Long awaited bank stress test results
Last week saw the release of the long-awaited bank stress tests for the UK banking system. This is the first ‘normal’ test following the Covid pandemic and the delay caused by the Russian invasion of Ukraine.
Cutting to the chase, all the banks tested passed without breaching their minimum capital requirements. The test itself, as is the way in the UK, was a tough one. It was more severe than the 2007-08 Global Financial Crisis, and in the words of the Bank of England “substantially more severe than the current macroeconomic outlook, as it combines increasing interest rates with considerably higher inflation than recent peaks, along with deep and simultaneous recessions in the UK and global economies with materially higher unemployment.”
To put some numbers on this
The banks had to model the following economic conditions, among others:
- UK average CPI inflation averaging 11% over the first three years of the test, peaking at 17%
- Household real incomes fall by 13% as a result
- UK Bank Base Rates rise to 6% in the first three quarters of the scenario
- UK GDP contracts by 5%
- Unemployment rises to 8.5%
- Residential property prices fall by 31%
- Commercial property prices fall by 45%
- Global GDP falls by 2.5%
In short, the stress test simulates a full head-on car crash for the both the global and UK economies. That’s the point of a stress test – to simulate an unlikely but plausible shock to the system, and to ascertain that the system has the capacity to continue to support the economy through lending and forbearance throughout.
So how did the banks fare?
The banks are tested against two key measures – their Common Equity Tier 1 ratio, and their leverage ratio. Technical banking jargon I know, but in essence the first of these, the CET1 ratio, measures capital strength considering the riskiness of individual loans, whereas the second measures capital strength against the balance sheet. Loans such as mortgages may be large, but as they are secured against real assets (property) tend not to lose very much money, in the event of default. Unsecured lending, such as on credit cards, is another story altogether!
Unsurprisingly, the above conditions are painful for a bank, any bank. Credit impairments (bad debts) are the main driver of losses. Improvements in balance sheets over the last few years have mitigated some of the worst impacts. House prices have risen making mortgages ever more secure, and regulation has ensured strict affordability standards, with the loan to income ratio tightly controlled. As a result, despite credit impairments costing 4.1% of the CET1 ratio, this is lower than in the 2019 test which saw a 5.2% hit.
Overall, after allowing for the benefits of higher interest margins, brought about by higher interest rates generally, and increases in expenses, influenced by inflation, the overall system ends with a CET1 ratio of 10.8%, and a leverage ratio of 4.7%. These compared to the regulatory requirements of 6.9% and 3.5% respectively.
The overall level of reduction in the CET1 ratio this year is 3.5%, a significantly lower figure than the 2019 result of 5.2%, strongly demonstrating the beneficial impact of better balance sheets and higher profitability.
No bank is required to improve its capital position because of the test, and at the low point in the test, the aggregate CET1 ratio is more than double the level before the Global Financial Crisis (GFC) even started.
Where does this leave us?
These results confirm our oft repeated assertion that the system today is unrecognisable from that before the GFC. Even some of the names are new! What these results demonstrate is that the system has the capacity to absorb substantial losses while still having the ability to continue to lend to the economy, and support customers that find themselves in difficulty. For shareholders there may continue to be strong dividends and share buybacks, and for creditors the strength of the businesses is, of course, a boon.
We continue to see value in the sector and view the events of March as idiosyncratic and unlikely to be repeated. Even the stress tests are doing less damage today to a strongly capitalized and resilient sector than in years gone by.