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The Bank of England’s banking stress tests are highly unreliable; methodological flaws may provide false risk comfort that make them worse than useless.

The stress tests build systemic instability into the UK banking system, pressuring banks to converge to the same models and risk management practices, and making them all blind to the same risks.

These flaws include their dependence on a single scenario and their use of ‘risk-weighted’ asset measures, which are unreliable because of their dependence on gameable risk models, and the use of a very low ‘pass’ standard, a 4.5% minimum ratio of capital to risk-weighted assets.

Even accepting the Bank’s own scenario, alternative tests using a higher capital standard or the superior leverage ratio would indicate that the UK banking system is actually very vulnerable.

The Bank of England’s banking stress tests are deeply flawed and may prove to be worse than useless if they give false risk comfort to financial markets, according to a new report from one of the UK’s top stress testing experts, released today by the Adam Smith Institute.

The report, “No Stress: the flaws in the Bank of England’s stress testing programme”, examines the Bank of England’s stress testing programme and challenges the Bank’s conclusion that the UK banking system has sufficient capital to withstand a new downturn and suggests that the UK banking system is actually very weak.

The report argues that the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test.

If the Bank used the standards set out in Basel III, depending on the level at which the Counter Cyclical Buffer was set, at best just two (of eight) banks would pass; if the CCB had been set to its potential maximum (2.5%) to produce a more rigorous and more credible test, then every single bank would have easily failed.

The Bank also failed to carry out any tests based on a minimum ratio of capital to leverage – which is much less dependent on unreliable risk models. Even the most undemanding of such tests – one based on a minimum leverage ratio of only 3% - would have revealed that the banking system was very weak. The Bank’s failure to apply this latter test is puzzling because the Bank expects UK banks to meet this minimum standard.

Overseas experience also indicates that stress tests are useless as indicators of bank vulnerability and can go catastrophically awry. Recent stress tests failed to notice the impending collapse, not just of one but of three national banking systems: Iceland in 2008, Ireland in 2010 and Cyprus in 2013, all of which collapsed shortly after being signed off as safe by regulatory stress tests.

The BoE asks us to believe that there are no icebergs out in the banking sector, though the report argues this is merely because the Bank’s own radar fails to detect them – essentially the same radar that completely missed the last iceberg that sank the banking system in 2007-2009.

The report calls for Bank’s stress testing programme to be aborted forthwith, and calls for reformers to focus on the restoration of sound accountancy standards. It also calls for an end to regulatory risk modelling and the re-establishment of strong bank governance systems that make decision-makers personally liable for the risks they take.

The author of the report is Kevin Dowd, professor of finance and economics at Durham University and a partner in Cobden Partners based in London. He said:

The Bank's party line is that the UK banking system is safe. However, it is simply impossible to assess the health of the banking system using a stress test based on a single scenario, which is all that the Bank considers. How do we know that the banking system will be safe under all the other scenarios that the Bank of England didn't consider? Well, we don't.

On the other hand, had the Bank carried out a meaningful stress test, then all sorts of awkward questions would have arisen - such as why the banking system is still in a mess despite the vast amounts of public money that have been thrown at it since the onset of the financial crisis. But no-one - especially not the Bank - wants to face up to the point that Bank's policy towards the banking system has been a very costly failure and continues to leave the banking system vulnerable.

Notes to editors:

To access the full report “No Stress: the flaws in the Bank of England’s stress testing programme”, click here.

The Adam Smith Institute is a free market, libertarian think tank based in London. It advocates classically liberal public policies to create a richer, freer world.