Credit: Jason Baker/Flickr

Stress tests: Is it possible to recession-proof banks?

The UK's major financial institutions all pass the Bank of England's stress tests, even if RBS and Standard Chartered only scrape through.

by Adam Gale
Last Updated: 07 Dec 2015

The City breathed a sigh of relief this morning after the country’s seven biggest financial institutions passed the Bank of England’s dreaded stress tests. Shares were up across the board, led by Barclay’s, which rose 4% to 232p by lunchtime.

Nobody likes exams, but count yourself lucky that yours never looked like this. Introduced last year, the central Bank’s stress tests involve subjecting banks to a hypothetical cascade of macroeconomic shocks to see whether they could survive without the need for a government bailout.

This year’s gruelling scenario was centred on a Chinese hard landing (with growth falling to a low of 1.7%) causing a further collapse in commodity prices and emerging market misery, coupled with $38 oil and a deflationary slump in Europe. As if that wasn’t enough, it imagined an extra £40bn in misconduct fines over the next five years. Presumably BoE governor Mark Carney thought bankers didn’t have enough pressure in their lives.

Though each bank is assessed individually to reflect its particular situation, the general idea is to have a high enough level of secure tier 1 capital (equity and retained earnings) given its exposure to risks to cover it in the event of the above doomsday scenario.

RBS and Standard Chartered both in fact technically failed to meet their targets based on their balance sheets at the end of last year, but the rather drastic ongoing restructuring programmes under Ross McEwan and ‘Nuclear’ Bill Winters respectively were sufficient to allay the central bank’s fears, for now.

Everyone passed then, but don’t crack open the caviar and champagne just yet. The financial system is not immune to the worst the global economy can throw at it, even if it is much more resilient than it was before the 2007-8 crisis.

It would be possible for the state to definitively recession-proof banks by requiring extremely high capital ratios, but doing so would greatly increase the costs of finance to the real economy. In effect, while the banks basically couldn’t fail, there would be a permanent credit crunch. Hardly ideal.

This is why Carney's Financial Policy Committee (FPC) has decided that the optimum Tier 1 ratio should be 11% - close to where most of the banks are now and significantly lower than the 18% thrown around at the international Basel Accords five years ago.

Carney justified this by pointing to the added security from new G20 requirements for the world’s biggest banks to have an especially high loss-absorbing capacity, greater supervision from the Prudential Regulation Authority (PRA) and the use of the countercyclical capital buffer.

That may sound like Dyson’s latest vacuum cleaning marvel, but it is in fact an attempt to make sure the banks only have to capitalise themselves to withstand high-risk conditions when it’s really necessary. In theory, this means the financial system should be secure without being so overburdened as to be ineffective.

The problem of course is that it depends on the FPC’s ability to predict rising risk levels accurately. One only needs to look back to the subprime bubble to see that this isn’t always possible – even the banks themselves didn’t understand the risks they were taking until it was too late.

With that in mind, it is interesting to note that Carney has the government’s buy-to-let programme in his sights. He welcomed the PRA’s intention to review underwriting standards and said 'the FPC will monitor developments in buy-to-let activity closely'.

Even if the authorities see one disaster coming, however, they can never be guaranteed to do it every time. Resilience is possible, yes, but indestructibility is a phantom. 

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