The Bank of England has published the results of it’s stringent 2016 stress tests, which incorporated a synchronised UK and global recession with associated shocks to financial market prices, and an independent stress of misconduct costs.
The Report made for sobering reading, and extracts on misconduct follow.
“The 2016 stress test also incorporates stressed projections, generated by Bank staff, for potential misconduct costs, beyond those paid or provided for by the end of 2015. These stressed misconduct cost projections are not a central forecast of such costs. They are a simultaneous, but unrelated, stress alongside the macroeconomic stress and traded risk scenario incorporated in the 2016 test. There is a very high degree of uncertainty around any approach to quantifying misconduct cost risks facing UK banks. The stressed projections relate to known past misconduct issues, such as mis-selling of payment protection insurance and misconduct in wholesale markets. They have been calibrated by Bank staff to have a low likelihood of being exceeded. They are therefore, by design, much larger than the amounts that had already been provided for by banks at end-2015. However, partly because they relate only to known issues, they cannot be considered a ‘worst case’ scenario.’
The Bank found that in relation to misconduct:
“Stressed projections for misconduct costs beyond those already provided for at the end of 2015. Around £30 billion of these additional misconduct costs are projected to be realised by the end of 2017, reducing the aggregate CET1 ratio by 1.6 percentage points. This compares to an aggregate of around £40 billion paid and another £18 billion provided for by banks, but not yet used, over the period 2011–15.”
They also spoke about their qualitative review, and about Banks’ failure to develop new models:
“Qualitative review An important objective of the concurrent stress-testing framework is to support a continued improvement in banks’ own risk management and capital planning capabilities. On that basis, as in previous concurrent tests, the Bank also undertook a qualitative review of banks’ stress-testing capabilities. The PRA Board judged that banks in aggregate have made progress this year, but was disappointed that the rate of improvement has been slower and more uneven than expected. As set out in the Bank of England’s ‘Approach to stress testing the UK banking system’, the qualitative review will be considered in the Bank’s broader assessment of banks’ risk management and governance arrangements for the purpose of setting the PRA buffers and will continue to influence the intensity of supervision of individual banks. In order to raise standards in model development and management, the Bank plans to publish expectations against which banks’ modelling frameworks will be assessed. The Bank, through the Basel Committee’s Working Group on Stress Testing, is also collaborating with other regulators in the review of bank and supervisory stress-testing programmes and, as needed, will be developing further guidance to enhance these programmes.”
There have been a number of developments since the launch of the 2016 stress test. As well as news around fines relating to the mis-selling of US residential mortgage-backed securities, the Financial Conduct Authority announced in August that its proposed PPI time-bar will be delayed until end-June 2019. During the first three quarters of 2016 the major UK banks made around £6 billion of additional provisions for misconduct costs and fines. Bank staff have taken these developments and other news into account in calibrating the stressed projections for misconduct costs and fines included in this test.
Development of new models: The Bank expects banks to continue to enhance their ability to model the impact of the stress over time. The 2016 review found that development of new models and approaches had slowed in more established areas of risk modelling such as credit risk. Beyond these traditional disciplines, banks are yet to make significant progress in developing their modelling capability. For example, banks continue to rely largely on judgement-based approaches when projecting their revenues and costs. In order to raise standards in model development and management, the Bank plans to publish expectations against which banks’ modelling frameworks will be assessed. The Bank, through the Basel Committee’s Working Group on Stress Testing, is also collaborating with other regulators in the review of bank and supervisory stress-testing programmes and, as needed, will be developing further guidance to enhance these programmes.”
The following chart illustrates with clarity how misconduct and related fines and remediation has the capacity to have the greatest negative impact on a bank’s capital reserve – outweighing even a severe UK macroeconomic downturn.