Skip to main content
  • This website sets cookies on your device. To find out more about how we use cookies please refer to our Privacy and Cookie Policy. By continuing to use the site, we’ll assume that you are content for us to set these on your device.
  • Close
Home > Prudential Regulation Authority > Supervisory activities – stress test scenario
 

Supervisory activities – stress test scenario

Capital instruments  |  Climate Change Adaptation Reporting  |  Stress test scenario Remuneration Rules  |  Run-off  |  Skilled Person Reviews  |  Stress testing

This page provides information on the 2017 stress test scenario, including the latest scenario firms can use, and how they should use it. This scenario was published on 21 April 2017.

Stress testing

For firms to which CRD IV applies, rules and expectations in relation to stress testing, scenario analysis and capital planning can be found in the PRA Rulebook in Chapter 12 of the Internal Capital Adequacy Assessment Process (ICAAP) rules and in Supervisory Statement 31/15 (see Related Links).

The PRA publishes a macroeconomic scenario for the United Kingdom to serve as a guide and, where relevant, as a severity benchmark, for firms designing their own scenarios for Pillar 2 capital planning stress tests. Note that the scenario is for stress testing purposes only. The stress scenarios incorporated in the Bank of England’s concurrent stress tests are not forecasts. Rather, they are coherent ‘tail-risk’ scenarios designed to be severe and broad enough to assess the resilience of UK banks to adverse shocks, which can occur even when risks are not elevated. 


Background to supervisory scenarios

As part of PRA efforts to strengthen firms' Pillar 2 stress testing, the PRA believes that supervisory scenarios will help firms to undertake stress tests using more appropriate scenarios, and will give firms a clearer indication of our expectations of appropriate severity. In addition, the scenarios are designed to encourage:

  • engagement of senior management: firms' awareness of the reputational considerations associated with undertaking stress testing exercises using recommended scenarios should result in senior management being better engaged in the stress testing process;
  • overcoming 'disaster myopia': during prolonged periods of economic stability, firms tend to underestimate the probability of adverse outcomes and the potential crystallisation of 'tail risks’. One way of addressing this is for supervisors to portray scenarios that represent a 'tail event' allowing firms to set their own stresses accordingly; and
  • benchmarking of results and approaches: asking firms to run scenarios that are broadly comparable in terms of severity will allow supervisors to more easily compare and benchmark individual results and firms' approaches to stress testing.

Stress test scenario for firms not participating in the 2017 concurrent stress test

On Friday 21 April 2017 the PRA published the 2017 stress test scenario for firms not participating in the 2017 concurrent stress test, available below.
2017 H1 Stress Scenario for firms not participating in the 2017 concurrent stress test

How the stress scenario should be used

In addition to the stress scenarios published by the Bank, every six months the PRA also publishes a scenario to be considered by banks and building societies that are not part of the concurrent stress test. 

Firms should consider the stress test scenario in the context of their business and specific risk drivers. This scenario should be used as a starting point with which to build and calibrate their own scenario/s under Pillar 2. This scenario reflects minimum adverse conditions, through which firms should assess their ability to maintain minimum specified capital levels.

The PRA is aware of the challenges of developing a macroeconomic scenario that is to be used by various firms operating under different business models and exposed to a variety of risks. Therefore, the scenario is intended to help firms calibrate the severity of their own capital planning stress scenarios under Pillar 2, and should not undermine firms’ efforts and responsibility to develop their own scenarios (which could include the annual cyclical scenario for the 2017 stress test).

Clarification on IFRS 9 for 2018 ICAAP stress testing and capital planning


This clarification, issued on Wednesday 25 October 2017, sets out information on how firms should incorporate IFRS 9 into stress testing and capital planning carried out as part of their ICAAP obligations from 2018. This is only applicable to firms:

  • to which CRD IV applies; and
  • that apply any of:
    • International Financial Reporting Standards (IFRS);
    • FRS 101; or
    • FRS 102 and have opted to use IFRS 9 for their financial instruments;

       in relation to ICAAPs based on accounts as at 31 December 2017 or a later date.

Background

IFRS 9 was issued in July 2014 and sets out new rules for accounting for financial instruments, replacing the rules in IAS 39. Following endorsement for use in the EU, IFRS 9 is effective for annual periods beginning on or after 1 January 2018. The most significant change for banks and building societies relates to the introduction of a forward-looking expected credit loss (ECL) model.

In December 2016, recognising the early stage of implementation of IFRS 9 in firms’ accounting arrangements, the PRA said that firms should continue to submit a full set of forecasts on an IAS 39 basis and separately provide reasonable estimates of the day one impacts of adopting ECL and ECL forecasts under base and stress scenarios.

In March 2017, the Basel Committee on Banking Supervision (BCBS) released details of standards for transitional arrangements (transitionals) to phase-in the impact of ECL accounting on capital resources (see External Links). The EU is expected to adopt similar arrangements in 2017. In a letter to CEOs, published on 25 September 2017, the PRA encouraged UK firms to use any transitionals agreed internationally and in the European Union as they adjust to the new regime, provided that the arrangements are broadly similar to those currently being considered. Subject to the need for sufficient resilience at the end of the transitional period, the PRA’s intention is that all aspects of supervision of a firm using the transitionals would be carried out using ‘transitional’ data on capital resources and not ‘fully loaded figures’.

This clarification on transitionals does not change the way the PRA sets the PRA buffers in 2018 - see Policy Statement 17/15 'Assessing capital adequacy under Pillar 2'. These will remain subject to supervisory decision on a case-by-case basis and will reflect a range of firm specific considerations, including the quality of the data used in the ICAAP.

The PRA intends to publish additional clarification for firms participating in Concurrent Stress Testing in due course.

Clarification

For ICAAP documents based on accounts as at 31 December 2017 or a later date, the PRA expects those firms in scope to prepare their ICAAP on an IFRS 9 basis. More specifically:

IFRS 9 starting point: Firms should use the initial date of application of IFRS 9 as a starting point for their ICAAPs rather than the closing IAS 39 balance sheet date. For example, firms with a December 2017 year-end should use 1 January 2018 as a starting point; firms with a 31 March 2018 year-end should use 1 April 2018.* This should allow firms to include Day-1 IFRS 9 impacts into forecasting starting points. Separately, firms should provide an IAS 39-comparable starting point to allow supervision to understand the Day 1 changes between the closing balance sheet under IAS 39 and the opening balance sheet under IFRS 9. Firms should separate out impacts due to expected credit loss provisioning and other elements, for instance, classification and measurement, breaking down this information by material portfolios and sectors where possible. This only applies the first time a firm switches over to IFRS 9.
 
* This information may come from ‘transition documents’ prepared together with, or shortly after, the firms’ audited year-end accounts and forming part of the firms’ opening balance sheet for 2018.
 
IFRS 9-based forecasts: Firms are expected to submit a full set of forecasts on an IFRS 9 basis for base and stress test scenarios. For ICAAPs based on accounts as at 31 December 2017, this information can be submitted on a reasonable endeavours basis. If a firm is unable to provide this information, it should contact its supervisor.
 
Transitionals and supervisory approach: It is likely that the Capital Requirements Regulation (CRR) will be amended to establish transitionals for the impact of IFRS 9 expected credit loss accounting on credit institutions’ regulatory capital resources. Based on the current draft legislative texts for amending the CRR, it appears probable that the use of these arrangements will be at the option of the individual firm.
 
The PRA’s position is that, subject to the need for sufficient resilience at the end of the transitional period, all aspects of supervision of a firm using the transitionals, including the firm’s stress tests, would be carried out using ‘transitional’ data on capital resources and not ‘fully loaded’ figures. In particular, since stress tests should reflect how stress would be experienced in reality, when a firm is using the transitionals such tests will fully take account of the arrangements.
 
Therefore, a firm using transitionals should produce base and stress-case capital ratios which incorporate the impact of IFRS 9 transitional adjustments.
 
Current drafts of the transitionals envisage that firms using them will be required to disclose publicly their actual (not stressed) capital ratios on a fully loaded as well as transitional basis. The European Banking Authority (EBA) is consulting on Guidelines for the appropriate disclosures, based on prior work by the BCBS, and published draft Guidelines for this disclosure on 13 July 2017.
 
To align with these disclosures and to allow a better understanding of the forecast modelling made by firms in their capital plans and stress tests, firms should include in their ICAAPs both fully loaded and transitional capital forecasts for their base and stress scenarios. This will allow a better understanding of the impact of fully loaded IFRS9 standards on banks’ capital ratios, albeit the PRA sets stress testing buffers based on capital ratios after the applications of transitionals.
 
Final remarks: The PRA’s approach will continue to recognise that firms will still be refining their IFRS 9 processes and practices during 2018 and that the quality of information will improve with time, while reinforcing the need for firms and the PRA to be prepared for the estimated impact of IFRS 9 on capital resources from 1 January 2018.
 
Firms unable to incorporate IFRS 9 in their ICAAP should contact their supervisors. If the PRA is unable to assess adequately the impact of a stress on a firm’s capital position under IFRS 9 and the firm is unable to provide sufficient information, the PRA may take action on a firm-by-firm basis as set out in paragraph 9.31 of Statement of Policy ‘The PRA’s methodologies for setting Pillar 2 Capital’.
 
Firms submitting their ICAAPs based on accounts as at 31 December or a later date before 31 December 2017 can refer to the Clarification issued on 6 December 2016 (below).
 
 

Clarification on IFRS 9 for 2017 ICAAP stress testing and capital planning

This clarification, issued on Tuesday 6 December 2016, sets out information on how firms should incorporate IFRS 9 into stress testing and capital planning carried out as part of their ICAAP obligations in 2017. This is only applicable:

  • to firms to which CRD IV applies;
  • to firms that apply International Financial Reporting Standards (IFRS) and so is not applicable to firms that apply UK GAAP; and
  • for ICAAPs based on accounts as at 31 December 2016 or a later date before 31 December 2017.

Background

IFRS 9 was issued in July 2014 and sets out new rules for accounting for financial instruments, replacing the current rules in IAS 39. Following endorsement for use in the EU, IFRS 9 is effective for annual periods beginning on or after 1 January 2018. The most significant change for banks and building societies relates to the introduction of a forward-looking expected credit loss (ECL) model.

In March 2016, recognising the lead time needed for implementation, the PRA said that firms should not model the impact of IFRS 9 as part of their ICAAP obligations in 2016 but that further guidance would follow on how to incorporate IFRS 9 from 2017 onwards.

This clarification covers the information firms should consider and include in their ICAAP reports ('ICAAPs') produced in 2017. The aim is to encourage firms applying IFRS to prepare forecasts for 2018 onwards on an IFRS 9 basis, to reinforce the need to be prepared for the new accounting standard, and to help the firms and PRA size and plan for the impact of IFRS 9. The PRA has an interest in consistent, proportionate and high-quality implementation of IFRS 9 and this clarification recognises that firms will be implementing IFRS 9 processes and practices during 2017 and the quality of information will improve with time. However, firms remain responsible for being prepared for the impact of IFRS 9 on capital resources from 1 January 2018.

In March 2017, the Basel Committee on Banking Supervision released details of standards for transitional arrangements to phase-in the impact of ECL accounting on capital resources (see External Links). Firms are asked not to factor possible transitional arrangements into their capital estimates at this stage.

This clarification doesn't change the way the PRA sets the PRA buffers in 2017 - see Policy Statement 17/15 'Assessing capital adequacy under Pillar 2'. These will remain subject to supervisory decision on a case-by-case basis and will reflect a range of firms specific considerations, including the quality of the data used in the ICAAP.

Separate communication is being provided to firms participating in Concurrent Stress Testing and in scope of Structural Reform. The PRA intends to publish additional clarification for firms participating in Concurrent Stress Testing in due course.

Clarification

For ICAAPs based on accounts as at 31 December 2016 or a later date before 31 December 2017, at a minimum:

  • Firms should continue to submit a full set of forecasts on an IAS 39 basis.
  • Firms should separately provide reasonable estimates of the day one impacts of adopting ECL accounting on the balance sheet and capital resources, broken down by material portfolios where possible. (The day one impact refers to the impact at the start of the annual period beginning on or after 1 January 2018 when the firm expects to first apply IFRS 9). Firms should briefly describe the economic conditions assumed at the time of implementation and discuss how different (eg worse) macroeconomic conditions at implementation may affect their impact figures. Firms should not, in their projections under the base case, factor into their estimates using their PRA buffer to absorb the impact of IFRS 9 at implementation. (The PRA buffer is only intended to be used in circumstances beyond the firm's normal and direct control, as set out in paragraphs 5.33-5.36 of Supervisory Statement 31/15 'The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP)', and is assessed on a firm-by-firm basis). Firms unable to provide this information when submitting their ICAAP should contact their supervisors to discuss a suitable deadline to provide the information at a later stage.
  • Firms should discuss in their ICAAP the expected impact of IFRS 9 on their capital plans and stress tests. This should be a qualitative, and where possible a quantitative, assessment of the impact of IFRS 9 on firms' capital needs and implications for capital planning over the ICAAP's horizon.
  • Firms should not factor possible transitional arrangements for ECL accounting into their estimates.

Where possible and on a reasonable effort basis, firms that have made sufficient progress in incorporating IFRS 9 into their capital planning and stress testing models should also provide the additional information below.

  • Estimates of forecast impact of adopting ECL accounting on impairment changes and the corresponding impacts on capital resources, over the ICAAP horizon, using firms' own methodology.
  • Estimates of how the day one and projected impairment charge impacts might evolve under a severe stress scenario, using firms' own methodology. To benchmark the severity of the stress, firms can refer to the Annual Cyclical Scenario (ACS) published by the Bank of England or the 2017 stress scenario above.

Firms unable to provide this additional information when submitting their ICAAP should make that clear in the ICAAP and may be contacted by their supervisors to agree a suitable deadline to provide the information at a later stage.

Where the PRA deems preparations for implementation of IFRS 9 to be insufficient the PRA may take action on a firm-by-firm basis.

Specific points for consideration by insurers

The 2017 stress test scenario aims to give firms a consistent basis on which to confirm that their planned capital resources are sufficient to remain solvent and adequately capitalised in order to continue to write business throughout the capital-planning horizon (normally three to five years).

Firms may consider the conditions implied by the parameters set out in the scenario in order to derive consistent assumptions, on a prudent basis, for key risk factors that would affect their projected capital requirements. Firms should also consider insurance risk aspects (eg recession-related claims) arising from the scenario.

Insurers may incorporate these assumptions into their capital planning processes, and be prepared to show this in discussions with their supervisors. Insurers should also examine the complementary relationship between the one-in-200-year required stress and the macroeconomic scenario used for capital planning purposes. For example, a four-year capital plan might assess how a firm expects to be able to continue to meet its capital requirements over the next few years in the face of a changing economic environment.

Archived resources

The H2 2016, 2015, H1 2015 and H2 2014 stress scenarios are included in the document below for information.

Archived resources for information - H2 2016 scenario

Archived resources for information - 2016 Key elements

Archived resource for information – H2 2015 stress scenario

Archived resources for information - H1 2015 and H2 2014 stress scenarios

 

 

Share