Shock to global economy could wipe out 40% of UK banks' capital

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The Independent Online

A major global economic shock would trigger a financial crisis that could wipe up to 40 per cent off the value of the UK banking sector, the Bank of England warned today.

The results of a "stress test" showed a sudden tightening in credit constraints or a substantial fall in asset prices would inflict "significant" damage on the financial system.

The Bank's financial stability report, published twice a year, said increased appetite for risky investments had pushed the financial system "further up the risk spectrum" over the past six months. But it insisted the financial system was "remarkably resilient" and said the chances of a shock hitting the UK were very low.

It identified six key risks and, for the first time, has published the results of stress tests carried out to see how the City of London would react. The risks were a disorderly unwinding of economic imbalances; a sudden rise in risk; a fresh spate of over-leveraged deals to take advantage of low risk premia; a sudden rise in household debt problems; collapse of a hedge fund; and disruption to the clearing and settlement system.

In its report, the Bank said: "Far and away the most likely outcome in the near term is that none of the vulnerabilities crystallises. Moreover, even if these vulnerabilities were to crystallise individually, they would be unlikely to erode to any significant extent the capital base of the UK banking system."

But the Bank admits it must consider a number of these risks crystallising simultaneously - something it describes as an "extreme but plausible scenario".

The Bank "stress-tested" two: a recession sparked by a spike in oil prices that forces banks to reassess companies' creditworthiness and causes a sharp turn in the credit cycle; and a substantial fall in asset prices triggering an "abrupt and widespread" rise in risk premia that in turn would have major implications for household and corporate vulnerabilities.

The bank tested a repeat of the early 1990s recession on the current financial system and found banks racked up losses as write-off rates on household and corporate debts soared, in turn cutting banks' incomes and lowering their ability to lend.

In the second scenario, the Bank raises rates by 1.5 percentage points - a 33 per cent rise at current rates of 4.5 per cent - while market rates also soared. This surge in borrowing costs again exposes vulnerable household and corporate debts.

"Illustrative calibrations of these broad severe stress scenarios suggest losses in either case could be equivalent to around 30 to 40 per cent of major UK banks' [regulated] capital," the report said. "The severe crystallisation of credit, liquidity and market risk in combination could lead to a material erosion of UK banks' capital, with potential knock-on effects to supporting markets, institutions and infrastructures."

The Bank stressed these were "extreme and highly unlikely" generated scenarios but added: "Given their implications, such scenarios merit careful consideration in financial firms' management planning."

Sir John Gieve, a deputy governor at the Bank, said: "Risk management in the financial sector has become much more sophisticated in recent years but the pace of innovation and growth of financial markets is raising the bar."