Banking News

Brexit risks added to Bank of England’s stress tests

(30 March 2017 – United Kingdom) England’s central bank will place the UK’s biggest lenders to a stress test against a deep economic slump and a sharp depreciation of the pound as the country prepares for the impact of withdrawal from the European Union.

While the Bank of England didn’t specifically target Brexit by name in its 2017 health-check scenarios, it said risks to financial stability will be influenced by the “orderliness” of that process.

UK banks must submit their contingency plans to the BoE’s Financial Policy Committee for approval and oversight, as the regulator seeks to ensure the supply of credit won’t be disrupted even if firms lose untrammelled access to the single market.

In the simulation, which covers seven UK banks, including HSBC Holdings and Barclays, UK output plunges 4.7 percent. The regulator flagged “rapidly” rising household debt as a concern, and began an investigation into the quality of new consumer lending. The tests spans the five years to 2021.

Other lenders covered by this year’s test are Lloyds Banking Group, Nationwide Building Society, Royal Bank of Scotland Group, Santander UK and Standard Chartered. The seven firms account for about 80 percent of the outstanding stock of lending by banks supervised by the BoE’s Prudential Regulation Authority.

It reflects the BoE’s judgement that global risks are “elevated and have increased somewhat over the last year,” while “underlying domestic vulnerabilities” are “broadly unchanged” from last year’s exercise.

This means the peak-to-trough decline in global gross domestic product is minus 2.4% in the 2017 test. While the UK contraction is slightly more severe than last year’s test, the impact on unemployment is the same — a rise to 9.5%. The scenario also foresees a 5% inflation rate by the end of 2018 and banks paying billions more in misconduct fines and settlements.

Prime Minister Theresa May plans to trigger departure talks in a letter to other EU leaders, which will start a two-year negotiation period before the UK formally departs.

The BoE said the resilience of the UK financial system depends in part on standards applied elsewhere. The BoE said standards in other jurisdictions should “at a minimum” be “consistent with agreed common international baseline standards.” This could become an issue after the UK quits the EU.

This year’s stress test will be the first to include an “exploratory” scenario in addition to the annual cyclical scenario. It is designed to assess the resilience of the system to risks that may not be “neatly linked” to the financial cycle, according to the central bank.

The separate seven-year test will ask banks to detail how they’ll change their business models  should returns remain stagnant below the cost of equity (around 12 percent). BoE Governor Mark Carney has said shrinking profitability is a “concern for financial stability” because it may reduce banks’ ability to recover from shocks by generating capital or selling stock.

The scenario “will consider how the resilience of the UK banking system might evolve if recent headwinds to bank profitability persist and intensify” due to low growth, low rates and persistently high costs, the BoE said.

At the same time, competition heats up in the retail deposit market from non-bank entrants driven by technology, putting “significant pressure” on banks’ profits. The BoE will not publish firms’ responses because they will contain sensitive information, such as potential country exits or business closures.

Results of the annual test will be published in the fourth quarter.