October 1, 2013 5:40 pm

BoE to stress-test big banks every year

The Bank of England has set out a framework for what will become one of the most important parts of its work to prevent another financial crisis – a yearly stress test of the UK’s biggest banks.

In a move to enhance the stability of the financial system, the BoE on Tuesday published a discussion paper setting out proposals for annual tests to gauge whether the UK’s most important lenders have enough high-quality capital to withstand a bout of market turmoil.

The BoE, which will take comments on the paper until January, expects to introduce the tests in full before the end of Mark Carney’s term as governor in five years’ time.

Mr Carney said on Tuesday: “This will materially strengthen the bank’s analytical capability to assess risks to resilience. Our intention is that stress testing evolves into an essential component of our prudential framework.”

Policy makers expect the tests to influence the work of the Financial Policy Committee, the BoE body charged with preventing a financial meltdown. The BoE expects to publish its results, which will be used to inform the FPC’s assessment of the health of the financial system, along with decisions taken by the UK’s banking supervisor, the Prudential Regulation Authority.

Paul Tucker, deputy governor for financial stability, said that the publicity the yearly tests would attract would make the FPC more accountable.

“We need to engage society – public, parliament – in debates about the resilience of the financial system and how we are supervising it in the good times as well as in bad times . . . stress testing can provide a quantum leap in transparency and accountability,” he said.

The tests are eventually expected to cover all of the major UK banks as well as subsidiaries of the biggest foreign lenders. The paper also considers expanding the tests to include medium-sized domestic lenders.

BoE officials have discussed a more ambitious definition of the exercise, suggesting that in future other foreign banks and non-banks such as central counterparties, which serve as intermediaries between lenders, should be added to a pool of companies subjected to testing.

The inclusion of small UK banks would be unlikely to justify the costs involved, though the BoE acknowledged their collective failure could pose a threat to stability.

The BoE will conduct a stress test exercise in the second quarter of 2014, though this will be far more limited in scope – covering only the eight largest lenders – than the eventual regime, which regulators say will require more personnel and data than they have at their disposal at present.

The paper is the outcome of an FPC proposal made in March. The FPC is set to take responsibility for designing scenarios that banks would need to withstand.

There are also plans for bespoke scenarios for individual firms, which the board of the PRA would approve. Regulators are expected to rely on a suite of models for the tests.

International regulators also focus on stress-testing banks

The UK is not alone in beefing up its stress testing regime, write Laurence Holdsworth and Claire Jones.

Though banks and companies have long used the tests, their popularity among regulators has grown substantially since the collapse of Lehman Brothers in the autumn of 2008. International regulators typically focus on stress-testing their most important banks – those that either have a large balance sheet or are interconnected to many other lenders.

Most, like the Bank of England, use them to assess how much capital their financial system needs. When they are used on institutions deemed less “systemically important”, the tests generally function as a surveillance tool and do not have policy implications.

Most of the regulators conducting stress tests do so every year and publish results in their financial stability reports. The data requirements and scenarios differ between regulators, though several use a variety of models to assess banks’ ability to withstand turmoil. The US Fed relies on 40 in-house models. Regulators differ on how much they reveal about the methodology. In recent years, lenders have also been encouraged to design scenarios with their business models in mind.

The reaction has been mixed. A 2010 assessment of European banks met with a lukewarm response from markets after it emerged that far fewer banks than expected had failed.

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