The new approach to stress testing banks in the U.K. that the Bank of England (BoE) announced earlier this week may help prevent a buildup in systemic risk, suggests a new report from New York-based credit-rating agency Fitch Ratings Inc.
Specifically, the countercyclical approach to stress testing that the BoE outlined on Oct. 21 “may help curb a rise in systemic risk because it forces banks to build up capital in times of perceived low risk,” the Fitch report says.
See: Bank of England publishes approach to stress testing U.K. banks
As the BoE believes that risks often build up during “exuberant” cycles, its stress test assumptions will become more severe when cyclical risks are rising, and they will be reduced once risks are considered to be falling, the report points out.
“Markets and financial institutions might consider risks lower in periods of strong credit and asset price growth. This was the case in the build-up to the 2008 financial crisis, when impaired loan figures reported by U.K. banks were flattered by strong credit growth and a booming real estate market boosted collateral values,” the Fitch report says. “Countercyclical stress-testing at this time might have helped identify mounting systemic risk, forcing banks to build up capital.”
At the same time, assessing the cycle will be crucial, because this will determine when stress assumptions change, the Fitch report warns: “Market confidence in the tests could be damaged if this is misjudged. Too mechanical an approach, reliant on a quantitative measure of the cycle, could exacerbate market volatility.”
The Fitch report notes that the central bank plans to develop a systematic approach to determining the annual cyclical scenario from year to year, “which should ensure consistency of data collected.” Furthermore, the tests will also include qualitative reviews, which Fitch sees as a positive “because they can help determine whether additional capital buffers are required to cover, for example, weak governance, data and controls.”