'Idiosyncratic' new stress tests to challenge weaker banks

Exclusive: Watchdogs will demand tough new stress tests

Watchdogs have told banks that they will demand tough new stress tests that could lead to many more failures from next year, The Independent has learnt.

In addition to an economic shock scenario created by the Bank of England, banks will from 2016 have to create simulated disasters tailored to their businesses and get them approved by regulators. They will then have to show they have the financial resources to pass these “idiosyncratic” tests under close supervision from the Bank’s Prudential Regulation Authority.

It come as the Government confirmed new powers for the Bank’s Financial Policy Committee over the housing markets. They will include the ability to limit the ratio of debt to income and the percentage of loan to house value banks are able to lend to borrowers at.

The FPC will also be able to limit banks’ “leverage ratio”, a measure of their ability to absorb losses on their lending. Separate consultations will be held over its call to be given powers over the buy to let mortgage market.

The addition of a new set of stress tests follows criticism that last year’s tests – focusing on a housing market shock – gave banks such as Standard Chartered and HSBC too easy a ride because their exposure to house prices was far less than big mortgage banks such as Lloyds or a building society like Nationwide.

The tests were ultimately failed only by Co-op, but both Lloyds and Royal Bank of Scotland scraped through and had to shake up their capital plans while the tests were running so they could achieve passing grades.

This year’s are likely to test the impact of a dramatic downturn in so-called emerging market economies, which should make them tougher for the beleaguered Standard Chartered, whose business is focused on Asia, and HSBC as well as Barclays, which has a big business in Africa.

The PRA is believed to have considered bringing in the tailored idiosyncratic disaster testing alongside them this year but ultimately settled on 2016 to give the current regime more time to bed in.

This year will be the first the Bank has run a test without a baseline scenario laid out by the European Banking Authority.

“We expect them to be significantly harder to pass,” said one industry source. “Of course we do our own stress testing but we think this may make it much more difficult for weaker banks.”

Co-op admitted it would fail last year’s tests before it had even heard the results. The Bank created a hypothetical scenario involving a deep recession, an unprecedented collapse in house prices and a sharp rise in interest rates and unemployment over a three-year period.

It was applied to just the eight biggest lenders and would have all but exhausted Co-op’s reserves. but it came as markets were focusing on turmoil in Russia’s economy as the greatest potential risk. All banks that struggle with the tests are obliged to show the PRA how they will secure enough capital to pass.

Stress testing has become a key tool for watchdogs to asses banks’ financial strength and ability to withstand shocks that might at first appear to be unlikely.

Paul Tucker, the former deputy governor for financial stability at the Bank of England, said at the time they were being formulated that “stress testing can provide a quantum leap in transparency and accountability”.