The U.K.'s largest lenders will be able to survive an extreme stress scenario, including a "chaotic" Brexit, Bank of England Governor Mark Carney said after the release of results of the regulator's annual stress test.
For the first time since the tests began in 2014, none of the seven participating lenders will be required to strengthen their capital bases to be able to withstand an adverse scenario more severe than the 2008 global financial crisis. The BoE's Financial Policy Committee, set up to monitor macroeconomic risks to the entirety of the U.K. financial system, said the stress test's adverse scenario included a number of elements that "could be associated with Brexit" and therefore concluded that the banking system could, in Carney's words, "continue to support the real economy even in the unlikely event of a disorderly Brexit."
But two lenders, Royal Bank of Scotland Group Plc and Barclays Plc, just barely scraped through the test, and the FPC acknowledged that a disorderly Brexit, i.e. one in which Britain exits the EU without a framework in place to avoid large-scale disruption to trade, combined with a severe global recession and higher-than-expected fines for misconduct, "could result in more severe conditions than in the stress test." raised the "countercyclical buffer" to 1%, or a total of £11.4 billion, from 0.5%, and said it would review the buffer again in the first half of 2018 in light of Brexit and other risks. The buffer is designed to ensure that banks hold extra capital in times of risk, and the FPC said in June that it viewed 1% as the correct level in a "standard domestic risk environment." The FPC
The increase will not require any banks to raise additional capital, as they already have sufficient margins over their regulatory requirements.
Barclays, RBS struggle
Based on their positions at the end of 2016, both Barclays and RBS would have failed to meet their individual systemic reference point — a benchmark for global systemically important banks higher than the baseline "hurdle rate". However, the BoE said that because both have improved their capital positions in the course of 2017, they would pass if the tests were re-run today.
Under the stressed scenario, RBS would have recorded a 7% common equity Tier 1 ratio, above its 6.7% hurdle rate but below its 7.4% systemic reference point. The 7% figure would be inclusive of converting its Additional Tier 1 bonds into equity and "management actions" that can include restrictions on dividends and bonuses.
RBS finished 2016 with a CET1 ratio of 13.4%, which improved over the course of 2017 to reach 15.5% at the end of the third quarter. In the stressed scenario, RBS would earn more income from higher benchmark interest rates (modeled to rise to 4%), but this would be canceled out by an increase in impairments in both corporate and retail lending books thanks to a downturn in the U.K. economy.
Barclays would see its CET1 ratio fall to 7.4% under the stressed scenario from 12.4% at year-end 2016, like RBS clearing its hurdle rate (6.8%), but falling short of its systemic reference point (7.9%). The bank's actual CET1 ratio had risen to 13.1% by the end of the third quarter, with the BoE noting that it had sold down its majority stake in Barclays Africa Group Ltd. over the course of 2017, boosting its capital position.
Like RBS, Barclays would benefit from higher net interest income due to higher interest rates, but suffer as a result of higher impairments, largely from its credit card portfolios.
Even though RBS failed the stress test in 2016 while Barclays passed, the Bank of England asked the institution to submit a plan showing how it would strengthen its capital position.
Ian Gordon, a London-based banks analyst with Investec, said the stress test result made no material difference to RBS' outlook.
"We are not very interested in the fact that RBS received a 'weak' score in the latest Bank of England stress test. For us, this changes nothing," he said in a November 28 note. Investec still rates RBS shares at "sell" thanks to the prospect of further fines from the U.S. Department of Justice and the "small matter" of the U.K. government's residual 71% stake in the bank, Gordon said.
Fintech disruption warning
Alongside the customary annual cyclical scenario testing banks' capital positions, the BoE also ran a new biennial "exploratory scenario," which takes a more qualitative view of how banks would manage in the face of structural, rather than cyclical, change. Such changes include a major drop in demand for global cross-border finance and heightened competition in financial services, especially from financial technology companies.
Banks "may need to give more thought" to structural challenges, particularly the growing prevalence of fintech, Carney said during the briefing, noting that with the Open Banking regime taking effect in the U.K. in 2018, it will be easier for customers to switch accounts and to shop around for financial products. It will also mean that fintech companies will start providing more services that have up until now have only been provided only by banks, he added. "This is potentially an exciting moment from a consumer perspective. But it is at least possible that some banks will become utilities, and the customer's core relationship with be provided by a non-bank," he said. "We are not looking to protect the banks, but they do need to look at their cost structure, as it may be more costly to keep customers in future."
Many banks appeared to assume that the cost of gaining and keeping customers was going to fall, Carney said.
Dividends, bonuses slashed
The other five lenders participating in the stress test were HSBC Holdings Plc, Santander UK Plc parent Santander UK Group Holdings Plc, Lloyds Banking Group Plc, Nationwide Building Society, and Standard Chartered Plc.
Under the stressed scenario, all five banks currently paying dividends — HSBC, Lloyds, Santander, StanChart, and Barclays — would scrap dividends in the first two years of the stress: Lloyds and Santander in line with company policy, and HSBC, StanChart, and Barclays because they would make losses and therefore become subject to regulatory restrictions on payouts. RBS has not paid a dividend since the financial crisis and would continue not doing so throughout the stress scenario, while Nationwide would continue to make distributions on its core capital deferred shares.
Overall, the participating banks are slated to pay out £26 billion in dividends in 2017 and 2018 under the test's "baseline" scenario.
Barclays, HSBC, and RBS would also have to stop coupon payments on AT1 bonds in 2017 and 2018 under the stress scenario, while Lloyds and StanChart would do so only in 2017, and Nationwide and Santander would continue to make payments. Bonuses and other distributions would also fall dramatically in the stress scenario, to just £500 million over the two years, compared to £4.4 billion in 2016, and baseline projects of £9.0 billion for 2017 and 2018.
Barclays, HSBC, Lloyds, and RBS would not pay any bonuses in either year of the stress scenario.
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