UK banks can pat themselves on the back, but the system is still feeling the stress

Breathe a sigh of relief: once again, all financial institutions have passed the Bank of England’s annual stress tests.

But look beneath the surface, and suddenly the various allowances made this week start to undermine the good news.

First, if the impact of the new accounting standard IFRS 9 that came into force in January was taken into full account, from a regulatory capital perspective two banks would have fallen well below the pass mark, with their capital levels having been dramatically dented.

Further, the Bank of England aims to continually hold banks to a higher standard, so this year the scenarios stayed the same as in 2017, but with supposedly higher pass marks, making them more challenging.

However, while the pass mark did indeed rise, a number of complex adjustments were permitted which brought it back within reach.

The net result was that we ended up with a pass mark that was broadly in line with what we had in 2017. Essentially, it is like our biggest banks were told to climb Snowdon, but then read in the small print that they’re allowed to take the train.

Now in their fifth year, it is fair to say that the 2018 bank stress tests failed to live up to the anticipation caused by the excitement of the multiple delays.

Earlier in November, the European Banking Authority put UK banks in the spotlight after they emerged as the poorest performers in its Europe-wide stress test. This week, the Bank was clearly keen to emphasise that UK institutions are in fact in very robust shape.

The stress tests have successfully improved banks’ capital strengths and shone a spotlight on efforts to improve transparency and resilience. Since the tests began, banks have upped their capital strength significantly, with the average core capital ratio up from 11 per cent in late 2013 to 17 per cent in 2018.

But for the second year running, all banks have survived a scenario that Mark Carney tells us is roughly two and half times harsher than the worst case “cliff-edge” Brexit. This might cause some to question where we go from here.

Stress tests take a huge amount of resources both from the firms and the regulator. While the UK tests set the standard globally, there remain some fundamental issues with the process.

Throughout 2018, the regulator has raised concerns about the standard of the models used to conduct the exercises, and this was again flagged as a concern in the results report on Wednesday.

The Bank of England governor fears that bank boards do not sufficiently understand and challenge the models they use. This inevitably raises concerns over the results.

Next year, the UK banking landscape may see more dramatic change as we exit the EU, ring-fence retail and institutional banking, further recognise the impact of IFRS 9 on capital, and near the demise of the Libor benchmark.

We can only hope that the Bank of England finds new ways to maintain its scrutiny on banks and continue its stress tests in this rapidly changing environment.