The Bank of England has released details of how it will stress test eight major UK banks in the future.
The announcement is the central bank’s move towards its medium-term stress testing framework, which it proposed in a discussion paper last October.
“Much has been achieved in recent years to put the UK banking system on a sounder footing, so that it can support the UK recovery,” said Mark Carney, the bank’s governor.
“The challenge now is to secure a strong, sustainable and balanced economic expansion. The Bank's annual stress test will help ensure our banks support that expansion by remaining resilient. Today's announcement represents a major step in that new framework.”
The stress testing exercise for 2014 will be based on the EU stress test but will include “additional UK layers” that will look at weaknesses particular to the UK banking system.
The EU stress test assesses the resilience of EU banks under a common adverse scenario, allowing for some variances across jurisdictions.
The UK central bank mentioned that it would calculate the ability of banks to withstand risks, predominately rising interest rates and housing market shocks.
“Although the events depicted in this stress-test scenario are extreme, and thus highly unlikely to transpire, by bringing together the microprudential standards for banks with a macroprudential assessment of the tail risks to which they must be resilient, the Bank is working to ensure that the UK financial system remains one that absorbs rather than amplifies shocks.”
One of the main thresholds for the UK variant test will be set at 4.5% of risk-weighted assets (RWAs), to be met with Common Equity Tier 1 capital in the stress – using a CRD IV end-point definition of CET1 in line with the UK implementation of CRD IV.
The central bank said that if a bank’s capital ratio falls below 4.5%, it is strongly presumed that the UK Prudential Regulatory Authority would require it to take action in bolstering its capital position. Although, the PRA might still require some firms to increase capital positions even if they meet the threshold.
To judge whether action would need to be taken, the regulator would look at a firm's leverage ratio, Tier 1 and total capital ratios on a risk-adjusted basis, the adequacy of its recovery and resolution plans and the extent to which potentially significant risks are not quantified adequately or fully as part of the stress.