UK banks pass the solvency test
The Bank of England, under the guidance of the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA), released the results of its 2021 bank stress test yesterday. This year, the Regulators tested the banks' abilities to withstand a severe economic scenario over the period 2021-2025, in addition to the economic shock produced by the Covid pandemic of 2020. The Bank of England tested the balance sheet strength of the eight largest UK lenders, measuring the adverse scenario's impact on the Core Equity Tier 1 (CET1) and the bank's leverage ratios. The banks tested were Barclays, HSBC, Lloyds, Nationwide, NatWest, Santander UK, Standard Chartered & Virgin Money.
This year the stress test incorporated extreme conditions, including a 31% decline in global GDP over the three years between 2020-2022 (compared to the 2019 level), a decline in UK GDP by £800bn over the period 2020-2022 (i.e. 37% of 2019 GDP), UK unemployment peaking at c.12%, a 33% decline in residential and commercial property, a 20% decline in UK equity prices, 140bps widening in IG-credit spreads and 480bps of widening in HY credit spreads. Such a scenario would indeed represent a considerable recession!
Under the severe conditions tested, the aggregate CET1 ratios of the eight banks tested would decline from the current 15.9% to 10.5%, and their leverage ratio from 5.7% to an average of 4.8%, comfortably above the minimum regulatory thresholds for both metrics.
In our view, the most interesting announcement from the Bank of England was the reintroduction of its counter-cyclical capital buffer (CCyB). The CCyB is an additional buffer that the regulator adjusts according to prevailing economic conditions. Each UK bank is expected to bolster its CCyB when conditions are supportive and utilise these funds during periods of economic stress to help maintain the flow of credit to all sectors of the economy. The Bank of England reduced the CCyB to zero during the pandemic but has now instructed banks to increase it to 1% by the end of 2022 and 2% by the end of Q2 2023. We believe investors should view the required increase as a prudent measure by the Bank of England and probably serves as a slight brake on the recent flurry of increased dividend and share buy-back programmes, following the period of distribution restrictions brought about by Covid.
As bondholders, we are comforted by all the banks passing such a severe test and welcome the prompt reintroduction of the buffer increase, which should provide some security to the flow of credit should the UK economy have a hard landing in the future.
