The U.K. stress test reveals the Bank of England’s growing concern about lenders being stuck with losing trades when markets get choppy.
The regulator will reprice lenders’ trading books to test how much capital they eat into when faced with losses and periods of reduced market liquidity. The BOE used a Feb. 20 snapshot of the financial-instrument portfolios as the basis for the 2015 exam. Traders weren’t told in advance so the test couldn’t be gamed, according to a person with knowledge of the matter.
“Repricing an enormous derivatives book isn’t easy; tweaking the system is quite difficult,” said Patricia Jackson, head of prudential advisory at accounting firm EY in London. “You’re dealing with a large number of positions. These processes are hardwired and changing them can be very difficult.”
Banks will be locked into losses on trades over periods of one day, one week, one month and one year under the scenarios, which are set to be published as soon as May, said the person, who asked not be be identified because the BOE’s schedule isn’t public.
With potential market stresses related to events in Greece and elsewhere, BOE officials have been sounding the alarm about low liquidity in recent months. Executive Director Chris Salmon said that structural changes in financial markets leave them less able to absorb shocks, leading to the type of volatility seen in U.S. Treasury bonds in October and the Swiss franc in January.
Jackson said the emphasis on trading and non-U.K. risks will have a “larger effect on the international banks.” HSBC Holdings Plc and Standard Chartered Plc, which generate most of their revenue outside of the U.K., both comfortably passed last year’s exams.
Seven lenders will take part in the 2015 exam: HSBC, Standard Chartered, Barclays Plc, Lloyds Banking Group Plc, Nationwide Building Society, Royal Bank of Scotland Group and Santander UK. Spokespeople for Barclays, Lloyds, HSBC, RBS and Standard Chartered declined to comment immediately on the trading-book treatment in the stress test.
The BOE said in a report last month that even small events are rippling through markets. Trading volumes in some sovereign bonds “appear to suggest that sudden changes in market conditions can occur in response to modest news,” according to the central bank.
“If you are less able to manage volatility then there’s a bigger profit and loss effect on the bank from any market break,” said Jackson, a former BOE official. “The effect on capital is more severe the longer you’re stuck in the trading position.”
JPMorgan Chase & Co. head Jamie Dimon said last year’s volatility in U.S. Treasuries was a “warning shot” to investors and that the next financial crisis could be exacerbated by a shortage of the securities.
The Oct. 15 gyration, when Treasury yields fluctuated by almost 0.4 percentage point, was an “an event that is supposed to happen only once in every 3 billion years or so,” and would have had serious consequences in a stressed environment, Dimon wrote in a letter to shareholders on April 9.
The stress test is the BOE’s second since taking over as the U.K.’s banking regulator in 2013 and reveals how its focus has shifted from domestic risks to international markets.
Last year the regulator modeled a rise in the BOE benchmark interest rate to 4 percent and house prices falling by more than a third, a financial catastrophe so severe that it had only happened once in the last 150 years.
The new scenarios include a model in which economic growth in China slows to just 1.7 percent and oil prices decline to $38 a barrel. That would provoke a drop in U.K. consumer prices and a period of deflation lasting almost two years. The model also takes into account currency fluctuations, including a 25 percent plunge in the euro against the dollar and a 15 percent drop versus the pound.
“This may be a sign that the bank fears that risks are increasingly leaning towards issues which no single central bank can successfully tackle in isolation,” said Richard Reid, a senior research fellow for finance at the University of Dundee in Scotland.
The BOE kept its capital pass mark of 4.5 percent common equity tier 1, a measure of financial strength, from last year, less than the level used in the 2014 European Union exams, and added a leverage ratio requirement of 3 percent. Lenders may have to raise additional capital after the tests even if they pass, the regulator said.