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
