OREANDA-NEWS. Today, the Bank of England is publishing the scenario for the 2015 stress test, which will be applied to the largest UK banks and building societies. The scenario has been agreed by the Financial Policy Committee (FPC) and Prudential Regulation Authority (PRA) Board.

The purpose of the test is to ensure that the UK banking system can withstand a severe shock and continue to provide financial services to the real economy. It ensures that the UK financial system is one that absorbs rather than amplifies shocks. Stress testing makes up one of the three pillars of the Bank of England’s framework to assess capital adequacy, alongside risk-weighted capital requirements and a leverage requirement.

The 2015 stress test will assess the resilience of the UK banking system to a deterioration in global economic conditions. The stress scenario is not a forecast of macroeconomic and financial conditions in the United Kingdom or other countries, nor is it a set of events that is expected, or likely, to materialise. Rather, it is a coherent, ‘tail-risk’ scenario that has been designed specifically to assess the resilience of UK banks and building societies to a severe shock.  

This year’s stress scenario incorporates the following elements:

  • A synchronised global downturn affecting Asia and the euro area in particular, and amplifying global disinflationary pressures;
  • severe financial market stress with a reduction in global risk appetite, particularly in indebted economies, reductions in market liquidity, and some defaults of counterparties; and
  • a slowdown in the UK driven by the downturn in its trading partners, fall in confidence, and correction in market risk appetite. Additional monetary stimulus is pursued in the UK and elsewhere, lowering and flattening yield curves.

Banks’ performance in the stress scenario will be reviewed against two key capital adequacy thresholds: a 4.5% CET1 risk-weighted capital ratio and a 3% Tier 1 leverage ratio. Up to 25% of Tier 1 capital can be met using relevant additional Tier 1 (AT1) instruments.

The results will inform the PRA and FPC’s judgements respectively on the capital adequacy of individual institutions and on the resilience of the banking system as a whole.

As in the 2014 stress test, if a firm’s capital ratio is projected to fall below the 4.5% CET1 threshold in the stress, there is a strong presumption that the PRA will require the firm to take action to strengthen its capital position. If a firm’s leverage ratio is projected to fall below the new 3% Tier 1 leverage ratio threshold, there is also a strong presumption that the PRA will require the firm to take action to strengthen its capital position. However, depending on the outcomes for specific firms, the PRA may still require action to strengthen capital positions even if the thresholds are met. To determine whether action is needed, the PRA will examine capital adequacy, the adequacy of recovery and resolution plans and the extent to which potentially significant risks are not quantified adequately or fully as part of the stress.

If the exercise reveals inadequate resilience at the level of the system, the FPC will consider a variety of actions, depending on the sources of potential risks, including recommendations to the PRA and Financial Conduct Authority.

The Bank of England will publish the results of the 2015 stress test alongside the Financial Stability Report in December.

Mark Carney, Governor of the Bank of England, said:

“Last year’s stress tests demonstrated how much stronger the core of the UK financial system has become since the financial crisis. The results showed that the post crisis reforms have put the UK banking system on a stronger footing and made it better able to support the real economy even in the face of a major domestic shock. This year’s test will have a different focus and is equally important. By assessing the resilience of the UK banking system against a major external shock, we will improve further our ability to identify vulnerabilities and we will ensure that banks have plans in place to address a wider range of possible stresses.

“As a forward looking regulator our job is never complete. Our focus is clear. To promote the good of the people of the United Kingdom, we are committed to ensuring that our major banks are resilient, that they can weather shocks without calling on taxpayer support, and that they can continue to lend even in adverse conditions. This year’s stress tests will build on last year’s work and advance our medium-term stress testing framework.”