Yesterday's Bank Crisis, Today

Stress tests are too backward looking.
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The curse of the rear-view mirror has struck again. The Bank of England's stress tests of U.K. banks were the toughest yet, but didn't model the impact of the Brexit negotiations or a withdrawal from the EU. Rather than bickering over whether such tests are too tough or too lenient, we should be questioning whether the process itself needs improving.

Safe As U.K. Housing

Impact of stress scenario on U.K. bank capital ratios in 2014 and 2016

Source: Bernstein analysis, Bank of England

Look at the chart above, tracking the impact of British stress scenarios on bank capital ratios in 2014 and 2016. An investor would guess that the risk profile of the U.K.'s No. 1 mortgage lender, Lloyds Banking Group, is getting better, while that of Asia-focused banks such as HSBC and Standard Chartered is getting worse. That probably reflects the BoE's gloomy 2016 scenario of a sharp economic slide in Hong Kong and China and a 1.9 percent contraction in the global economy -- a scenario drawn up in March, months before the Brits voted to quit the EU.

That doesn't match up to what financial markets are worried about now. The prospect of an economic slowdown in the U.K., even if that hasn't yet come to pass, has made the more international rivals of Lloyds and RBS look more attractive to investors since the June vote.

It's true that regulators did test for a house-price crash, so Lloyds deserves some credit for its balance-sheet strength. But investors should be listening to BoE chief Mark Carney's words, rather than looking at the financial modeling, to appreciate the rising risks ahead. He warned on Wednesday of "high and rising" household indebtedness and the squeeze from sterling's fall since the Brexit vote.

Brexit Drag On Banks

U.K. lenders Lloyds and RBS have strongly underperformed more global rivals since the June vote

Source: Bloomberg

You might wonder what the harm is of a backward-looking stress test, so long as it leads banks to further strengthen their bank balance sheets to protect taxpayers. RBS, for example, had to bolster its capital plan after failing multiple hurdles. It will make deeper cost cuts and sell more assets. What's wrong with that?

Well, remember that the BoE's moves on monetary policy since the referendum have been all about spurring banks to lend more rather than retrench.

You also have to wonder if a backward-looking stress test can distort the picture. Given RBS was also hurt by litigation provisions and misconduct charges, you can see how one-off settlements that have little to do with the underlying business might make it difficult to track its capital strength from one year to the next. The BoE said it’s modeling another 40 billion pounds ($50 billion) of misconduct costs for the sector over the next four years, as Bloomberg News colleague Stephen Morris notes, and warned that could rise.

If anything, the deeper issue for Britain's bankers is profit, not capital.

Profit Problem

U.K. banks feature among Europe's ten worst performers in terms of return on equity (ROE)

Source: Bloomberg Intelligence

RBS and Standard Chartered are both expected to make losses in 2016, according to Investec analysts, who reckon all big U.K. lenders save Lloyds will fail to generate a return on equity above 10 percent before 2019. If the best way to bolster your balance sheet is by finding a sustainable business model that generates profit, we seem to be a long way from that.

Stress tests, as Bernstein's Chirantan Barua puts it, should tell you what is going to happen, rather than what's already taking place. At a time when interest rates may be about to turn -- with potentially painful consequences for asset values -- their failure to do that should be a worry.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the authors of this story:
    Lionel Laurent in London at
    Marcus Ashworth in London at

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    James Boxell at

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