Bank of England announcement of latest stress tests – Thoughts from 4most’s Chris Warhurst

Yesterday the Bank of England kicked off the 2017 stress testing season with publication of two economic scenarios.  While the second Annual Cyclical Scenario (ACS) looks at capital positions under stress and – given the economic assumptions are little different from last year, succeeds in its aim of making the exercise predictable – the first ever Bank Exploratory Scenario (BES) tests the banks’ ability to react to a world where the picture is one of compressed profit margins and competition for funding.  
 
The introduction of the BES is designed to look at weaknesses beyond those probed in the standard stress tests that regulators request. Given the recent increased competition for deposits, rather than asking another question about capital adequacy, the BES examines the possibility of even greater competition for both retail deposits and lending in the UK. The assumed net impact of increased competition in lending and deposit markets in the scenario is a fall of around 40% in the spread between market retail deposit and lending rates relative to current levels.  
 
How might banks react to this challenge if it materialised? It may suggest they would need to change their views of optimisation from return on equity considerations, reflecting the lack of a capital stress, to returns against funding.  This might mean shifting business to higher margin, riskier sectors, such as unsecured to restore profit margins.  As a result, higher credit costs could be created by banks’ actions rather than external economic pressures. The Bank of England will be as interested in how such a scenario would alter the banking landscape in the UK as a whole as much as it is in the results of individual lenders.