, interest rates rise to 4% rather than fall as the UK struggles with imported inflation and current account deficit.

From a fixed income debt holders’ perspective this test should be welcome as it gives investors a high degree of comfort, even at the AT1 or Coco bond level of the bank capital structure. It is worth remembering that all bonds are ultimately bail-inable (i.e. Coco-like) not just bank bonds which carry the moniker; so don’t let the label frighten you. Imagine how many high yield bonds would be converting to equity or being restructured with rising rates plus 1150 basis points of spread widening which takes the cost of their debt close to 20%.

AT1 spreads may have tightened a lot in 2017 as this nascent sector slowly becomes mainstream, but we think it is one of the few sectors where spreads have further to compress in 2018.

There is also a second test this year that covers another scenario, much less of a shock but more of a long term trend of declining profitability in an ultra-low rate environment, with ever slowing growth and increased competition. The purpose of this test is to see how banks can adapt their business models and continue to lend to the real economy, rather than monitor their capital levels over the ten year horizon that this test covers. An interesting and maybe much more likely scenario for us to monitor.

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