While speaking at a conference in London, Donald Kohn of BoE discussed the UK experience with stress tests and outlined the ways in which stress tests in the UK differ from those in the U.S. He took a deep dive into the causes and consequences of procyclical risk-based bank capital and the role the Financial Policy Committee (FPC) envisions for the CCyB, informed by stress tests, in countering this tendency. Finally, he offered an overview of the modeling challenges and the remaining information gaps in this area, also revealing that BoE is expected to release an updated approach to stress testing document later this year.
Mr. Kohn revealed that, in 2019, BoE is undertaking a qualitative review of the effectiveness of the stress testing models of banks; the Prudential Regulation Committee (PRC) is expected to include the reference to qualitative review outcomes in this year’s publication of bank-specific assessments. He explained that FPC has adopted the CCyB, using the stress tests as a key input to the decisions on the level of risks and required capital. The stress tests have been an important element in enabling the FPC to move the CCyB up and down as the risk environment has evolved, but they also have proved invaluable in several other dimensions. FPC uses the stress test results together with indicators and judgment to assess the level of risk and of the banking system’s resilience to that risk. To assess the risk environment and the likely resilience of the banks to risk events, FPC considers a wide range of economic and financial indicators as well as supervisory and market intelligence. Stress tests serve as a check on the FPC judgment and help it to detect changes in the structure and composition of bank balance sheets that affect their resilience to unexpected developments. However, there is no mechanical link between the outputs of the stress test or the readings from a set of indicators and the setting of CCyB.
For CCyB to be able to counter the inherent procyclicality of bank risk-based capital calculations, the stress test inputs to the FPC decisions should generate estimates of rising losses as risks increase. However, he highlighted that challenges and gaps remain in research related to the modeling of the dynamic evolution of financial networks and focus on the interaction of contagion channels. In addition, key challenges remain for further development and research on further integrating solvency and liquidity stress into a single modeling framework. Areas of gaps include extending models to the wider global banking system; considering feedback channels between banks and the real economy; considering links to the wider financial system and the impact of banks’ actions on other institutions; and researching the implications that information contagion plays in financial stability. Beyond banking sector stress tests, a major challenge is the development of a general equilibrium macro-financial framework that can mimic the way that the wider financial system and real economy endogenously generate crises. Such models could be used to find weak points in the financial system, where adding resilience could bring significant benefits for the system as a whole.
Overall, the stress tests are an important cross-check on FPC and PRC judgment and should be helpful to overcome any inaction bias that might creep into capital determination at some later date. However, Mr. Kohn warned that the CCyB and the stress tests have not been tested in an economic downturn. He concluded: "We need to be sure that capital builds up sufficiently with risks so that when the CCyB is released those who are funding banks have the confidence to support banks’ efforts to continue lending to households and businesses even as the economy falls into recession. We need to make sure we do release the CCyB promptly, even proactively as in 2016, to allow banks the scope to make those loans even as loses begin to rise-and we need to assure that the stress test scenarios and results are fully supportive of an appropriate release."
Related Link: Speech
Keywords: Europe, UK, Banking, Stress Testing, CCyB, Macro-Prudential Policy, Procyclicality, Contagion Risk, BoE
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