2016’s test will be the third run by the Bank of England, and is used as a measure of how well Britain’s banks would be able to cope should the world suffer a major economic shock in the coming year.
The test is designed to ensure that banks are in possession of right tools — such as sufficient liquidity and relatively strong capital positions — to weather an economic storm.
Predictably, its pretty apocalyptic, setting out major collapses in a whole heap of asset classes and a massive worsening of economic conditions. As the BOE puts it “In the Bank’s 2016 stress scenario vulnerabilities across financial markets and the global and UK economies crystallise.”
Here’s what Britain’s banks will have to resist in this year’s stress test:
- Global growth crashes — “The stress scenario incorporates a synchronised global downturn in output growth. Relative to the baseline scenario, growth in China and Hong Kong is particularly adversely affected. GDP growth troughs at -1.9%, as it did during the 2008 global financial crisis.”
- Oil falls to $20 per barrel — “Having fallen significantly during 2015, the price of oil troughs at US$20 per barrel, reflecting the further slowdown in world demand.”
- Emerging market currencies tank — “There is volatility in financial markets with emerging market currencies depreciating against the US dollar.”
- Property prices drop nearly a third in Britain — “property prices fall globally. Falls in Chinese and Hong Kong property prices are particularly pronounced, following rapid recent growth. In the United Kingdom, residential property prices fall by 31% — this is particularly concentrated in regions which have recently experienced more rapid price increases.” Commercial real estate prices will crater even more, falling 42%.
- UK GDP tanks, and unemployment surges — “The level of UK GDP falls by 4.3%, accompanied by a 4.5 percentage point rise in unemployment. The combined impact of increases in the cost of credit, the contraction in world demand, falls in asset prices and heightened uncertainty have a pronounced impact on domestic growth.”
It’s important to note that the scenario presented in the stress test isn’t supposed to be indicative of what the BOE actually thinks will happen to the British and world economies. It’s merely a total worst case scenario. The scenario presented is however, way worse than in the past two stress tests, reflecting genuine fears about the state of the global economy. Here’s how the BOE’s economic shocks are presented compared to the last two tests:
Along with an increase in the severity of the scenario presented to banks, the requirements, in terms of capital levels, have also been made tougher by the BOE. In this year’s stress test, the minimum capital levels for the biggest UK banks will increase from 4.5% to between 7 and 8%. Here’s what the Bank of England has to say (emphasis ours):
The 2016 stress test incorporates a domestic stress which is broadly as severe as the 2014 exercise in terms of its impact on GDP and unemployment. That said, there are significant differences between the UK scenarios incorporated in the two tests. The stress to UK residential property prices is slightly less severe in the 2016 test. Other financial market and asset price shocks such as those to UK equity prices and CRE prices are, however, more severe in the 2016 exercise.
Overall, the stress incorporated in the 2016 test is broader than either of the stresses in the preceding concurrent tests. That reflects the desire of policymakers to use the stress-test framework to help set capital requirements and buffers for all stress-test participants each year.
Stress tests have gained a lot of popularity with central banks since the financial crisis when numerous banks across the globe collapsed or had to be bailed out by governments. Nowhere was that more true than in Britain, where the government, then led by prime minister Gordon Brown, had to pump billions of pounds into both RBS and Lloyds to keep them afloat.
In December 2015, Standard Chartered and RBS both came close to failing the BOE’s stress test, although they just squeaked through. Despite missing targets, the two banks had just enough emergency capital after being run through a hypothetical economic collapse by the UK’s banking regulator.