Tough tests for struggling banks

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The health of UK banks is being tested against their ability to withstand the worst recession since the Second World War, the City watchdog said today.

The Financial Services Authority (FSA) has published details of the gloomy scenarios used to assess the vulnerability of banks' loan books and capital strength.

It is currently testing against a fall in overall GDP of more than 6 per cent - with the UK remaining in recession until 2011 and unemployment hitting 12 per cent - as well as a 50 per cent peak-to-trough fall in house prices and a 60 per cent fall in commercial property prices.

The FSA stresses that the scenarios are not forecasts of what will happen, but are "deliberately designed to be severe".

The tests were used on banks such as Royal Bank of Scotland and Lloyds Banking Group applying to dump "toxic" assets in the Government's taxpayer-backed insurance scheme, and to assess the health of the Dunfermline building society, which collapsed in March.

The watchdog said it will not publish the results because the tests are now a firm part of its day-to-day supervision of the sector.

"Given that the application of the tests has and will continue to evolve, the precise parameters used have changed and will change over time," it said.

In January, the FSA said banks should be able to maintain a core tier one ratio - a key measure of capital strength - of 4% even after the stress test.

Building societies applying to use the Government's credit guarantee scheme announced last October were also required to maintain a tier one ratio of 7 per cent following the exercise.

The tests come as the FSA turns its focus from the alphabet soup of complex financial instruments which shook banks' balance sheets and caused the initial crisis, to the impact of recession on their loan books.

It said: "The key challenge now is that the weakness of the financial system has produced an economic situation which may in future produce significant loan losses and further impair the strength of banks and building societies in an adverse feedback loop."

The "crucial issue" was to identify future potential loan losses even among loans which currently would not be considered impaired on an accounting basis, the FSA added.

The FSA's decision to keep the results secret contrasts with that of US regulators, who have recently published the results of stress tests on 19 major banks.

The watchdog is also taking part in a Europe-wide stress-testing exercise of banks which will be completed by September.