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12 January 2017

Bank of England: The Bank’s approach to stress testing - letter from the Governor

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The Bank of England has published the Governor’s reply to the recent proposal of Sir John Vickers that the Bank supplements its current approach to stress testing by publishing parallel results that take market-based measures of equity capital, rather than regulatory capital, as a starting point.

Mr. Carney agrees with the general point that market indicators of the health of the UK banks are extremely useful to regulators and policymakers. The Financial Policy Committee (FPC) monitors a variety of market-based indicators, which are published alongside the Record of its discussions. Those indicators include CDS premia, the price to book ratio, and a market-based leverage ratio for the major UK banks.

Mr. Vickers expressed concern around book measures of capital for major UK banks, suggesting that price to book ratios below one were evidence of market participants doubting the accuracy of those measures. Mr. Carney is of the view that current low price to book ratios reflect investors' concerns about low long-term profitability for UK banks - with return on equity of the major UK banks averaging just 2% in 2015. Various headwinds continue to dampen bank profitability, including misconduct costs and weak investment banking returns.

Mr. Carney said: “As part of our stress testing approach, we construct a central projection of a bank's capital position over a five year period, and then calculate how that capital position would change in response to a severe stress scenario. We use a baseline forecast of a bank's profitability to construct the projection of its capital position. It is possible to back out an implied price to book ratio from this forecast, after making an adjustment for misconduct costs. We find that our baseline projection for the four largest UK banks equates to a price to book ratio of between 0.7 and 0.8, consistent with the actual price to book ratio at the time the stress tests were published. This is not a coincidence - we look at the prevailing price to book ratios as one cross-check of our base line forecasts for bank profits.

This reconciliation exercise suggests that it is not necessary to make an adjustment to capital at the start point of the stress test, as we have already captured weak valuation effects through weak baseline projections for bank profits. That weak baseline will translate into lower capital ratios over both the base and stress projection.”

Mr. Carney touched four other issues:

  • A key issue is how to treat the difference between regulatory capital and the standard accounting measure of capital, so-cailed 'shareholders' equity'.
  • The second issue relates to the overlap between the central projection described earlier and market valuations
  • Third, market-indicator based stress tests could run counter to the Bank's intention that its stress tests are countercyclical.
  • Finally, publishing alternative supplementary stress test results would run the risk of confusing the Bank's communication around its stress tests.

Full letter

© Bank of England

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