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Investment & Strategy

UK Banks 2016 Stress Test Separates grain from chaff

The Bank of England (BOE) conducts a stress test annually to assess banks’ resilience to a range of adverse shocks. The BOE not only checks the banks’ ability to withstand very severe shocks but also whether they would be able to maintain the supply of credit to the real economy.

In March 2016, the BOE commenced its third concurrent stress test of the UK banking system. It covered seven major UK banks and building societies, which accounted for ~80% of Prudential Regulatory Authority (PRA) regulated banks’ lending to the UK real economy. The 2016 stress test was the first one under BOE’s new approach to stress testing. It was much more rigorous than 2014 and 2015 as it incorporated a very severe synchronised UK and global economic recession with associated shocks to financial market prices, and an independent stress of misconduct costs.

The BOE announced the results of the 2016 stress test on 30 November. Four of the seven participating banks, viz. HSBC, Lloyds Banking Group, Nationwide Building Society and Santander UK passed the stress test (based on balance sheet at 2015-end). However, the PRA Board identified capital inadequacies at The Royal Bank of Scotland (RBS), Barclays and Standard Chartered.

RBS lagged the minimum Common Equity Tier (CET) I capital and Tier I leverage ratios requirement by a significant margin. However, as a pre-emptive measure, RBS updated its capital plan to incorporate additional capital strengthening actions after an internal assessment of its capital strength and possibly due to a poor performance in the European Banking Authority’s stress test in July 2016. This was accepted by the PRA Board, but it would continue to monitor RBS’ progress against its revised capital plan. Barclays and Standard Chartered missed certain capital thresholds, but given their actions to augment capitalisation in 2016, the PRA did not require them to submit a revised capital plan.

The key positive was that the Financial Policy Committee (FPC) judged that the stress test showed that the banking system is in aggregate capitalised to support the real economy in a severe, broad and synchronised stress scenario. Further, it said that no system-wide macro-prudential actions on bank capital were required. This is likely to boost investor confidence in the UK banks. Additionally, the FPC maintained the UK countercyclical capital buffer (CCYB*) at 0% due to uncertain economic outlook in the UK. The purpose of maintaining the buffer at 0% is to prevent banks from hoarding capital and constraining lending to the economy. The FPC reaffirmed that barring any significant change in economic outlook, it expects to maintain CCYB at the current rate till June 2017.

Another major feature was the drawdown in CET I capital (the fall in aggregate CET I capital ratio from start to stressed point; an indicator of downside risk over a specified time period). Under the 2016 stress scenario, banks’ aggregate CET I capital ratio is expected to fall from 12.6% at 2015-end to a low (stressed) point of 8.8% in 2017. This implies a drawdown of 3.8%. Although the drawdown was higher in 2016 than in 2015 (360 bps) and 2014 (240 bps), the low point of 2016’s CET I ratio was higher than the 2015 and 2014 level of 7.6% each, indicating that the banks have made significant headway in strengthening capitalisation.

Among the major UK banks, HSBC and Lloyds witnessed the lowest drawdown in 2016. We note that HSBC is the only bank which has passed all the stress tests since 2014. We prefer HSBC and Lloyds given their solid fundamentals, robust capitalisation and attractive shareholder return potential (in the form of dividend or share buyback).

 


Author
Shekhar Kedia

Equity Expert

Data & recommendations as of December 12th, 2016 close

This document is an objective and independent explanation of the content of the recommendation and cannot be considered as adapted to a person or based on the analysis of the situation of a person.