On December 1, 2015, the Bank of England released the results of its second round of annual stress tests, which aim to measure the capital adequacy of the UK banking system. This exercise is intended to function as a financial health check for the major UK banks, and purports to test their ability to withstand a severe adverse shock and still come out in good financial shape.

The stress tests were billed as severe. Here are some of the headlines:

“Bank of England stress tests to include feared global crash”

“Bank of England puts global recession at heart of doomsday scenario”

“Banks brace for new doomsday tests”

This all sounds pretty scary. Yet the stress tests appeared to produce a comforting result: despite one or two small problems, the UK banking system as a whole came out of the process rather well. As the next batch of headlines put it:

“UK banks pass stress tests as Britain's ‘post-crisis period’ ends”

“Bank shares rise after Bank of England stress tests”

“Bank of England’s Carney says UK banks’ job almost done on capital”

At the press conference announcing the stress test results, Bank of England Governor Mark Carney struck an even more reassuring note:

The key point to take is that this [UK banking] system has built capital steadily since the crisis. It's within sight of [its] resting point, of what the judgement of the FPC is, how much capital the system needs. And that resting point — we're on a transition path to 2019, and we would really like to underscore the point that a lot has been done, this is a resilient system, you see it through the stress tests.[1] [italics added]

But is this really the case? Let’s consider the Bank’s headline stress test results for the seven financial institutions involved: Barclays, HSBC, Lloyds, the Nationwide Building Society, the Royal Bank of Scotland, Santander UK and Standard Chartered.

In this test, the Bank sets its minimum pass standard equal to 4.5%: a bank passes the test if its capital ratio as measured by the CET1 ratio — the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets (RWAs) — is at least 4.5% after the stress scenario is accounted for; it fails the test otherwise.

The outcomes are shown in in Chart 1:

Chart 1: Stress Test Outcomes for the CET1 Ratio with a 4.5% Pass Standard

Note: The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Based solely on this test, the UK banking system might indeed look to be in reasonable shape. Every bank passes the test, although one (Standard Chartered) does so by a slim margin of under 100 basis points and another (RBS) does not perform much better. Nonetheless, according to this test, the UK banking system looks broadly healthy overall.

Unfortunately, that is not the whole story.

One concern is that the RWA measure used by the Bank is essentially nonsense — as its own (now) chief economist demonstrated a few years back. So it is important to consider the second set of stress tests reported by the Bank, which are based on the leverage ratio. This is defined by the Bank as the ratio of Tier 1 capital to leverage exposure, where the leverage exposure attempts to measure the total amount at risk. We can think of this measure as similar to total assets.

In this test, the pass standard is set at 3% — the bare minimum leverage ratio under Basel III.

The outcomes for this stress test are given in the next chart:

Chart 2: Stress Test Outcomes Using the Tier 1 Leverage Ratio with a 3% Pass Standard

Based on this test, the UK banking system does not look so healthy after all. The average post-stress leverage ratio across the banks is 3.5%, making for an average surplus of 0.5%. The best performing institution (Nationwide) has a surplus (that is, the outcome minus the pass standard) of only 1.1%, while four banks (Barclays, HSBC, Lloyds and Santander) have surpluses of less than one hundred basis points, and the remaining two don’t have any surpluses at all — their post-stress leverage ratios are exactly 3%.

To make matters worse, this stress test also used a soft measure of core capital — Tier 1 capital — which includes various soft capital instruments (known as additional Tier 1 capital) that are of questionable usefulness to a bank in a crisis.

The stress test would have been more convincing had the Bank used a harder capital measure. And, in fact, the ideal such measure would have been the CET1 capital measure it used in the first stress test. So what happens if we repeat the Bank’s leverage stress test but with CET1 instead of Tier 1 in the numerator of the leverage ratio?

Chart 3: Stress Test Outcomes Using the CET1 Leverage Ratio with a 3% Pass Standard

In this test, one bank fails, four have wafer-thin surpluses and only two banks are more than insignificantly over the pass standard.

Moreover, this 3% pass standard is itself very low. A bank with a 3% leverage ratio will still be rendered insolvent if it makes a loss of 3% of its assets.

The 3% minimum is also well below the potential minimum that will be applied in the UK when Basel III is fully implemented — about 4.2% by my calculations — let alone the 6% minimum leverage ratio that the Federal Reserve is due to impose in 2018 on the federally insured subsidiaries of the eight globally systemically important banks in the United States.

Here is what we would get if the Bank of England had carried out the leverage stress test using both the CET1 capital measure and the Fed’s forthcoming minimum standard of 6%:

Chart 4: Stress Test Outcomes for the CET1 Leverage Ratio with a 6% Pass Standard

Oh my! Every bank now fails and the average deficit is nearly 3 percentage points.

Nevertheless, I leave the last word to Governor Carney: “a lot has been done, this is a resilient system, you see it through the stress tests.”

——

[1] Bank of England Financial Stability Report Q&A, 1st December 2015, p. 11.

[Cross-posted from Alt-M.org]