Bank of England stress test scenario and UK financial stability outlook

The Bank of England has today published the latest outlook from the Financial Policy Committee and outlined the scenario for 2018’s bank stress tests, providing us with an indication of its likely areas of focus in assessing UK financial stability.
 
FPC outlook on domestic and international risks
 
The Financial Policy Committee’s (FPC) update on the health of the UK financial sector and associated stress testing assumptions show it believes levels of domestic risk in the banking sector and economy appear to be little changed over the last year. The Financial Policy Committee does note an increase in risk appetite in some places, notably in US corporate debt markets. Domestically, the increase in high mortgage loan-to-income advances just below 4½ times income shows lenders bumping up against the 15% proportion of new lending the regulator allows above that limit. In fact the focus is now firmly on the evolution of domestic risk appetite, which is seen as a bigger threat than Brexit at this time.  As the Bank’s stress test is seen as encompassing the risk of Brexit, no additional capital buffers are seen necessary to cover this risk. The focus around Brexit is instead on continuity of the banking system, particularly in terms of derivative contracts. 
 
This year’s stress test
 
The Bank’s stressed macroeconomic assumptions mirror those used last year.  The stated purpose of the Annual Cyclical Scenario (ACS) is that is remains fairly constant, and adjusts for position in the economic cycle and perceived risks. This year it seems the economics have not been adjusted for the point in the cycle. This keeps the overall peak-to-trough stress constant and throws more light on the changing quality and composition of firms’ portfolios and changes in the way they model regulatory capital.  But the main motivation for keeping the stress exactly the same is to look at the impact of the introduction of the IFRS 9 accounting standard on capital given a common set of stressed assumptions.
 
Impact of IFRS 9 introduction on stress tests
 
The impact of the introduction of IFRS 9 is to make the low point in capital ratios under stress lower and sooner. But the change in the accounting standard is not intended to make the stress test tougher against the system as a whole. To achieve this, hurdle rates will be adjusted to reflect IFRS 9 impacts, but not so much they conflict with minimum capital requirements. The overall picture is complicated by other tweaks to hurdle rates to incorporate systematic domestic risks for the first time. Again, across the system these are offsetting movements in regulation elsewhere, but the impact on individual banks will depend on the systematic risk they present.
 
Comparison with EBA stress tests
 
The larger banks are currently engaged in a parallel exercise for the European Banking Authority (EBA). The current EBA exercise focusses on an abrupt reassessment of risk, worries about private and public debt levels and profitability and liquidity problems in the banking sector and is more explicit about the narrative than the Bank of England exercise. The current EBA severe projections are more severe than in its previous vintages. The UK would see the level of its GDP reduced by 8% relative to base, the unemployment rate hit 8.8%, and house prices 35% lower than would otherwise have been the case, by 2020.  The Bank of England’s stress test is of a similar severity in terms of unemployment and house prices, envisages a lower GDP loss but much higher interest rates.