UK Stress Testing: Putting stress to the test

In October 2015, the BOE of England (BOE) published details of the 2016 Stress Test Scenario, which formed the basis of the stress tests that were conducted in 2016 to assess the resilience of the UK banking system. Last year’s exercise has been revised and represents the BOE’s first “annual cyclical scenario” (ACS). It models substantial deterioration in UK and global economic conditions according to the financial cycle, based on genuine Financial Policy Committee fears over current asset markets. In 2017, the BOE will extend stress testing to include an ‘exploratory scenario’.

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 BOE’s words, “will incorporate a broader range of domestic and global risks than the BOE’s previous concurrent stress tests.” In our view, the 2017 scenarios will bear similar principles to the ACS (Annual Cyclical Scenario), which will end up capturing different macroeconomic elements associated with Brexit to test the BOE’s resilience.

UK banks will need to demonstrate sufficient liquidity and capital positions to withstand a range of major collapses. For example, a severe global downturn, market volatility, rising unemployment, depreciating currencies in emerging markets and a substantial drop in asset and commodity prices. Over and above, we expect the BoE to run ‘exploratory scenarios’, such as understanding the financial impact under negative interest rates. These assessments may be not just quantitative but also qualitative. For example, where an assessment may be carried out to understand how Banks would cope with their systems, operations and infrastructure under such a scenario, other scenarios may also include major political risks such as terrorism or even global conflict.

These ‘exploratory scenarios’ could be geared towards both emerging and latent threats that could affect financial stability. Again, the stress would be applied only to the seven major banks. 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. Each bank would have to adhere to its individual hurdle rate as well as new thresholds -the hurdle rate required by all banks as capital is 4.5 percent of their assets weighted by risk.

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 that the decline in UK GDP is much less severe over the five year horizon than would be expected, although accompanied by a stubborn rise in unemployment. The high unemployment rate is likely to be a substantial test for UK mortgage providers, due to the resulting increase in loan defaults.

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 put in place in other markets. It could be said that the impact may be more severe if the economic and political challenges currently facing the EU and Eurozone were incorporated – notably high debt levels, the migration crisis, security concerns and the aftermath of Brexit.

Conduct risk is another area where both regulators and banks should adopt an evolved approach, and there is high uncertainty around which methods should be used 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 that a bank will face misconduct fines – the effectiveness of control frameworks on suitability should also be accounted for.

All of this represents a clear trend from the BOE 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 strive 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.

In addition to the core data, the BOE will continue to make scenario-specific data requests as appropriate, these will vary, depending on the nature of the stress scenario being explored in a particular year. This information will give the BOE the flexibility to gain deeper insight into the way institutions have taken account of specific features of the scenario in their projections. It will also allow the BOE to examine areas of balance sheets that are likely to be particularly affected in a given scenario. Additionally, as provision of core data becomes more automated over time, participants should have more time to provide scenario-specific data.

Going forward, the BOE will introduce the Biennial Exploratory Scenario (BES) as part of its annual concurrent stress tests. Although it is unlikely to release details of the BES before its kick-off in Spring, banks should ensure that they have the appropriate resources in place to run two or even multiple scenarios simultaneously. Additionally, they should begin to identify key data gaps and limitations that could be exposed through new scenarios. Banks need to address not just regulatory submissions but also implement an internal capital management process.

There is 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), are the most effective method for determining balance sheet vulnerabilities. UK banks should ensure that they are able to present and analyse risks from across their balance sheets, from different portfolios, in order to best understand the complexity of risks they face. The scenarios have to be run on very granular data, for instance, contract level. 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, as well as ensure banks are meeting requirements under BCBS 239.

Banks also need to have the flexibility to model their own scenarios, not just as a regulatory requirement, but also as an internal capital management exercise. Consistency between calculations and regulatory reports, as well as internal reports, is imperative. Banks need to trace back results and calculation logic all the way from regulatory returns to origination, with a capability to view the entire data lineage. Over and above the methodology, design and implementation of models, banks need to ensure there are controls and a comprehensive governance process in place across the entire stress testing framework.