UK bank 'stress tests' becoming increasingly complex, says expert

Announced last year, the new test will be carried out every other year and will be based on the anticipated effect of longer-term economic stress on the UK's largest banks. It is focused on how, rather than whether, banks would meet their regulatory requirements and maintain their business models in a world of weak global growth and persistently low interest rates, lasting over a seven-year period.

The exploratory test will "complement" this year's cyclical stress test, which is designed to ensure that the UK's banks hold significant capital to absorb losses and continue lending under a severe stress scenario. That scenario, which has now been published by the Bank of England, reflects reduced demand from foreign investors for UK assets, a fall in the value of sterling and an increase in the central 'bank rate' of interest.

Separately, the central bank's Financial Policy Committee (FPC) published its latest assessment of the overall level of risk to the UK's financial stability. It has announced a new review of the credit quality of new lending to consumers in response to historically high levels of lending, and has also asked firms to provide it with their "comprehensive plans" to adapt to the UK's withdrawal from the European Union.

Banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, said that the testing matrix was "becoming more complex for both financial institutions and regulators".

"It is interesting to note the current focus for stress testing to include local geo-political issues such as Brexit, in addition to pan-European and global financial issues," he said.

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

The 2017 stress tests will be applied to the UK's seven largest banks and incorporate the same stressed outcomes for UK activity and unemployment as last year, as there was no need for an adjustment, according to the Bank of England. However, the global aspect of the test is tougher than in 2016, in order to better reflect the continued rapid growth of credit in China and a downturn in foreign investor demand for UK assets driven by the UK's "large current account deficit", it said.

Banks will be expected to meet their minimum Common Equity Tier 1 (CET1) capital requirements, which averaged 6.5% in 2016, once the stress scenario is applied, with higher standards applicable for the largest and most important 'globally systemic' banks. The Bank of England will generally require those banks that fail to meet these standards to take action to improve their positions, as in previous years.

The Bank of England expects to publish the results of this year's stress tests in November.