Stressful times for lenders awaiting capital test results

Banks may cut new lending to raise capital reserves if they fail tests, reports Alex Catalano

REC 12.14 p10 logosOn December 16th, the Bank of England will unveil the results of its stress tests to see if eight UK lenders have enough capital to withstand a bad shock to the economy.

The general feeling is that Barclays, HSBC, Lloyds, Standard Chartered, Co-operative Bank, RBS, the UK arm of Santander and Nationwide probably will pass the test, even though the BoE’s worst-case scenario is harsher than that of the recent European Banking Authority’s Europe-wide ‘comprehensive assessment’.

“It’s hard to make comparisons between the two, as the methodology is different,” says Samuel Tombs, senior UK economist at Capital Economics. “But as one or two UK banks only passed the EBA test by a slim margin, there’s a risk banks will have to raise more capital, hindering new lending.”

The EBA’s test required banks to have a tier-one capital ratio of 5.5% of risk-weighted assets. Lloyds passed by the narrowest margin of the UK four, at 6.2%, with RBS next, at 6.7%. Lloyds stresses that it meets all the test’s capital benchmarks and “will continue to ensure that its robust capital position is maintained”.  While the EBA only looked at the UK’s big, high-street players – Barclays, Lloyds, RBS and HSBC – the BoE’s Prudential Regulatory Authority (PRA) also tested four more UK lenders. Until now the other, smaller, lenders have avoided the limelight.

The PRA’s stress tests looks at “particular vulnerabilities” in the UK banking system: how well banks and building societies can cope with a very severe fall in commercial and residential real estate prices, or a sharp interest rate rise, in the next three years.

“The PRA is applying much tougher and more stringent scenarios,” says Rob Smith, KPMG’s banking risk director. The UK test’s worst-case scenario posits a 35% fall in house prices and a 30% fall in commercial prices, from Q4 2013 levels; the EBA’s test assumes 19% and 12% drops respectively.

However, just because the PRA’s property shock is twice as big as the EBA’s, it doesn’t follow that the impact will be twice as hard. “It’s not a linear relationship,” notes Smith. “The impact will be bigger, but we don’t know whether that means a bank will fail the test. I expect that they won’t, but the market was surprised by one or two of the results in the EBA test.”

The impact on banks will vary depending on the nature of their loan portfolios. Given the property price drops being assumed, those with bigger commercial and residential exposure will clearly be more affected.

But again, it is not a straightforward picture. The PRA requires UK lenders to risk-weight commercial real estate loans using “slotting” criteria that defines five different loan categories, attaching different regulatory capital requirements to each. But depending on a loan’s loan-to-value ratio, a 30% drop in value may not tip it into a higher risk-weighting, soaking up more regulatory capital.

Nonetheless, the results of the UK stress test may lead banks that need to bolster capital ratios to cut back on new lending.“Given the trend for higher commercial real estate LTV ratios, it will be interesting to see what impact the results have on the debt supply,” says Smith. “With 80% LTVs coming though in London, if you applied the PRA scenario of a 30% fall in values, the LTV ratio would be over 100%.”

Lenders must deal with an extra check

As well as their stress tests, the EBA and Bank of England are also putting an additional constraint on banks: the leverage ratio, or amount of capital they have to hold as a percent of their unweighted assets.

Regulators feel that capital rules based on risk-weighting assets allow banks to game the system, as they use internal models to assign the weightings. “The leverage ratio disregards individual banks’ assumptions about the riskiness of their assets, so there’s an additional check on the banking system that wasn’t there before,” says Capital Economics’ Tombs.

The Bank of England wants big banks to have a 4.05% (capital to assets) leverage ratio from 2019, up from 3% now, with an extra 0.9% “countercyclical” buffer being used to cool lending if the economy is getting overheated.