UK banks in better shape to withstand a property crash

UK banks are in much better shape to withstand a property crash than they were in 2007-2008 according to the latest Bank of England stress tests.

UK banks would suffer impairment rates on their real estate loan books of about half those experienced in the financial crisis, and impairment charges of under a third as much.

The 2016 test, the third under the Bank’s new approach to stress testing, was tougher than the 2014 and 2015 tests and modelled sharp falls in residential and commercial property prices, of 31 percent and 42 percent respectively, as well as a severe global and UK economic and financial crash.

The findings say that because the quality of major UK banks’ CRE books has improved materially since the financial crisis, the proportion of their loans “with an LTV of more than 100 percent after three years of the stress test scenario is much smaller than it was after the financial crisis.”

This is “despite the fall in CRE prices in the stress test broadly mirroring the decrease observed after the 2007-2008 financial crisis.” (See chart below).

The stress test report notes that banks have disposed of their less well performing assets, tightened their underwriting standards, left most higher-risk lending to non-UK banks and non-banks, and, crucially, cut the size of their books.

The result is that UK CRE impairment rates under the 2016 scenario would be materially lower than those incurred by banks in the period following the 2007–08 financial crisis, at just over half those levels, while impairment charges are under a third as much, at less than £5 billion compared with over £15 billion, “because of the sizable reduction in the size of the CRE books.” (see chart below).

In terms of overall outcomes of the seven lenders examined, Royal Bank of Scotland was the worst performer, falling short of its common equity Tier 1 (CET1) capital and Tier 1 leverage hurdles. It has submitted a revised plan to strengthen its capital base which the Bank’s Prudential Regulation Authority will monitor.

Barclays and Standard Chartered each fell short of one hurdle but have already taken steps to strengthen their capital positions and did not have to submit revised capital plans. HSBC, Lloyds, Nationwide and Santander all passed.

Overall under the scenario, banks’ books would be impaired by £63 billion over two years, including overseas loans. Banks like Lloyds that are now principally focused on UK business remained well above their hurdle rates throughout the stress.

The Bank of England remains vigilant on property, believing it is expensive, with prime “appearing overvalued on some metrics” and susceptible to a sudden rise in interest rates. The stress test factored a more severe, 49 percent, fall for prime.

While the results acknowledge that the asset quality of participating banks’ UK residential mortgage books have also improved markedly due to more prudent lending as well as the rise in house prices, the Bank remains concerned about buy-to-let.

From the start of 2009 to the end of 2015, the outstanding stock of buy-to-let lending grew by around 6% a year on average, compared with around 0.3% for owner-occupier mortgages. “This rapid growth means that the vulnerability of banks’ buy-to-let portfolios to a severe economic downturn has not been observed, so it is more uncertain than the performance of owner-occupier mortgages in a stress”, the results say.

Core data collection

There are some notable comments for the property lending community in the section covering future stress tests. Here it notes that in September 2016, the Bank rolled out a core stress-testing data set to participating banks. This, it says, is “critical” for analysis and will be collected as part of every future stress test, which should increase the degree of automation, and therefore ease, of the data collection and submission over time.

A number of CRE bodies have been calling for standardised data to be collected for all UK property lending.

The Bank also reaffirmed that it will keep the UK ‘countercyclical buffer rate’ – a requirement for UK banks to set aside extra capital – at 0 percent until at least next June 2017.

The 0 percent buffer was announced in July soon after the vote to leave the European Union which heightened uncertainty around the UK economic outlook. Keeping the buffer at 0% reverses a decision in March 2016 to increase it to 0.5% in March 2017 and is intended to encourage banks to keep lending rather than hoarding capital.

In July the Bank said the 0 percent rate will reduce buffers by £5.7 billion raising banks’ capacity to lend by up to £150 billion.