The Bank of England’s Headline Stress Test: An Exercise in Really Weird Accounting

(For the previous blog in this series, see here.) This posting goes through the Bank of England’s headline stress test and explains that the reassuring conclusion that the Bank drew from them – that the UK banking system is in healthy shape – cannot be taken seriously because the Bank set the pass standard way too low. On the other hand, if we repeat the Bank’s stress tests but impose higher minimum capital standards in line with those called for under Basel III we find that the UK banking system is in very poor shape.

In this posting, I will go through the Bank of England’s 2015 headline stress test – the test based on the CET1 ratio – the ratio of CET1 (Common Equity Tier 1) capital to RWAs (Risk-Weighted Assets). The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 4.5%: roughly speaking, a bank passes the test if its capital ratio (as measured by the CET1 ratio) post the stress scenario is at least 4.5% and it fails the stress test otherwise.

The outcomes for the 7 banks involved – Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, the Nationwide Building Society, the Royal Bank of Scotland Group plc, Santander UK plc and Standard Chartered plc - are given in Chart 1:

Chart 1: Stress Test Outcomes for the CET1 Ratio with a 4.5% Pass Standard

Notes to Chart 1 at end

By this test, the UK banking system might look to be in reasonable shape. Every bank passes the test, although one (Standard Chartered) does so by a slim margin of under 100 basis points and another (RBS) does not perform much better. Nonetheless, according to this test, the UK banking system looks broadly healthy overall.

However, the choice of a 4.5% pass standard is odd, because the Bank itself requires that UK banks meet not only the 4.5% minimum but also meet an additional requirement – usually known as a Capital Conservation Buffer (CCB) – of a further 2.5%, making for a minimum of 7%.

If we apply the Bank’s stress test to a 7% pass standard, we then get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes for the CET1 Ratio with a 7% Pass Standard

Notes to Chart 2 at end

We now get a rather different picture: two banks (Standard Chartered and RBS) fail the test and two more (Barclays and HSBC) barely pass with surpluses of less than 100 basis points. Only three (Lloyds, Santander and Nationwide) are above the pass standard with room to spare.

As I evaluate the results in Chart 2 using the Bank’s own criteria, I can see two banks that did not remain above international agreed minimum standards and two others that nearly didn’t – that’s 4 banks out of 7.

Furthermore, even the 7% pass standard is less than the minimum required CET1 ratio that will be implemented under Basel III by the end of the stress period, as it ignores two additional components of the total minimum capital requirement that will be in place by then – the Counter-Cyclical Capital Buffer and the Global Systemically Important Banks (G-SIBs) Buffer. The first of these is an additional buffer meant to counter cyclical factors and is set at the discretion of the Financial Policy Committee (FPC); it is current set at 0% but can be set as high as 2.5% under the Basel III rules. The second is an additional buffer applied to institutions that the FPC deems to be globally systemically important: the values of these buffers were announced in February 2015: 2% for Barclays, 2.5% for HSBC, 1.5% for RBS and 1% for Standard Chartered. These additional buffers will all be implemented as additional capital requirements by the start of 2019.

It would therefore be prudent to include these components in the pass standard as well, and in so doing, to set the Counter-Cyclical Capital Buffer to its maximum possible value of 2.5%.

Chart 3 shows the outcomes if we apply these more stringent capital requirements as the pass standard in the stress test:

Chart 3: Stress Test Outcomes for the CET1 Ratio with the Potential Maximum Basel III Pass Standard

Notes to Chart 3 at end

In this case, no less than four banks (Standard Chartered, RBS, Barclays and HSBC) are clear failures with outcomes well below the pass standard aka the maximum possible required CET1 ratio under fully-implemented Basel III. Lloyds is exactly equal on the pass standard, Santander is only a tiny bit over it and only Nationwide is comfortably above. Overall, the banking system clearly fails the stress test exam – and this despite the fact that the stress scenario was a mild one!

Pulling all these results together. The UK banking system passes the stress test exam if we take the Bank’s preferred (low) pass standard of 4.5%, which just happens to conveniently support its preferred narrative that the system is sound. However, the banking system performs far less well if we take a pass standard to be 7% (which was the minimum required CET1 ratio by end-2015), and it unmistakably fails the test if we take the pass standard to be the maximum requirements that could be in place under Basel III by the end of the stress period.

Put another way, even if we blindly accept all the major features of the Bank’s stress tests but the pass standard – if we accept the Bank’s chosen scenario, its use of the CET1 ratio as its capital-adequacy metric, the Bank’s own calculations etc. – and merely alter the pass standard to come into line with what the minimum capital requirement might plausibly be under Basel III by the end of the stress period, itself hardly a demanding standard – then we get a very different outcome to the one portrayed by the Bank: the UK banking system would then revealed to be massively capital-inadequate.

At the risk of belabouring the obvious, there are two further points about the Bank’s credibility that cry out from these results:

First, if the outcome of the stress test happens to depend critically on the choice of pass standard, then the outcome of the Bank’s stress test is not robust and therefore neither reliable nor credible – and this is especially so if the Bank’s preferred pass standard happens to coincide with its own self-interest which is to reassure us that the banking system is sound.

Second, the plausibility of the Bank’s view that the UK banking system is in good shape should not be contingent on such finer issues as whether the pass standard should be 4.5% (i.e., the pass standard implemented by the Bank) or higher (e.g., the pass standard promised by the Bank): if the UK banking system really were in good shape, this resilience should come through in all the tests, not just the least demanding test that happens to be the one that the Bank prefers. Moreover, for the test to be credible, the pass standard should be as high as is reasonably plausible. Conversely, for the Bank even to be suspected of applying the minimum pass standard they think they can get away with – when higher pass standards would give more negative outcomes – is to undermine the credibility of the whole exercise. The Bank’s stress tests need to be above suspicion if they are to be convincing.

If you don’t find this argument convincing, consider the medical analogy. A doctor is performing a medical check-up on a patient. He has a choice of tests to conduct: Test 1 has weak power to detect a particular problem, Test 2 has more power and Test 3 is more powerful still. By Test 1 there is no sign of any problem, by Test 2 there are hints that there could be a problem and hence a need to follow up, and by Test 3 the patient is clearly poorly. However, Test 1 is so weak that the doctor is not allowed to use it; instead, the weakest test he is allowed to use is Test 2, and the best practice advice among medical practitioners is to use Test 3 or something even stronger.

So what does the doctor do?

He tells the patient the results of test 1 and the patient thinks she is fine.

In the next blog, I will examine stress tests based on the more reliable leverage ratio as a capital adequacy metric.

Notes to Charts

Notes to Chart 1

(a) The pass standard is the bare minimum requirement (4.5%), expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 2

(a) The pass standard is the sum of the bare minimum requirement (4.5%) and the Capital Conservation Buffer (2.5%), both expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Notes to Chart 3

(a) The pass standard is the sum of the bare minimum requirement (4.5%), the Capital Conservation Buffer (2.5%), the maximum Counter-Cyclical Capital Buffer (2.5%) and the Global Systemically Important Banks Buffer, which varies across the banks. These percentages are expressed in terms of the CET1 ratio - the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets.

(b) The outcome is expressed in terms of the CET1 ratio post the stress scenario and post any resulting management actions. The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).