Britain's financial regulator is resuming its stress tests of the country's largest banks and said it will apply an economic shock greater than the 2008 financial crisis – but after the market turmoil of recent days the health check may not be going far enough to test the potential pain from interest rate rises.
The Bank of England will return to its annual cyclical scenario stress test this year, and will release results in summer 2023. Its last ACS test was in 2019; there have been two years of pandemic-related stress checks and testing was postponed in March following Russia’s invasion of Ukraine. The BoE said the 2022 ACS will test the resilience of UK banks to deep recessions in the UK and global economies, large falls in asset prices, higher global interest rates and trading losses for investment banks.
But it may not be stressful enough after Britain's two-year Gilt yield surged more than 100bp in two days and sterling slumped to an all-time low on Monday against the dollar after new UK finance minister Kwasi Kwarteng on Friday announced a raft of tax cuts backed by huge increases in borrowing.
Under the adverse scenario in the ACS stress test, UK bank rates rise to 6% in the first quarter of 2023 and then gradually reduce to below 3.5%. But markets are signalling rates will jump to 5.7% in February and hit 6% in March and remain there through the year, and forward rates implied by Sonia futures suggest they will remain above 6% until September 2024. That compares to expectations in August that rates in 2023 would peak at 2.75%.
"The market is already pricing in rates going to c. 6% in early 2023 (and beyond that level through the remainder of the year), which, in our view, calls into question the credibility of the ACS as a true stress test to the extent that this element in the scenario is maintained," said John Cronin, analyst at Goodbody.
The ACS also does not include any impact from sterling weakness in currency markets, with the level against the dollar and euro assumed in the scenario to be flat. Sterling plummeted to US$1.0327 on Monday. It had stabilised to US$1.0817 on Tuesday, but it is still down 20% against the greenback this year.
Although a weak pound could cause pain in some areas, it is higher interest rates that could spark a jump in defaults by UK households and businesses, which could substantially ramp up losses for banks.
Lloyds Banking Group and other lenders have temporarily withdrawn and repriced mortgage offers for customers due to the market volatility of recent days, reflecting expectations the Bank of England will continue to increase rates and underscoring concerns about the impact on households.
Eight firms will be tested in the ACS – HSBC, Lloyds, Barclays, NatWest, Standard Chartered, Santander UK, Nationwide Building Society and Virgin Money.
Positive factors for banks are that their credit assessment models and testing of affordability are far superior than when the financial crisis hit in 2008, and there are far fewer high loan-to-value products in the market, bankers said. Banks typically test affordability based on the standard variable rate plus three percentage points, so in recent months that would have tested if they could afford a rate of 5%–6%. About 90% of new UK borrowers are also now on fixed-rate mortgages, so the pain only lands when they have to remortgage, and there has been a trend to have five-year deals from two years previously.
The BoE and Prudential Regulation Authority will use the ACS test to assess balance sheets and how well banks can withstand potential losses. Regulators will use the results to assess the capital buffers banks need, and whether any of them need to strengthen their capital position.
The 2022 ACS will cover a five-year horizon, starting at the end of June 2022. This year's test will for the first time assess the impact of higher global interest rates, due to the threat of cost shocks and high and persistent inflation around the world. It takes into account potential trouble spots such as US corporate borrowing, euro area vulnerabilities from high public debt levels, and exposure to China and Hong Kong property lending.
The BoE said its stress scenario is more severe than the global financial crisis for the UK and the world. UK GDP contracts by 5% in its adverse scenario and world GDP contracts by 2.5%. UK unemployment rises to 8.5%, residential property prices plunge by 31% and the UK stock market crashes 45%.
Investment banks also have to take losses, which the BoE said takes into account the liquidity of trading book positions. Under the ACS, banks have to apply a price shock to their market risk positions as of July 8. It will capture risks from leveraged lending and examine the ability of banks to withstand the default of seven potentially vulnerable counterparties.
Corporate bond spreads widen in the stress test. The spread between the yield on investment-grade corporate bonds and risk-free interest rates increases to 419bp in the UK from 171bp, and in the US they rise to 574bp from 141bp. For high-yield bonds, spreads increase to 1,953bp in the UK from 541bp, and to 1,695bp in the US from 434bp.
The BoE said consumer price inflation increases sharply in the stress scenario, and annual UK inflation averages around 11% over the first three years. Commodity prices increase sharply, and oil prices jump to an average of US$160 per barrel in the third quarter of 2022 before falling back to below US$100.
Updated story: Updates implied interest rates, details on bank credit testing paragraph 4 and 10