Banking system is ‘significantly more resilient’

Lloyds Banking Group, Trinity Road, Halifax.
Lloyds Banking Group, Trinity Road, Halifax.

The UK banking system is “significantly more resilient” than a year ago, Bank of England governor Mark Carney has said after most major lenders passed a test to see how they would cope with severe economic stress.

The Co-operative Bank was the only institution to fail the exercise and has been told it must reduce its loan book by £5.5 billion by 2018.

The test results also raised concerns about state-backed Lloyds Banking Group - which employs around 6,000 people in Calderdale - and Royal Bank of Scotland (RBS), although improvements and changes to their plans this year mean they have been given the all clear.

The Bank found that a severe downturn with house prices plunging 35% would wipe out the Co-op’s capital because of the effect on its risky commercial property and sub-prime home loans.

However, the Co-op said the result came as no surprise and that it was much stronger than in 2013 following the first year of a restructuring plan.

The test examined how lenders’ balance sheets would stand up to a potential Doomsday scenario of economic crisis by calculating the ratio of capital against loan assets on their balance sheets in such an event.

Firms were not allowed to respond to the stress test by cutting the supply of lending.

Mr Carney said: “This was a demanding test. The results show that the core of the banking system is significantly more resilient, that it has the strength to continue to serve the real economy even in a severe stress, and that growing confidence in the system is merited.”

He added: “Most importantly, the results suggest that the banking system is strong enough to continue to serve households and businesses during a severe shock.”

The test judged that Lloyds Banking Group,which was formed when Lloyds merged with the Halifax Bank of Scotland (HBOS) and is 25% owned by the taxpayer, would fall to a capital ratio of 5% under the test scenario, though by taking severe actions such as cost-cutting this would be 5.3%. It compares with a minimum benchmark set by the Bank of 4.5%.

The group, which includes the Halifax and is heavily exposed to the UK housing market, “remains susceptible to a severe economic downturn”, the test found.

But it said that, in light of the measures it already had in train, it did not require Lloyds to submit a revised capital plan.

The results did not comment on whether the test would affect Lloyds’ ability to pay a dividend next year, though it assumed that payouts would not be made in the stress scenario.

For RBS, 80% owned by the state, the capital ratio would fall to 4.6% in the stress scenario, or 5.2% after “strategic management actions” which could include cost-cutting.

The Bank said it would ordinarily have required RBS to submit a revised capital plan but, given the progress already made and the capital strengthening actions in its updated plans, this would not be necessary.

These included the issue of £2 billion worth of “Coco” bonds that RBS plans to issue in 2015, which would convert into shares as a fail-safe to boost the bank’s capital ratio should it fall to 7%.

The RBS result comes after it suffered embarrassment following a European stress test exercise earlier this year. It initially appeared to pass with ease but later had to admit it got its sums wrong and had only scraped through.

Five other lenders passed today’s test with no judgment by the Bank’s Prudential Regulation Authority (PRA) that they needed to strengthen their balance sheet further.

Allowing for emergency “management actions”, Barclays would see its capital ratio fall to 7.5% under the scenario with HSBC scoring 8.7%, Nationwide 6.7%, Santander UK 7.9% and Standard Chartered 8.1%.

The Co-op would fall to a theoretical minus 2.6%.

It is the latest challenge for the Co-op after a £1.5 billion hole was found in its balance sheet last year and it slipped out of the control of the wider Co-op group, and is now majority controlled by investors including US hedge funds.

With the Co-op in the early stages of its turnaround plan, chief executive Niall Booker said it was “no surprise” that the bank failed the stress test. He warned the bank was unlikely to make a profit until 2017, at the earliest.

Mr Booker added: “The bank is much stronger than a year ago. As the regulator notes today, we have achieved the target of building our capital base and the actions we have taken during the first year of our business plan have made the bank more secure for the benefit of all stakeholders.”

The Co-op is not required to raise additional capital due to the test failure but has agreed to accelerate the reduction in risk-weighted assets, particularly those residential mortgage assets susceptible to severe stress, by 2018.

Shares in the UK’s major banks were all higher after the stress test results.

Lloyds’ price rose slightly as markets saw a better prospect of it re-starting dividends, subject to the approval of the PRA.

Chief executive Antonio Horta-Osorio said: “These results are a clear demonstration of the progress the group has made over the first two full years of our strategic plan, which was announced in June 2011.

“The stress test was based on our balance sheet as at the end of 2013 and since then we have made further significant progress in strengthening our capital position and delivering on our strategy.”

The Bank of England said it would review the exercise and set out plans next year for developing the stress testing framework further, including a greater focus on the impact of an international downturn.

The test results were published at the same time as the Bank’s Financial Stability Report, which highlighted how weakness in the global economy could affect the outlook for stability in the UK.

It said the recent sharp fall in the oil price should support growth but also pose risks.

The report also raised concerns about a rise in risks from UK housing, saying this increase had not so far happened but that household debt levels remained high, supporting the Bank’s decision six months ago to take measures to prevent a property bubble from taking hold.

It also said changes were needed in the way banks were run following a series of scandals - which was most recently highlighted by the foreign exchange-rigging affair.

The report said: “Recent misconduct and other operational failings have highlighted that rebuilding confidence in the banking system requires more than financial resilience.

“That, and changes to the banks’ business models in response to commercial and regulatory developments, make it important for banks to continue to enhance the effectiveness of their governance arrangements.”