Annual stress tests for banks are meant to ensure they remain financially secure, but tougher conditions could make it harder to get a loan, writes Economics Producer Neil MacDonald.
For anyone concerned about the future of Britain’s banks, there is big news. Starting in 2014, and every year after that, our major banks will be subjected to stress tests by the Bank of England.
The tests should make it much less likely that our banking system ever comes close to collapse again. But it will also fundamentally influence how much we can borrow and how much we have to pay for it in ways we may not be happy with.
The stress tests will ask awkward questions about how well our banking system is prepared for bad times. Banks lend money to their customers, but they know that some of those loans will not get repaid. A wise bank makes a calculation about how many loans will have to be written off and keeps some spare cash, or capital, to cover those losses.
Why might a loan not get repaid? Some borrowers will lose their jobs. Some companies will invest their money in expanding their output just when the economy turns down. Property developers will build flats on the expectation of getting one price and then find the market has softened and they have to accept a lower price.
Banks have been making loans for years so they should have a good idea of how many loans will go bad. But as they make money from lending, it is reasonable to suspect they might tend to look on the bright side when they think about how all their loans might perform in the future.
Enter the stress test. Now the Bank of England will get the banks to look at how their portfolio of loans might perform if things go rather worse than they hope.
The bank will come up with a scenario where economic output shrinks, unemployment rises and house prices fall. Under this scenario, many more loans will never be repaid. The question behind the stress test will be: can the bank survive these bigger losses? It will force banks to confront the question of their viability if the world turns out to be more hostile than they hoped.
The idea now is that by carrying out the tests in times of (relative) calm, problems can be spotted quickly and perhaps everyone can feel a little bit more confident in the viability of the banking system.
But it is important to recognise the dangers here. The fact is that a failed stress test could be a death sentence for a bank. If an individual bank is shown to be vulnerable to an economic downturn, one reasonable conclusion might be that it needs to raise more capital to make itself safer.
But raising capital can be expensive at the best of times, and how enthusiastic would any investor be about putting money into a bank that has just failed a stress test?
The reality is that stress-testing is designed to turn up bad news. There would be no point in doing it if the authorities were not prepared to deal with the consequences. A bank might need to raise more capital, and if it is not able to do so, that might lead to questions about whether it is a viable institution.
Because stress-testing can have such powerful consequences, there is a big issue about just how stressful they should be. If sufficiently gloomy assumptions are made about the future performance of the economy, then pretty much any bank in the world could be made to fail the test.
But if the assumptions are made too easy, then everyone will pass with flying colours and nothing of value will have been learnt. The tests will have no credibility in the eyes of investors or customers.
So far, the bank has not said precisely what assumptions it will make about economic growth, unemployment or house prices. But its choices about these key variables will determine how stressful these tests are for UK banking. By issuing Tuesday’s discussion paper, the bank is effectively inviting politicians – and the electorate – to think about how much risk they want to take out of our banking system.
One solution for banks would simply be to make fewer loans or charge more for them and, as far as possible, restrict them to the richest customers and strongest companies. This would help them pass a stress test but would not necessarily be a great outcome for the economy as a whole.
One way to think about what has been happening to our banking system over the last five years is that it is slowly becoming less risky. But many first-time house buyers looking for a mortgage or small business needing a loan have lost out. Tougher stress tests will tend to mean tighter lending conditions.
And of course the banks themselves will be taking a very close interest in how these tests are arranged. They will have to produce the data that goes into them and there will be a massive incentive for them to present their loan books in the best possible light to their regulators. The success of the tests will depend on how straightforward the banks are with their regulator.