The Bank of England gave Britain’s state-backed lenders a narrow pass in its debut annual stress tests on Tuesday, but warned that next year banks would face tougher checks of their capital strength and international exposure.
Lloyds Banking Group Plc (LYG) and rival Royal Bank of Scotland Plc (RBS) scraped through a doomsday scenario of plummeting house prices and soaring unemployment after both took pre-emptive measures to boost their defences against potential losses.
The Co-operative Bank, which nearly collapsed last year before being bailed out by bondholders, was the only bank to fail the test, which was tougher on lenders with high exposures to British mortgages.
Co-op Bank, whose core capital fell to -0.2% under the stresses, said it would not have to tap shareholders for additional capital but would probably not make a profit in the next three years as its works out a recovery plan with the BoE.
Although Lloyds’ narrow pass raised questions about whether it can convince the regulator to allow it to pay a dividend for 2014, investors said both Lloyds and RBS had performed credibly in a test which simulated the impact of a property crash and rising interest rates.
“While the passes weren’t great, they were passes…The test was deliberately harsh and what’s key is they passed and we can move forward,” said David Moss, head of European equities at F&C Investments.
Britain decided to introduce annual stress tests of its banks in the wake of the 2007-09 financial crisis which required taxpayers to pump 66 billion pounds into RBS and Lloyds to keep them afloat.
“The results show that the core of the banking system is significantly more resilient (and) that it has the strength to continue to serve the real economy even in a severe stress,” Bank of England Governor Mark Carney said.
This year’s stress tests required banks to have a core capital ratio of 4.5% of risk-weighted assets but from next year, the BoE said that it would also assess banks’ leverage ratios, a measure that doesn’t adjust assets for their riskiness.
Regulators are increasingly focusing on leverage ratios amid widespread distrust of banks’ own assessment of the riskiness of their assets.
Both Lloyds and Royal Bank of Scotland had leverage ratios below the current 3% requirement under the Bank of England’s stressed scenario. Barclay’s leverage ratio was 3% under the stress test.
From 2019 onwards, large UK banks will have to have a leverage ratio of 4.05%, that could be increased in boom times by an extra buffer of another 0.9% to cool lending.
The BoE confirmed on Tuesday that for now there is still no need for banks to boost their buffers. The U.K.’s housing market, which had threatened to overheat at the start of the year, has cooled in the last few months.
The Bank of England stress test added a number of additional layers on top of those applied by European regulators in an E.U.-wide test of 123 banks in October, including a rise in interest rates to 4% from 0.5% currently.
Under the stress scenario, RBS’s core capital ratio fell to just 4.6%, a whisker shy of the 4.5% minimum required, before actions it had taken this year to shrink its balance sheet were taken into account. Lloyds’ core capital ratio was 5.0% before its actions were taken into account.
RBS, which is 80%-owned by the state, said it would sell 2 billion pounds ($3.1 billion) of notes to bolster capital.
“We recognise that there is still much work to be done to improve the resilience of our balance sheet,” Chief Executive Ross McEwan said in a statement.
Britain’s other large banks, HSBC Holdings Plc (HBC), Standard Chartered Plc (SCBFF), Santander UK and Barclays Plc (BCS), scored comfortably in the test with pass rates of between 7% and 8.7%.
But the Bank of England warned that a stress test focused on emerging market shocks — which would affect HSBC and Standard Chartered more — could come in future and investors said none of the banks could afford to sit back.
“There will be no let-up even for those who passed with flying colours,” said Neil Williamson, co-head of EMEA credit research at Aberdeen Asset Management.