FSA stress tests banks for four-year downturn

Banks in the UK must stress test their capital levels against a "worst-case" recession more severe than any since World War II, the Financial Services Authority revealed today.

While US regulators carried out a one-off stress test of the leading 19 banks, using two two-year stress scenarios, the UK regulator has added the enhanced test to its regular supervisory measures, and so will not be publishing the results, it said.

The single scenario used consists of a severe recession with GDP falling 6% from its peak in early 2008 to a trough in 2010 - so far, the UK has seen four quarters of falling GDP quarter-on-quarter, and the scenario would represent a further 1% drop. Growth would not return until 2011, and would be below the historical trend until 2012. Unemployment would rise to 12% from its current level of 7.1%, and property prices would plunge, with house prices down 50% from their peak in October 2007.

"The property price scenarios do look quite stretched. Since the peak in 2007, UK house prices are down 22% on the Halifax Index and another 35% fall would be required to hit the stress test. Similarly, UK commercial property prices are down 43% and another 30% fall would be needed to hit the stress test," commented Jonathan Pierce, a London-based banking analyst at Credit Suisse.

The US stress tests, imposed earlier this year, compelled leading banks to test against two scenarios - the more severe of them was similar to the FSA's, including unemployment of 10.3%, a 47% drop in house prices, and a return to economic growth in mid-2010. But the key difference is in the duration - US banks were only asked to assess their capital adequacy until the end of 2010, while UK banks were told to ensure their capital would be above the 4% core Tier I level over the next five years, allowing for their ability to raise more capital, for example by selling assets, in future if necessary.

The FSA warned its focus had now moved on from toxic assets such as subprime loans to the second-order effects of the general economic decline. "The key challenge now is that the weakness of the financial system has produced an economic situation that might in future produce significant loan losses and further impair the strength of banks and building societies in an adverse feedback loop. The crucial issue for stress testing is not, therefore, as it is sometimes suggested, to 'identify the bad assets on the bank's balance sheets', but to identify future potential loan losses even among loans that currently would not be considered impaired on an accounting basis," it wrote.

Earlier this month, the Committee of European Banking Supervisors announced it was helping local authorities run "an EU-wide forward-looking stress-testing exercise on the aggregate banking system", aimed at identifying systemic weaknesses, but refused to reveal details of the test or the stress scenarios involved.

See also: Stress-test success masks bigger problem with banks
US banks require $74.6 billion in additional capital, stress tests reveal
US banks told: prepare for 47% drop in house prices