The 2017 stress test results point to an ongoing transition from financial risks to non-financial risks in terms of the critical focus for many banks. While this round of stress test results has been positive in terms of banks’ capital position, the exploratory scenario suggests that banks’ readiness to long-term industry trends, in particular the rise of FinTech, appears to be less resilient. This calls for the industry’s strategic agenda to move on from prudential resilience to long-term sustainability of business and operating models.
All of the UK’s seven largest lenders passed the Bank of England’s stress test this year. Under what has been a particularly grueling scenario partially to simulate the impact of a disorderly Brexit, banks were pitted against a 4.7% drop in UK GDP, the Pound crashing 27% versus the Dollar, house prices devaluing by a third, and £40 billion of misconduct charges. These make the economic scenario in this test more severe than the Global Financial Crisis.
For the first time since the Bank of England (BoE) started its stress tests in 2014, no bank needs to raise additional capital. The participating banks had an average CET1 capital ratio of 8.3% after severe losses in the test scenario, compared with an aggregate hurdle rate of 6.7%. To lock in banks’ resilience, the Financial Policy Committee (FPC) also increased the system-wide countercyclical capital buffer from 0.5% to 1% to address the risk that losses on credit assets tend to rise substantially during recessions.
The industry is at an inflection point. Nearly a decade on from the Global Financial Crisis, banks are significantly more capitalised and liquid. The industry agenda needs to move on from complying with immediate capital adequacy requirements to addressing the impact of long-term industry trends on their business and operating models.
For the first time, BoE included a ‘biennial exploratory scenario’ (BES) in the stress test. Under this, banks are asked to outline their long-term business plans to a prolonged low growth, low interest rate environment as well as heightened competitive pressures from FinTech.
The drive for profitability will continue. Banks expect their statutory return on equity (RoE) to reach 8.3% by 2023 in the exploratory scenario. A few tailwinds will help, most notably lower misconduct costs, and continued reductions in operating costs. But this projected RoE is lower than most banks’ profitability target of over 10% and pales in comparison against banks’ profitability pre-crisis.
Banks’ responses to unfavourable industry trends can be seen as a ‘turbo-charged’ business as a usual. The most active response of banks to the exploratory scenario was to accelerate and extend existing business plans, highlighting the continuation of cost-cutting initiatives as a way to balance books. Banks project reducing their operating expenses from £72bn in 2016 to £60bn by 2023 (a 17% drop) under the exploratory scenario. Overall, banks highlighted the use of technology as an efficiency driver, rather than necessarily a new path to growth.
While technology-enabled efficiency drives take over as the key driver of change over the next few years, banks must not lose sight of broader shifts brought about FinTech and related regulations. With PSD2 and Open Banking coming in force in January, banks are being propelled to shift from a one-stop-shop of financial services to a platform hosting a range of financial services providers to the benefit of the end-consumer. Banks may lose the primary customer relationship in the open banking era, and the Bank of England was right in pointing out the risk of “greater and faster disruption to banks’ business models than banks project”.
Strategic risk aside, execution risks are abundant in harnessing the power of technology in banks’ business plans to mitigate unfavourable industry trends. Fulfilling a dual mandate of radical cost reduction and enhanced service delivery will be challenging. This also requires front-loading IT investment and higher ongoing running costs of new IT systems.
Banks’ planned spending under the exploratory scenario on cyber risk and misconduct cost mitigation may also prove to be insufficient. Despite the rise in cyber-attacks lately and expected escalation of cyber risks associated with the use of FinTech, banks’ projected spending on cyber under the BES remains close to their current levels.
The 2017 stress test results point to a transition of financial risks to non-financial risks. While banks are significantly more capitalised and liquid, they may prove less prepared for the effect of FinTech both on their opportunity landscape and their risk agenda.
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