27 March 2017

Bank of England: 2017 stress test scenarios explained

The 2017 stress test includes two stress scenarios.  Alongside the annual cyclical scenario, the Bank is, for the first time, running an additional exploratory scenario.  This represents an important step towards achieving the Bank’s vision for stress testing, which it set out in 2015.

The annual cyclical scenario incorporates a severe and synchronised UK and global macroeconomic and financial market stress, as well as an independent stress of misconduct costs. The sizes of the shocks to different sectors and economies are adjusted each year to deliver a similar stressed outcome unless the assessment of vulnerabilities warrants a change to that outcome.

The stressed outcome for UK activity and unemployment is the same as in the 2016 annual cyclical scenario.  For the global economy, the stressed outcome is worse than in 2016, largely reflecting continued rapid growth of credit in China.

As highlighted in recent Financial Stability Reports, the United Kingdom’s large current account deficit creates a vulnerability to a reduction in foreign investor appetite for UK assets and increases in funding costs for real-economy borrowers.  The 2017 cyclical scenario incorporates a sudden increase in the rate of return investors demand for holding sterling assets and an associated fall in sterling. 

The scenario incorporates a rise in Bank Rate, differentiating it from the 2016 exercise, in which Bank Rate was cut to zero.  This reflects a challenging trade-off between growth and inflation in the scenario.  The higher path for Bank Rate is not designed to change the overall severity of the stress.  In aggregate, banks are likely to see higher impairments but also higher interest income. This aspect complements the exploratory scenario, in which interest rates persist at very low levels.  Together the two scenarios will allow the impact on banks of both rising and persistently low Bank Rate to be assessed.

The results of the annual cyclical scenario are used to ensure that the banking system as a whole, and individual banks within it, have sufficient capital to absorb losses and maintain the supply of credit to the real economy, even in a severe stress.

The benchmarks — or hurdle rates — above which banks will be expected to maintain their capital positions in the 2017 cyclical scenario have been set on the same basis as in the 2016 test.  All participating banks will be expected to meet their minimum CET1 capital requirements, which averaged 6.5% in 2016.  Globally systemic banks will be held to a higher standard.  Failure to meet these standards in the stress will generally result in banks being required to take action to improve their positions, if they have not already done so.

The aim of the Bank’s 2017 exploratory scenario is to consider how the UK banking system might evolve if recent headwinds to bank profitability persist or intensify.  It incorporates weak global growth, persistently low interest rates, stagnant world trade and cross-border banking activity, increased competitive pressure on large banks from smaller banks and non-banks, and a continuation of costs related to misconduct.  The test will have a seven-year horizon to capture these long-term trends.

The exploratory scenario is not focused on bank capital adequacy.  It will focus not on whether, but how, banks would meet regulatory requirements and build sustainable business models in such an environment.  Its purpose is to explore the impact of banks’ actions on both the real economy and the future resilience of the system to shocks.

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