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)
