- Stress testing the UK banking system: key elements of the 2022 annual cyclical scenario
Bank of England
The Bank of England (Bank) is returning to the annual cyclical scenario (ACS) stress-test framework in 2022. This follows two years of Covid-19 pandemic crisis-related stress testing and its decision to postpone the test in March following Russia’s invasion of Ukraine. The Bank’s 2022 ACS will test the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, large falls in asset prices and higher global interest rates, and a separate stress of misconduct costs.
The Financial Policy Committee (FPC) and Prudential Regulation Committee (PRC) will use the test to assess bank balance sheets and the resilience of the UK banking system. By using stress tests to determine banks’ ability to withstand an adverse scenario, the Bank aims to ensure they are able to absorb rather than amplify shocks, and serve UK households and businesses.
The stress applied under the ACS is not a forecast of macroeconomic and financial conditions in the UK or abroad resulting from the current geopolitical situation and government responses to it.footnote It is not a set of events that is expected, or likely, to materialise. Rather, as per previous ACS scenarios, it is a coherent ‘tail risk’ scenario designed to be severe and broad enough to assess the resilience of UK banks to a range of adverse shocks.
While previous stress tests have incorporated the impact of higher interest rates in the UK, this ACS will for the first time test UK banks’ resilience to higher global interest rates, in the face of a series of global cost shocks and high and persistent global inflation. The paths for interest rates are simply assumptions for the purposes of the stress test and are not an indication of how policymakers might respond in such an environment. In the scenario, UK Bank Rate is assumed to rise rapidly to 6% in early 2023 before later being reduced gradually to under 3.5%.
The stress scenario is more severe than the global financial crisis for both the UK and the world. In the stress scenario, weaker household real income growth, lower confidence and tighter financial conditions result in severe domestic and global recessions. In the UK, GDP contracts by 5.0%, unemployment more than doubles to 8.5% and residential property prices fall by 31%. World GDP falls by 2.5%.
The FPC and the PRC judge the scenario to be appropriately calibrated in light of the FPC’s assessment of the underlying level of risks and vulnerabilities in the UK and global economies and financial markets. They have also taken account of downside risks facing the economy as well as the heightened uncertainty in recent months.
For the first time, and as announced previously, the 2022 ACS will assess the ring-fenced subgroups of the existing participating banks on a standalone basis, where these differ materially from the group as a whole.
The 2022 ACS will cover a five-year horizon, with a start point of end-June 2022.
Banks will continue to be assessed on an International Financial Reporting Standard 9 (IFRS 9) transitional basis and the associated hurdle rate adjustments will continue to apply. Nevertheless, the FPC and PRC recognise that at the beginning of a real stress under IFRS 9 there is the potential for large capital drawdowns due to earlier provisioning. The Bank continues to consider its approach for an enduring treatment for IFRS 9 beyond the 2022 ACS, and intends in the coming months to engage with the ACS banks to investigate any options they may have to factor the level of credit loss provisions required by IFRS 9 into their future planning.
The results of the test will be published in summer 2023 and, along with other relevant information, will be used to help inform banks’ capital buffers (both the UK countercyclical capital buffer (CCyB) rate and Prudential Regulation Authority (PRA) buffers).