BoE sets out 2024 stress testing roadmap

Introduction

The Bank of England might have cancelled the 2024 annual stress test for banks, but on 27th June 2024 it made clear stress testing remains very much in focus. 

It made two announcements: 

1. Published the two macroeconomic stress scenarios it will use for its ‘desk-based’ stress testing exercise, and which it expects banks to use as a ‘template’ for their ICAAP stress testing; and
2. Launched the second round of its system-wide exploratory stress test (SWES).

In this article we summarise the two announcements and provide some insights into what they mean for banks.
 

1. Desk based Stress Test
 

Brief background: 

• The Bank is carrying out a desk-based stress-test (DBST) exercise in 2024 instead of its usual annual stress test of the major UK banks – the Annual Cyclical Scenario (ACS) exercise. Meanwhile, the Bank is in the process of reviewing its approach to bank stress testing, and we expect them to publish an update on that in the second half of 2024.
• The DBST is meant to test the resilience of the UK banking system to downside risks and to support the Financial Policy Committee (FPC) and Prudential Regulation Committee (PRC). The exercise will not involve firm submissions of stressed projections and the Bank has emphasised that no individual bank numbers will be published as part of the results in Q4 2024. 

Scenario summary:

• The Bank has published two scenarios: 
  1. A ‘rates up’ scenario (a global supply shock scenario) - Central banks hiking interest rates (UK Bank Rate goes up to 9%), in a high inflation scenario motivated by a global supply shock, with increases in geopolitical tensions and commodity prices; and
  2. A ‘rates down’ scenario (a global demand shock scenario) - Global central bank rates falling close to zero, following a global demand shock and below target inflation. Apart from the paths for rates and inflation, the scenarios are largely the same (in fact, many paths are actually identical).
• Table 1 and Table 2 below show a summary of scenario narrative, stress transmission channels, and shock severities for the key macro-economic variables. UK inflation rate and bank rate projections are the two variables that have divergent forecasts compared to the previous ACS scenarios.

Insights :

• The most interesting aspect of the two scenarios is the rates up scenario. We know the BoE wasn’t content with banks’ ability to model high interest rates and high inflation in the 2022/23 ACS. 
• In the new scenario rates go much higher – to 9% in the UK.  This is the highest level since the early 90s and these levels of rates are unlikely to be reflected in banks’ models.  Banks using this scenario for their ICAAPs will need to be very careful how they model and justify the impacts of these very high interest rates on impairments, net interest income and RWAs, given the interest rate paths are outside the range on which the models will have been trained on. 
• For mortgage impairments, banks will need to consider the degree of protection that stress tested interest rates provide and the uplift in mortgage payments from rolling off a fixed rate at lower interest rates. 
• And for consumer credit impairments, Banks will also need to think through and quantify the implications of a further squeeze on household budgets from another round of commodity price spikes and any ‘contagion’ effect, as consumers prioritise their mortgage payments. 
• Banks shouldn’t just lift the scenario and apply it without considering how to adapt it for their own portfolio and circumstances. It will be important to consider the narrative of the scenarios in calculating impacts on bank balance sheets.  For example, sectoral impacts including higher commodity and import prices, and geopolitical tensions likely mean a weak outlook for exporting industries. 

2. System-Wide Exploratory Scenario
 

Brief background :

• The Bank has launched Round 2 of the system-wide exploratory scenario exercise. In June 2023, the Bank launched it’s first system-wide exploratory scenario to assess and better understand system-wide dynamics. The exercise covers a diverse range of participants including large banks, insurers, central counterparties (CCPs), and a variety of funds.
• In Round 1, participants were asked to assess the impact of a hypothetical stress scenario on their business and to explain the actions they would take in response. The Bank has now relayed the sectoral and system-wide observations from Round 1 back to the participants. 
• In Round 2, participants have been asked to consider how their response to the SWES scenario would change in light of these industry wide actions. 

Scenario Summary :

• The SWES exercise incorporates severe, but plausible, 10-day shocks to rates and risky asset prices. 
• The scenario severity is wider ranging and more persistent than observed both in the March 2020 ‘dash for cash’ and September/October 2022 LDI (Liability Driven Investment) events.
• Table 3 and Table 4 below show a summary of scenario narrative, stress transmission channels, and cumulative shock severities over a 10-day period for the key macro-economic variables. The majority of the market moves occur in the first 3 days of the scenario. Key factors shocked include 10-year nominal gilts yields, 10-year US treasury yields and sterling investment grade corporate bond spreads.

Insights:

• One of the key purposes of the BoE’s exploratory stress tests is to understand better how participants might behave under stress and, moreover, to challenge the credibility of some of that proposed behaviour.  
• Having a second round provides the BoE with a way of adjusting the scenario and some of the guidance. By challenging the first-round results, they can potentially make the scenario more consistent with the behaviour of other participants and with what they expect to see in systemic stress.
• The areas of focus of the second round, therefore, tell us where the BoE is most sceptical about participants’ responses.   
• The BoE obviously expected to see more pressure and gilt sales in the scenario so will look at this in round 2. The BoE also thinks the mismatch between aggregate sales and desired purchases of corporate bonds would be consistent with further falls in corporate bond prices.  
• When completing their second-round submissions, participants should take care to revisit the credibility of their proposed actions in light of the revised scenario and guidance.  Participants should challenge themselves to consider whether the actions they are proposing (and the impacts they are proposing those actions have) are consistent with what they and other participants would really do if that scenario were to come to pass.

What next?
 

If you would like to discuss stress testing then please get in touch with our experts.