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Bank of England stress test approach will bring 'more intrusive supervision', says expert

The Bank of England has published details of its approach to stress testing the UK's banking system over the next three years, including the introduction of an annual cyclical scenario that will link the severity of the test to developments in financial markets.21 Oct 2015

These tests will "bring even more intrusive supervision to the market," said financial regulation expert Michael Ruck of Pinsent Masons, the law firm behind Out-Law.com.

The stress test will be more severe in an upswing, such as when growth in credit is rapid or asset prices are high, the bank said.

The bank will also investigate risks unrelated to the financial cycle, with a twice-yearly look at emerging or latent threats to financial stability or individual banks, it said.

Clear 'hurdle rates' will be set for each firm, setting minimum capital requirements, and extra requirements will be added for globally systemic banks.

"Banks will be forced to employ extra resources to deal with these tests, and the impact on their share price and reputation could be severe if significant issues are highlighted," said Ruck.

A stress test is designed to examine the potential impact of a hypothetical adverse scenario on the health of the banking system and individual institutions within it. In doing so, stress tests allow policymakers to assess banks’ resilience to a range of adverse shocks and ensure they are adequately capitalised, not just to withstand those shocks, but also to support the real economy if a stress does materialise, the bank said.

The approach announced today has been developed based on lessons learned from previous stress tests in 2014 and 2015, and on feedback to a discussion paper published by the bank in 2013, it said.

The stress test will cover banks with total retail deposits greater than £50 billion, which will effectively mean the same set of firms covered in the 2015 test. UK subsidiaries of foreign-owned investment banks will not be brought into the test this time, but that will be kept under review, the bank said.

The bank plans to develop its own modelling capabilities to improve its ability to challenge banks' own results and build feedback from across the banking system in its test results.

Mark Carney, governor of the Bank of England said: "The United Kingdom needs banks than can weather shocks without cutting lending to the real economy. Our first concurrent stress tests run in 2014, centred on the housing market, gave us assurance that the banking sector as a whole was well-placed to withstand such a severe scenario. We have also recognised however the need for our approach to evolve."

"The Bank of England is taking steps to ensure we can assess a range of future risks from a number of different sources to inform our micro- and macro-prudential policy decisions. Our approach embodies a comprehensive and detailed approach, a desire to deepen and strengthen our analysis, and the flexibility to respond to changing risks," he said.

The stress testing framework is likely to evolve further to reflect regulatory developments, including structural reform of the banking sector, the bank said.

The bank is running stress tests on Barclays, HSBC, Lloyds, Royal Bank of Scotland, Santander, Standard Chartered and Nationwide in 2015. The Co-operative Bank, which failed similar tests in 2014, is not being tested this year as it is now too small to "have a material impact on the resiliences of the financial system", the bank said in March.

The Bank of England will publish the results of the 2015 tests alongside its annual Financial Stability Report in December.

The European Banking Authority (EBA) announced in March that it will not run its own stress tests in 2015, but was instead planning to run a 'transparency exercise' to gather data on banks' balance sheets and portfolios. This would be similar to an exercise run by the EBA in 2013, it said. The authority published a 'tentative' list of banks to be included in this exercise in July.