Before looking forward to what might come next, it is useful to look back and take stock of the evolution of BoE stress testing. In 2013, the Financial Policy Committee (FPC) recommended that the Bank of England and PRA should develop proposals for regular stress testing of the UK banking system. As a result, the Bank released a Discussion Paper in October 2013 outlining the proposed stress testing framework. Feedback on this paper was supportive of regular, concurrent UK stress testing, which influenced the design of the Bank's first concurrent stress test in 2014. The BoE then published, “The Bank of England’s Approach to stress testing the UK banking system” in 2015. Figure 1 below shows a timeline of how the Bank’s stress testing exercise has evolved over the last decade.

Figure 1: History of BoE Stress Testing

We expect stress testing to continue to play a critical role in supporting both the FPC and the PRA in meeting their statutory objectives. The PRA’s 2024 priorities (for both UK deposit takers and international banks) highlight stress testing as part of its expectations for banks in assessing their financial resilience and emphasises the regulatory expectation that stress testing should be used as a business planning tool and not just a tick box exercise.

Overall, the recent past leads us to expect the BoE to continue to look to assess a broad range of risks through its concurrent stress testing programme. In particular, we expect climate and NBFIs risks to remain high on the agenda. However, any increase in breadth and/or scope of stress testing is unlikely to be sustainable given the heavy workload and resource requirements that teams already face both at the BoE and at participating firms. In particular, the ACS is a very demanding exercise for the BoE and the banks. It seems likely the BoE is considering these trade-offs as part of its review.

We set out below some viable options split by the two dimensions of the trade-off:

• Reducing the burden of the ACS; and
• Assessment of a broader range of risks

Options to reduce the burden of the ACS

• Cancellation of the ACS

The ACS has played a key role in helping the FPC and the PRA co-ordinate their policy responses to ensure that the entire banking system, and individual banks within it, have sufficient capital buffers to be able to withstand a future stress. It has played a central role in FPC communications about the resilience of the banking system.

It is unlikely that the BoE will permanently cancel the ACS.

• Reducing the frequency of the ACS

One option could be that the ACS is run every other year instead of being run annually. This could exist with a trigger for launching any one-off out-of-cycle exercises in adverse circumstances. This pattern could be seen as a formalisation of observed practice over the past 5 years.

A reduced frequency, similar to existing biennial EBA stress tests, could pose operational challenges for banks used to operate on an annual cycle and would place a premium on high-quality documentation and more automated processes as a way of minimising key person risks.

• Shorten the timeline

There is a potential for the BoE to explore streamlining the end-to-end stress testing process. Indeed, the BoE response to a report by its Independent Evaluation Office in 2019, said ‘The Bank will compress the stress-testing timeline for the ACS’.

The BoE may well look to reduce the timeline, most likely by reducing the time between submissions and publication (currently around 6 months). The BoE may also look to reduce the time banks have for submission from around 14 weeks. This would be consistent with the Bank’s comments on continuous improvement as an objective of the BoE’s stress testing framework. Any reduction in timeline would require improvements in banks’ stress testing execution.

• Reducing scope

Participants could be expected to submit less and only relevant information for STDF (“Stress Test Data Framework Manual”) template and unstructured data request submissions. The reduced scope of data submission can help to simplify the stress testing processes, as banks will focus only on the most relevant data needed for the exercise.

Options to assess a broader range of risks

• Increase the frequency of the BES

One option could be to run the BES every year instead of every other year. This could be done as part of swap with the ACS (moving it to every other year). Banks would need to have agile stress testing capabilities to respond to a new BES each year, and to respond to and quantify emerging risks.

In terms of future BES exercises, we think a second climate stress test - ‘CBES 2.0’ – is the most plausible candidate to be launched next, potentially in 2025. This would allow the BoE to explore how much progress banks had made since the original CBES and would enable the BoE to push banks to improve their modelling and integration of climate risks. Banks should continue to enhance their climate stress testing capabilities following feedback from CBES, including deepening their modelling capabilities.

• Introduce additional scenarios in the ACS

The BoE could introduce multiple scenarios by including an additional stress scenario that represents a different economic shape like L or W, instead of the standard U or V shape. A variant of this idea would be to include climate stresses as part of the ACS.

These scenarios could also be made bespoke instead of automatically calibrating it based on the current economic cycle. This was seen in the 2021 exercise, where the BoE provided an intensified scenario taking into account the FPC’s reverse stress test of August 2020.

Because of the additional burden this would place on participating banks, we think this option would probably be more likely if combined with a reduced frequency ACS. This option would mean banks would need to run multiple scenarios simultaneously, requiring efficient and agile stress testing processes.

• Increased participant coverage

The FPC’s October 2023 record explicitly states that as part of the concurrent stress testing framework review in 2024, the Bank would assess whether the participant coverage remains appropriate for future exercises.

In the past the BoE has considered but ruled out including medium-sized UK banks and UK investment banking subsidiaries of foreign-owned banks in its stress-testing framework. But given the Bank’s recent focus on assessing system-wide risks, including through the SWES exercise (which includes 54 participants), the Bank could re-consider an increased coverage of firms in its stress testing framework based on their significance to overall UK financial stability. Most likely this would be as participants in future BES exercises rather than as regular participants of the ACS. A more extreme variant of this could be to re-design the ACS to be more like the SWES (i.e. a traded risk stress on a wide range of institutions).

There are some other outstanding issues that the BoE may consider and clarify as part of its review of stress testing:

• IFRS 9 Transitional Arrangements:

In the 2022/23 ACS (and for exercises since 2018), banks were assessed on the basis of IFRS 9 transitional arrangements and using IFRS9 adjusted hurdle rates. This meant adjustments to both the impact of impairments on stressed capital ratios (boosting stressed capital ratios) and to the hurdle rate (lowering hurdle rates). IFRS9 transitional relief will reduce to zero by 2025.

Switching to non-transitional results and unadjusted hurdle rates would make the ACS tougher (all other things being equal). The BoE has been engaging with ACS participants to develop an approach for future stress tests. We would expect the BoE to clarify its approach as part of its review.

• Basel 3.1:

The two capital buffers, PRA buffer (firm specific) and Countercyclical Capital Buffer (system wide), are calibrated using information from the stress tests and other relevant information.

The PRA's CP16/22 outlines proposals to implement remaining parts of the Basel III standards in the UK. While there are no proposed changes to the combined buffer or PRA buffer frameworks, changes to Pillar 1 risk weight methodologies could impact both buffer frameworks. The PRA expects these measures to decrease the capital drawdown of some UK firms in a severe scenario, which may also decrease the total quantum of Pillar 2B buffer capital assessed through stress tests. The PRA plans to review its buffer-setting regime and exercise appropriate supervisory judgment.

In the near-final PS17/23, the PRA did not propose any policy changes to the Pillar 2 Capital framework, but acknowledged that adjustments will be necessary to address double counts and changes in RWAs when implementing Basel 3.1 standards. The PRA plans to conduct an off-cycle review of firm-specific Pillar 2 capital requirements before the implementation date of Basel 3.1 standards in 2025. For international banks who need to run regulatory stress testing exercises under multiple regimes (e.g. BoE, EBA/ECB, Fed), divergence across Basel 3 implementation globally could pose extra operational challenges.

Banks will need guidance on BoE expectations with regards to Basel 3.1 in the ACS, including, for example, the operation of the output floor.

• Hybrid PD Models:

Hybrid models were excluded from the 2022/23 ACS. But they are likely to be included in future exercises. Many firms who have redeveloped Pillar 1 PD models to incorporate cyclicality assumption are simultaneously updating their Pillar 2 models to account for cyclicality.

Estimation of cyclicality across different stress scenarios should be a key consideration for banks as it can lead to significant variability in the forecasted risk weights. As previously discussed, the key to selecting the “right” cyclicality value for forecasting peak stress RWAs, is to minimise not the point-value itself, but the uncertainty around the point-value.

We would expect hybrid models to be included in the next ACS in 2025.