Picture this. Inflation is rampant, peaking at 17%. Income and employment plummet. Property and asset prices take a plunge. Global recessions are in full swing and interest rates are standing high at 6%. Things are looking grim.
Horror, right?
That’s the extreme scenario the Bank of England gives several of the UK’s major banks during its annual stress test. The scenario used this year was even more extreme than the global financial crisis of 2007/08.
Banking stress tests are designed to evaluate a banks’ ability to withstand a series of shocks, while continuing lending activity and offering support to borrowers through it all.
This article isn’t personal advice. If you’re not sure an investment is right for you, ask for financial advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Past performance isn’t a guide to the future. Ratios shouldn’t be looked at on their own.
CET1 ratio – what is it and why is it important?
The key ratio used to assess a bank's resilience during the testing is the CET1 ratio. It measures a bank's ability to absorb losses and keep a stable financial position.
Regulators often require banks to maintain a minimum CET1 ratio to make sure they can withstand economic shocks. The higher the number, the more financially resilient the bank is considered to be.
What were the results?
The headline results were positive. Every bank included in the test was found sufficiently strong to withstand a severe economic shock and able to support households throughout economic turmoil.
The stress test is based on the balance sheets as of June 2022. Since then, major UK banks’ capital ratios have risen – the combined CET1 capital ratio was 14.6% in the first quarter of 2023.
Still, from the starting CET1 ratio of 14.2%, the aggregate ratio fell to 10.8% in the first year of the stress scenario. Staying significantly above the test’s hurdle rate of 6.9%, which is the minimum level to be considered ‘safe’.
The Bank of England welcomed the banks’ improvements in capital position over recent years. It quoted increased quality of assets, better deposit balances and regulatory changes that reflect underlying risks more efficiently as key drivers.
Which banks performed the best?
Source: Bank of England Stress Testing Results 2022/23.
While all banks in the test beat the hurdle rate, there were still differences between individual names.
Looking at the CET1 low points during the test, Barclays and Standard Chartered (SCB) had the least capital flexibility, while staying above their hurdle rates.
Having more capital flexibility gives room for things like dividends and buybacks. So, UK-listed peers like Lloyds or NatWest might have more scope to return capital to shareholders. Nothing is guaranteed though.
Dividends vs share buybacks - what investors need to know
Is the UK banking sector attractive?
We think there’s potential for upside from the UK banking sector, and these results support the case that banks are in a strong financial position. That’s not necessarily been reflected in the valuations of some of the UK’s largest listed banks, which are close to all-time lows.