The recent stress tests conducted by the Bank of England provided largely positive news for the UK's largest lenders, but how valuable are there results by the time they've reached the CEOs' in-trays?

The Bank of England’s second annual stress test of banks passed five banks. It pointed to weaknesses with Royal Bank of Scotland and Standard Chartered but said that recent actions should be sufficient to overcome these. So in effect, all banks passed.  

Of course stress testing of banks is a good idea but it also worth noting the limitations. First, the time delays in getting the results. Stress testing is a laborious process and so by the time one exercise is finished, it’s about time to start again. The risks can have changed in the meantime and so can the profile of assets. 

Second, stress testing is done using hypothetical scenarios. In the Bank of England case this was a sharp slowdown in China, an oil price of $38 a barrel, weak demand and deflation in the eurozone and on top of this banks’ capital taking a hit from misconduct fines. The question, of course, is how accurate any central bank or regulator forecast of events is likely to be given that financial shock is, by its nature, something unexpected. 

The trend is that the forecast scenarios become more severe and that regulators continue to push up capital ratios. In the UK this is likely to take the form of countercyclical buffers – capital built up in good times to provide protection in bad times. An announcement on this is expected in 2016. 

Meanwhile, analysts are predicting that the impact of the ECB’s Supervisory Review and Evaluation Process (SREP) will be to raise core equity Tier 1 capital for the major eurozone banks to about 12%, which is three times what they held before the crisis.

Like the stress tests, SREP, together with other capital add-ons such as systemic buffers, are good ideas in theory. But there will come a point when the benefits of higher capital and safer banks outweigh the downside of less lending to the real economy. 

When this point arrives, will regulators have the courage to take actions in the opposite direction of – if not reducing capital – at least holding it steady?

Brian Caplen is the editor of The Banker.

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