Context: The Bank of England released the results of their annual stress test exercise for UK Banks.
Impact for the fund:The results revealed that UK banks are robust and capable of withstanding a severe stress (much worst than a disorderly Brexit) and rock solid capital levels have increased the overall resilience of the financial system.
Bank of England Stress Test
The Bank of England released the results of their annual stress test exercise earlier this month. Overall the results revealed that UK banks are robust and capable of withstanding a severe stress and rock solid capital levels have increased the overall resilience of the financial system. All banks passed the stress test, and no bank needs to take remedial action. On Aggregate banks’ core equity ratios (CET1 ratio) would fall by 520bps to 9.3% under the stress scenario, well above the hurdle rate of 7.5%, with no banks’ individual capital positions falling below 8.5%.
The stress scenario used by the Bank of England, is designed to simulate a true “apocalypse” scenario. This is indeed more severe than the global financial crisis, with for example world GDP declining by 2.6pp (1.2pp during the financial crisis) or residential property prices declining by 33% (17% during the financial crisis). At 9.3% CET1 ratio at the low point of the stress scenario, UK banks would still have more than twice the amount of equity buffer than in 2007. This reflects the strong capital accumulation (CET1 ratio c3x higher than pre-GFC) as well as the strong de-risking of banks’ business models towards low-risk activities such as retail mortgages. As bondholders this is highly positive as there is a higher amount of equity buffer to absorb losses that would be significantly lower than that experienced during the GFC.
In the face of geopolitical uncertainty (Trade wars, Brexit etc.), bondholders can take great comfort from the very strong performance of banks in the stress test. Nevertheless, it is paramount to keep in mind that the stress test is designed to reflect an unprecedented extreme stress scenario. In particular, there have been some amalgamation between the stress test and Brexit – where in our view even a disorderly hard Brexit impact would be nowhere near the stress test impact. Fortunately the Bank of England, that has previously been vocal about the fact that the stress test is in no way designed to reflect a Brexit scenario, has disclosed an estimated impact of a disorderly Brexit. While the stress test impact is above 500bps of capital drawdown, the Brexit scenario leads to c200bps of capital drawdown – significantly lower impact. Under the disorderly Brexit scenario the average CET1 ratio of banks would remain well above 12%, very strong.
For UK issuers held in our Fund – mostly the UK-domiciled global banks (HSBC, Standard Chartered) and national champions (Lloyds, RBS, etc.) the results of the stress test support our positive view of the European financials sector underpinned by ever-stricter regulation. Banks have significantly increased their capital positions and de-risked their business models – leading to higher capacity to absorb losses and lower potential losses in a stress. Furthermore, any impact from current geopolitical issues such as Brexit are highly manageable for our issuers, even in a tail risk scenario (not our base case). We have strong visibility on the future path of capital accumulation over the coming decade – with Basel IV due to be implemented from 2022 to 2027, again setting the bar for capital requirements higher, a continuation of the strengthening of European financials’ fundamentals. Despite the strengthening of fundamentals, we continue to capture extremely large spreads and yields on high quality issuers in our fund, with spreads of more than 400bps in GBP.