Banking Stress Tests: RBS remains the weakest link

As part of the revamped system of financial regulation introduced since the 2008 global financial crisis, the Bank of England subjects Britain’s leading commercial banks to regular stress tests.

These tests are designed to see if the banks have sufficient capital and liquidity to be able to absorb losses from so-called tail risk events, i.e. Black swan shocks that affect both the domestic and the international economy.

The latest stress test has a nightmare scenario for the banks to contend with. It modelled how the commercial banking system would cope in a situation in which UK real GDP shrinks by 4.3% amid a worldwide recession (global output declining 2%), unemployment rising 4.5 percentage points, the world oil price halving and average UK house prices dropping by 31%.

The harshness of the test was added to by including an estimated provision of several £ billion to cover losses from mis-selling of financial products.

The latest results have just been published in the Bank’s November 2016 Financial Stability Report and three lenders need to improve the amount of capital on their balance sheets after failing the tests. Part state-owned Royal Bank of Scotland must improve their balance sheet by £2bn and Barclays and Standard Chartered - are required to submit revised capital raising plans.

Extra capital can be raised in several ways including selling off poorly-performing parts of a business (a process known as divestment or de-merger). RBS may eventually have to go to the capital markets and raise fresh equity from the issue of new shares. Share prices in RBS fell quite sharply today on news that the Bank had not passed the stress test hurdles.

HSBC, Lloyds Banking Group, Nationwide and Santander UK all passed the stress test and, despite elevated risks following the Brexit vote, the Governor of the Bank of England, Mark Carney declared himself moderately confident that there is a sufficient fire-break in the system should another major financial shock hit the British economy.

This short video from the Bank of England explains what stress testing is and why it is considered important as part of financial oversight / regulation.