March 27, 2017 / 1:15 PM / 8 months ago

UK toughens stress tests with sterling drop, wider bond spreads

LONDON, March 27 (IFR) - Global GDP will fall by 2.4%, sterling plunges against the dollar, UK interest rates rise to 4% and US corporate bond spreads will widen by 1,150bp under the 2017 “stress test” scenario for Britain’s big banks.

The Bank of England set out stress test scenarios on Monday for this year’s health check of seven bank and building societies. The annual test is aimed at making sure they are resilient enough to withstand a deep global and UK recession and severe stress in financial markets.

Most scenarios are similar to last year’s test, but some have changed as the Bank of England said global vulnerabilities “are elevated and have increased somewhat over the past year”.

Under this year’s test the peak-to-trough fall in global GDP will be 2.4%, compared with a 1.9% decline in the 2016 exercise.

UK GDP falls by 4.7%, compared with 4.3% in the last test, although the stressed scenario for unemployment is kept the same at 9.5%.

UK base interest rates rise to 4% under the 2017 stress test, in contrast to last year’s test, in which base rates were cut to zero. The result is that banks will suffer higher losses from bad loans, but benefit from higher interest income.

US corporate profitability falls and the cost of corporate credit rises under this year’s scenario. Ten-year US government bonds yields rise to 3.5% and financial market participants become risk-averse.

Investment-grade US corporate bond spreads increase to 515bp from about 135bp and high-yield US corporate bond spreads widen to 1,615bp from 465bp. The 1,150bp rise in high-yield is 100bp more than in last year’s test.

The sterling exchange rate index falls by 27% from its Q4 level and troughs at US$0.85 to the pound.

Oil prices fall to US$24 per barrel under the stressed scenario, and remain at that level until 2019.

China’s GDP growth falls from around 7% a year to a 1.2% contraction by the end of 2017 under the test. Singapore’s GDP contracts by 7.2% and India’s annual growth slows to 2.2%.

Other changes are similar to last year’s test, including a projected 56% fall in Hong Kong commercial real estate prices, a 40% drop in UK CRE prices and a 33% drop in UK residential property prices.

Banks will also have to apply misconduct fines and costs for known issues.

Analysts said the domestic stress of the test is similar to the 2016 scenario, but the global stress looks tougher.

The results of the test will be released between October and December.

Each bank has to remain above a benchmark capital levels, which have been set for each at the same as in 2016.

If they fall below that level under the stressed scenario they will be required to take action, which could include having the raise capital or stopping dividend or bonus payments.

The seven banks had to have a minimum common equity Tier 1 ratio of 6.5% on average under the 2016 test. The four most globally significant - HSBC, Barclays, Royal Bank of Scotland and Standard Chartered - had to hold slightly more capital.

RBS failed last year’s test and had to submit a new capital plan, which was accepted by regulators. Barclays and Standard Chartered passed the test only after taking into account “strategic management actions”.

The Bank of England is also this year making banks go through a second test at the same time, known as an “exploratory scenario”.

That will test them over a seven-year horizon to capture longer-term trends. It is not focused on bank capital adequacy, but is about their business models and sustainability. (Reporting by Steve Slater)

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