This is important for banks because:
It is proposed that banks would have to conduct three types of stress test annually:
- A set of common stress scenarios designed by the Bank of England;
- A set of bespoke stress scenarios designed by individual banks, and approved by the Prudential Regulatory Authority (PRA) Board; and
- A common baseline scenario designed by the Financial Policy Committee (FPC).
No details of these scenarios are included at this stage. It is also not known what standard banks will be required to meet, nor whether this will include a minimum leverage ratio as well as a risk-sensitive capital ratio.
A suite of models would then be used by the Bank of England and by the banks themselves to translate these scenarios into projections of bank profitability and capital ratios. This in turn would inform the judgement of the PRA in assessing the capital adequacy of individual banks, and of the FPC in assessing the adequacy of capital across the banking system.
Initially the framework will be applied only to the eight largest UK banks. But it is proposed to extend it to medium-sized banks, significant UK subsidiaries of foreign global systemically important banks, and central clearing counterparties in due course.
It is proposed that the stress test results and the policy and supervisory responses by the FPC and the PRA Board should be made public.
Higher capital requirements – banks will have to raise sufficient capital to meet "minimum international standards" even after the impact of stress tests. However, the Discussion Paper dismisses a 4.5 percent common equity tier 1 capital ratio (the Basel 3 minimum before any buffers are applied) as being far too low for this purpose and suggests at least a 7 percent ratio as a minimum starting point. A severe but plausible stress test could easily translate to banks having to meet a 10-12 percent capital ratio in order to provide sufficient headroom above 7 percent.
Leverage ratio – although not mentioned in the paper, banks may also be required to meet a post-stress minimum leverage ratio, just as in the capital adequacy assessment undertaken by the PRA earlier this year.
Uncertainty – it will be difficult for banks to undertake efficient and effective capital planning in a world in which both the PRA and the FPC formulate judgements based on multiple stress scenarios and multiple modelling of the results. Moreover, year by year changes to the scenarios, the models and the judgements will only increase the unpredictability and instability of capital requirements.
Cost – of the elaborate stress-testing processes and of raising sufficient capital to meet the judgemental requirements of both the FPC and the PRA.
Disclosure – the publication of bank-by-bank results may cause some excitement in the market, and banks that are deemed to be short of capital may find the cost and availability of funding moving against them.
To discuss the implications further please contact Giles Williams, Clive Briault or Steven Hall.