On 27 March the Bank of England (BoE) will publish the scenarios for its 2017 banking sector stress testing exercise. For the first time, the exercise will include an 'exploratory' scenario. Run in alternate years alongside the now familiar annual cyclical scenario (ACS), the exploratory scenario will enable the BoE to test the resilience of the banking system to a wider range of threats.
Based on what the BoE has already disclosed, we know that the exploratory scenario will assess the impact of weak global growth, persistently low interest rates and a continuation of declines in cross-border banking activity. It will run over a seven-year time horizon in order to capture long-term trends. Rather than focusing on the implications for capital directly, it will assess the impact on business models, including structural weaknesses.
The results of the exploratory scenario will be considered alongside the ACS, the Internal Capital Adequacy Assessment Process (ICAAP) and other relevant information in setting each bank's Prudential Regulation Authority (PRA) buffer.
For the major UK banks involved – Barclays, HSBC, Lloyds, Nationwide Building Society, RBS, Santander UK and Standard Chartered – the exploratory scenario introduces a new set of challenges. Many banks already find it difficult to run the ACS to the timetable set by supervisors; the addition of the exploratory scenario could significantly stretch capacity. Banks may also need to develop their capability to integrate their business planning and strategy analysis into their stress testing framework. Further, although the BoE has indicated that the data submissions for the exploratory scenario will be less extensive than for the ACS, they are still likely to involve new data fields that banks may find difficult to populate. The additional two weeks that the PRA has provided firms for submission of the exploratory scenario results, although helpful, is probably not going to make a material difference to banks that will need to take all the results through their governance structures at the same time.
More generally, the scenario is an important reminder of the BoE's focus on business strategy, which is increasingly put at the heart of its analysis. Last year Sam Woods, Chief Executive of the PRA, spoke of the end of the 'revolutionary period' in which reforms to prudential standards were required, enabling banks now to 'renew their business models for the new world'.i
Why has the BoE chosen to focus on this topic?
As demonstrated by the 2016 stress testing exercise, capital is no longer considered a primary concern for the UK banking sector as a whole. In September 2016, the aggregate Common Equity Tier 1 (CET1) ratio for the major UK banks was 13.5%ii, consistent with the (system-wide) level of capital considered as optimal by the Financial Policy Committee (FPC)iii.
At the same time, banking sector profitability has become a major issue. Average reported Return on Equity (RoE) has been persistently low over the past several years, and remains well below pre-crisis levelsii. UK banks' price-to-book ratios also remain subdued, reflecting a perceived decline in their ability to generate acceptable returns for shareholders.
There are a number of themes that the BoE has previously identified as contributing to low profitability:
- Conduct and restructuring-related costs. Underlying RoE (stripping out one-off charges) was more than double reported RoE in 2015, according to BoE analysis.
- Poor investment banking profitability. The BoE estimates that RoE for the investment banking units of UK banks are below those for retail bankingii. While some element of the weak profitability may be cyclical, the BoE considers that at least some can be attributed to structural factors.
- Sale or closure of non-core businesses. This has been a major support of capital ratios in the past few years, but results in reduced income diversity and less flexibility to raise capital in the future.
- Elevated cost bases. Including as the result of increased costs of compliance, and of structural changes in the banking sector due to regulatory changes.
- Persistently low interest rates.
What might the 2017 exploratory scenario involve?
Considering the focus on profitability, the following questions might inform the BoE's assessment:
Assessing profitability of business models: Which business models are most susceptible to persistently low interest rates? More generally, how sustainable is maturity transformation as a business model? How stable is fee income as a source of revenue, and how closely is it linked to specific business lines?
Probing long-term resilience: How quickly can banks increase capital ratios organically through retained earnings? The BoE has stated that it will use the exploratory scenario to understand this better. It has been estimated that the average UK bank requires four years to increase its capital ratio by one percentage point through retained earnings.ii
Addressing the implications of 'Brexit': How will the UK's withdrawal from the European Union affect business models? How will restructuring activities affect bank profitability?
Challenging banks' capabilities to assess and understand their business models and strategy processes: What is the effectiveness of banks' own business model analysis and strategy capabilities? This has been an increasingly important consideration for supervisors, and an integral part of the annual Supervisory Review and Evaluation Process.
Conclusion
In its third year, the BoE's banking sector stress testing framework continues to develop, putting pressure on banks to keep up with supervisory expectations. The latest addition – the exploratory scenario – reflects the shift of primary focus from capital to profitability. Although it will be a major logistical exercise, the requirement to better-integrate 'business-as-usual' business planning and strategy processes with the stress test is consistent with supervisory expectations more broadly and so an area banks will anyway have to develop.
Footnotes
i Sam Woods, Mansion House City Banquet, The revolution is over. Long live the revolution!
ii Bank of England, 2016 Financial Stability Report.
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