The Bank of England (BoE) on Monday presented the scenario for its second annual stress tests,which it said expanded on last year's excerise to include more of a focus on global risks.The BoE said it was modelling a milder stress scenario for the UK economy than last time.Its assumed peak-to-trough decline in the global economy was only a third of the fall that happened in the 2008 crisis.
The number of banks being tested is slightly lower as the Co-operative Bank,the only failure in last year's test,has been excluded because it is in the process of shrinking under a drastic restructuring plan.
However, the BoE is expected to announce an expansion of the exercise to include more institutions this summer.Officials are considering including the UK operations of foreign banks in the exercise as well as large insurers and asset managers.
For the first time the stress test includes an assessment of how banks' leverage ratios - measuring equity to total assets - emerge from a crisis as well as their capital ratios, which measure equity to risk-adjusted assets.
The five-year stress scenarios, including a slowdown in China's real economic growth from 7 Percent to 1,7 percent and a one-third fall in chinese and Hongkong house prices,is likely to put most strain onHSBC and Standard Chartered,which are UK-based but earn most of their profits in Asia.
The six banks and one building society - including Barclays,LLyods Banking Group,Royal Bank of Scotland,Santander UK and Nationwide-will be tested against two key minimum 'thresolds' in the stress scenario: a 4,5 per cent common equity tier one capital ratio and 3 per cent leverage ratio.
Banks have been told that they could be required to raise more capital even if they remain above the thresolds for capital and leverage but fall short on qualitative aspects of the test , such as the strength of reporting and controls.
In this year's test the UK economy declines by as much as 2,3 per cent while residential property prices drop by a fifth, there is a prolonged period of deflation and interest ratesfall to zero for almost two years.
a) What risk would you put into a banking stress test ?
b) Why are these risk scenarios extreme but possible ?