For the first time since it (belatedly) began conducting stress tests in 2014, none of the UK’s major banks need to raise additional capital. More importantly, the Bank of England and the system could withstand a disorderly Brexit. As Bloomberg recaps, "the stress-test scenario therefore encompasses a wide range of U.K. macroeconomic risks that could be associated with Brexit,” the BoE said. As a result, it "judges the U.K. banking system could continue to support the real economy through a disorderly Brexit."
This year’s stress tests, described as the toughest ever, were outlined by the Financial Times as follows:
In the stressed scenario, which the BoE said included a 50 per cent drop in US equity markets, a rise in UK unemployment to 9.5 per cent and a 33 per cent fall in British house prices, the capital levels of the country’s seven biggest banks fell from 13.4 to 8.3 per cent of risk-weighted assets. But the BoE said that since the start of the year, the banks have increased their average capital levels to 14.4 per cent. It added that capital levels have more than trebled since the 2008 financial crisis.
The stress test estimated that the UK banking system in aggregate would incur losses of £50bn within the first two years in this scenario. A decade ago, this would have wiped out its entire capital base. The tests assumed that the banks stopped paying bonuses, dividends and additional Tier 1 debt coupons. Five of the seven major banks, HSBC, Lloyds Banking Group, Santander UK, Standard Chartered and the Nationwide Building Society passed without reservations. As expected, the weakest banks were Royal Bank of Scotland and Barclays. While both failed the stress tests based on end-2016 data, they had increased capital via disposals during the current year.
The BoE did acknowledge that tough as they were, the stress tests did not reflect a worst-case scenario. Indeed, a hard Brexit in combination with “a severe global recession and stressed misconduct costs” could force them to drawn down their capital buffers substantially more – in which case lending to the broader UK economy would be damaged.
The BoE confirmed that would go ahead with an increase in the counter cyclical capital buffer in a year’s time when it will become binding. The 0.5% increase to 1.0% is a broader defence against macroeconomic risks. According to the FT.
The Bank of England is forcing UK banks to hold an extra £6bn in capital to guard against risks beyond that of Brexit, as it called on the UK and the European Union to introduce legislation to avoid a post-Brexit crisis in derivatives and insurance markets.
The BoE said on Tuesday that it is raising a special buffer half a percentage point, to 1 per cent, to lock in capital that banks are currently holding voluntarily. The aim is for lenders to better withstand against “material” macroeconomic risks beyond Brexit, such as global debt levels, asset valuations and misconduct costs.
The idea of the buffer is to force lenders to put aside more capital during good times to draw down upon in bad. At 1 per cent — which is the level the BoE considers to be the right level in a “standard” risk environment — lenders need to hold around £11.4bn in aggregate.
The banks have sufficient capital to cover the £6 billion increase, but will need to incorporate this new requirement within their regulatory capital buffers. The BoE’s Financial Policy Committee will review the adequacy of the capital buffer again during the first half of 2018 and the central bank warned that it could be raised again.
Turning to the tricky subject of Brexit, BoE Governor Mark Carney noted that if the UK left in a “sharp and disorderly” way, there would be “an effect on households and businesses; there will be some pain associated with that. This is about minimising that, dampening that.”
Carney also flagged other potential risks from Brexit. For example, the collection of insurance premiums from six million UK customers who have insurance policies with EU companies and 30 million European policy holders sending payments the other way. Then there’s the mind boggling £26 trillion ($34.6 trillion) of notional uncleared OTC derivative contracts, about a quarter of which the BoE says could be difficult for "financial firms to service". The central bank estimates that about £12 trillion of these contracts mature after 1Q 2019. According to the BoE, there is no precedent for moving such huge volumes of contracts into new legal entities.
"Each major dealer will have several thousand counterparties, with whom contracts will require renegotiation, potentially impacting tens of thousands of underlying clients. There are no precedents for these large-scale novations within an 18-month period. Effective mitigation of the risk, other than through a bilateral agreement, would require EEA states to legislate to protect the long-term servicing of existing contracts with UK counterparties and the UK government."
The FT commented on Carney’s plea for a transitional agreement.
Mr Carney told the press conference a transitional arrangement should be agreed — “the sooner the better”. The BoE would like an implementation period of at least 24 months, he added. Pushing a four-point action plan, the BoE repeated calls for lawmakers on both sides of the Brexit negotiations to agree a transitional arrangement. Regulators have previously said that an agreement needs to be in place by Christmas otherwise financial companies will start to launch their worst-case contingency plans.
He said the point of the check list was to “catalyse” action and to ensure that secondary legislation can be drafted and approved to deal with the vast amounts of derivatives contracts and insurance policies that are facing legal uncertainty. Both UK and EU legislation would be needed to ensure continuity, he added.
The BoE also warned that UK lawmakers needed to get a legal and regulatory framework in place so that after the so-called Withdrawal Bill, secondary legislation can be swiftly agreed, which deals with much of the detailed financial regulation on which the system depends.
So, Brexit and OTC derivative uncertainties notwithstanding, it all sounds rather reassuring with the BoE benchmarking the banks against its "toughest ever" stress tests. However, we are finding it difficult to overcome a couple of nagging doubts. Regulators are always backward looking and fighting the last crisis, rather than the next one. Furthermore, thanks to the intervention of Mark Carney and his colleagues, this credit bubble is considerably larger and more global than the previous one. Carney can worry about that another day, if he's still in the UK.