16 12 2014

Assets collapse, loans go bad … Britain’s banks brace for a serious stress test

Simulated ‘market tantrum’ likely to be the first of an annual event under Bank of England’s new regulatory regime

House prices fall by an unprecedented 35% and base rates jump above 4%, putting pressure on household finances already feeling the pain of falling real incomes. Unemployment doubles to 12% and inflation rockets in an economy being buffeted by a sharp drop in the value of the pound.

In the worst slump in almost a century, Britain’s big banks are struggling to fund themselves on the international financial markets as they face the prospect of a wave of homebuyers and big companies defaulting on their debts.

This bleak scenario is the stress test the Bank of England is running on seven banks and one building society to assess their financial strength, with the results to be released at 7am on Tuesday.

These are the first tests to be run concurrently on lenders and are likely to become an annual event, incorporating lessons learned from the 2008 crisis, when banks such as Royal Bank of Scotland were exposed as running on wafer-thin capital ratios and unable to withstand the storm.

Analysts at Morgan Stanley said: “Annual stress tests form the third leg of the Bank of England’s approach to regulating bank capital.” The other two involve looking at the risks attached to assets and the leverage ratio method of assessing capital strength.

Although the tests are based on hypothetical scenarios, the results could have implications for the banks taking part. Dividend payouts to shareholders could be at risk or banks could be forced to pull out of businesses. Institutions could be forced to raise more capital. The Co-op Bank has already warned it might fail while Lloyds Banking Group’s hopes to pay a dividend for the first time since 2008 could be scuppered.

This comes only weeks after stress tests conducted by the European Banking Authority (EBA), which the four UK banks involved – Barclays, HSBC and bailed-out Royal Bank of Scotland and Lloyds Banking Group – all passed. Those four are now being included in the Bank of England’s test along with Co-operative Bank, Nationwide building society, Santander UK and Standard Chartered.

Some of the scenarios are the same as those tested by EBA, such as a “market tantrum” in Brazil, India, Indonesia, South Africa and Turkey, but the UK-specific test is tougher. Threadneedle Street’s approach is also different because the regulator takes accounts of efforts banks would make to improve capital positions once the crisis is under way. But the Bank has said it could exercise discretion and come down hard on a bank even though technically it managed to struggle over the line in terms of capital strength.

The market, too, “will credit those that have a more substantial cushion than those that do not”, according to analysts at Morgan Stanley. So how will Britain’s well-known high street names fare?

■ Barclays will want to avoid a re-run of events last year when boss Antony Jenkins was forced to ask shareholders for £6bn. The central bank is not assessing banks on the same measure this time around and Jenkins will want to head off any scenario under which the bank would need to turn to its investors again.

■ Co-operative Bank has already admitted that it looks likely to fail the stress test, which comes after an 18-month period in which it has already been forced to raise almost £2bn of fresh capital. As a result the UK’s largest mutual, the Co-operative Group, has been forced to give up its 100% ownership which now stands at just 20%. A bonus package for Niall Booker, the chief executive, is having to be rewritten and a disposal programme is likely to be accelerated.

■ Lloyds Banking Group – 24% owned by the taxpayer – is focused on being able to resume dividend payments for the first time since the 2008 crisis. A strong stress test result might be seen as a green light for payments, although its exposure to the mortgage market – its Halifax arm is the biggest lender – could be a negative. “We view Lloyds as most at risk, due to its large exposure to UK mortgages,” say analysts at Citi.

■ Nationwide building society, like Barclays, was forced to take steps to bolster its capital position last year when the Bank of England was focusing on the leverage ratio – measuring capital relative to the size of loans.

■ Royal Bank of Scotland had to admit it had made mistakes in the European stress tests, which it eventually passed with a narrow margin after taking account of the error. The 81%-taxpayer owned bank will want to avoid embarrassment this time.

■ Spanish bank Santander has been contemplating a flotation of its UK arm since 2010, but that has been postponed on a number of occasions. The results of the stress tests may not revive the process but are a challenge for new boss Nathan Bostock, who joined from RBS six months ago.

■ HSBC was the strongest of the UK banks in the EBA stress tests and will not be as exposed to the UK economy as some of the more domestic banks.

■ Standard Chartered might not have been much of a focus for the City in the past but these tests come at a time when investors are questioning the capital position of the bank because of its exposure to commodities and the economies of India, China and Korea. Any weakness detected in the capital position could intensify the pressure on chief executive Peter Sands.

While there are eight lenders on the list this year, more banks could be added next year, according to Robert Smith of KPMG, who believes the large UK subsidiaries of overseas banks could be included in the future.

Experts are also watching to see if the Bank of England adopts the approach of the US central bank, the US Federal Reserve, which also includes an analysis of internal control systems.

When it announced the terms of the tests in April, the Bank of England said that even if banks did remain above the minimum level it was setting – 4.5% core tier one capital – it could still demand action. Among the other reasons it cited was “the extent to which potentially significant risks are not quantified adequately or fully as part of the stress”