The results of the Bank of England's stress tests on banks are worrying, and not just because state-owned Royal Bank of Scotland (RBS) failed and Barclays (BCS) and Standard Chartered struggled to meet minimum capital in the worst-case scenarios.
They are worrying because, in my opinion, the test's worst-case scenario does not account for the rise in uncertainty that exists after the recent twists and turns in global politics. The test criteria were set out in March of this year at a time when a vote to leave the European Union in the June referendum was not considered a serious possibility.
The criteria were tougher than the ones set out for banks in tests in 2014 and 2015 and, it can be argued, they imagined a U.K. economy in worse shape than during the 2007-2009 global financial crisis.
The scenario assumes annual world GDP shrinking by 1.9% at the lowest point, as it did in 2008; also, U.K. GDP shrinks by 4.3% while unemployment shoots up by 4.5%. U.K. house prices are assumed to fall by 31% and commercial real estate prices by 42%.
In China and Hong Kong, places where some British banks have significant business, residential property prices are assumed to fall by 35% and 50% respectively.
This year's stress tests also judge banks against the Bank of England's new hurdle rate framework. This means that banks that are considered systemically important are held to a higher standard, which reflects the phasing in of additional capital buffers required by the Basel rules for global systemically important banks.
Following the stress tests, RBS needed to update its plan to show how it will raise an additional £2 billion ($2.5 billion). It submitted details on how it will cut further costs, reduce its risk-weighted assets and sell non-core businesses to improve its capital ratio.
Barclays and Standard Chartered would need to raise capital in the worst case scenarios, but the Bank of England said it was happy with the plans these banks had already presented, so they did not need to come up with further measures.
Nonetheless, the stress test scenario, although the most severe ever, did not go far enough to take into account the multitude of risks that have appeared between March and now. The Brexit vote is the most important for the U.K., because it makes the government less able to support various sectors of the economy.
The most vulnerable is the housing market, which is very important for the health of banks not only because of the mortgages on their books, both for homeowners and for buy-to-let investors, but also because consumers are more confident when house prices rise. Property is also used as collateral for certain business loans.
The central bank noted that "the asset quality of participating banks' U.K. mortgage books has improved markedly since the 2007-08 financial crisis." Still, it added, "a large part of this improvement in asset quality is related to a rise in residential property prices of around 30% since their post-crisis trough, which has boosted collateral values on outstanding loans."
The Bank of England's stress tests assume a fall in U.K. house prices of around 31%, which would indeed be worse than the almost 20% decline recorded at the height of the global financial crisis. But unlike then, the U.K. now has less room to subsidize home prices with government money.
Britain has a budget deficit of around 5% of GDP, the highest among developed economies, and a current account deficit around the same level. The fall in the pound's exchange rate since the Brexit vote in June has meant that a floor was put under interest rates, because the weaker currency is pushing inflation higher.
Therefore, with debt growing and becoming more expensive to finance, the government will hardly be in a position to extend more help programs for home buyers, such as its previous Help to Buy initiatives that have propped up home prices.
These unlikely-to-be-repeated initiatives have played a big part in halting and even reversing the house price decline during the global financial crisis. Shareholders in U.K. banks should therefore pay even more attention than usual to home prices in the event of any economic weakness.
