This is the first of a series of postings on the Bank of England’s 2015 stress tests of the financial strength of the UK banking system, which concluded that the banking system is able to withstand a severe stress scenario and still function well. It turns out that the stress scenario – often described in the press as a ‘doomsday’ scenario – is surprisingly mild. And because of this, we cannot conclude that the UK banking system is strong enough to withstand a severe stress scenario. To make matters worse, the much vaunted rebuilding of the UK banks’ balance sheets didn’t happen either and UK banks may be as vulnerable now as they were in 2007.

On December 1 last year, the Bank of England released the results of its second round of annual stress tests of the capital adequacy or financial strength of the UK banking system. This exercise is supposed to be a financial health check for the major UK banks – it tests their ability to withstand a severe adverse shock and still come out in good financial shape.

The stress tests covered six major banks and one building society – Barclays, HSBC, Lloyds Banking Group, the Nationwide Building Society, The Royal Bank of Scotland Group, Santander UK and Standard Chartered. Between them these institutions account for over 80% of lending to the UK economy.

The stress tests were billed as severe and the press would commonly label the stress scenario as a ‘doomsday’ one. Here are some of the headlines:

“Bank of England stress tests to include feared global crash”

“Bank of England puts global recession at heart of doomsday scenario”

“Stress tests: the Bank of England’s doomsday scenario”

“Banks brace for new doomsday tests”

All this is pretty scary, but fortunately there was a happy ending: there are one or two small problems but on the whole, the banks come out smelling of roses:

“UK banks pass stress tests as Britain's "post-crisis period" ends”

“Bank of England signals end of the financial crisis era”

“Bank shares rise after Bank of England stress tests”

“Bank of England’s Carney says UK banks’ job almost done on capital”

Phew! The Bank of England put the UK banks through a daunting stress test but the banks came out in good shape and we can sleep safely in our beds.

Going further, at the press conference announcing the stress test results Bank of England Governor Mark Carney couldn’t have been more reassuring:

UK banks are now significantly more resilient than before the global financial crisis.

This year’s test complements last year’s effort. It is focused on an emerging market stress that prompts reassessments of global prospects and asset prices; considers the implications of deflation not inflation; and places greater emphasis on exposures to corporates rather than households. It also includes an unrelated but important stress of costs for known misconduct risks.

The stress test results, taken together with banks’ capital plans, indicate that the UK banking system would have the capacity to continue to lend to the real economy even under such a severe scenario.

They testify to the value of the reforms that have rebuilt capital and confidence in the UK banking system.[1]

The key point to take is that this [UK banking] system has built capital steadily since the crisis. It's within sight of [its] resting point, of what the judgement of the FPC is, how much capital the system needs. And that resting point - we're on a transition path to 2019, and we would really like to underscore the point that a lot has been done, this is a resilient system, you see it through the stress tests.[2]

The message was that there would be no more major increases in capital requirements and we were now at the end of the post-financial crisis era.

Well, it’s a great story Mark, but it just ain’t so.

Let’s go back to the stress scenario. This single scenario envisages a hypothetical global downturn emanating from China: economic growth there falls from just under 7.5% to 1.7%, and trigger a Chinese/Hong Kong house price crash. Financial markets freeze up, some trading counterparties fail, emerging currencies slide against the dollar, the UK and the Eurozone go into recession and the oil price tumbles. Plus various other bits and pieces including the misconduct issues that Governor Carney mentioned in his remarks at the press conference.

But how severely would this scenario impact the UK?

The answer is surprising.

Consider the main variables hitting the UK banking system as the scenario takes its course:

Bank Rate is projected to fall from 0.5% at the end of 2014 to 0% in 2015Q3 and then stay there. CPI inflation is projected to fall from 0.1% at the end of 2014 to bottom out at -0.9% in 2015Q1 and then recover to 0.5% by end-2019.
Annualised real GDP growth rate falls from 0.6% at the end of 2014 to bottom out at -1% in 205Q4 and recover to 0.9% by end-2019.
Unemployment falls from 5.7% at the end of 2014 to peak at 9.2% in mid-2017 and then fall back to 7.2% by end-2019. UK residential and commercial property prices fall by 20% and 35% respectively.
Bank lending expands by 9%: this looks odd for an adverse scenario, especially given the long contraction in bank lending post-2007.
Impairments on lending to UK businesses remain modest.
Bank pre-tax losses of £37 billion: this compares to UK bank losses of at least £98.4 billion over 2007-2010, and which wiped out at least 185% of banks’ capital.[3]
The Vix financial market volatility index – often called the ‘fear index’ – is projected to rise from just over 20% at the end of 2014 to peak at 46% in 2015 before falling back. This compares to its 2008 peak of just short of 70%.[4] Annualised world GDP growth dips to -0.7% before recovering, compared to its fall to -2% in the Global Financial Crisis.

The rise in the unemployment rate and the falls in UK property prices are on the moderately severely side but are still lower than what we have witnessed in other countries in the EU since the onset of the Global Financial Crisis. For their part, the other projections in the Bank’s adverse scenario range from mildly adverse to highly optimistic. Not exactly doomsday.

The banks’ projected reaction to this scenario is also on the mild side. The capital ratio that the Bank prefers to cite when discussing the stress tests, CET1 capital divided by Risk-Weighted Assets, falls on average by 3.6 percentage points from 11.2% at end-2014 to 7.6% by end-2016; its secondary stress test capital ratio, roughly speaking, the ratio of capital to total assets, falls on average from 4.4% to 3.5% over the same period; and the CET1 capital measure falls by £55.5 billion from £298.1 billion to £242.6 billion.

In short, the Bank’s stress scenario is not particularly stressful.

But if this is so, then how do we know that the UK banking system is strong enough to withstand a severe stress test?

We don’t.

The Bank’s confidence that the banking system is sufficiently “capitalised to support the real economy in a global stress scenario which adversely impacts the United Kingdom” may be a touch premature.

The banking system might be able to withstand a mildly adverse scenario, but we cannot extrapolate from any such conclusion to infer with any confidence that the banking system can withstand a more adverse scenario.

If the stress tests can’t be relied upon, let’s turn to a different test that we can rely upon – the inter-ocular trauma test more popularly known as a reality check: just look at the data and see what they say

Well, there is the good news and the bad news.

The good news is that by the capital-adequacy measure that the Bank cites most - the ratio of Tier 1 capital to RWAs – the banks are getting stronger. By end-September 2015, the average value of this ratio across the UK banking system had risen to 13%.[5] An alternative capital ratio, the ratio of Common Equity Tier 1 capital to RWAs, had risen to 12% by the same date.[6] Back in 2007, the average ratio of Tier 1 capital to RWAs across the big UK banks was little more than 6%.[7] By this comparison, the Bank of England is entitled to claim that the UK banking system has undergone a major recapitalization.

Moreover, given its view that the optimal Tier 1/RWA ratio is about 13.5% - and about 11% if certain risk measurement improvements are made - then the Bank could also rightly say that the job of recapitalizing the banking system is nearly done: only another 50 basis points to go.

But before getting the champagne out, we should pause to note that there are several rather big ‘ifs’ in there.

One relates to the Bank’s confidence that the optimal Tier 1/RWA ratio is about 11% post the risk measurement improvements they have called for. A few years ago the experts – the Basel Committee (including Bank of Canada Governor Mark Carney) and the Vickers Committee – were telling us that the optimal ratio was 18%. Now the experts – including Bank of England Governor Mark Carney – are telling us that the optimal ratio has gone all the way down to 11%. So one wonders whether they were right then or right now. Personally, I don’t believe they were right then or right now: I don’t believe any of it, and this is in large part because I have no confidence whatever in the RWA measure on which these recommendations are based.

Why the Bank relies on this measure I don’t know: a brilliant analysis by its own (now) chief economist in 2013 elegantly destroyed whatever credibility the RWA measure might once have had. Comparing the average leverage and average RWAs of the big global banks in the run-up to the crisis, Andy Haldane sardonically observed that as the crisis approached,“ the risk traffic lights were flashing bright red for leverage [whilst] for risk weights they were signaling ever deeper green.” Thus, RWA really means Really Weird Assets and the inescapable implication is that RWA-based capital ratios should not be touched with a barge pole.

So the bad news is that the capital ratios based on an RWA denominator tell us nothing useful about the banks’ real capital strength – except, perhaps, to signal that a higher ratio of capital to RWAs might perversely indicate a weaker bank.

A basic principle of good scientific methodology is that measures of the things we measure should actually measure the things that we think they measure.

We therefore need to reject RWA-based measures as nonsense and go back to old-fashioned ratios of true capital to un-risk-weighted assets. According to data from the Bank itself:

The UK banks’ average leverage ratio (as judged by the ratio of equity to total assets) in 2007 was about 4.3%.[8]
By end-September 2015, the average leverage ratio was 4.6% if we go by the ratio of Tier 1 capital to leverage exposure, and 4.2% if we go by the more reliable ratio of CET1 capital to leverage exposure.[9]

To pull all this together, the Bank’s stress tests have no real stress in them and the recapitalisation of the UK banking system didn’t happen.

The core metrics indicate that UK banks may be just as weak now as they were in 2007 – and maybe more so.

In the following postings, I will further explore the Bank’s stress tests and suggest additional reasons why the Bank’s confidence in them might be premature.

Sneak preview: even if we accept every single feature of the Bank’s stress tests – and we shouldn’t – the banking system only just passes the tests. Adversely stress the slightest feature and one or more or all of the banks fail the test. This has got to make you wonder…

References:

[1] Financial Stability Report Press Conference, 1st December 2015, ”Opening remarks by the Governor,” p. 1

[2] Bank of England Financial Stability Report Q&A, 1st December 2015, p. 11.

[3] Local Authority Pension Fund Forum, “UK and Irish banks capital losses – post mortem,” September 2011, p. 3.

[4] https://uk.finance.yahoo.com/q/bc?s=%5EVIX&t=my. Accessed December 20 2015.

[5] Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, p. 9.

[6] Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, chart B.1.

[7] Bank of England, “Financial Stability Report,” December 2015, Issue No. 38, chart B.1.

[8] Bank of England Financial Stability Report June 2010, p. 44, chart 4.1. This chart shows that in 2007 banks’ average ratios of assets to equity was about 23. This makes for a leverage of 1/23 or approximately 4.3%.

[9] Data assembled from Annex 1 of the Bank of England’s 2015 stress test report.