It is always easy to be wise after the event. Bank regulators should have been more wary of the risks to the banking sector through dubious loans issued to sub-prime lenders and the folly of “securitising” such loans in blocks and believing that that would make an investment grade product. They should have considered that runaway property bubbles usually end in tears and that without a viable financial sector; the edifice of capitalism comes crashing down. Consequently, states needed to underwrite the survival of the banks or risk a worse calamity. The appetite for risk was too high and the depth of liquidity held in many banks too shallow to allow them to survive a financial tsunami as cataclysmic as the Global Financial Crisis.
Having been asleep at the wheel when the Global Financial Crisis struck, bank regulators have been at pains to ensure that lightening doesn’t strike twice and that banks under their responsibility have adequate reserves to deal with a fresh financial crisis of similar proportions. These “stress tests” have been conducted within the Eurozone, the US and the UK, to name but a few. Should banks within these jurisdictions be found wanting by the stress tests then the regulators have the power to insist that remedial action is taken.
[CAD:FXAcademy CTA #121]In the latest round of stress testing, the Bank of England is attempting to ensure that UK based banks are fit enough to deal with a global economic slump, partly because UK banking is highly international in nature. The scenario imagines a sharp downturn in the Eurozone, a 2.3% contraction in the UK economy and a collapse of growth in China to just 1.7%. The failure of Chinese growth could lead to a major crash of property prices in Hong Kong with 40% wiped off valuations – this could affect UK banks lending in that market, such as HSBC, for instance. British banks need to ba able to demonstrate that they could handle a 2% drop in Eurozone output within the scenario. For good measure, it also supposes that UK house prices delate by 20% over a five year time window.
To pass the simulation, banks will need to show that under the test scenario they will be able to maintain a “core capital ratio” of 4.5% - this represents the difference between the cash that they hold and their investments (in the troubled areas).