Stress testing can and has been used in a variety of different ways, and the appropriate degree of disclosure varies according to the purposes of the tests.
This Financial Services Authority (FSA) statement clarifies how stress tests have been used within the UK, provides information on the macro economic parameters currently being used, and describes how the UK approach fits within the EU-wide stress testing exercise on the aggregate banking system being co-ordinated by the Committee of European Banking Supervisors (CEBS).
The UK authorities have not applied stress testing in the same way as in the US - a single exercise covering simultaneously the top 19 banks which account for two thirds of the assets of the US banking system. Instead, over the last eight months since the intensification of the financial crisis, the FSA has:
Greatly increased the use of stress tests as an integral element of our ongoing supervisory approach.
Begun the process of embedding this revised approach in our intensive supervisory regime.
Used stress tests to inform policy decisions such as access to the Credit Guarantee Scheme (CGS) and the Asset Protection Scheme (APS) working closely with the other Tripartite authorities.
The stress tests are used within the context of our current regulatory framework for UK bank capital. On January 19th 2009 we published a statement that we expected UK banks to maintain Core Tier 1 capital, as defined by the FSA, of at least 4% of Risk Weighted Assets after applying an FSA defined stress test. This current framework will remain in place until the Basel accord, which is implemented through EU capital requirement directives, has been modified to reflect the lessons learned from recent events. A similar approach was adopted for building societies who applied for the CGS in Q4 2008 which required them to be able to maintain 7% after stress effects at the Tier 1 level.
The stress tests analyse all the relevant variables which may affect an institution's capital adequacy. These include its revenue generation potential given scenarios for GDP growth and interest rates, the probability of default and possible losses given default within its loan book, and possible declines in the market value of assets held in the trading books, as well as any known firm specific events. The tests have been applied where appropriate at the group level.
The tests look forward over five years but with greater detail over the first three. They are used to identify if at any time in the next five years there is a danger that under the stress scenario the level of capital will fall below the 4% Core Tier 1 minimum. In evaluating the institution's ability to meet the minimum requirement under the stress scenario, the FSA may consider actions that management could propose to take if and when the stress develops. Such actions may include the evolution of the balance sheet size, capital raising and asset sales.
The stress tests used are not forecasts of what is likely to happen but deliberately designed to be severe. Their purpose is to consider whether an institution would be able to sustain adequate capital and liquidity under conditions which at the time the stress is conducted are considered unlikely to arise. They therefore aid our determination of whether firms are able to comply with our regulatory framework.
Stress testing is necessarily forward looking and therefore involves an element of judgement. This is particularly true given that the most important challenge facing the banking system has changed over the last six months.
In the early stages of the crisis, a crucial concern was the presence on bank balance sheets of specific complex structured securities (sometimes called "toxic assets") whose values were severely depressed, and the accounting for which was sometimes unclear. But significant action has already been taken to reflect legacy asset losses in published accounts, and our stress tests allow for further possible write downs in the event of further price reductions and for variations in accounting practice.
The key challenge now is that the weakness of the financial system has produced an economic situation which may 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 which currently would not be considered impaired on an accounting basis.
Since the FSA's use of stress tests has not been a one-off exercise, but instead embedded in our regular supervisory processes, the FSA will not, as a matter of practice, be publishing details of the stress test results. Furthermore given that the application of the tests has and will continue to evolve, the precise parameters used have changed and will change over time.
But we believe it is useful to provide information on the key macro economic parameters used in stress tests conducted over the last four months and currently being used today. These parameters were used, for instance, in the stress tests applied to those banks considering utilisation of the APS, and in the analysis of the Dunfermline Building Society which identified future potential threats to capital adequacy. The banks participating in the APS have in addition submitted to HMT full details of the specific assets proposed for inclusion in the scheme and further detailed analysis of the assets determined the design and pricing of the scheme.
The current stress scenario models a recession more severe and more prolonged than those which the UK suffered in the 1980s and 1990s and therefore more severe than any other since the Second World War. It assumes a peak-to-trough fall in GDP of over 6%, with growth not returning until 2011 and only returning to trend growth rate in 2012. It models the impact of unemployment rising to just over 12% and, crucially, the impact of a 50% peak-to-trough fall in house prices and a 60% peak-to-trough fall in commercial property prices.
The UK approach to stress tests is similar to that followed in most counties, other than the US, which have applied stress tests to inform decisions on specific institutions and as part of intensified supervisory processes, rather than as a one-off, system wide and publicly disclosed process. CEBS has, however, now committed to co-ordinating a Europe-wide stress testing exercise to inform assessments of the aggregate health of the banking system. This exercise will use common approaches and scenarios and aims to increase the level of aggregate information available to policy makers in assessing the European financial system's resilience to shocks.
The exercise is not intended to assess specific institutions' need for recapitalisation, which to the extent necessary will continue to be done by national authorities using appropriate national approaches. The FSA will be participating in this exercise and the EU wide scenarios will be agreed by the European Commission and CEBS. The exercise will be completed by September 2009.
