Stress testing the UK banking system: 2021 Solvency Stress Test results

We have announced the results of our 2021 solvency stress test of the UK banking system.
Published on 13 December 2021

The primary responsibility of the Financial Policy Committee (FPC), a committee of the Bank of England, is to contribute to the Bank of England’s financial stability objective. It does this primarily by identifying, monitoring and taking action to remove or reduce systemic risks, with a view to protecting and enhancing the resilience of the UK financial system. Subject to that, it supports the economic policy of Her Majesty’s Government, including its objectives for growth and employment.

The Prudential Regulation Authority (PRA) is a part of the Bank of England and responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms. The PRA has two primary objectives: to promote the safety and soundness of these firms and, specifically for insurers, to contribute to the securing of an appropriate degree of protection for policyholders. The PRA also has a secondary objective to facilitate effective competition. The PRA’s most significant supervisory decisions are taken by the Prudential Regulation Committee (PRC). The PRC is accountable to Parliament.

This document has been produced by Bank staff under the guidance of the FPC and PRC. It serves three purposes. First, it sets out the Bank’s approach to conducting the 2021 solvency stress test of the UK banking system. Second, it presents and explains the results of this exercise. Third, it sets out the judgements and actions taken by the PRC and FPC that were informed by the test results and analysis. The annex, setting out the individual bank results, has been formally approved by the PRC.

The sections and annex were finalised on 9 December 2021.

Executive summary

The Bank’s 2021 ‘solvency stress test’ (SST) shows the major UK banks are resilient to a severe path for the economy in 2021–25 on top of the economic shock associated with the Covid-19 (Covid) pandemic that occurred in 2020. These results support the FPC’s judgement that the system is resilient to outcomes for the economy that are much more severe than the Monetary Policy Committee’s (MPC’s) central forecast.

Reflecting the circumstances of the pandemic, the SST differs from the Bank’s usual annual cyclical scenario (ACS) stress test. The aim of the SST has been to cross-check the FPC’s judgement, made in December 2020 following a ‘reverse stress test’, that banks have sufficient capital to continue to support UK households and businesses even if economic outcomes are considerably worse than expected.

The major UK banks’ resilience in the test reflects a strong end-2020 starting point, with an aggregate Common Equity Tier 1 (CET1) capital ratio of 15.9%, and Tier 1 leverage ratio of 5.7% (excluding the software asset benefit that is due to expire at the start of 2022). That robust starting position is in part due to the build-up of capital since the global financial crisis, reflecting post-crisis reforms including higher capital requirements. Further support to capital ratios was provided by actions taken during 2020 by the banks, the Bank, including the PRA, and public authorities more broadly in response to the pandemic. These actions included the banks’ cancellation of final 2019 dividends.

The major UK banks’ aggregate CET1 capital ratio falls by 5.5 percentage points in the stress to a low point of 10.5%. A significant driver of this reduction is credit impairments, and the majority of these occur on UK-based lending. This low point compares to a 7.6% ‘reference rate’, which comprises banks’ minimum requirements and systemic buffers, and is adjusted to account for the impact of International Financial Reporting Standard 9 (IFRS 9). The aggregate Tier 1 leverage ratio low point of 4.8% is also above the reference rate of 3.7%. All eight participating banks remain above their reference rates for both CET1 capital and Tier 1 leverage ratios.

As previously indicated, the aim of the SST has been to update and refine the FPC’s assessment of banks’ resilience and ability to lend in a very severe intensification of the macroeconomic shock arising from the pandemic. Consistent with the nature of the exercise, the FPC and PRC will therefore not use the SST as a direct input for setting capital buffers for UK banks. No individual bank is required to strengthen its capital position as a result of the test.

The Bank intends to revert to the ACS stress-testing framework for 2022. Due to its broader and countercyclical nature the ACS framework is well suited to informing the setting of capital buffers, including the UK countercyclical capital buffer. The FPC judges that the results of the SST, together with the central outlook and the return to the ACS framework for 2022 are consistent with the PRC’s decision to transition back to its standard approach to capital-setting and shareholder distributions.

Box A: The Bank’s approach to stress testing

Each year, the Bank usually carries out a stress test of the major UK banks that incorporates a single severe but plausible adverse scenario.footnote [1]
The Bank’s usual annual stress test – the annual cyclical scenario (ACS) – seeks to stress major UK banks at the same time against a single hypothetical adverse scenario, to assess how the scenario could impact the health of the UK banking system. The stress applied is a coherent, low probability scenario designed to be severe and broad enough to assess the resilience of UK banks to a range of adverse shocks. The results of the ACS are used by the FPC and PRC to inform the setting of banks’ capital buffers, in order to ensure that the banking system as a whole, and individual banks within it, have sufficient capital to absorb losses and maintain the supply of credit to households and businesses in a future stress.

In order to build up banks’ capital buffers outside stress so they can then be released to support the economy in a stress, the Bank has an explicitly countercyclical approach to stress testing.
The Bank’s general approach is to set the severity of its stress tests – in terms of the levels that various economic indicators are assumed to reach – in a long-run context, independent of the short-term outlook. During periods in which the economy, credit and asset prices are growing rapidly and risk premia are compressed, it makes the stress scenario more severe, so that banks build up their buffers of capital ready for the next stress.

During periods of stress, the FPC uses stress tests to assess whether the buffers of capital that banks have built up are large enough to deal with how the prevailing stress could unfold.
Once the economy enters a stress, to ensure that banks are able to continue to serve the economy in a range of possible outcomes, a different stress-testing approach is required. The Bank uses stress tests to assess whether the buffers of capital that major UK banks have built up are large enough to deal with how the prevailing stress could evolve as new information unfolds. The FPC needs to assess the likelihood of outcomes, given the current economic outlook, that might jeopardise banks’ resilience and challenge their ability to absorb losses and continue to lend. In this way the FPC can judge whether there is merit in increasing banks’ resilience to these outcomes, recognising the economic costs – through restricting lending – that doing so can have in making the central outlook for the economy worse. The Bank can carry out a ‘reverse stress test’ (RST), to identify paths for the economy that generate the same capital impact on banks that they have been capitalised against in previous annual stress tests.

The FPC used this reverse stress-testing approach to monitor the outbreak of Covid and its impact on the banks.
In response to the outbreak of Covid and the significant impact on the UK and global economic growth outlook, the Bank carried out an RST in 2020 to generate a range of macroeconomic scenarios that would reduce banks’ capital buffers in aggregate by 5.2 percentage points. This targeted the level of capital depletion that banks experienced in the 2019 ACS in the face of severe, but plausible, synchronised shocks to the UK and global economies. The resulting paths for the economy in the 2020 RST were different in shape to the 2019 ACS because they were conditioned on the idiosyncratic shock related to the Covid outbreak. One of these scenarios was a ‘double-dip’ recession with a renewed fall in output as the Covid outbreak develops. The 2021 solvency stress test has acted as a cross-check on the RST.

1: Overview of the solvency stress test

The Bank’s 2021 solvency stress test (SST) has acted as a cross-check on the FPC’s judgement that the banking system is resilient to outcomes for the economy that are much more severe than the MPC’s central forecast.
As described in Box A, once the economy enters a stress, such as that driven by the Covid outbreak, the Bank of England (hereafter referred to as ‘the Bank’) uses stress tests to assess whether the buffers of capital that major UK banks and building societies (hereafter ‘banks’footnote [2]) have built up are large enough to deal with how the prevailing stress could unfold.

The Bank’s ‘reverse stress test’ (RST) exercise in 2020 found that very severe economic paths for the UK and global economies would be needed in order to deplete regulatory capital buffers by 5.2 percentage points, in line with the drawdown in the 2019 annual cyclical scenario (ACS). Based on that, in December 2020 the Financial Policy Committee (FPC) judged that UK banks, in aggregate, had capital buffers that allowed them to lend in, and remain resilient to, a wide range of possible outcomes for the UK and global economies.

The SST has acted as a cross-check on the FPC’s judgement of how severe the pandemic-related stress that began in 2020 would need to be to jeopardise banks’ resilience and challenge their ability to absorb losses and continue to lend. The macroeconomic scenario underlying the SST is a severe path for the economy in 2021–25 on top of the economic shock associated with the Covid pandemic that occurred in 2020. It is broadly consistent with the ‘double-dip’ scenario generated in the RST.

The Bank published interim results in the July Financial Stability Report, which took into account early credit projections from participating banks, and for areas other than credit were based on Bank staff’s desktop analysis. This document sets out the full updated and final results of the 2021 SST, including bank specific outcomes. Eight major banks are included in the test including, for the first time, Virgin Money UK.

The 2021 SST shows that the banking system in aggregate is resilient to an extremely severe stress scenario.
The eight participating banks started the SST with an aggregate Common Equity Tier 1 (CET1) capital ratio of 15.9% of risk-weighted assets (excluding the software assets benefit that is due to expire in 2022, as explained in Section 2) (Chart 1). That is somewhat higher than previous years, in part due to actions taken during 2020 by banks and public authorities, including the banks’ cancellation of final 2019 dividends (see Section 2 for more details). At the low point of the stress in 2022 the major UK banks’ aggregate CET1 capital ratio, on a transitional International Financial Reporting Standard 9 (IFRS 9) basis, is 2.8 percentage points above the ‘reference rate’.footnote [3] Banks’ aggregate Tier 1 leverage ratio also remains above the reference rate in the stress.

Chart 1: Banks started the stress test with a strong capital position in aggregate, and even at the low point remain some way above the reference rate

Aggregate CET1 capital ratio of major UK banks and impact of the 2021 SST scenario (a) (b) (c)

Major UK banks’ aggregate CET1 capital ratio has increased in recent years, from 4.3% in 2007 to 15.9% at end-2020 (excluding the software assets benefit). Even at the low point of the SST of 10.5% it remains some way above the reference rate of 7.6%.

Footnotes

  • Sources: Participating banks’ Stress Testing Data Framework (STDF) data submissions, PRA regulatory returns, published accounts, Bank analysis and calculations.
  • (a) The CET1 capital ratio is defined as CET1 capital expressed as a percentage of risk‑weighted assets, where both terms are defined in line with the Capital Requirements Regulation (CRR) and the UK implementation of the Capital Requirements Directive (CRD V) via the PRA Rulebook. Unless otherwise stated, any references to EU or EU-derived legislation throughout this document refer to the version of the legislation which forms part of retained EU law.
  • (b) Major UK banks are Barclays, HSBC, Lloyds Banking Group, Nationwide, NatWest Group, Santander UK, Standard Chartered and, from end-2020, Virgin Money UK. Prior to 2011, data are Bank estimates of banks' CET1 ratios. Capital figures are year-end.
  • (c) 2020 capital ratio and impact figures exclude the software assets benefit (see Section 2 for a full description of this).

The CET1 capital low point in the SST is higher than that observed in the 2020 RST and the 2019 ACS, despite a broadly similar drawdown, reflecting the higher start point (Chart 2).The drawdown of 5.5 percentage points in the SST is also broadly in line with the interim results published in July 2021.

Chart 2: The impact of the SST is broadly consistent with last year’s RST and the 2019 ACS, but the capital low point is higher

Impact of recent Bank stress tests (a) (b) (c) (d) (e)

The bars show that banks’ aggregate capital ratio falls by 5.5 percentage points in the SST, broadly consistent with the impact of last year’s reverse stress test and the 2019 annual cyclical scenario. The low point is higher, reflecting a stronger starting point.

Footnotes

  • Sources: Participating banks' STDF data submissions, published accounts, Bank analysis and calculations.
  • (a) See footnote (a) to Chart 1.
  • (b) The RST and SST capital ratios incorporate the effect of amendments in the CRR ‘Quick Fix’ applicable from 27 June 2020 to allow 100% transitional relief of eligible IFRS 9 provisions until the end of 2021 (see footnote 5).
  • (c) The impact of the 2019 ACS does not include the conversion of Additional Tier 1 (AT1) instruments that was a feature of that test.
  • (d) Capital ratio figures for the 2021 SST shown in the chart exclude the software assets benefit.
  • (e) The reference rate used in the SST is determined in the same way as the hurdle rate used in the 2019 ACS except for changes in the transitional relief implemented as part of the CRR ‘Quick Fix’. Both reference and hurdle rates comprise the sum of each bank’s minimum capital requirements and any systemic buffers that they are required to hold.

The results confirm the FPC’s previous judgement that UK banks, in aggregate, are resilient to a much more severe scenario than the MPC’s central forecast and have sufficient capital to support UK households and businesses even if economic outcomes are considerably worse than expected. While the SST was designed as an exercise specifically to test banks’ resilience against an intensification of the macroeconomic shocks arising from the pandemic seen in 2020, the FPC judges that the results are informative about banks’ overall resilience to other shocks that could arise.

Since the end-2020 balance sheet cut-off date for the 2021 SST, the aggregate CET1 capital ratio of the major UK banks has picked up further to 16.5% in 2021 Q3 (see Financial Stability Report December 2021, ‘2: In focus – Resilience of the UK banking sector’).

2: Broad narrative of the scenario and results

The macroeconomic scenario is very severe, representing an intensification of the shocks seen in 2020.
Earlier in 2021, the Bank published the scenario to be used in the SST. The scenario incorporates paths for economic and financial market variables, including GDP, property prices and unemployment (Chart 3).

The scenario used for the SST has been designed to assess banks’ end-2020 balance sheets against a severe path for the economy in 2021–25 on top of the economic shock during 2020 associated with the Covid pandemic. It is broadly consistent with the ‘double-dip’ scenario generated in the FPC’s RST of August 2020 and represents an intensification of the macroeconomic shocks seen in 2020.

Between end-2020 and the trough of the stress, UK GDP falls by 9% (Chart 3), with a sharp dip at the beginning of 2021. When combined with the economic shocks already seen in 2020 it implies a cumulative three-year loss over 2020–22 (with respect to the pre-Covid baseline) of 37% of 2019 UK GDP. UK residential and commercial property prices fall by around 33% and unemployment rises by 5.6 percentage points to peak at 11.9%. Certain sectors such as hospitality, leisure, construction and transport are more affected than others. Although GDP growth turns positive later in the scenario and unemployment starts to fall back, output remains below its pre-recession projected path throughout the scenario, and even during the recovery phase confidence remains low. Underlying these projections it is assumed that no new government support measures are introduced, and that existing schemes end in March 2021.

Chart 3: The 2021 SST is a very severe path for the economy, and more so in some respects than the 2019 ACS

Peak-to-trough changes in key variables (and peak in unemployment): 2019 ACS and 2021 SST (a) (b)

The bars show UK GDP falling by 9% and unemployment peaking at 11.9% in the 2021 SST. It is more severe in some respects than the 2019 ACS. Bank Rate falls in the stress, whereas it rose in the 2019 ACS.

Footnotes

  • Sources: Bank of England and Bank calculations.
  • (a) The unemployment bars show the peak level of the Labour Force Survey UK unemployment rate.
  • (b) The Bank Rate bars show the peak-to-trough change in percentage points.

There is a severe and synchronised slowdown across the world, with global GDP falling by 9.6% (Chart 3). Financial market participants are disappointed by progress in global macroeconomic outcomes, with perceptions of risk increasing. Equity prices in the UK fall 20%. Interest rates remains low, with Bank Rate turning negative in line with the market-implied path of the November 2020 Monetary Policy Report (MPR). Credit risks rise in a number of markets, with investment-grade US corporate bond spreads rising by 140 basis points and high-yield US corporate bond spreads by around 480 basis points. While there are shocks to several financial market variables, there is no separate traded risk scenario like in the ACS exercises.

The macroeconomic scenario for the 2021 SST is considerably more severe than the MPC’s latest central projection from the November 2021 MPR. In that forecast, UK and global GDP continue to recover from the effects of Covid. Cumulative UK GDP losses, relative to the pre-Covid baseline forecast, total 19% of 2019 GDP and unemployment rises only slightly to a peak of 4.5% in that projection.

The macroeconomic stress scenario is also more severe in some respects than the 2019 ACS. In that scenario UK GDP fell by 4.7%, unemployment peaked at 9.2% and Bank Rate rose to 4.0% (Chart 3). The pace of the recovery in the SST is faster, however. More broadly, the relative severity across the different aspects of the scenario is different to previous ACS exercises, reflecting the idiosyncratic nature of the shock related to the Covid outbreak. There is a greater stress on the real economy, including the UK, and movements in asset prices are smaller, consistent with a smaller rise in risk premia in the scenario.

The pandemic has underlined the importance of banks being able to provide credit to UK households and businesses. Banks must conduct the test on the basis that they satisfy the demand for credit throughout the scenario, with lending to the UK real economy expanding by 3.1% in total over the five years of the stress. This reflects an important macroprudential goal of stress testing – to help assess whether the banking system is sufficiently capitalised not just to withstand the stress but also to be able to maintain the supply of credit to the real economy in the face of severe adverse shocks.

Banks are assessed on the basis of IFRS 9 transitional arrangements, against an IFRS 9 adjusted reference rate framework.
As set out when the SST was launched in January, the results of the 2021 SST reflect internationally agreed transitional arrangements for the IFRS 9 accounting standard. Under IFRS 9, which was introduced in 2018, banks provide for expected credit losses on all loans before those losses are incurred, resulting in earlier recognition of losses relative to the previous accounting standard. Arrangements have been put in place to offer banks transitional relief as they adapt to the new standard, with that relief reducing gradually to zero by 2025. Banks participating in the stress test have been assessed on this transitional basis. This means that they have been allowed to ‘add back’ a proportion of capital losses that are associated with earlier recognition of impairments under IFRS 9. In response to the pandemic, transitional relief was extended by the European Union authorities as part of the Capital Requirements Regulation (CRR) ‘Quick Fix’.footnote [4] footnote [5]

Each bank’s performance in the test is assessed against ‘reference rates’ for their risk-weighted CET1 capital and Tier 1 leverage ratios. These reference rates comprise the sum of each bank’s minimum capital requirements and any systemic buffers that they are required to hold, and so are determined in the same way as the hurdle rates used in the 2019 ACS.footnote [6] That they are called reference rates instead reflects that they do not inform the setting of capital buffers, since the SST is aimed at assessing banks’ resilience to risks arising from the pandemic and their ability to lend.

Reference rates have been adjusted to take into account the impact of the IFRS 9 accounting standard, which reduces CET1 at the capital low point by bringing forward the point in a stress at which banks provision for losses. These adjustments follow the approach the Bank adopted in 2018 and 2019, and recognise the additional resilience provided by the earlier provisions taken under IFRS 9. Although participating banks are judged on a transitional basis, for transparency the Bank also calculates and publishes both capital low points and reference rates on an assumed non-transitional basis (see Box B).

Banks began the SST with robust capital positions, in part due to actions taken in 2020.
At end-2020, the start point for the 2021 SST, participating banks had an aggregate CET1 capital ratio of 16.2% of risk-weighted assets and Tier 1 leverage ratio of 5.8% of total exposures (including the software assets benefit). These capital positions have strengthened considerably since the global financial crisis (Chart 1), reflecting post-crisis reforms including higher capital requirements introduced by the FPC alongside other regulatory authorities. And despite banks making substantial provisions for credit losses due to the pandemic, capital ratios rose over the course of 2020. This in part reflects actions taken by banks and public authorities in response to the pandemic. In particular, the cancellation of final 2019 dividends in line with the Bank’s request supported capital ratios by 0.4 percentage points.footnote [7] In addition, the extension of IFRS 9 transitional relief, as described above, provided further support.

Since December 2020, software assets have been included in CET1 and broader regulatory capital, as part of the CRR ‘Quick Fix’. The PRA has stated that from 1 January 2022 the treatment of software assets will be updated, requiring all intangible software assets again to be fully deducted from regulatory capital resources. This change reflects that there is no credible evidence that software assets could absorb losses effectively in stress, and is to ensure that banks’ CET1 capital helps firms to remain a going concern and sustain lending to the real economy.footnote [8] The software assets benefit is therefore excluded in the 2021 SST from 2022 onwards (the system-wide low point occurs in 2022), and, in order to increase comparability of system-wide start and low points in the SST, the change in the major UK banks’ aggregate capital ratio is expressed relative to a start point that also excludes the software assets benefit. Excluding the benefit of software assets, the end-2020 aggregate CET1 capital and leverage ratio start points are 15.9% and 5.7%.footnote [9]

The stress reduces banks’ capital positions substantially, but the system and all eight participating banks remain above their reference rates for both CET1 capital and Tier 1 leverage ratios.
The final results of the SST show that, on a transitional IFRS 9 basis, banks’ aggregate CET1 capital ratio falls to a low of 10.5% by the second year of the stress – a decrease of 5.5 percentage points from the start, excluding the benefit of software assets (Charts 1 and 2). A key driver of this change is substantial credit impairments. The aggregate Tier 1 leverage ratio falls by 1.0 percentage points to a low of 4.8%. If individual banks’ reference rates were aggregated, at the capital low points the UK banking sector would exceed its indicative CET1 capital and Tier 1 leverage reference rates by 2.8 percentage points and 1.1 percentage points respectively (Chart 4 and Table A). The UK banking sector remains above the indicative aggregate reference rates in all years of the stress. There is even greater headroom above minimum requirements.

No individual bank falls below its reference rate for either the risk-weighted CET1 capital or Tier 1 leverage ratio (Chart 4 and Table A). The scale of the drawdown does differ by bank, however, with many of those banks that have a relatively high share of exposures in the UK generally experiencing larger reductions in capital ratios. This primarily reflects the severity of the UK scenario, and is explained further in the next section. There is no conversion of banks’ AT1 instruments in the stress as no bank’s CET1 ratio falls below 7% on a non-transitional IFRS 9 basis. The major UK banks’ aggregate CET1 capital ratio recovers somewhat over the second half of the stress scenario to reach 13.5%. That is, nevertheless, weaker than the starting position.

Chart 4: All banks remain above their CET1 capital ratio reference rates in the SST

Projected CET1 capital ratios in the stress scenario (a) (b) (c) (d)

All eight participating banks in the SST remain above their CET1 capital ratio reference rates; Lloyds Banking Group has the lowest headroom, with a low point of 7.8% compared to its reference rate of 7.7%.

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) See footnote (a) to Chart 1. Aggregate CET1 capital ratios are calculated by dividing aggregate CET1 capital by aggregate RWAs at the aggregate low point of the stress in 2022.
  • (b) The minimum CET1 capital ratios shown in the chart do not necessarily occur in the same year of the stress scenario for all banks. For individual banks, low-point years are based on their post-strategic management actions and CRD V restrictions.
  • (c) There is no conversion of banks’ AT1 instruments in the stress as no bank’s CET1 ratio falls below 7% on a non-transitional IFRS 9 basis.
  • (d) The start points for all firms and the aggregate are shown including the software assets benefit (in contrast to Charts 1 and 2). For banks with a low-point year in 2021, the low-point figures include the software assets benefit, whereas for banks with a low-point year in 2022, the low-point figures exclude the software assets benefit, in line with the regulatory treatment as set out in the PRA’s Policy Statement PS17/21.

Table A: All banks remain above their CET1 capital and Tier 1 leverage ratio reference rates in the SST

Results of the 2021 SST on a transitional IFRS 9 basis (a) (b) (c) (d) (e) (f)

Per cent

CET1 capital

Tier 1 leverage

Dec. 2020

Low point

Change (excluding effect of software assets)

Reference rate

Dec. 2020

Low point

Change (excluding effect of software assets)

Reference rate

Barclays

15.1

9.4

-5.4

8.1

5.3

4.1

-1.1

3.7

HSBC

15.9

10.4

-5.4

7.7

6.2

5.1

-1.0

3.9

Lloyds Banking Group

16.2

7.8

-7.9

7.7

5.8

3.9

-1.7

3.8

Nationwide

36.2

17.0

-19.1

8.4

5.2

5.0

-0.3

3.6

NatWest Group

18.5

10.4

-7.9

7.0

6.4

4.4

-1.9

3.6

Santander UK

15.2

11.2

-3.7

8.2

5.1

4.1

-0.9

3.5

Standard Chartered

14.4

10.9

-3.5

7.1

5.2

4.9

-0.2

3.6

Virgin Money UK

13.9

8.9

-5.0

6.1

5.0

4.1

-0.8

3.3

Aggregate

16.2

10.5

-5.5

7.6

5.8

4.8

-0.9

3.7

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) The CET1 capital ratio is defined as CET1 capital expressed as a percentage of risk-weighted assets (RWAs), where these are in line with CRR and the UK implementation of CRD V via the PRA Rulebook.
  • (b) The Tier 1 leverage ratio is Tier 1 capital expressed as a percentage of the leverage exposure measure excluding central bank reserves, as defined in Rule 1.2 of the Leverage Ratio part of the PRA Rulebook.
  • (c) Minimum aggregate CET1 ratios are calculated by dividing aggregate CET1 capital by aggregate RWAs at the aggregate low point of the stress in 2022. Minimum aggregate Tier 1 leverage ratios are calculated by dividing aggregate Tier 1 capital by the aggregate leverage exposure measure at the aggregate low point of the stress in 2022.
  • (d) The minimum CET1 ratios and leverage ratios shown in the table do not necessarily occur in the same year of the stress scenario for all banks. For individual banks, low-point years are based on their post-strategic management action and CRD V restrictions.
  • (e) The December 2020 figures for all firms and the aggregate include the software assets benefit, in contrast to Charts 1 and 2. For banks with a low point in year 1, low-point figures include the software assets benefit, whereas for banks with a low point year in or after year 2, they exclude the software assets benefit, in line with the regulatory treatment as set out in the PRA’s Policy Statement PS17/21. For CET1 capital ratios, low points occur in year 1 for HSBC, Nationwide, Standard Chartered and Virgin Money UK, year 2 for Barclays, Lloyds Banking Group, NatWest Group and the aggregate, and year 5 for Santander UK. For Tier 1 leverage ratios, low points occur in year 1 for Barclays, Nationwide and Standard Chartered, year 2 for Lloyds Banking Group, Virgin Money UK and the aggregate, year 3 for HSBC and year 5 for NatWest Group and Santander UK. The changes in CET1 capital and Tier 1 leverage ratios shown in the table for all banks exclude the effect of software assets, so for some banks the change is not simply equal to the difference between the December 2020 and low-point figures.
  • (f) The aggregate reference rate is calculated as a weighted average of reference rates in the aggregate low-point year.

Box B: SST results on a non-transitional IFRS 9 basis

The Bank calculates and publishes results on a non-transitional basis but does not assess participating banks on this basis.
Although participating banks are judged in the SST on a transitional IFRS 9 basis, for transparency the Bank also calculates and publishes both capital low points and reference rates on an assumed non-transitional basis. The CET1 capital and Tier 1 leverage non-transitional reference rates include IFRS 9 adjustments made using the Bank’s current approach, consistent with that published in the November 2018 and December 2019 Financial Stability Reports.

Table 1 sets out the aggregate stress-test results on a non-transitional basis. On a non-transitional basis, the aggregate CET1 capital and Tier 1 leverage ratios drop to low points of 9.9% and 4.5% respectively, against reference rates of 7.0% and 3.5% (Table 1). At an aggregate level, the drawdowns on a non-transitional basis are slightly larger than on a transitional basis (Table A), reflecting the effect of transitional relief in ameliorating the capital impact of the stress on a transitional basis. All individual banks remain above their reference rates on a non-transitional basis, as they do on a transitional basis.

Table 1: While banks are not assessed on a non-transitional basis, even on this basis all banks remain above their CET1 capital and Tier 1 leverage ratio reference rates

Results of the 2021 SST on a non-transitional IFRS 9 basis (a) (b)

Per cent

CET1 capital

Tier 1 leverage

Dec. 2020

Low point

Change (excluding effect of software assets)

Reference rate

Dec. 2020

Low point

Change (excluding effect of software assets)

Reference rate

Barclays

14.3

8.2

-6.2

7.0

5.0

3.6

-1.5

3.3

HSBC

15.7

9.8

-5.9

7.2

6.2

5.0

-1.1

3.9

Lloyds Banking Group

15.0

7.8

-6.8

7.7

5.5

3.6

-1.8

3.3

Nationwide

35.6

16.9

-18.6

8.3

5.2

5.0

-0.2

3.6

NatWest Group

17.5

10.3

-6.9

7.0

6.1

4.4

-1.6

3.6

Santander UK

15.1

11.2

-3.6

8.2

5.1

4.1

-0.9

3.5

Standard Chartered

14.3

10.8

-3.4

7.1

5.1

4.9

-0.2

3.5

Virgin Money UK

12.9

7.4

-5.5

6.1

4.7

3.5

-1.1

3.3

Aggregate

15.7

9.9

-5.8

7.0

5.6

4.5

-1.1

3.5

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) See footnotes (a), (b), (c), (d) and (f) to Table A.
  • (b) The December 2020 figures for all firms and the aggregate include the software assets benefit, in contrast to Charts 1 and 2. For banks with a low-point in year 1, low-point figures include the software assets benefit, whereas for banks with a low point year in or after year 2, they exclude the software assets benefit, in line with the regulatory treatment as set out in the PRA’s Policy Statement PS17/21. For CET1 capital ratios, low points on a non-transitional basis occur in year 1 for Barclays, HSBC, Nationwide, Standard Chartered, Virgin Money UK and the aggregate, year 2 for Lloyds Banking Group and NatWest Group, and year 5 for Santander UK. For Tier 1 leverage ratios, low points on a non-transitional basis occur in year 1 for Barclays, Lloyds Banking Group, Nationwide, Standard Chartered and Virgin Money UK and the aggregate, year 3 for HSBC, and year 5 for NatWest Group and Santander UK. The changes in CET1 capital and Tier 1 leverage ratios shown in the table for all banks exclude the effect of software assets, so for some banks the change is not simply equal to the difference between the December 2020 and low-point figures.

3: Key drivers of the results

The results of the SST incorporate a number of key judgements. These judgements inform adjustments Bank staff have made to the participating banks’ projections. The next few sections describe the drivers of the results in more detail.

Key drivers of the weakening in capital positions include substantial impairments and higher risk-weighted assets (RWAs).
Banks’ aggregate CET1 capital ratio falls substantially in the first two years of the stress (Chart 1). A number of factors reduce banks’ capital positions, with other factors cushioning the impact of the stress. Table B decomposes the change in the aggregate CET1 capital ratio and leverage ratio between the start point in 2020 and the low point in 2022 into each of its constituent components. One of the key drivers of the capital drawdown for the banking system is credit impairments, alongside an increase in RWAs (Table B). Net interest income and net fee and commission income are key factors cushioning the impact of the stress.footnote [10]

Table B: Impairments and higher RWAs are key drivers of lower capital ratios

Contributions to the changes in the aggregate CET1 capital ratio and Tier 1 leverage ratio between the start and low points of the 2021 SST (a) (b) (c) (d) (e) (f) (g) (h)

Percentage points (unless otherwise stated)

CET1 ratio

Tier 1 leverage ratio

End-2020

16.2%

5.8%

End-2020 excluding software assets benefit

15.9%

5.7%

- Impairments (including IFRS 9 relief)

-4.9

-1.5

- RWAs or leverage exposure

-2.1

0.2

- Misconduct costs

-0.4

-0.1

- Net interest income

7.1

2.2

- - of which sterling

4.7

1.4

- - of which non-sterling

2.4

0.7

- Net fee and commission income

2.6

0.8

- Trading operations

0.2

0.1

- Discretionary distributions

-0.6

-0.2

- - of which dividends

0.0

0.0

- - of which variable remuneration

-0.2

-0.1

- - of which AT1 coupons and other distributions

-0.3

-0.1

- Expenses and taxes

-7.4

-2.2

- Other

0.0

0.0

Stress low point (before AT1 conversion)

10.5%

4.8%

Impact of AT1 conversion

0.0

0.0

Stress low point (after AT1 conversion)

10.5%

4.8%

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) The CET1 ratio aggregate low point and Tier 1 leverage ratio aggregate low point are in year 2.
  • (b) The CET1 ratio is defined as CET1 capital expressed as a percentage of RWAs, where both terms are defined in line with CRR and the UK implementation of CRD V via the PRA Rulebook.
  • (c) The Tier 1 leverage ratio is Tier 1 capital expressed as a percentage of the leverage exposure measure excluding central bank reserves, as defined in Rule 1.2 of the Leverage Ratio part of the PRA Rulebook.
  • (d) Trading operations comprise: investment banking revenues net of costs, market risk losses, counterparty credit risk losses, losses arising from changes in banks’ fair value adjustments, prudential valuation adjustments and losses on fair value positions not held for trading.
  • (e) Changes in RWAs impact the CET1 ratio, whereas changes in the leverage exposure measure impact the Tier 1 leverage ratio.
  • (f) To produce aggregate results in a single currency, the Bank converts the results of US dollar reporters HSBC and Standard Chartered into sterling. This aggregation is done on a dynamic exchange rate basis, ie based on the exchange rate paths specified in the scenario, except for the row showing the contribution of changes in ‘RWAs or leverage exposure’. For this row alone, the impact is calculated on a constant exchange rate basis, ie based on exchange rates prevailing at the start of the test.
  • (g) Expenses comprise administrative and staff expenses, excluding upfront variable remuneration which is included in discretionary distributions.
  • (h) ‘Other’ comprises other profit and loss and other capital movements. Non-exhaustively, other profit and loss includes share of profit/loss of investment in associates and other income, and other capital movements include pension assets devaluation, prudential filters, accumulated other comprehensive income, internal ratings-based shortfall of credit risk adjustments to expected losses, and actuarial gain/loss from defined-benefit pension schemes.

This decomposition differs from the way the Bank has presented results of previous ACS exercises, which showed the difference in capital impact for each line item, from the start point to the stressed low point year, in the stress scenario relative to the baseline scenario. The baseline scenario was based on a macroeconomic scenario in line with the MPC’s central forecast. This year banks were not asked to submit baseline projections, to help facilitate changes to the usual timetable and in recognition of ongoing operational challenges within participating banks as a result of the pandemic. When presented based on the difference between the start and low point of the stress instead, a number of components in Table B, in particular net interest income and expenses, appear larger than on the usual baseline-to-stress basis. That is because they present banks’ underlying revenues and costs in the two years between the start and low points.

Banks incur credit impairments of more than £70 billion over 2021 and 2022.
A key driver of the material fall in the aggregate capital ratio is credit impairments (Table B). The Bank published interim results of the 2021 SST in the July Financial Stability Report, based on early credit impairment projections from participating banks. Resubmissions since the interim results have not materially changed these results.

Credit impairments stand at more than £70 billion between end-2020 and the low point of the stress in 2022. When the impairments banks actually incurred in 2020 are included, this rises to over £90 billion of impairments between the outbreak of Covid and the 2022 capital low point.

Over the five years of the stress, and excluding 2020, banks incur impairment charges totalling around £90 billion, which corresponds to an aggregate impairment rate of 2.8% (Table C). Around 80% of these are projected to occur by the capital low point.

Table C: Impairments are estimated at over £90 billion over the five years of the SST

Aggregate cumulative impairment charges and rates over the five years of the stress (a) (b) (c)

2021 SST

2019 ACS

Charge (£ billion)

Rate (per cent)

Charge (£ billion)

Rate (per cent)

UK lending to businesses

21.6

7.8

27.3

9.5

- of which leveraged lending

1.9

-

3.2

-

UK lending to individuals

31.7

2.5

47.8

4.2

- of which UK consumer credit

26.1

24.3

31.2

27.8

- of which UK mortgages

5.6

0.5

16.6

1.6

Total UK

54.0

3.2

76.2

4.9

Non-UK lending to businesses

21.0

4.0

43.2

6.2

- of which leveraged lending

2.9

-

5.8

-

Non-UK lending to individuals

15.2

4.1

28.6

7.0

Total non-UK

37.4

2.4

74.5

4.2

Total

91.5

2.8

150.7

4.5

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) Cumulative impairment charge rates = (five-year total impairment charge) / (average gross on balance sheet exposures), where the denominator is a simple average of 2020, 2021, 2022, 2023 and 2024 year-end positions.
  • (b) Other wholesale lending is included in the total UK, total non-UK and total figures, but not in those for lending to businesses. Other wholesale lending consists of lending to financial institutions, housing associations, sovereigns, quasi-sovereigns and other wholesale counterparties.
  • (c) Non-UK figures in the 2019 ACS include the effect of the large depreciation in sterling in that exercise, which raises impairments when translated into sterling terms.

The majority of these impairments are on UK-based lending.
Around 60% of total impairments over the five years of the stress are incurred on banks’ exposures to UK borrowers (Table C). This is higher than the share of UK lending in banks’ credit exposures, of just over 50%, which in part reflects the severity of the UK scenario. The share of UK impairments is also higher than in the 2019 ACS, which was based on a scenario embodying deep simultaneous recessions in the UK and global economies.footnote [11]

There is a broadly even split between impairments on lending to individuals (mortgages and consumer credit) and lending to corporates (Chart 5). In the UK, the severity of the initial unemployment shock increases defaults on consumer credit exposures in particular, in line with the impact of unemployment as observed in the past. The strong rebound in residential property prices helps to limit losses on mortgages.

Chart 5: Around 60% of impairments over the stress scenario are incurred on UK exposures, and the split of total impairments between retail and corporate is fairly even

Aggregate cumulative impairment charges (and rates) over the five years of the stress (2021–25) (a) (b)

The portions of the circle show that £53 billion of the £90 billion credit impairments over 2021-25 are incurred on UK exposures. The split of total impairments between retail and corporate is fairly even.

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) See footnote (a) to Table C.
  • (b) Does not include other wholesale lending.

Impairment losses on UK corporates in the stress are material, at 7.8% of exposures, in part reflecting that debt in the corporate sector increased during 2020. Nevertheless, as explained in October Financial Stability in Focus, these impairments are mitigated by a number of factors. Actions by UK authorities – including the Government and the Bank of England – and support from the financial sector play a particularly important role in limiting losses in the SST.footnote [12] The low level of interest rates in the scenario also limits companies’ debt-servicing costs, and the major UK banks have limited exposures to sectors with particularly low aggregate interest coverage ratios (ICRs).footnote [13] As explained in Box C, while the results of the SST reveal vulnerabilities in some corporate sectors, these are not judged to be a material threat to banks’ resilience.

Impairments totalling £36 billion over the five years are incurred on banks’ non-UK lending to the real economy in the SST (Chart 5). The global low interest rate environment helps to limit corporate impairments by reducing companies’ debt-servicing costs. The impairment rate of 4.0% on non-UK corporate exposures is substantially below that for UK corporates, which first and foremost reflects that UK banks’ exposures to non-UK corporates are more concentrated among larger companies. These are judged to be less at risk of default in part because they generally have more diverse sources of income and greater access to sources of funding such as capital markets.

Given the relative severity of the scenario for the UK economy, many of those banks that have a relatively high share of exposures in the UK experience higher impairment rates, which is a key driver of their generally higher capital drawdowns (Table A). In addition, aggregate impairment rates are relatively high for those banks that are more active in unsecured and corporate lending, since mortgage losses are relatively low in this scenario.

Banks are also judged to be resilient to potential losses on leveraged lending.
The FPC has been monitoring closely the leveraged lending market and the loosening in underwriting standards in recent years (see Financial Stability Report December 2021, ‘Overview of risks to the UK financial system’). Leveraged loans are loans to companies that are highly indebted or owned by a private equity sponsor.footnote [14] As such, they are a risky form of lending which may translate into larger losses in a stress. At the two-year scenario low point in the SST total projected losses on these exposures are estimated to be £3.6 billion. The core UK banking system is therefore judged to be resilient to direct losses associated with leveraged lending.

While substantial, total impairments are limited by the recovery embodied in the scenario.
When the impairments banks actually incurred in 2020 are included, overall credit impairments in the SST between 2020 and 2022 are £90 billion. While substantial, these are lower than the £120 billion implied by the 2020 RST, despite the fact that the FPC and PRC judge both macroeconomic scenarios to be of broadly equal severity.

A key factor explaining this difference is the more granular approach taken by the Bank in assessing the impact of the scenario in this exercise, in conjunction with the detailed credit submissions from participating banks. In particular, the strong rebound in residential property prices later in the scenario is estimated to help limit losses on mortgages in the SST. Indeed, under IFRS 9 losses are recognised before they are incurred. This means that the more the economic recovery reduces impairments later in the scenario, the fewer losses there are to be brought forward.

The impact of the transitional arrangements for IFRS 9 in the stress is relatively limited, compared to the 2019 ACS for instance. That reflects two factors. First, the steep macroeconomic downturn early in the scenario leads to defaults early in the stress, and this effect is accentuated by the increase in loans already classified as at a heightened risk of default during 2020. Those newly defaulted provisions in 2021 and 2022 are not eligible for transitional relief, which means that the amount of losses that banks are allowed to ‘add back’ is commensurately smaller than would otherwise have been the case. Second, as described above overall impairments are limited somewhat by the strong recovery in the scenario, reducing the amount of offsetting IFRS 9 transitional relief. The impact of transitional relief does, nevertheless, vary by bank (see ‘Annex 1: 2021 solvency stress test: bank specific results’ in the annex for more detail).

RWAs increase due to higher risk weights on credit exposures.
RWAs are a risk-adjusted measure of banks’ assets, used to calculate regulatory CET1 capital requirements, and they increase when banks’ underlying risk increases. Aggregate RWAs rise by 24% in the first two years of the stress (Chart 6), contributing substantially to the reduction in banks’ aggregate CET1 capital ratio (Table B). Higher RWAs are accounted for mainly by higher risk weights on banks’ credit exposures, largely reflecting rating grade migration on corporate lending, particularly outside the UK. Although impairments on UK mortgages are judged to be relatively low in the SST as described above, higher risk weights on mortgage lending still contribute materially to higher RWAs due to the impact of higher unemployment. The increase in RWAs overall is smaller than in the 2019 ACS. In the later years of the scenario RWAs fall back somewhat, consistent with the reduction in unemployment and improvement in economic activity.

Chart 6: Aggregate risk weights are projected to rise materially in the scenario

Participating banks’ historical and projected aggregate risk weights (a) (b)

The line shows that banks’ aggregate risk weights rise materially in the scenario from around 30% to 38% of the UK leverage exposure measure, a historically high level, before falling back to 31% by 2025.

Footnotes

  • Sources: Banks’ published accounts and related public disclosures, participating banks’ STDF data submissions, PRA regulatory returns, Bank analysis and calculations.
  • (a) For the period from 2007–11, the aggregate risk weight is defined as RWAs divided by Total Balance Sheet Assets. For the period from 2012–15, the aggregate risk weight is defined as RWAs divided by the Basel III leverage exposure measure, and from 2016 it is defined as RWAs divided by the UK leverage exposure measure (excluding qualifying claims on central banks). RWAs are defined using the prevailing regulatory standard at each date. Virgin Money UK is included from 2018 onwards.
  • (b) The figures for 2020 and 2021 include the software assets benefit.

Banks’ overall profits fall sharply in the early part of the stress.
Banks generate substantially weaker profits in the stress than in recent years, making a loss of close to £60 billion in the first year (Chart 7). While that largely reflects credit impairments, banks’ underlying income is also weak. For instance, the income banks earn through fees and commissions for services provided is projected to fall in the first year, reflecting weaker economic activity.

From the second year of the stress, banks’ annual profit before tax returns to close to its pre-pandemic average of approximately £30 billion per year, contributing to the modest pickup in capital ratios. The recovery in profit reflects that the rebound in economic activity in the scenario leads to lower impairments and higher fee and commission income, balanced against the continued drag on net interest income from the low interest rate environment. In the five years of the stress scenario overall, banks are projected to earn around £70 billion in profit, only returning to positive cumulative profit in the fourth year (Chart 7).

Chart 7: Banks make substantial losses in the first year of the stress

Cumulative profit before tax in 2021 SST (a)

Footnotes

  • The line shows that banks make substantial losses of around £60 billion in the first year of the scenario, before returning to cumulative profit in Year 4. Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) For HSBC and Standard Chartered, annual profits are converted from US dollars to sterling using exchange rates consistent with the scenario.

Although banks’ expenses contribute to the reduction in capital positions over the stress (Table B), this reflects their underlying costs, and they are lower at the low point of the stress than in 2020. That fall reflects lower bonuses – in line with banks’ bonus policies – and planned reductions in restructuring costs and other staff costs.

Banks’ net interest income is suppressed by low interest rates, although a reduction in expensive wholesale funding provides some support.
The largest component of banks’ income is their net interest income (NII), which they earn by receiving higher interest on assets, like loans, than they pay out on liabilities, like deposits. Overall, although it contributes positively to the change in capital ratios (Table B), NII falls by 3% in the first year of the stress and thereafter remains broadly flat. Non-sterling loan margins – a measure of the spread between average non-sterling loan and deposit rates – fall sharply in the first year, whereas the decline for sterling loan margins is more gradual (Chart 8). These paths for margins are materially weaker than the 2019 ACS, in which interest rates rose.

Chart 8: Both sterling and non-sterling loan margins are lower in the SST than the 2019 ACS

Sterling and non-sterling loan margins in the 2021 SST (a) (b)

The lines show that both sterling and non-sterling loan margins are lower in the SST than the 2019 ACS. Both margins fall, with non-sterling margins falling sharply in year 1.

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) Sterling loan margin calculated as net interest income received on sterling loans minus that paid on deposits divided by sterling loans.
  • (b) Non-sterling loan margin calculated as net interest income received on non-sterling loans minus that paid on deposits divided by non-sterling loans.

Falls in policy rates in the scenario in both the UK and abroad from their already low levels weigh on margins early in the stress. This is in part because banks would be unable to pass on these lower rates in full to depositors given that these rates are already only just above zero. The path for margins is further depressed by an assumption that UK mortgage borrowers with standard variable-rate mortgages continue to switch to cheaper fixed-rate products, in part due to the continued price incentive. Mortgage margins are judged over time to reduce somewhat, although remain at high levels historically. Banks’ NII in the stress is also supported by falling funding costs as banks move away from relatively expensive wholesale funding towards cheaper retail deposits, which increase in the scenario consistent with the expansion in lending.

The traded risk impact is relatively benign.
The Bank did not publish a separate traded risk scenario for the SST. While there are falls in asset prices across equity and corporate bond markets, as described in Section 2, they are less severe than in previous Bank stress tests. That reflects a smaller rise in risk premia in the scenario given an expectation from market participants that markets remain functional, with the stress in the real economy relatively more severe reflecting the idiosyncratic nature of the shock related to the Covid outbreak. As a result, the impact of financial market developments in the stress is relatively modest, with trading operations contributing slightly positively to the change in banks’ aggregate capital ratio (Table B).

Banks earn client revenue from their investment banking operations of £39 billion over the first two years of the stress to the low point, somewhat lower than recent years. That is only partly offset by £11 billion of losses from a range of items: losses on their trading books, valuation adjustments on the securities they hold, defaults of major counterparties, and reductions in the fair value of items held on banking books such as bonds within banks’ liquid asset buffers. Separately to the effect on banks’ profits, banks’ RWAs increase by £47 billion, consisting of higher RWAs for counterparty credit risk, market risk and credit valuation adjustment risk. The impact of the stress through all of these channels is smaller than the 2019 ACS.

Aggregate misconduct costs are lower than in recent years.
The SST incorporates stressed projections for potential misconduct fines and other costs beyond those paid or provided for by the end of 2020. Banks are asked to provide stressed projections for misconduct costs that relate to known misconduct issues and have a low likelihood of being exceeded.

Banks have lower exposures to material historical issues, such as payment protection insurance (PPI), than has been the case in recent years. Misconduct charges total £7 billion over the first two years, around half the level in the 2019 ACS.

Strategic management actions are relatively limited overall.
Banks are invited to submit planned strategic management actions that they would take during the scenario in order to boost their capital ratios. These can include actions such as sales of parts of their business but must be consistent with the market-wide stress, be executable in stress and form part of, or be consistent with, the bank’s recovery plan.

At the aggregate level, the scale of these is relatively small in the SST, for instance compared to the 2019 ACS. This largely reflects banks’ robust starting capital ratios, which in part is due to actions banks had already taken to support capital ratios, including cancelling final 2019 dividends in March 2020. Furthermore, by the second year of the scenario the recovery in output is already beginning, and so banks are judged likely to want to continue to hold on to their existing business lines, rather than downsize or sell them, in order to benefit from this recovery.

Banks take action to cut distributions in the stress.
Banks make different types of distributions, such as paying out dividends to shareholders, paying out variable remuneration to staff, or buying back shares. The ability to not pay out or reduce distributions in a stress can support banks’ resilience. When a stress materialises banks can reduce distributions through a variety of mechanisms: established policies that link distributions to earnings, voluntary cuts (including strategic management actions) or automatically as a result of capital regulations. These regulations state that if a bank’s capital falls into its combined capital buffer, it is subject to a limit on the proportion of its profit it is allowed to distribute.footnote [15] The total amount it is allowed to distribute is the maximum distributable amount (MDA), which is a share of a banks’ earnings.

In March 2020 the major UK banks cancelled planned outstanding dividends from the earnings they accrued in financial year 2019, following a request from the PRA to do so as a precautionary step given the unique role that banks needed to play in supporting the wider economy through a period of economic disruption.footnote [16] In December 2020 the PRA judged that banks had the capacity again to make prudent payouts.footnote [17] In the SST banks are assumed to pay out these dividends from their 2020 earnings. That banks pay these 2020 dividends in the SST reflects that banks would take final decisions on dividends in early 2021 before the most severe part of the scenario. Planned share buybacks in 2021 are assumed to be cancelled, however.

Thereafter, banks are assumed to take action to cut distributions. Most banks do not pay dividends from the first two years of the stress. In part this reflects that many banks make losses, especially in 2021, and those banks that do return to profit in 2022 prioritise rebuilding capital. Banks resume dividend payments in the later years of the scenario. Finally, a small number of banks fall into their combined capital buffer – although fewer than in the 2019 ACS – with the resultant MDA restrictions reducing the amount that they can distribute.

The impact of the stress is generally more severe for more UK-focused banks than globally active banks.
The impact and drivers for individual banks in the SST varies somewhat (Chart 4 and Table A). Those banks that have a relatively high share of exposures in the UK generally experience a relatively large capital drawdown. That primarily reflects the severity of the UK macroeconomic scenario and its effect on impairments. While there is a severe slowdown in the global economy in the SST scenario, the effects on those UK banks that have significant exposures overseas depends on the particular markets to which they are exposed. In addition, other non-credit factors contribute to larger falls in capital for UK-focused banks. The annex contains more details on individual banks.

The drawdown in the SST is broadly the same as the 2019 ACS.
Overall, the reduction in the major UK banks’ CET1 capital ratio in the SST – at 5.5 percentage points – is broadly the same as the Bank’s 2019 ACS (5.2 percentage points).footnote [18] Nevertheless, the mix of drivers is somewhat different (Table D). Net interest income provides materially less support to the capital ratio, due to the lower path for interest rates in the SST scenario than the 2019 ACS, in which interest rates rose sharply (Charts 3 and 8). Net fee and commission income is somewhat weaker in the SST, reflecting the sharper drop in economic activity than the 2019 ACS.

Offsetting this are a number of factors that limit the scale of the drawdown in the 2021 SST relative to the 2019 ACS. In particular, impairments are lower (Table C). Despite more severe falls in economic activity in the SST than the 2019 ACS, the effect on impairments is more than offset by the beneficial impact of lower interest rates and the more rapid recovery in output in the SST. Although lower impairments in the SST together with other factors (as described above) imply less favourable offsetting IFRS 9 transitional relief, impairments net of this relief are still somewhat smaller (Table D). Other factors that provide more support to capital ratios in the SST relative to the 2019 ACS are a smaller traded risk impact, a lower increase in RWAs, and smaller misconduct costs.

Table D: While the overall fall in the capital ratio in the SST is similar to the 2019 ACS, the drivers are different

Contributions to the changes in the aggregate CET1 capital ratio between the start and low points of the 2021 SST and 2019 ACS (a) (b)

Percentage points (unless otherwise stated)

CET1 ratio

2021 SST

2019 ACS

End-2020/2018

16.2%

14.5%

End-2020/2018 excluding software assets benefit

15.9%

14.5%

- Impairments (including IFRS 9 relief)

-4.9

-6.1

- RWAs

-2.1

-2.7

- Misconduct costs

-0.4

-0.8

- Net interest income

7.1

9.7

- - of which sterling

4.7

5.4

- - of which non-sterling

2.4

4.2

- Net fee and commission income

2.6

3.2

- Trading operations

0.2

-1.5

- Discretionary distributions

-0.6

-0.4

- - of which dividends

0.0

0.0

- - of which variable remuneration

-0.2

-0.2

- - of which AT1 coupons and other distributions

-0.3

-0.2

- Expenses and taxes

-7.4

-7.8

- Other

0.0

1.4

Stress low point (before AT1 conversion)

10.5%

9.3%

Impact of AT1 conversion

0.0

0.6

Stress low point (after AT1 conversion)

10.5%

9.9%

Footnotes

  • Sources: Participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) See footnotes (a) to (h) to Table B.
  • (b) Regarding footnote (f) to Table B, the rationale for calculating the RWA impacts on a constant exchange rate basis is that given the large depreciation in sterling in the 2019 ACS, showing these impacts on a dynamic exchange rate basis would suggest a larger than warranted impact from increasing RWAs/exposures. On the alternative dynamic exchange rate basis, the RWA and leverage exposure impacts in the 2019 ACS would have been much more negative. The aggregate low points are unaffected by this presentational choice.

The capital impact in the SST is also in line with the RST.
The SST has been designed to act as a cross-check on the FPC’s judgements based on the RST carried out in 2020. The aggregate capital drawdown is similar to that exercise (Chart 2), validating those judgements. The drivers are to some extent different, however, reflecting in part that participating banks’ projections have revealed dynamics not fully captured by the aggregate desktop analysis underlying the RST. The drag on capital ratios from credit impairments and higher credit RWAs is smaller, reflecting the sharp recovery in the SST scenario and the Bank’s more granular assessment of the impact of the scenario. Offsetting that are more negative impacts from a range of other factors. For instance, larger shocks to financial market variables are included in the SST than the RST, reducing slightly the gains on banks’ trading operations (even if the impact on traded risk is smaller than the 2019 ACS). And other income banks make in the test is lower than the RST, due to the lower starting level of income at end-2020.

Box C: Vulnerable corporate sectors in the solvency stress test

Changes in consumer spending patterns and increases in corporate debt associated with the pandemic could lead to increased bank impairments in the stress.
The Covid pandemic resulted in a material change to consumer spending patterns. Spending on travel, entertainment and hospitality fell sharply both as a result of mandated closures and reduced capacity, and a general increase in precautionary behaviour by consumers. In addition to lower profits, debt levels among some sectors and types of businesses – such as small and medium-sized enterprises – have increased materially since the start of the pandemic, as noted in the October Financial Stability in Focus, which could increase corporate vulnerabilities and bank losses.

As part of the SST participating banks and Bank staff have examined the potential risks to the UK banking system were these developments to continue and become more entrenched. The stress scenario incorporates an intensification of the structural changes embodied in the MPC’s recent forecasts, which assume scarring and a weaker path for UK GDP in the longer term relative to before the pandemic.

While a number of broad service sectors are identified as potentially vulnerable, the extra impairments associated with acutely vulnerable subsectors are judged to be small.
The set of broad sectors identified as potentially vulnerable to increased credit losses includes: arts, entertainment and recreation; wholesale and retail trade; and accommodation and food. The impairment rate in the SST for these potentially vulnerable sectors is estimated, at over 9%, to be somewhat higher than for the broader UK corporate sector (7.8%).

These sectors are broad industrial classifications, however, and not all of these exposures are likely to be vulnerable to a much more severe evolution of the pandemic and consequent economic shock. Some sectors contain sizable components which performed well during the pandemic, such as warehousing and delivery.

It is challenging to identify and quantify the ‘extra’ risk, relative to the broader corporate sector, associated with those subsectors that are in fact acutely vulnerable. The loss rate on the narrower subsectors is estimated to be approximately one and a half times as high as for the broader corporate sector. There is significant uncertainty around this number. Nevertheless, it is judged that the scale of this ‘extra’ vulnerability is likely to be small. It is estimated to contribute around 10% of UK corporate impairments, which reduces banks’ aggregate CET1 capital ratio by only 0.2 percentage points at the low point.

The FPC judges that the major UK banks are resilient to direct losses associated with these vulnerable sectors. The FPC and PRC will continue to monitor the effect of the pandemic on particularly vulnerable corporates and bank resilience.

Box D: Amplification and feedback effects

It is important to assess the impact of system-wide dynamics in a stress.
As set out in the Bank’s October 2015 Approach Document, the Bank is committed to enhancing the role that its own models play in the stress test, with a key aim being to better capture the role that system-wide dynamics could play in a stress.

The global financial crisis in 2008–10 highlighted the importance of mitigating systemic risk in the banking system. This includes understanding how feedback and amplification channels during a stress can drive contagion losses and exacerbate the impact of an initial shock. For example, during the financial crisis the interbank market provided a mechanism by which problems quickly spread between banks, amplifying the effects of the crisis.

The Bank models how solvency contagion could arise through interbank exposures.
One of the Bank’s models is the solvency contagion model, which considers how risks might spill over between banks, over and above the direct first-round effects of a stress on each bank’s resilience in isolation.

In the event of a stress to the banking system, a shock to a particular bank’s assets causes the value of its capital position to deteriorate, increasing its probability of default. In turn, this causes banks with claims on the first bank to reassess the market value of those claims, causing their own capital positions to deteriorate. These subsequent reductions in bank capital may lead to further rounds of contagion as losses spread through the system.

The model analyses the likely impact of the stress scenario on each bank’s assets, its subsequent increased probability of default, and so the impact on the capital position of other banks in the system, including what would happen as these subsequent losses reverberate through the system.

The results of the model show that solvency contagion risk has increased but remains relatively small, in line with the evolution of interbank exposures.
The results of the model together with Bank staff’s judgement indicate that the solvency contagion risk between participating banks based on the results of the 2021 SST has increased in recent years, for instance relative to the 2017 ACS. The overall impact on the system via this channel remains small, however, and well below its level before the financial crisis.

Changes to the regulatory framework for the banking system since the financial crisis, alongside a range of other factors, help to explain the large reduction in solvency contagion risk.footnote [19] The introduction of stricter liquidity regulations, especially the Liquidity Coverage Ratio, has deterred some interbank lending, and in particular unsecured lending. In addition, tighter capital requirements have been associated with a significant improvement in banks’ capital positions. This improvement helps reduce, all else equal, the impact that a given fall in capital is likely to have on banks’ probability of default. As a consequence, any revaluation of interbank exposures following a shock is less severe and has less amplification effect.

The increase in estimated solvency contagion risk in the 2021 SST relative to recent years – for instance, the 2017 ACS – is driven by an increase in interbank exposures over the past two years, with these standing at £14 billion at end-2020 (Chart A). However, interbank exposures remain well below the £113 billion estimated at the time of the financial crisis in 2008.

Chart A: While they have picked up in recent years, interbank exposures remain far lower than at the beginning of the financial crisis

Aggregate exposures between major UK banks (a)

The bars show that interbank exposures between major UK banks have picked up from £9 billion in 2016 to £14 billion in 2020, but remain far below their 2008 level of £113 billion.

Footnotes

  • Sources: Large exposures data, participating banks’ STDF data submissions, Bank analysis and calculations.
  • (a) Participating banks excluding Virgin Money UK. Data are Q4 for each year. Interbank exposures in 2008 are estimated using data collected through the large exposures policy. Banks to which the requirement applies were required to report exposures to counterparties where the value was equal to or exceeded 10% of eligible capital. Because not all interbank exposures were reported, it is likely that interbank exposures in 2008 are underestimated. Interbank exposures in 2016 and 2020 are estimated using data submitted by the banks for the stress test where they must report all their interbank exposures.

The Bank’s solvency contagion model captures only one partial source of systemic risk. The Bank remains committed to further ongoing work to monitor and assess systemic risk in the banking system and broader financial system.

4: Use of the findings of the solvency stress test

The FPC continues to judge that the UK banking system remains resilient to outcomes for the economy that are much more severe than the MPC’s central forecast.
The primary aim of the SST was as a cross-check on the FPC’s judgement of how severe the pandemic-related macroeconomic stress that began in 2020 would need to be to jeopardise banks’ resilience and challenge their ability to absorb losses and continue to lend. The macroeconomic scenario underlying this SST was therefore calibrated in a different way to – and in some respects is more severe than – previous Bank ACS exercises.

The results of the stress test confirm the FPC’s previous judgement about the resilience of the system, in aggregate, to a very severe macroeconomic stress, much more severe than the MPC’s current economic forecast. The FPC continues to judge that UK banks are able to continue to support UK households and businesses even if economic outcomes are considerably worse than expected.

The results show that no individual bank falls below its reference rates (Table A and Chart 4). No individual bank is required to strengthen its capital position as a result of the test. The annex contains more details on individual banks, including Virgin Money UK who participated in the stress test for the first time.

The stress test will not be used as a direct input for setting capital buffers.
As indicated when the SST was launched, the focus of the exercise was to enable the FPC to update judgements about how the banking system could continue to support the economy through the pandemic-related stress. Consistent with the nature of the exercise, the FPC and PRC will therefore not use the SST as a direct input for setting capital buffers for UK banks, including the UK countercyclical capital buffer rate and PRA buffers.

The FPC judges that the results of the test, together with the central outlook and return to the ACS framework for 2022 (see Section 5), are consistent with the PRC’s decision to transition back to its standard approach to capital-setting and shareholder distributions.

The Bank’s qualitative review found continued improvements in data and analysis.
A key objective of the Bank’s concurrent stress-test framework is to support a continued improvement in banks’ own risk management and capital planning capabilities. The experience of 2020 and the Covid outbreak have highlighted the importance of banks having robust internal stress-test processes in place. For that reason, as in previous years, the Bank has undertaken a qualitative review of banks’ stress-testing capabilities as part of the 2021 SST. Nevertheless, the scope of this review was reduced, in order to manage the burden on participating banks.

The Bank found continued improvements in the overall quality of data provided and analysis across a number of areas, especially for those banks where material deficiencies had been identified previously. While participating banks have made encouraging progress overall, the Bank observed some weaknesses in banks’ abilities to assess the impact of the stress on net interest income. In addition, some improvement is required in their articulation of mitigating management actions (even if these actions were limited in scale on an aggregate basis in this exercise, as described above).

Bank staff also found that banks are making good progress overall in addressing the feedback from the Bank’s 2019 assessment of compliance with the Basel Committee on Banking Supervision stress-testing principles.

5: Stress testing in 2022

For 2022, the Bank intends to revert to the ACS stress-testing framework.
Having used the SST to test the resilience of the UK banking system against a much more severe evolution of the pandemic and consequent economic shock, the Bank intends to revert to the ACS stress-testing framework for the coming year. Due to its broader and countercyclical nature, as explained in Box A, the ACS framework is well suited to informing the setting of capital buffers for the system and its core banks.

Further details of the 2022 ACS will be published in 2022 Q1. When designing the ACS exercise, the Bank will reflect on changes that have occurred since the Bank published its approach to stress testing in 2015, and any lessons learnt from the Covid pandemic, including on the implications of IFRS 9. Furthermore, the test will assess the ring-fenced subgroups of existing stress-test participant banks on a standalone basis for the first time.

The Committees

The Financial Policy Committee:

Andrew Bailey, Governor
Jon Cunliffe, Deputy Governor responsible for financial stability
Ben Broadbent, Deputy Governor responsible for monetary policy
Dave Ramsden, Deputy Governor responsible for markets and banking
Sam Woods, Deputy Governor responsible for prudential regulation
Nikhil Rathi, Chief Executive of the Financial Conduct Authority
Sarah Breeden, Executive Director for Financial Stability Strategy and Risk
Colette Bowe
Jon Hall
Anil Kashyap
Elisabeth Stheeman
Carolyn Wilkins
Charles Roxburgh attends as the Treasury member in a non-voting capacity.

The Prudential Regulation Committee:

Andrew Bailey, Governor
Jon Cunliffe, Deputy Governor responsible for financial stability
Ben Broadbent, Deputy Governor responsible for monetary policy
Dave Ramsden, Deputy Governor responsible for markets and banking
Sam Woods, Deputy Governor responsible for prudential regulation
Nikhil Rathi, Chief Executive of the Financial Conduct Authority
Julia Black
Tanya Castell
Antony Jenkins
Jill May
John Taylor

Annex

  1. See The Bank of England’s approach to stress testing the UK banking system and Box 5 of the August 2020 Financial Stability Report for a description of the Bank’s approach to stress testing.

  2. Banks participating in the 2021 SST are Barclays, HSBC, Lloyds Banking Group, Nationwide, NatWest Group, Santander UK, Standard Chartered and Virgin Money UK. Throughout this document the term ‘banks’ is used to refer to the eight participating banks and building societies. These banks account for around 75% of the outstanding stock of PRA-regulated bank lending to the UK real economy.

  3. This aggregate ‘reference rate’, which comprises banks’ minimum requirements and systemic buffers, has been adjusted to account for the impact of IFRS 9 (see Section 2 for more details).

  4. The proportion of losses that banks are allowed to add back depends on when they are made. For provisions made during 2018 and 2019, banks are allowed to add back CET1 equivalent to up to 50% of their ‘IFRS 9-related’ provisions in 2021. At the CET1 capital low point (on a transitional basis) of this year’s stress test in 2022, this falls to 25%. Full recognition of IFRS 9 takes effect from 2023. In 2020 transitional relief was extended as part of the CRR ‘Quick Fix’ (see ‘Statement by the PRA on the Capital Requirements Regulation (CRR) ‘Quick Fix’ package’). For relevant provisions raised from 2020 onwards, therefore, the CET1 add-back percentages are set at 100% in 2020 and 2021, 75% in 2022, 50% in 2023, and 25% in 2024, with full recognition from 2025.

  5. The ‘Quick Fix’ is part of a series of measures taken by European authorities to mitigate the impact of the Covid-19 pandemic on institutions across EU Member States, and in accordance with the European Union (Withdrawal Agreement) Act, forms part of the CRR that applies in the UK to PRA-regulated firms.

  6. The only difference is that they have been updated for the changes in the transitional relief announced as part of the CRR ‘Quick Fix’, as described in footnote 5.

  7. PRA statement on deposit takers’ approach to dividend payments, share buybacks and cash bonuses in response to Covid-19.

  8. PRA Policy Statement PS17/21, Section 6.

  9. The interim SST results published in the July Financial Stability Report cited numbers for starting capital positions and low points including the software assets benefit.

  10. Box D explains how the Bank models the effect of the scenario on how risks may spill over between banks and thereby the market value of their claims on other banks.

  11. The 2019 ACS figures for non-UK impairments, as shown in Table C, include the effect of the large depreciation in sterling in that exercise, which raises impairments when translated into sterling terms.

  12. While government-guaranteed loans are included in the SST, losses on the government-guaranteed part of these loans are not included, as the Bank’s focus in the SST is solely on losses incurred by banks.

  13. The ICR is calculated by dividing a business’ earnings before interest and taxes by its interest expense during a given period.

  14. A leveraged loan as defined in the stress test as a loan to a borrower that either (or both) (i) has a debt to earnings before interest, tax, depreciation and amortisation (EBITDA) of more than 4 times, or (ii) is majority owned by a private equity sponsor.

  15. The combined buffer is defined as a bank’s countercyclical buffer, its capital conservation buffer, and any applicable systemic risk buffers. More information on the PRA’s implementation of distribution restrictions can be found in PRA SS6/14, ‘Implementing CRD: Capital buffers’, January 2021.

  16. PRA statement on deposit takers’ approach to dividend payments, share buybacks and cash bonuses in response to Covid-19.

  17. PRA statement on capital distributions by large UK banks.

  18. Prior to the conversion of AT1 into CET1 capital that was a feature of the 2019 ACS.

  19. For more on these other factors, see Bank of England Quarterly Bulletin 2013 Q3, ‘Recent developments in the sterling overnight money market’.

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