Test, test, test

There is clear pressure on banks to lend to the real economy at this time, but they should also test their lending capacity using stress and scenario analysis. John Mongelard highlights some key points that could help illuminate risk management techniques.

Stress testing is not just a regulatory obligation that banks need to do to satisfy their regulator and to demonstrate their financial resilience.

In fact, in the current circumstances it is an essential business planning and risk management tool to help understand your financial and operational resilience. 

The challenge is the level of uncertainty now is greater, or at least feels greater than it was before.

We are at a time when anyone’s guess might eventually be proved right. To help you through this guess work and to calibrate your own stress or sensitivity analysis we set out some useful benchmarks below.

Stress testing

The Bank of England usually does an annual stress test of the largest six banks.

However, in 2020 we have seen stress scenarios come to life (and the test itself cancelled). So how does a pandemic compare to the 2019 BoE stress test?

Below I compare the Office of Budget responsibility’s scenario to the 2019 BoE stress parameters.

The OBR scenario suggested a three-month lockdown and a three-month gradual lifting of the lockdown, which is not implausible given the amount of the economy that is being shut down. In many ways the OBR scenario is similar or more severe than the Bank of England stress test scenario.

For example, the reality of the COVID-19 aftermath may mean there is a multi-year impact on GDP and unemployment, if the lockdown measures continue in some way going forward or until we develop a vaccine.

The GDP in the OBR model is very different to the BoE stress test but it is unemployment and asset price declines (e.g. HPI) that drive credit risk models, accounting and RWA calculations. 

The table below compares a range of benchmarks. Some of the differences relate to timing differences and some to different expectations by respective experts.

	OBR Scenario	BoE Stress test	HMT consensus (April)	Barclays	LBG
GDP Year 1	35% fall in Q2 2020 13% fall for 2020 as a whole	-4.7%	-4.7	-8.0%	-5.0%
GDP Year 2	GDP recovery in 2021 bounce back of +18% in GDP	1.3%	4.3%	6.3%	3.0%
Unemployment Year 1 (2020)	10%	9.2%	6.4%	6.7%	5.9%
Unemployment 2021		8.8%	5.3%	4.5%	5.4%
Government support	furlough, CBILS, CLBILS, job retention, the self-employed scheme, consumer mortgage and unsecured holidays *	nil
Shape of stress	U-shaped, multi-year	V-shaped One-year stress

*1 in 9 mortgages have taken a payment holiday. This is 1.2 million households. The regulators said there had been 60,000 mortgage holidays per day for last 3 weeks

Conclusion

There is no right answer to trying to predict the future. However, each Board should own their base case parameters and be able to justify why the business remains robust.