Navigating the Bank of England's 2022/23 Stress Test

Scenario Overview

• In September 2022, the Bank of England (BoE) launched its Annual Cyclical Scenario (ACS) stress test of the UK banking system.

The exercise covered the 8 largest UK banks and building societies (hereafter referred to as ‘banks’), including 4 ring-fenced subsidiaries of Barclays, HSBC, NatWest, and Lloyds, accounting for 75% of lending to the UK real economy.

• The 2022/23 scenario was a severe global stress that was more severe overall than the 2008 global financial crisis (GFC).

Scenario elements included rapid interest rate hikes, persistently high inflation, elevated unemployment rates, a sharp decline in asset prices, and a global recession. As shown in Figure 1, Figure 2, and Figure 3, the 2022/23 ACS stress scenario is more severe than both the GFC and recent market movements.

• The BoE states that the ACS scenario is not a forecast of macroeconomic and financial conditions and is instead designed to be a severely adverse scenario.

However, because the BoE has raised interest rates 14 consecutive times since December 2021 (from 0.1% to 5.25% in August 2023), the current interest rate trajectory closely aligns with that laid out in the ACS stress scenario (Figure 4).

Summary of Results

• All eight individual banks were sufficiently resilient to withstand the severe stress scenario.

This meant no banks were required to strengthen their capital position following the stress test and remained above their CET 1 capital and Tier 1 leverage ratio hurdle rates on an IFRS 9 transitional basis.

• There was a smaller aggregate drawdown compared to the 2019 ACS (the most recent ACS prior to the 2022/23 ACS).

Despite the stress test including global increases in interest rates and a cost-of-living stress, the reduction in aggregate CET1 ratio in year 1 (3.4%) was considerably smaller than the drawdown in the 2019 ACS (4.8%). The largest drivers of this were lower RWA inflation and lower impairments.

• Lower impairments than 2019 were driven by higher starting asset quality.

Cumulative impairments over the 22/23 ACS were £125 billion, £26 billion less than the 2019 test. This was driven by both retail and wholesale portfolios:

Retail - Although retail impairments continued to be driven by affordability pressures from higher cost of living and interest rates, the overall level of impairments was lower than 2019 driven by mortgages. This reflected the BoE’s judgement of an improvement in starting asset quality as a result of higher property prices leading to lower LTV ratios, improved underwriting standards and continued reduction in poor quality pre-GFC lending. It is however worth noting that property prices (both residential and commercial) have declined since.

Wholesale - Inclusion of loans backed by Government support schemes during the pandemic contributed to lower corporate impairment rates in the 22/23 ACS. CRE impairment rates were broadly flat compared to 2019, as the improvements in CRE prices were offset by the higher severity in the scenario (45% decline).

• There was also a muted impact from RWA inflation due to improved asset quality and a higher start point.

At the low point of the stress, average risk weights peak at 39% (an increase of 5 percentage points). This compares with a peak of 46% in the 2019 ACS. The much lower inflation in RWAs is driven by the improved asset quality referred to above, as well as the impact of temporary post model adjustments. These were included in the start of the stress test for some banks, due to the anticipated move to a hybrid modelling approach for mortgage portfolios, which will increase RWAs for these portfolios.

• Banks gain through net interest income associated with higher interest rates, but the benefit has been dampened.

Higher global interest rates in the stress result in higher net interest income, as the spread between what banks earn on their assets, compared to what they pay on their funding widens. However, the BoE have also assumed a higher proportion of customers moving to interest-bearing balances and that banks pass through more interest rates increases than recently observed, which suggests the benefit from net interest income could have been much higher.

• The qualitative review highlighted that banks should continue to strengthen their stress test capabilities.

Although the BoE noted that banks continued to improve in data quality and analysis, they highlighted further progress needs to be made on the impact of stress testing across different workstreams.

Why should banks care

• It is likely the BoE will look for improvements in how banks reflect the impacts of high interest rates and inflation both in the context of the ACS but also for broader stress testing.

This year’s ACS tested the banking sector’s resilience against increasing interest rates and cost of living stresses alongside a global financial crisis. Overall, the BoE judged that cost of living effects led to a 15% increase in impairments on mortgages and 30% on unsecured loans. The BoE noted ACS participants found reflecting the impact of high inflation and interest rates on credit risk very challenging. Banks should therefore look to improve their ability to appropriately capture the impacts of high rates and inflation in stress testing.

• The BoE qualitative review highlighted some shortcomings in banks’ stress testing capabilities, and a need for continued improvements in banks’ impact assessment across the stress test.

Firms will receive individual feedback on areas of focus and will therefore need to respond to that feedback and enhance their capabilities ahead of next year’s ACS.

• Given the high inflation and high interest rate environment is likely to persist, banks should consider what insights produced from the ACS might be usefully deployed more broadly.

Stress testing should be a business and risk management tool and not just a regulatory compliance exercise. The fact that the ACS scenario shares some similarities with the actual outlook, makes it more likely that the insights could prove useful beyond the ACS exercise (for example in pricing).

• The results reinforce the importance of being able to identify and quantify novel risks.

Banks should ensure they have visibility into these risks through effective risk identification functions. Further, banks should strengthen their risk modelling capabilities to be prepared for quantifying such risks as and when they arise.

• These relatively benign results support the BoE’s focus on exploring risks for the broader financial system, including through the system-wide exploratory scenario.

The BoE’s recent launch of the system-wide exploratory scenario (SWES) which covers banks and non-bank financial institutions (NBFIs), will be an opportunity for the BoE to understand better these broader risks. Banks and other participants should ensure they are well prepared to participate in that exercise and to ensure they can make the exercise useful for their institutions.

• Banks should consider what the switch to hybrid models will mean in a stress testing context.

Hybrid models were excluded from this year’s ACS. But they are likely to be included in future exercises. For banks moving to the hybrid PD modelling approach, the methodology used to estimate the cyclicality assumption could result in high variations for the peak stress risk weights projected in the ACS exercises. Banks should consider how to approach this in the context of stress testing, including for the ACS.