On 28th November, the Bank of England published the results from its 2017 stress tests, which provided an assessment of the stability of UK’s banking system.
The headlines show that the major UK banks have all passed the stress tests and are deemed strong enough to keep lending in a scenario more severe than that of the 2008 global financial crisis, which is good news for the sector. It was also noted that the stress tests encompassed a wide range of UK macroeconomic risks, which the Bank of England said could be associated with Brexit and concluded therefore that UK banks could handle a disorderly ‘hard Brexit’ and maintain lending to the UK economy.
Behind these headlines, the stress tests and accompanying Financial Stability Report contained a number of important implications for UK consumer credit regulation, such as future consumer credit market regulation and the application of IFRS 9.
4most assesses some of the points raised by the stress tests:
Bank of England stress tests to prompt regulatory changes for consumer credit lenders
The stress tests reveal wider concerns from the Bank of England about UK consumer borrowing, which is likely to prompt further regulatory changes that will affect all UK lenders, notably those involved in consumer credit lending.
The Financial Policy Committee (FPC) continues to express concern about the rapid growth of consumer credit and believes that lenders have been underestimating the losses they could incur in a downturn. Under the stress test scenario, the Bank of England have judged that 20% of unsecured loans might go bad during a downturn and have further revealed that the UK banking system would incur consumer credit losses of around £30 billion, with the consumer credit impairments of major banks to be estimated at around £21 billion. As a result of these stress tests, the FPC have decided to set new regulatory capital buffers (‘PRA buffers’) for individual lenders so they can absorb its losses on consumer lending.
The important point for the wider sector is that the PRA will be applying similar standards to smaller lenders that were not part of the stress test on their capital plans. The regulators are likely to apply the same assumptions (that 20% of unsecured loans are likely to go bad during a downturn) to smaller banks. Tier 2 banks and smaller consumer credit lenders should, therefore, take into account these assumptions in upcoming conversations with regulators.
Bank of England’s approach to applying IFRS 9 to future stress tests raises questions
As of next January, UK banks will need to adhere to IFRS 9, a new accounting standard which provides for a new credit impairment model that will behave differently under stress test conditions. The FPC notes that bank capital, as measured under IFRS 9, will fall more sharply in the early part of a stress, before recovering more rapidly – and without adjustments to the stress-testing framework, banks would need to maintain higher capital ratios to meet the standards demanded.
The FPC has therefore said it will take steps to ensure that the interaction of IFRS 9 accounting with its annual stress test does not result in a de facto increase in capital requirements. While this approach is no doubt helpful to banks, in that they do not have to raise capital buffers again, it does however raise questions about the likely response from investors and the wider markets on banks’ capital in such scenarios.
For instance, in the heat of a recession, capital buffers will fall lower under IFRS 9 than they previously would have done. If this point is not understood by private investors, or if they do not have faith in the low apparent regulatory buffers driven by the pro-cyclicality of IFRS9, then this could further exacerbate financial instability. It is, after all, investors and the markets who are the ultimate arbiters of whether banks have enough capital.