Bank of England to stress test banks every year

The UK’s biggest banks will undergo rigorous annual stress tests from 2014 to help avoid another financial crash.

The Bank of England has said it will stress test the UK’s biggest banks every year from 2014 in order to prevent another financial meltdown.

In a discussion paper,  the Bank has set out a framework designed to regularly put banks to the test to see if they can withstand the strain of severe, but plausible, worst case scenarios.

The stress tests will evaluate the impact of these scenarios on the capital position of banks individually as well as the system as a whole and the results will be made public.

The new regime is designed to avoid a repeat of the banking crisis of 2008 which led to £65 billion of taxpayer money being used to bailout the Royal Bank of Scotland and Lloyds Banking Group.

Institutions important to UK financial stability are to be included.

Initially eight major banks will be put to the test in March 2014; Barclays Group, The Co-operative Bank, HSBC Holdings Group, Lloyds Banking Group, Nationwide Building Society, Royal Bank of Scotland Group, Santander UK and Standard Chartered Bank Group.

But gradually the system will test all but the smallest lenders, including UK subsidiaries of foreign banks and central counterparties to ensure the same resilience standard across the board.

Preparing for the worst

The tests will revolve around capital adequacy, which measures whether a bank has enough cash to absorb losses from bad loans and still honour withdrawals.

There are international standards which dictate what capital levels banks are meant to keep to maintain this balancing act, but the stress tests will challenge how sufficient these really are.

Scenarios could include a housing market crash, a recession, a rise in unemployment, or external shocks which impact the UK like the Eurozone crisis.

UK banks have used stress tests for capital planning before, but there have been inadequacies which the new regime intends to stamp out, like poor design and banks being overly optimistic about how they will cope.

The new stress tests will involve a common scenario designed by the Financial Policy Comittee (FPC) which will be implemented system-wide, as well as bespoke scenarios tailored by individual institutions that need to be approved by the Prudential Regulation Authority (PRA) Board before go ahead.

Kicking the banks into shape

The Bank of England said the stress tests won’t be used to give pass or fail judgements on the health of banks.

Rather they will help the FPC and PRA - who are charged with regulating the sector and maintaining financial stability - to take action, like ordering banks to increase capital in specific areas or demanding management changes.

Should the capital adequacy fall short of the standard required in a crisis, banks might be forced to cut bonuses, issue shares or cancel dividends to strengthen capital levels. And if it can’t do these things it might lead to questions about how viable the institution is.

At the very least, banks will have to have sufficient capital to absorb losses in the stress scenario and not fall below internationally agreed minimum standards.

So banks might be required to hold more capital than the minimum international standard just to survive the stress tests, which could influence how much we can borrow and how much we have to pay for it.

Under construction

The stress tests are yet to be finalised.

The Bank of England hopes the discussion paper  will engage a broad range of parties to contribute suggestions to the final design before the first round of stress testing begins in March 2014.

In particular it is hoping to get views on  the level of detail needed to strengthen the credibility of the process, as well as views on the scenario designs.

You can help shape the stress tests by getting in touch via email: stresstestingdp@bankofengland.co.uk.

Comments will be taken until 10th January next year and the results of the first stress test will be available at the end of 2014

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