FSA stress tests

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They were not so stressful after all. The Financial Services Authority, Britain’s lead financial regulator, has lifted the veil on the scenarios it used to test the capital strength of the banks it monitors. These include those that have sought government protection, such as Lloyds/HBOS and Royal Bank of Scotland, as well as those that thought about doing so but did not, such as Barclays. Investors were not impressed. After learning what the tests comprised, they sold bank stocks.

At first glance, the exams look fairly stiff. They assume a peak-to-trough slump in gross domestic product of more than 6 per cent, and a rise in unemployment to more than 12 per cent. That is harsher than the stress modelling applied to US banks. The FSA also tested for a peak-to-trough fall in house prices of 50 per cent and in commercial property of 60 per cent. Banks passed if their core tier one capital ratio survived all this and remained above 4 per cent. Yet investors had expected more stringent tests than this.

They are are right to be concerned. Credit Suisse points out that market forecasts are already for a peak-to-trough fall in GDP of 4.5 per cent with unemployment reaching 10.5 per cent. On that basis, the FSA’s tests do not add much of a safety buffer. The property price test is more convincing. UK house prices have fallen by 22 per cent from their 2007 peak on the Halifax index. They would have to drop another 36 per cent to hit the FSA’s level.

Shareholders need more reassurance that the FSA’s models evolve as conditions change. Still, the FSA left itself some wiggle room, saying that its tests incorporate the possibility that banks might boost their capital by selling assets. Indeed, that may explain why Barclays is now selling one of the jewels in its crown, its asset management arm BGI.

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