Earlier this week, the Bank of England published details of the 2016 Stress Test Scenario, which will form the basis of the stress tests that will be conducted later this year to assess the resilience of the UK banking system. This year’s exercise has been updated and represents the Bank’s first “annual cyclical scenario” (ACS), which models a substantial deterioration in global and UK economic conditions according to the financial cycle, based on genuine Financial Policy Committee fears over current credit, financial and other asset markets.
This year’s new model arguably represents the most severe and robust macroeconomic stress test scenario put in place for the UK banking system. It is also the most comprehensive and, in the Bank’s words, “will incorporate a broader range of domestic and global risks than the Bank’s previous concurrent stress tests.” UK banks will need to demonstrate sufficient liquidity and capital positions that would withstand a range of major collapses, which include a severe global downturn, market volatility, rising unemployment, depreciating currencies in emerging markets and a substantial drop in asset and commodity prices.
One of the main focuses for this year’s scenario is a sharp downturn in China and Hong Kong. This reflects recent concerns expressed by the Financial Policy Committee and will have been designed not only to test UK banks with a significant exposure to Asian markets, but also determine how the impact of declining commodity prices and company share prices will affect bank’s balance sheets. This broader-scoped stress test will require UK banks to understand and capture the complexities of these risks and their inter-dependencies throughout the global economy.
For instance, an oil price drop to $20 per barrel is unlikely to be confined to a single part of a balance sheet, but would affect a range of portfolios. In order to fully understand the risk this presents, it requires a detailed understanding of the value chain of oil (and other commodities) and how a slump in prices would impact across a range of sectors. For example, exploration, production, shipping, energy and infrastructure are all inextricably linked to the price of oil, and sovereign-debt markets and currencies, particularly in emerging markets like Brazil and South Africa, will be impacted by a decline in commodity prices. Banks should capture the stress of commodities by defining the value chain of their portfolios and calibrate the shock on commodity sensitive companies, in particular focusing on concentration to specific counterparties.
There is also a question as to whether banks are appropriately set up to fully capture these risks or whether the established Bank of England stress test templates, such as the firm data submission framework (FDSF), is the most effective method for determining balance sheet vulnerabilities. In any case, UK banks should ensure that they are able to present and analyse risks from right across their balance sheet, from different portfolios, in order to best understand the complex risks they face. An effective way for banks to achieve this rigorous analysis is to adopt a system of “optimally granular data sets” to allow the identification and analysis of a significant range of risks.
At a domestic level, this scenario also includes a severe level of stress, with substantial impacts on UK residential and commercial property, UK GDP and unemployment. It could be argued here that the decline in UK GDP is much less severe over the five year horizon than would be expected, accompanied by such a stubborn rise in unemployment. The high unemployment rate is likely to be a substantial test for UK mortgage providers, as it would result in a high increase in loan defaults. This scenario is likely to test whether measures put in place since the financial crisis, such as the Mortgage Market Review and more rigorous affordability tests, have been effective in reducing banks’ exposure to risky mortgage loans.
While this year’s stress test scenario is broad in scope, the projected impacts on GDP, unemployment and property prices for the Euro area are relatively modest compared with the models they have put in place with other markets. It could be argued that the impacts could be more severe if it incorporated the range of economic and political challenges the EU and Eurozone currently face, notably high debt levels, the migration crisis, security concerns and the prospect of Brexit. Indeed immigration is now shifting the bias in favour of Brexit, which has ramifications not only in the UK but also in the rest of Europe. However, the Bank of England has also stated that, from 2017, it will complement ACS tests with an additional ‘exploratory scenario’ stress test which will explicitly examine emerging threats to financial stability from a public policy perspective. This could incorporate major political risks such as terrorism, global conflict or, indeed, further instability caused by the UK’s Referendum on the EU (which will, of course, have been determined by June 2016).
Conduct risk is another area where both regulators and banks should adopt an evolved approach. Indeed there is high uncertainty around methods to quantify conduct risk. A new framework to capture future misconduct costs should be built around several factors such as the complexity and diversity of products offered, the multiplicity of operating jurisdictions and the legal complexity of each organisation. The more intense these factors are, the more probable it is for a bank to face misconduct fines. The effectiveness of control frameworks on suitability should also be accounted for.
All this represents a clear trend from the Bank of England and its Financial Policy Committee to ensure that stress tests become more rigorous, complex and broader in scope. UK banks need to ensure they are prepared for these stress tests through effective analysis of balance sheet vulnerabilities and by adopting an integrated approach to their risk management functions. Parker Fitzgerald stresses that it is insufficient to simply focus on stress testing as a compliance based exercise, banks should continue striving to build optimal granular data infrastructure and risk data aggregation as per BCBS 239 requirements. There is also an urgent need to understand the business model so as to project forward net income for the baseline and the ability to stress test vulnerabilities.