Leveraging Up on Bank Stress (I): the Bank of England’s Leverage Ratio Stress Test

(For the previous posting in this series, see here.) This posting goes through the Bank of England’s stress tests of UK banks’ leverage ratios – roughly speaking, their ratios of capital to leverage exposure. The banks perform poorly according to this test even under the very low 3% pass standard used by the Bank. Moreover, almost all banks fail the test under the higher minimum standards called for under Basel III when it is fully phased-in – and even those pass standards are much lower than they should be. These results confirm that the UK banking system is in very poor shape.

In an earlier posting, I suggested that the leverage ratio – the ratio of bank capital to its leverage exposure – is a better capital adequacy metric than capital ratios that use a denominator expressed in terms of Risk-Weighted Assets (RWAs). This is because the leverage exposure is a more reasonable and much less gameable measure than the RWA measure.

In this posting, I will go through the Bank of England’s second stress test – the test based on the Tier 1 leverage ratio, i.e., the ratio of banks’ Tier 1 capital to their leverage exposures. The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 3%: a bank passes the test if its Tier 1 leverage ratio post the stress scenario is at least 3%, and it fails the stress test otherwise.

The outcomes for this stress test are given in Chart 1:

Chart 1: Stress Test Outcomes Using the Tier 1 Leverage Ratio with a 3% Pass Standard

charts ab
charts ab


(a) The pass standard is the bare minimum requirement (3%), expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure.

(b) The outcome is the Tier 1 leverage ratio post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

By this test, the UK banking system looks to be in pretty poor shape. The average outcome across the banks is 3.5%, making for an average surplus of 0.5%. The best performing institution (Nationwide) has a surplus (i.e., outcome minus pass standard) of only 1.1%, four (Barclays, HSBC, Lloyds and Santander) have surpluses of less than one hundred basis points, and the remaining two don’t have any surpluses.

You should also keep in mind that this 3% pass standard is itself a very low one. Despite its pretensions to impose tough new capital standards, Basel III still allows banks to fund up to 97% of their leverage exposure by borrowing and to have as little as 3% equity to absorb losses. Thus, if a bank has a leverage ratio of 3%, then it only takes only a loss equal to 3% of that leverage exposure to wipe out all its equity capital and render it insolvent.

Basel III’s minimum capital requirement is also way below the capital standards maintained by non-financial corporates, which only rarely have capital ratios below 30%.

In any case, the Basel 3% minimum requirement would not have helped had it been in place before the financial crisis: by 2007, UK banks’ average capital to asset ratios had fallen to just under 4% - still above the Basel III minimum, but not enough to prevent the collapse of the UK banking system.[1] There is, therefore, no reason to expect that such a minimum capital ratio would protect the system in the face of a recurrence of the recent crisis.

Going back to our stress test, you have an easy exam with a very low pass standard, and yet the UK banking system barely scrapes through, if even that.

It is also curious that the two weakest banks hit the pass standard right on the nose: had the stress been even a smidgeon more severe, they would have failed the test. It is almost ‘as if’ the stress test had been deliberately engineered to ensure that the adverse scenario was as adverse as it could possibly be without actually pushing any bank over the edge.

To be clear: I am not suggesting that the good folks at the Bank would even dream of fixing their stress test to produce such an outcome. But I am saying is that it is quite a coincidence to get not just one but two banks whose post-stress outcomes just happen to come out to be exactly equal to the pass standard.

Be all this as it may, the Bank’s assessment was much more upbeat than any Jeremiad of mine. Regarding the five best-performing banks (i.e., the ones that actually got a surplus) it reported that the PRA Board had judged that the “stress test did not reveal capital inadequacies” for these banks and saw no need to mention that their surpluses were rather on the small side – 0.3% for Barclays, 0.4% for Santander, 0.7% for HSBC, 0.9% for Lloyds, and only 1.1% for the star of the class, the Nationwide.

As for the two dunces that got surpluses of exactly zero in the leverage ratio test, the PRA Board carefully noted that their capital positions remain above the threshold CET1 ratio of 4.5% and meet the leverage ratio of 3%”. Nice choice of words.

Despite their capital inadequacies, these two then got off with of a slap on the wrist from the PRA and their capital plans were approved.

The Bank’s overall assessment was then this:

The stress-test results suggested that the banking system was capitalised to support the real economy in a global stress scenario which adversely impacts the United Kingdom, such as that incorporated in the 2015 stress scenario.[2]

Personally, I would have slightly re-edited this statement to read as follows:

The stress-test results suggested that the banking system only just managed not to fail the test under the 2015 stress scenario and obviously we cannot draw any conclusions about whether the banking system would have passed the stress test under any other stress scenarios that we did not consider.

It might also have pointed out that the banking system would have failed the stress test if the stress scenario had been more adverse or if the hurdle had been even a little higher.

There is another problem as well. The 3% pass standard assumed in this test took no account of the additional leverage ratio requirements that will be phased-in under Basel III: these are the additional leverage ratio requirements corresponding to the Counter-Cyclical Capital Buffer and Globally Systemically Important Institutions Buffer. If we include these to their maximum possible extent under fully phased-in Basel III, then we get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes Using the Tier 1 Leverage Ratio with the Potential Maximum Basel III Pass Standard

Charts ab2
Charts ab2


(a) Author’s calculations based on information provided by the Bank of England’s ‘The Financial Policy Committee’s review of the leverage ratio” (October 2014) based on the assumption that the pass standard is the potential maximum required minimum leverage ratios under fully-implemented Basel III.

(b) The outcome is expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure - post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

If the earlier outcomes reported in Chart 1 were bad, these are disastrous: the overall average shortfall is 0.85%,[3] only one bank (Nationwide) scrapes through the test with a surplus of under 0.1% and the other six banks fail.

It gets worse, too: it turns out that even these outcomes are still overly optimistic.

More on this in the next posting.


[1] See P. Alessandri and A. G. Haldane, “Banking on the state,” November 6, 2009, chart 2, p. 24.

[2] Quotes from Bank of England, “Stress testing the UK banking system: 2015 results,” pp. 9-10.

[3] And if we applied those other adjustments too, then we would get an even higher average shortfall, i.e., 0.85% + 3.5% – 1.89% = 2.46%. Ouch!

Excellent, we can stop doing government now


PJ O'Rourke once asked perhaps the most interesting question we can ask about government. Namely, when are we done? When have we passed all the laws that need to be passed and we can fold the tent and quietly creep away? When have we addressed all those problems that can be addressed by legislation and thus have no need to support a class of legislators? He didn't know the answer to that but we now do: we have reached that point. We're done:

The traditional summertime sound of the ice cream van chime has, for decades, been music to the ears of pensioners, as well as children, who duly venture outside for a weekly treat. But a city council's decision to ban vendors from pausing on the street for longer than 15 minutes has caused great upset amongst the elderly, who fear they won't make it to the van in time. The crackdown has been branded "ridiculous" and prompted more than 65 people, many of them pensioners, to write to town hall chiefs, warning that they are too frail to adhere to such a time limit. Previously, ice cream vans were allowed to remain static for 20 minutes but could stay as long as they liked if they had a queue. The new rules mean that they must leave their spot within 15 minutes, only staying an extra quarter-of-an-hour maximum if there are people waiting. If they breach the 30-minute limit, they face having their licence to trade revoked.

Pensioners have been writing in to point out that, given the NHS' ability to perform hip replacements, it can take them 30 minutes to get to the van. But our objection is not to what this rule is, it's to the existence of the rule at all. This is clearly and obviously something that can be left to the market unadorned to solve. After all, the point of the ice cream van is that it is mobile: it goes to where the customers are. If there are none it will move on: if there're lots it will stay longer. This is what we want: our aim is always to at least attempt to increase the consumption opportunities of the population and "stay if you've got customers, move if you don't" obviously maximises that, our goal.

This regulation is not just therefore ridiculous (seriously, that grown adults working on the taxpayers' money, even dream of the idea that the parking time of an ice cream van needs regulating?) it is counter-productive, it takes us further away from our aim of maximising the people getting what the people want. We have therefore reached Peak Government, we have solved all possible problems and are now left meddling where there is no need to.

Which, while the thought that anyone tried to regulate Mr. Whippy is depressing, is actually a cheerful message, isn't it? For now we have ahead of us the pleasant task of firing the politicians given that their predecessors have already managed to complete the necessary tasks.

The simple existence of a set of parking time regulations for ice cream vans proves that this is so.

Financial Advice should be no Laughing Matter


When the Financial Conduct Authority sets out to be helpful, as its latest Financial Advice Market Review does this week, it is hard to know whether to laugh or cry.  The strategic problem is that its own regulatory approach is causing the market which it is supposed to protect and grow, to fail.  The strategic solution would be to abolish the FCA but it is Osborne’s baby and he will not do that.  So the new FAMR shows the advisers and their clients how to do their business in another market beyond the FCA’s clutches. It is all a bit subtle: financial “advice” is regulated but financial “guidance” is not. The government’s Money Advice Service, for example, is not regulated no matter what rubbish it may advise. The FCA wants the Treasury to make the distinction more explicit and advisers to understand how they can exploit that.  Advisers should be “navigating the boundary between providing helpful guidance based on a customer’s circumstance (such as a financial ‘health check’ prompting customers to think about their financial needs and priorities) and [not] straying into an implicit personal recommendation.” (p.28).  It is OK to talk about X (must be nameless, wink, wink, nudge, nudge) who has very similar circumstances and wisely adopted course Y provided one does not actually recommend Y to the client.

And the FCA will now offer “new guidance to support firms who wish to offer 'streamlined advice' on a limited range of consumer needs." This should include, it says, "a series of illustrative case studies highlighting the main considerations firms need to take into account when developing such models.” “Streamlined” advice is, of course, guidance, not advice. (p.35).  Terminology is a problem as the FCA also refers to this category as ‘simplified’ or ‘focused’ or ‘basic’ advice.  “Nudges” and “rules of thumb,” in case you were wondering, are guidance, not advice.

The FCA makes the distinction that, following guidance, it is the client who decides the course of investment whereas, according to them, the client always follows advice.  This is a non-difference as the decisions are always made by the client in both cases.

One should not mock as there is a genuine attempt, in all the muddle, to shift finance advice from regulated bureaucracy to a mass market.   The FCA is excited by the idea of “robo-advice,” allowing the consumer to provide her details and options to her tablet, or whatever, and receive an investment plan back.  Banks and the other big players, who can see competitive advantage over the independent professionals, are equally excited.  And because banks’ computers are never wrong, this will be “guidance,” not “advice.”  Importantly, it could become value for money for the consumers currently locked out by the FCA.

Tax havens aren't quite the problem many seem to think


Yet another report from Oxfam shouting about the iniquities of inequality, the way in which tax havens rob governments of their rightful dues and....well, you get the story, you've heard it screamed at you often enough. But the real point to pick up from this is how unimportant that issue of tax havens actually is:

In a report titled End the Era of Tax Havens, Oxfam said wealthy people funnelling cash to “secrecy jurisdictions” such as the Cayman Islands and Bermuda were contributing to the wealth divide.

It said the Treasury was losing around £5bn a year from British “tax-dodgers” holding more than £170bn in tax havens.

It also highlighted the impact on the global wealth gap, saying governments are thought to be losing £120bn, with the world’s poorest regions missing out on £43bn.

£120 billion certainly sounds like a lot of money. But is it actually? In comparison to what?

The global economy is around $70 trillion, global tax revenues are some $23 trillion. Being generous with exchange rates we might say that the tax dodging (not that we accept the sum itself but let's work with what we're being given) is 1% of government budgets. So, who thinks that the world would be just peachy if governments had another 1% of revenue? How many problems does anyone really think this will solve? No, serious question.

Then think about the effort being being applied here. If 1% really is an important number then why not apply that same effort, or possibly less as it might actually be easier, in making governments just that 1% more efficient at what they do? We would have that same lovely outcome of making the world a better place but we'd have expended a great less energy in getting there. Odd then that the people shouting most about the havens aren't the people shouting about the efficiency with which the money is used really.

Leave aside all of the other arguments about tax and havens. Is 1% actually an important number?

Help to Save will only harm

First, Help to Buy, now Help to Save. What will be the next headline-grabbing, vote-seeking but yet fiddling, complicated, expensive and ultimately destructive policy from the UK government? Help to Buy helped to buy votes (at taxpayers' expense) by subsidising house purchases. As UK house prices were rising fast, it was almost universally popular. Not in the Adam Smith Institute of course: we explained its damaging consequences on the blog. By adding further to the demand for housing, but doing nothing to increase supply (such as easing the UK's suffocating 1940s planning policies), the scheme simply stoked prices further.

Under Help to Save, around 3.5m people on universal credit or working tax credits who save up to £50 a month will receive a cash bonus of 50% of their savings after two years. Then they can save for another two years, with the same deal.

That amounts to a cash gift of £1200 from taxpayers. Not that many of the 3.5m will get that amount: £50 a month is a huge amount for people on benefits to save – indeed, half of UK adults have less than £500 set aside for emergencies.

Of course, if interest rates were not kept artificially low by the Bank of England (in concert with other people's central banks), saving might be more attractive. And if there were not so much onerous regulation on hiring and firing, more people on benefits would be able to get a job, and move on to a better one. Help to Save looks like a measure to plaster over the cracks opened up by earlier ones.

And think about the administrative complexity of the scheme. The UK's tax code is already nearly the world's longest, and its welfare code is pretty dense too: but here we are, adding another couple of dozen pages. Just think about the rules, and the staff, you need to create and manage even a trifling scheme like this. First, you have to identify those who qualify – and check their bona fides. Which means rules, documents and civil servants. Then you have to check what they are saving, so you need access to their account – or are you setting up a special account for them? Ditto. You need to check that the two-year and then four-year schedule has been met. Ditto. Then you need to pay over the cash, so you need to raise payments, dispatch them, make sure it is all done correctly, deal with mistakes and complaints.... Ditto.

It does not take much reflection to see that this scheme – and countless others like it – will occupy a sizeable civil-service task force, probably in several centres throughout the country, and that the cost of the scheme could well be a significant proportion of the intended benefit. Are there not cheaper and easier ways to help poorer families? Like taking them out of National Insurance entirely?

Irregular Immigration in the EU

The last couple of years have seen a huge amount of migrants come into the EU. They have come for a variety of reasons, but the principal ones have been to flee conflict and secure a better standard of living. Much of the media and public will infer from the second reason that this is to claim extensive welfare benefits that are available for asylum seekers, and if this is true it is of course a problem. But the cost of asylum seekers is of course amplified by the fact they are not allowed to work. This makes them very costly as they are not contributing in taxes, and rightly or wrongly this causes resentment. The macroeconomic benefits of migration however, have long been documented, and two recent papers address the potential economic benefits of the irregular migration that has been seen on the continent.

A paper from the Federal Reserve Bank of Dallas notes that the US used to be the main recipient of irregular immigration, but this has shifted to the European continent for a number of reasons, mostly dependent on proximity. The open borders within the exterior EU border has previously made it easy for migrants to move where they want to go, principally Germany, Austria and Sweden. The standard economic benefits are again discussed, not just for the immigrants themselves, but for recipient countries; they have higher rates of GDP growth, private investment, innovation and entrepreneurial activity. This applies to both informal and formal labour, but with asylum seekers these benefits are not entirely applicable as long as they are restricted in joining the formal labour force, they are possibly going to be working in the formal sector but the fiscal benefit will not be seen by the government as it will not be taxed.

However, in order to protect those benefits over the long term, Orrenius and Zavodny make a case that an effective border control has to be implemented, and if asylum seekers are to be allowed to work then failed asylum seekers have to be removed. This is of course a huge policy challenge with the many entry points onto the European landmass, but will mean that the EU is able to welcome not only asylum seekers but those who wish to work in the EU, balancing the line between the huge fiscal cost of irregular migration and high wages behind a border which is rigorously enforced, sending an incentive for more irregular migration.

The second paper, from the IMF again repeats the message of the first “Rapid labor market integration is also key to reducing the net fiscal cost associated with the current inflow of asylum seekers. Indeed, the sooner the refugees gain employment, the more they will help the public finances by paying income tax and social security contributions. Their successful labor market integration will also counter some of the adverse fiscal effects of population aging.”

We know that the general effects on wages at the lowest level are mostly temporary and limited, so this shouldn’t stop policy makers from loosening restrictions on asylum seekers to mitigate the potentially huge fiscal and political impacts of having many hundreds of thousand of new dependents on the state.

The bad consequences of Brexit


We already know that if the UK votes to leave, then no British firm will be able to sell goods to Europe, British visitors will be barred from there, we'll all lose our holiday homes there, and no UK football club will be able to sign European players; but even worse consequences might follow. Almost certainly, without the protection of EU environmental regulation, British rivers will turn to blood, and a multitude of frogs will emerge from them. With no winds blowing across the Channel the dust here will probably turn into lice, and swarms of flies will descend.

With no Common Agricultural Policy, our livestock will all become diseased, and this will cause boils to break out in people. Without the ability to send our weather across to Europe, thunder and hail will stay in Britain, and swarms of locusts will feed on the flattened crops.

If the UK leaves, the light will be gone from our lives and a thick darkness will envelop the land. It is highly likely that the firstborn of every family will die. While people might be ambivalent about this happening to the Queen, it would be a tragedy for everyone else.

We have to get the message across that the only way to avert these disasters is to remain within the EU.

Why are people so illogical about vaping?


There're certain subjects that seem to turn people into drooling idiots. Those subjects often involve people enjoying themselves so we can at least construct some clues as to why the idiocy. Vaping seems to be one of those subjects. The basic point is really easy enough for anyone to understand: human beings rather like the effects of nicotine and vaping is about 5% as dangerous or less as a manner of ingesting nicotine as the other popular method, smoking tobacco. Being able to abolish 95% of the damage done to health by a product seems like a pretty good idea to us but there are those out there who disagree:

Legislators across the country are bringing bills to statehouses to raise the vaping age in line with the smoking age to a new high of 21 in some states. Politicians and public health activists argue e-cigarettes could hook kids on nicotine and lead to them to transition to tobacco and, therefore, need to be more tightly regulated.

It's obviously true that that is possible: but what we need to know is whether it is true. Is vaping a substitute or a complement to cigarette smoking?

“We should regulate tobacco products proportionate to their risks, and e-cigarette evidence suggests they’re less risky products,” said the Cornell study’s lead author Dr. Michael F. Pesko. “While there’s some risk, it would be a mistake to regulate them the same way we regulate cigarettes.”

The study backs up research published in 2015 showing the drive to ban the under 18s from buying and using e-cigarettes had the exact opposite effect that policy makers intended.

Smoking rates among 12-17-year-olds actually rose in states that banned e-cigarette sales to minors, according to the study by Abigail Friedman of the Yale School of Public Health, published in the Journal of Health Economics found.

“Such bans yield a statistically significant 0.9 percentage point increase in recent smoking in this age group, relative to states without such bans,” Friedman said. The study controlled for smoking rates within states and statewide cigarettes.

It's a substitute so far from making it more difficult, or taxing it more, if we're seriously concerned about human health we should be subsidising it.

In other news the European Union has started discussions on raising the taxation level on vaping to equal that on cigarettes. As we note, there's something about some subjects that just turn people into drooling idiots.

As Charlie Bean says, we're richer than we thought


Or as Sir Charles Bean points out in his new report, we're richer than we thought and getting ever richer faster too:

Improving analysis of the digital economy could show that Britain’s economy is growing faster and consumers are better off, according to former Bank of England deputy governor Charlie Bean. Bean, who published his government-commissioned review of official economic statistics on Friday, said the U.K.’s growth rate could be between one-third and two-thirds of a percent higher with improvements to data collection.

“Measuring the economy has never been harder than it is today,” Bean told reporters at the Data Science Institute at Imperial College London. While digital activity is clearly adding to the economy, it’s not necessarily being picked up by the current methodologies, he said.

This is something that one of us has been banging on about for some time now. We know, absolutely, that we're not measuring the economy properly. This is also more than just a small statistical quirk too. For there's plenty who keep telling us that the economy is growing more slowly than it did in the past and thus the government must do something. However, if it's simply that we're not measuring growth properly then there is no need to that larger state. And as we say, we know we are measuring it wrongly, we're just not sure how wrongly.

A favourite example is WhatsApp. We have three methods of measuring GDP, production, incomes and consumption and all of them are measured at market prices. WhatsApp is currently free and carries no advertising. Thus it appears not at all in either the production or consumption variants of GDP. The engineers who make it are indeed paid so there's some, what, $50 million? $100 million? appearing in US GDP by the income method. But there's a billion users of the app and people are getting some to all of their telecoms needs from it. And we really cannot say that those billion are all getting only 10 cents of value from their use at most. Ten cents a year that is.

We really do know that we're measuring this digital economy wrongly: our question is how wrongly, not whether. That in turn means we're richer than we think we are and also that we're getting richer faster too.

Strangely, bequests don't seem to increase wealth inequality


An interesting finding from Denmark, that bequests and inheritances don't appear to increase wealth inequality:

Our work suggests – contrary to the popular belief – that bequests need not increase inequality even if rich parents have rich kids. In fact, in Denmark, the post-bequest distribution is more equal (if measured in relative terms) than the pre-bequest distribution.

And as we have been assured for years concerning income inequality it is that relative measure which matters. It's also worth pointing out that Denmark is significantly (by 10 percentage points or so) more unequal in its wealth distribution than the UK.

This has an interesting effect on taxation policy of course: the prime objective of inheritance taxation is to try to stop fortunes elf-replicating down the generations. It's also an interesting comment on Thomas Piketty's insistence that inheritance will become all in the near future. It just doesn't seem to work out that way.

We can see that there could be a demographic structure which was more problematic. Say, something like China, where there's a whole generation which is likely to be the only descendant of four grandparents. That's likely to concentrate wealth. But a population that is roughly stable is going to have just as much splitting of wealth between children thus bringing down the amount that any one of them gains. But it is interesting, isn't it? If inheritance doesn't increase wealth concentration then why do we tax it with such moral fervour?