Stress testing the UK banking system: 2014, key elements

thumbnail of key-elements-of-the-2014-stress-test Original by Bank of England, 2014, 23 pages 

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Bank of England, April 2014

  • Stepping stone towards the medium-term stress-testing framework.
  • In co-operation with the European Systemic Risk Board.
  • the EU-wide test is intended to complement, not substitute, other supervisory stress tests
  • The ‘UK variant’ test will explore particular UK macroeconomic vulnerabilities facing the UK banking system at the current conjuncture vulnerabilities stemming from the UK household sector in particular;
  • use a dynamic balance sheet definition
  • use a suite of models to assess the impact of scenarios on firms’ profits and capital ratios, including firms’ own models as well as models run by the Bank
  • it is a coherent, ‘tail-risk’ scenario that is designed specifically to assess the resilience of UK banks and building societies, predominantly to a stress affecting the household sector.
  • surveys indicate that house prices are expected to increase further going forward
  • But the low interest rate environment can also pose risks to financial stability. For example, a sharp snap back in interest rates — especially if not accompanied by strengthening incomes —
  • Over 40% of respondents to the Bank of England’s 2013 H2 Systemic Risk Survey highlighted interest rate risk as one of the main risks to UK financial stability See Systemic Risk Survey: survey results 2013 H2,
  • UK household and corporate balance sheets are likely to be highly sensitive to fluctuations in property prices and sharp rises in debt servicing costs relative to incomes.
  • Hence, a key part of the stress scenario for the UK variant test examines the resilience of banks and building societies to a housing market shock and to a snap back in interest rates.
  • A particular feature of the UK mortgage market is that a large proportion of the stock of mortgages is on variable rates
  • To explore interest rate risks more fully, the UK variant stress scenario in 2014 assesses risks associated with a sharp rise in both short and long-term interest rates, thus complementing the EU-wide test.
  • the scenario involves both rising unemployment and a rise in income gearing due to higher interest rates
  • sterling falls by about 30% over the first year
  • The yield curve steepens in the early parts of the scenario and then flattens as Bank Rate is tightened
  • sharp contraction in economic activity
  • The contraction in economic activity is associated with a sharp pick up in unemployment
  • Real wages decline throughout the Scenario
  • Liquidity conditions in the market deteriorate as the supply of credit to the CRE
  • market is reduced.
  • Equity prices decline by almost 30% from 2013 Q4 levels and remain subdued, before starting to recover towards the latter parts of the scenario.
  • The fall in GDP in the scenario is also smaller than that assumed in previous stress tests conducted in the
  • United Kingdom. This is by design, reflecting the fact that the United Kingdom has already experienced a deep recession recently.
  • The falls in property prices in the stress scenario are consistent with a rapid deterioration in UK economic and financial conditions and a sharp rise in interest rates from very low levels. The
  • latter is a key feature of stress scenario, intended to explore vulnerabilities emanating from the current, unprecedented, episode of prolonged low interest rates.
  • Recent financial crisis was in the context of sharply falling interest rates, which — other things equal — would have acted to support housing valuations. The stress scenario, by contrast, involves a snap back in interest rates, both in the United Kingdom and globally,
  • Estimates from a simple dividend discount model of house prices attribute around three quarters of the assumed 35% fall in house prices to the sharp rise in interest rates in the stress scenario.
  • disposable income in the scenario are broadly similar to the experience of the early 1990s
  • A relatively unusual feature of the stress scenario — both with respect to UK historical experience and previous stress tests conducted in the United Kingdom — is that house prices fall by more than CRE prices.
  • As a result, estimated risk premia — as implied by conventional asset pricing models called ‘dividend discount models’
  • The baseline scenario will be the same as that used for the purposes of the
  • EU-wide stress test co-ordinated by the EBA
  • (eg dynamic versus static balance sheet)
  • The baseline macroeconomic scenario has been designed by the European Commission. It is, therefore, not consistent with the MPC’s forecasts for the economy as outlined in the Inflation Report.
  • Under the baseline scenario, the UK recovery continues to gain momentum. Real GDP growth accelerates, reaching annual rates of around 2.5% in both 2014 and 2015, before moderating somewhat in 2016. Unemployment continues to decline, though at a more gradual rate than in the recent past. By 2016, the headline unemployment rate falls to an annual average of 6.4%. Annual CPI inflation remains close to the
  • MPC’s target of 2% throughout the projection horizon. As economic conditions improve, long-term interest rates gradually start to revert to more normal levels. The steady economic recovery and increasing confidence is also reflected across a range of asset prices. House prices continue to rise, growing by about 5% in both 2014 and 2015, before decelerating somewhat in 2016. In cumulative terms, house prices rise by about 14% over the entire projection horizon.
  • The commercial property market also sees continued growth. CRE prices rise by about 4% in 2014 and 2015, before growth moderates somewhat. In cumulative terms, CRE prices rise by around 12% over the entire projection horizon.
  • A key threshold for the UK variant test will be set at 4.5% of risk-weighted assets (RWAs)