Advanced Operating Models
Aug 01, 2016

Key elements of the 2017 UK Stress Test

The Bank of England (BOE) has published the stress testing scenarios for 2017 for the banking industry. 2017 stress test requires banks to report on Biennial Exploratory Scenario (BES) in addition to the Annual Cyclical Scenario (ACS). Stress scenarios for 2017 reflect the increased concerns on global vulnerabilities, with rapid Chinese credit growth as a daunting factor.

The Annual Cyclical Scenario (ACS) for 2017

Some of the most significant points of the 2017 ACS are:

  • The peak-to-trough fall in global GDP in the scenario is 2.4% in 2017, which is larger than the 1.9% fall postulated in the 2016 scenarios. Similarly, Chinese GDP also falls by a larger proportion in the 2017 scenario relative to that in the 2016 scenario
  • UK GDP falls by 4.7%, which is also larger than the 4.3% fall in the 2016 ACS
  • The scenario for unemployment is the same as in 2016 scenario — the peak is 9.5% during Q2–Q4, 2018
  • On the asset prices side, the shock for US bond spreads is higher in 2017 as compared to that in 2016
  • The percentage decline in commercial real estate (CRE) prices in 2017 ACS is smaller than that in 2016 — this can be largely attributed to a decline in CRE prices in 2016
  • The Sterling exchange rate index falls (depreciates) by 27% relative to its Q4 2016 value
  • The bank rate is assumed to peak at 4% in the 2017 scenario, which is different from the 2016 scenario in which it was cut to zero

Other than the above, the ACS will continue to include stressed misconduct costs (due to fines, etc.), which will have to be included by banks in their projections.

The hurdle rates (common equity tier 1 capital requirements)in 2017 scenarios have been set on the same basis as in the 2016 test. Hurdle rates in 2016 varied between 6.1% and 8.1% because the requirements included Pillar 2A charges, which vary across banks.

In addition to the hurdle rates, banks must also meet a minimum Tier 1 leverage ratio threshold. A maximum of 25% of the threshold may be comprised of Additional Tier 1 capital (AT1). In July 2016, central bank reserves were excluded from the leverage exposure measure, so it is expected that the framework will be adjusted soon to offset the effect of this exclusion.

For Global Systemically Important Banks (G-SIBs), results will be judged against a “systemic reference point." These buffers, to be phased in between 2016–19, will eventually range between 1–2% of risk-weighted assets (RWA), to be met with CET1 capital. G-SIBs will also have an additional buffer of 35% of their corresponding risk-weighted capital buffer — to be met with Tier 1 capital.

Policy Responses: Banks falling below their hurdle rates or systemic reference points will have to take action to strengthen their capital positions, if they have not done so already. The Prudential Regulation Authority (PRA) may require banks to further strengthen their capital positions even if they do not fall short of the regulatory thresholds. The PRA and the Financial Policy Committee (FPC) may adjust the regulatory buffers, including the counter cyclical capital buffer (CCyB) ratio, sector-specific capital requirements, and the bank-specific capital buffer, in response to the results of the stress tests and other relevant information.

The results of the 2017 ACS will be published in Q4 2017.

The Biennial Exploratory Scenario (BES) for 2017

This is the first time that the Bank of England has included the BES in addition to the ACS in its stress testing framework. The BES is calibrated to a 10-year period while the ACS is calibrated to a 5-year horizon. The purpose of this scenario is not so much to test capital adequacy (which is the aim of the ACS), but to find out more about banks' possible strategic responses to persistent stress, which may shed light on future developments in the UK banking system. The BES attempts to explore strategic changes that large banks might make to their business models, examine banks' decision-making capabilities, and test their ability to consider a structurally more challenging environment. Some of the key details of the BES are as follows.

  • The BES scenario envisages profitability persisting at low levels for a long period of time. This scenario is therefore different from the average actual expectation that profitability will improve in the near term
  • Global trade volumes are hypothesized to be 30% below the level implied by a continuation of the pre-crisis trend. This is accompanied by a reversal of financial globalization
  • Slower productivity growth results in a 50% cut in global GDP growth to 1.9%. Therefore, return to capital and interest rates both remain at very low levels. Emerging markets face a marked slowdown
  • Cross-border banking activity declines, consistent with weak global growth and trade prospects. Demand for cross-border lending and demand for trade finance, both remain low
  • The UK bank rate is cut to zero in the first year of the scenario and remains low thereafter. Long-term interest rates remain low as well
  • Competitive pressures intensify, resulting in a decline of around 40% in the deposit-lending rate spread, relative to current levels

Expectations from Banks: The exploratory scenario has been calibrated for ten years, beginning in 2017 Q1, and extends through to 2026 Q4, but banks are expected to report on the results for the first seven years. The remaining three years have been provided to help banks generate their results. In addition to the above, misconduct costs, costs of cyber security risks, and IT investments will also need to be incorporated in the results. Banks should aim for overall return on equity to meet or exceed the costs of equity. Minimum capital requirements and regulatory buffers should be met by the end of the seventh year of the scenario.

Policy Response: BES does not constrain banks with range of management actions they can take in response to the scenario (as opposed to the ACS, where banks need to show actions they will take to keep capital above required thresholds); therefore, the results of the BES are expected to help the regulators assess the likely changes in the UK banking system in the given scenario of persistent low profitability.

For the BES, aggregate results will be published, including implications for future resilience of the banking sector.

About the author

Sadanand Tutakne

Sadanand Tutakne

Assistant Vice President, Risk Analytics

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