Stress tests are worth doing – but they need to be properly designed

Outlook

Outlook Lloyds is in a tight spot. After coming in last of the UK banks under the weekend’s European stress tests, it received the inevitable bashing by the stock market yesterday. This was accompanied – and worsened by – a flurry of analysts declaring Lloyds was now clearly so weak that it wouldn’t be able to pay a dividend for years. To base such claims on the European stress tests seems unfair. For a start, don’t forget that Lloyds actually passed the tests, although without as many flying colours as its rivals.

Besides, the comparison with its rivals is an apples-with-pears job. The test focused on what would happen if there were a dramatic slump in house prices. Given that Halifax makes a quarter of all UK mortgages, of course its finances looks worse than other UK banks by that metric.

Not that they shouldn’t stress-test for the housing market. An increase in interest rates could trigger a pretty rapid house price decline across the country.

But banking risk isn’t just about home loans. As Lloyds’ disastrous Bank of Scotland arm taught us with its stupid lending in the Noughties, commercial property – shops and offices – can be just as dangerous.

Lending to the eurozone and eastern Europe is none too risk-free either. Fancy lending to Russian corporates since the Ukraine crisis, anyone? RBS and Barclays do, with regular abandon. And, while we’re at it, how about emerging markets in Asia, where HSBC and Standard Chartered so boldly go?

Had the stress tests based more assessment on cataclysms in those banking markets, Lloyds would have not looked quite as weak compared with its more internationally focused UK rivals.

That’s not to say the stress tests were a waste of time. Far from it. There’s nothing like a fire practice to get the adrenaline pumping and focus minds. It’s just that this drill only tested for a fire in the kitchen, when it’s more likely to be blazing away in the boiler room and the cigar lounge of the directors’ suite.

There’s another reason the European tests shouldn’t affect the Lloyds dividend. It’s not the European Banking Authority which decides whether the bank can make payouts to shareholders. That assessment is made by the Prudential Regulation Authority – which is conducting bank stress tests of its own, which are tougher than those of the Europeans.

The results will be out just before Christmas: only then will Lloyds’ chief Antonio Horta-Osorio find out if he’ll be playing Santa for shareholders.