Comment: Bank of England’s new test

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THE decision by the Bank of England to do a new stress test on UK banks’ balance sheet strength predicated on a very severe international slump is sensible. Last year’s equivalent exercise by the Bank focused on how well our lenders could handle a prolonged major homegrown downturn.

Few would say the earlier stress test was anything but highly challenging to the banks’ capital cushions, including major house price and stock market falls, a big shrinkage in GDP, rising interest rates and surging unemployment. It was a 1930s depression-type scenario.

Martin Flanagan. Picture: Fiona Hanson/PA

Martin Flanagan. Picture: Fiona Hanson/PA

But the financial crisis of 2008 highlighted starkly how interconnected the world is now financially and economically. Economic and financial contagion knows no boundaries. It is not possible to make us Fortress Britain and let the world pass us by.

Just as the collapse of Lehmans investment bank, with its global interconnectedness with other international banks, for a time seemed to threaten the whole global financial system, China is now a major swing factor in economic terms.

With its voracious demand for commodities sustaining western economies, China is an economic swing factor way beyond its shores.

As such, it is no surprise at all that the BoE’s latest doomsday scenario for British banks postulates a sharp slowdown in China (unlike the more measure current easing of GDP growth in that country).

The Bank also puts forward a stress test incorporating a 2 per cent contraction in the eurozone, destination of 40 per cent of the UK’s exports and so, whether inside or outside the European Union, pivotal to our economic well-being.

Major headwinds from overseas would dent our exports, and that in turn would throw us on the tender mercies of a strapped UK consumer for any growth at all.

The BoE posits a nightmare scenario where deflation has Britain in its grip for seven consecutive quarters, leading to the biggest fall in prices since the 1930s, with base rates slashed to zero and the wider economy shrinking by 2.3 per cent.

With inflation at zero per cent in February this year, the UK is already flirting with “technical deflation”. This is currently comfortably short of the chronic and dangerous “psychological inflation” envisaged under the new stress tests that would picture millions of consumers contributing to the theoretical economic stagnation by putting off purchases because they think prices have farther to fall.

Six banks and one building society are taking part in the latest stress test: HSBC, Lloyds, Royal Bank of Scotland, Barclays, Santander, Standard Chartered and Nationwide. The Co-op Bank is not taking part, having failed the previous UK-centric stress test and also having a more parochial business than the other six. Crucially, the BoE says that any UK lender falling below a minimum 4.5 per cent capital cushion in the latest theoretical downturn will have a requirement to raise money to bolster their capital positions.

Gone are the pre-crash days when RBS under Fred Goodwin could cavalierly adopt an aggressive lending and acquisition strategy with a core tier one capital ratio of just 4 per cent… and with the full agreement of regulators.

Many capital ratios are now hovering around 12 per cent, meaning there would be a lot of slack even in the severe global economic dislocation delineated by the BoE before danger point levels would be reached.

It is one of the few good outcomes of the crash that regulators have learnt to be forewarned is to be forearmed.