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U.K. Banks Show Balance Sheet Resilience In Latest Stress Test

The U.K.'s seven major banks and largest building society have passed the Bank of England's (BoE) latest stress test. In the results published yesterday, each institution exceeded the capital and leverage hurdles set in the exercise, with none required to revise capital or distribution plans. S&P Global Ratings believes this outcome illustrates the groups' robust balance sheets and resilience to potential stress, including a further escalation of the COVID-19 pandemic.

The groups participating in the stress test were Barclays, HSBC Holdings, Lloyds Banking Group, Nationwide Building Society, NatWest Group, Santander UK Group Holdings, Standard Chartered, and--for the first time-- Virgin Money UK. Together, they represent about 75% of lending to the U.K. real economy. The exercise's initial results were an input to the BoE's decision to remove its pandemic-related restrictions on dividends and share buybacks earlier this year (see "Bulletin: U.K. Banks Are Freed To Increase Shareholder Distributions," published on July 13, 2021).

The stress test was based on the severe but plausible scenario of a synchronized global slowdown following close on the heels of last year's deep recession. For the U.K. economy, the stress assumptions included a 37% cumulative GDP decline across 2020-2022, a 33% peak-to-trough fall in domestic property prices, and unemployment peaking close to 12%. Applying this scenario to banks' balance sheet resulted in a material hypothetical hit to their capital ratios.

Our strong ratings on the eight participating institutions (the group stand-alone credit profiles range from 'a' to 'bbb') are consistent with high resilience to stress, which the BoE exercise appears to confirm. The U.K. banking sector booked significant credit provisions in the first half of 2020 and has steadily released them this year as economies recovered from the effects of the pandemic and defaults remained benign. Provision coverage still stands above pre-pandemic levels, which, in conjunction with solid capitalization, provides a cushion for banks to manage a severe economic slowdown, which is not our central expectation. The emergence of the COVID-19 omicron variant may cause banks to delay the release of remaining IFRS 9 management adjustments, which are qualitative overlays that supplement modeled credit provisions.

Stress Test Outcome Indicates Solid Capitalization

Under the stress test scenario, participating banks' common equity tier 1 (CET1) ratios in aggregate fell from a starting point of 15.9% at year-end 2020 (excluding software assets) to a low point of 10.5%. The 5.5 percentage point drawdown in the CET1 ratio is slightly higher than for previous exercises but the low point exceeded 10% for the first time due to the stronger starting position (see chart 1).

Chart 1


The main element contributing to the CET1 drawdown in the stress scenario was credit impairment charges, which diluted the aggregate ratio by 4.9 percentage points (see chart 2). An increase in risk-weighted assets, driven by an adverse credit migration of corporate borrowers, was also a sizable drag on capital. Misconduct costs were lower than in previous stress tests because banks have addressed most legal and regulatory cases, and modeled traded risk losses were also lower because the BoE stressed market values less extensively this time round. Mitigating these sources of capital dilution were banks' earnings and cuts to shareholder distributions. The participating institutions were projected to be substantially loss-making in the first year of the stress but then return to profitability.

Chart 2


The stress test resulted in £91.5 billion of cumulative credit impairment charges across the eight participating institutions, with the majority on domestic exposures (see chart 3). The sharp rise in the unemployment rate resulted in significant modeled impairment losses on consumer credit, while modeled losses on residential mortgages benefited from an assumed recovery in property prices toward the end of the stress period. Modeled impairments on corporate exposures were material but partly mitigated by government and central bank actions that have already been implemented in response to the pandemic, including loan guarantees. Modeled losses on leveraged loans were a manageable £4.8 billion over the stress period, which appears to have eased the BoE's previous concerns about this asset class.

Chart 3


The stress test was conducted using IFRS 9 transitional capital ratios, but the BoE also published results on a nontransitional, fully loaded basis. In aggregate, the CET1 drawdown was 30 basis points higher on the nontransitional basis at 5.8 percentage points, and the low-point CET1 ratio was 60 basis points lower at 9.9%. The greater impact on the nontransitional basis reflects the mitigating effect of IFRS 9 transitional relief on capital dilution under the stress scenario.

Everyone Passed

The individual stress test results for the eight participating institutions showed they all exceeded their respective hurdle rates for the exercise (see chart 4). This was also true on an IFRS 9 nontransitional basis. Unlike the 2019 edition of the stress test, there were no assumed conversions of banks' additional tier 1 instruments to equity in the latest exercise because each group's nontransitional CET1 ratio remained above the 7% trigger ratio.

Chart 4


The impact of the stress test was greatest for domestically focused retail and commercial banks due to the relative severity of the U.K. macroeconomic assumptions and the absence of a specific traded risk stress scenario (see chart 5). Lloyds had the lowest buffer to its CET1 hurdle rate under the stress test, with its low-point CET1 ratio during the stress period 10 basis points above the hurdle on both a transitional and nontransitional basis. Nationwide had the largest buffer to the CET1 hurdle, primarily because its binding regulatory constraint is the leverage ratio. Nationwide also experienced the largest percentage point decline in its CET1 ratio under the stress scenario, which partly reflects its point-in-time capital models for residential mortgages, which it expects to replace from January 2022.

Chart 5


The participating institutions also exceeded their leverage ratio hurdles through the stress period (see chart 6). Lloyds' low-point leverage ratio was again closest to the hurdle rate, exceeding it by 10 basis points according to the IFRS 9 transitional ratio and 30 basis points on the nontransitional basis.

Chart 6


The institution-specific modeled impairment rates for each category of lending show some variation around the sector averages (see table 1). We view these rankings as an interesting data point but not a prediction of potential relative credit performance.

Table 1

Projected Cumulative Five-Year Impairment Charge Rates On Domestic Lending Under The Stress Scenario, Ranked
Ranked best to worst
Mortgage lending to individuals Non-mortgage lending to individuals Commercial real estate (CRE) lending Lending to business excluding CRE
HSBC (0.1%) Santander UK (14.0%) Santander UK (5.2%) Standard Chartered (3.8%)
Nationwide (0.3%) HSBC (18.2%) Barclays (5.4%) NatWest (6.1%)
Virgin Money (0.3%) Lloyds (23.8%) NatWest (5.8%) Santander UK (8.5%)
Barclays (0.4%) Virgin Money (24.2%) HSBC (7.5%) Lloyds (8.6%)
NatWest (0.6%) NatWest (26.7%) Lloyds (7.7%) Virgin Money (8.6%)
Santander UK (0.6%) Nationwide (26.8%) Barclays (8.7%)
Lloyds (0.7%) Barclays (31.7%) HSBC (8.9%)
Disclosure excludes banks with de minimis portfolios and/or de minimis impairment charges in each category. Institutions with identical rates are listed alphabetically. Source: Bank of England.

Climate Stress Test To Come Next Year

The BoE supplements its annual solvency stress tests with biennial exploratory exercises focusing on specific topics. In May 2022, it plans to publish the results of an exploratory climate stress test that will consider the vulnerability of banks' business models to differing climate policy pathways and associated changes in global warming. Unlike the solvency stress tests, the exploratory exercises do not determine capital requirements or include bank-by-bank results, but primarily inform the BoE's policymaking.

Countercyclical Buffer Increased To 1%

Alongside the stress test results, the BoE announced it will increase the U.K. countercyclical capital buffer (CCyB) to 1% from 0% with effect from December 2022. The CCyB requires banks to hold additional capital against future losses, which can be released when a shock occurs. The BoE duly cut the CCyB to 0% in March 2020 in response to the COVID-19 pandemic, having previously intended to raise it to 2% by year-end 2020. The BoE considers that a 2% rate is appropriate in a standard environment when risks are neither elevated nor subdued, and it judges that current credit conditions meet this definition. Therefore, the BoE intends to further increase the U.K. CCyB to 2% in the second quarter of 2022--taking effect in the second quarter of 2023--assuming the economic recovery proceeds on track and there is no material change in the outlook for financial stability.

The increase in the CCyB does not materially affect our expectations for U.K. banks' capital and leverage positions, including our risk-adjusted capital ratios. The sector currently operates with sizable headroom to regulatory requirements and banks' capital targets had anticipated a higher CCyB.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Richard Barnes, London + 44 20 7176 7227;
Secondary Contacts:William Edwards, London + 44 20 7176 3359;
Osman Sattar, FCA, London + 44 20 7176 7198;

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