2021 Stress testing the UK banking system: the Bank of England’s approach

March 2020 marked the first time – since its inception in 2014 – that the Bank of England (BoE) cancelled its annual stress tests for the UK’s biggest lenders. Instead, they undertook a desktop analysis of the UK banking sector resilience. In late 2020, the Financial Policy Committee (FPC) judged that most banks have capital buffers that allow them to operate and remain resilient to a wide range of possible outcomes for the UK and global economies.

On 20 January 2021, the BoE published the details of their 2021 solvency stress test to assess the major UK banks and build societies against a UK and global scenario that reflects a severe path for the current macro-economic outlook.

Eight institutions are taking part in the 2021 solvency stress test, as these account for around 75% of lending to the UK real economy. These banks all have a diverse range of business models, and some operate across a broad range of international markets.

They are:

• Barclays
• HSBC Holdings
• Lloyds Banking Group
• Nationwide
• NatWest Group
• Santander UK Group Holdings
• Standard Chartered
• Virgin Money UK – for the first time

2021 stress test

This year’s Stress Test will simulate a double dip fall in UK GDP, approximating to a further 9% fall in UK output in 2021 Q1.

Banks will be asked to test the resilience of their end-2020 balance sheets against the below stresses:

• Cumulative UK GDP losses over the period 2020-22 of around £800 billion (37% of 2019 UK GDP)
• A peak unemployment rate of around 12% and a three-year average of 8.9%
• A fall in residential and commercial property prices by 33%
• A drop of 9% in the UK’s real GDP from end-2020 to the trough
• A drop of 9.6% in the World’s real GDP from end-2020 to the trough

The BoE gives particular consideration to the risks associated with the changes to the economy in the past year. A key focus of the 2021 stress test will be to examine the potential risks to the UK banking system were these trends to continue and become more entrenched.

The stress scenario incorporates an intensification of these changes to the economy, assuming a weaker path for UK GDP in the longer term, driven by changes to consumer habits and production decisions.

Globally, the scenario assumes weak world trade, with ongoing weaknesses particularly apparent in countries more exposed to vulnerable sectors and more reliant on tourism, high oil prices and/or have greater dependency on external finance.

The impact of the 2021 stress test

The results of the 2021 solvency stress test will act as a cross-check on the FPC’s judgement of how severe the current stress would need to be in order to jeopardise banks’ resilience and challenge their ability to absorb losses and continue to lend.

The BoE has also stated that there will be no direct link from the results of the stress test to the regulatory response. However, the outcome of the test will be used:

• To update the FPC’s judgements about the most appropriate ways in which the banking system can continue to support the wider economy during times of stress
• As an input into the Prudential Regulation Authority’s (PRA) transition back to the standard approach to capital-setting and shareholder distributions through 2021

Timetable

The timetable for the 2021 solvency stress test will be staggered. As briefly mentioned above, participating banks will need to submit their projections for credit impairments and credit risk-weighted assets (RWAs) in April, instead of the usual deadline of June. The additional stressed projections will be submitted in June, as usual, with bank specific results to be published in Q4 2021.

To help with this change to the usual timetable, and due to the ongoing operational challenges within banks, participating banks will not be requested to submit baseline projections and the ring-fenced subgroups of stress-test participants will not be included in the 2021 tests.

Background

The annual BoE stress test informs the setting of capital buffers by the FPC and the PRA. Firms that are not part of this annual stress test must carry out their own stress testing, and the participating banks will have to submit their findings in April. The PRA publishes a stressed scenario every six months to guide banks and build societies designing their own scenarios. Every two years, the BoE also runs an additional scenario intended to probe the banking system’s resilience to risks that may not be precisely linked to the financial cycle – known as the biennial exploratory scenario.

The BoE’s approach to stress testing aims to build banks’ capital buffers up when the economy is growing so that they can be drawn down during periods in which the economy is in stress. Therefore, these stress tests are designed to simulate the worst-case scenarios and assess how firms can cope with severe economic scenarios.

[1] Bank of England: Approach to stress testing [2] Bank of England: Key elements of the 2021 stress test [3] Bank of England: Guidance on the 2021 stress test