Stress testing the UK banking System: 2015 key elements

Original by Bank of England, 2015, 17 pages 

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Builds on the 2014 stress test approach but extends it with the following:

  • Include global as well as domestic risks
  • Traded risk scenario
  • Leverage ratio threshold as part of a hurdle rate framework

Context to stress against in 2015

  • Euro zone area is nearly 50% of UK exports
  • Moderation of China growth in accordance with the IMF world Economic Outlook (WEO)
  • large current account deficits in a number of emerging market economies exposed to rapid capital outflow
  • market liquidity may not have reached a new equilibrium
  • 2015 concentrates on further deterioration of global nominal growth

Qualitative difference between 2014 and 2015 stress test

  • 2015 assesses resilience to a difference set of risk relative to 2014
  • Principally focused on the resilience to severe financial market shocks (rather than houeshold market shock)
  • Previously UK banking system assessed against a single global state of the world.
  • Focuses on exploring vulnerabilities stemming from the rest of the world rather than domestic risk. 2014 concentrated on stressing the UK housing market
  • 2015 explores deflationary macroeconomic environment associated to reduction in bank rate and extraordinary monetary policies. 2014 included inflation shock in the UK only and associated monetary policy
  • 2015 concentrates on UK domestic corporate exposures which were identified in 2014 as a key area of focus. 2014 was more on UK household sector.
  • Hit to economic activity is highest ok Euro zone and emerging markets
  • Incorporates a traded risk scenario designed by the bank of England. 2014 applied the EBA methodology.
  • Traded risk scenarios designed to be consistent in both severity and geographic impact with the macro-economic stress scenario
  • 2015 test scenarios test bank’s ability to withstand default of a number of counterparties

Requirements

  • Risk capital threshold i.e. hurdle rate set at 4.5% of RWA to be met with common equity Tier 1 (CET1)
  • CET1 set at 3% of the leverage exposure measure to be met with Tiers 1 capital where relevant additional Tier 1 instruments would be permitted to comprise 25% of this requirement.
  • Banks are not assumed to reduce the flow of lending as a means of preserving capital through changes in prices relative to their funding costs or through non-price terms. Has to reduce organically. Guidance has been provided to banks ion their balance sheet modelling.

Scenario broadly speaking

  • World GDP is a useful metric to gauge severity of shocks to activity
  • Key objective of stress testing is to explore events that have not happened in recent history but may nevertheless be judged possible macroeconomic outcomes.
  • Inspect UK GDP history from 1871 on !
  • For other countries than UK, decline in activity is within historical experience. Nevertheless comparison to these historical outturns is a useful gauge of the scenario’s severity
  • Downturn in Euro area is more prolonged relative to other advanced economies
  • Introduction of coordinated shocks across countries
  • IMG found that factors such as heightened uncertainty and wake up calls that changed investor’s perceptions in addition to financial interlinkages were important in explaining comovements during the 2008 crisis
  • Two particularly important variables that affect overall severity are unemployment and property prices
  • Residential and commercial real estate prices often comove during crises
  • Downturn in housing markets are highly synchronised across coutnries (Claessens, Kose and Terrones – 2011)

Key factor scenarios (non-exhaustive, only key elements mentioned)

  • Longer time horizon than 2014 stress test
  • reduction in commodities prices
China
  • The renminbi is allowed to depreciate 10ç% against US dollar by 2015 Q4
  • SHIBOR interest rate initially rise sharply and peak in Late 2015
  • Chinese property market at 365% below their level at end 2014 through 2016
  • Falls in commercial property prices more pronounced
  • Sharp falls in real estate investment and industries associated with construction
Euro zone
  • Output growth slows due to combination of international spillovers and domestic amplifications
  • Domestic consumption and investment fall.
  • real GDB goes down to -2.1% in 2016 Q1
  • Aggregate GDP growth turns positive in 2017
  • Inflation turns positive in 2018 but subdued until end of scenario
Emerging market
  • Downturn in economic activities especially those with ties with China
  • Investors demand higher risk premia on foreign borrowing triggering sharp slowdown in capital inflows
US
  • Suffers spillovers from the global slowdown
  • Less affected than some other regions as considered a safe-haven for capital
UK
  • output growth turns negative in 2015 Q3 as export demand falls sharply and spillovers from confidence effects
  • Inflation turns negative for the first 7 quarters, Largest fall in the price level for over 80 year