The critical role of Capital Stress Testing

Key takeaways

• Why is capital important to institutions?
• The evolution and standardisation of capital requirements.
• The purpose of performing capital stress testing.
• Key considerations when performing capital stress testing.

Capital stress testing, as a regulatory, co-ordinated activity emerged from the 2007-2008 financial crisis following several high-profile financial institutions experiencing near-terminal capital shortfalls and requiring government intervention and the resultant public backlash. Within the UK alone, ubiquitous high street institutions such as Lloyds Banking Group, Royal Bank of Scotland Group (now Natwest Group), Bradford and Bingley and Northern Rock all required some form of rescue in order to safeguard the UK financial services sector as well as the wider economy as a whole.

Ensuring the financial stability of banks and building societies is a global concern and a major focus for regulatory bodies, governments and central bank as well as customers, employees and shareholders of these institutions. 

Why is capital important to institutions?

The move towards global standards based on lessons learned from past occurrences has led to an increasing amount of mandatory capital required to combat the actual and perceived risks facing the banking sector.

The capital of a financial institution refers to money and or assets owned by the institution that can act as a buffer to absorb any losses arising from their activities and, where no further capital exists to absorb such losses, that institution is then insolvent.  Therefore, the availability of these buffers are of utmost importance during an economic downturn, when such losses may crystallise.

However, simple market equilibrium will result in Financial Institutions attempting to find the optimum balance of holding sufficient capital for regulatory compliance, whilst seeking not to hold too much, given capital is generally more expensive than debt, due to the inherent higher risk premium attached to capital.

The most common forms of capital held by UK financial institutions will include:

• The most common forms of capital held by UK financial institutions will include:
• Share capital & share premium
• Retained earnings
• Perpetual & convertible bonds
• Subordinated debt
• Revaluation reserves
• General provisions

As capital rules have been refined over time, driven by the Basel accords, there has been recognition that not all capital can be assumed to be as loss-absorbing as others (if at all) and therefore capital has been divided into different tiers of loss absorbing quality along with prescribed deductions – items with little or no loss-absorbing qualities, such as goodwill or other intangible assets, deferred tax assets relying on future profitability or investments in own shares – to ensure the reported capital position best reflects the loss-absorbing capabilities of an institution.

The evolution of capital requirements

The Basel Committee on Banking Supervision (BCBS) are the primary global standard setter for prudential regulation and have published three main accords with regards to capital requirements.  This has led to financial institutions and regional regulators to consider the minimum amounts of capital a financial institution must hold and in what forms it must be held. 

These have evolved as summarised below:

Basel I – 1988

• Advocated the use of a risk-weighted approach by banks, where different exposure types are weighted to reflect their perceived credit risk.
• Basel I introduced five asset classes, but subsequent accords have refined the classification and methodologies for calculating risk weighting.
• Introduced an international minimum standard of a minimum 8% of risk-weighted assets to be held as capital.

Basel II – 2004

• Introduced the 3 pillars concept:
  • Minimum capital requirements
  • Supervisory review
  • Market discipline
• Refinement to the definitions and classifications of capital to better reflect the different grades of quality.
• Incorporation of operational and market risk into the framework.

Basel III – 2010

• Following the 2007 – 2008 financial crisis, significantly increased the amount of capital required to be held.
• In particular, increased the amount of capital required to be held as Core Equity Tier 1 (CET1) capital.
• Introduced capital buffers to operate as additional layers of capital required, beyond the minimum.
• Introduced a liquidity framework (not impacting on capital requirements).

The buffers referred to above, include, but not limited to:

Capital Conservation Buffer

The capital conservation buffer is intended to set aside capital during normal times that can be drawn down upon, if necessary, during periods of stress.  Institutions are required to hold this from CET1 capital.

Countercyclical Buffer

The countercyclical buffer is a variable buffer intended to set aside capital during high credit growth to mitigate the risk of unbeknown systemic risk accruing.  Similar to the Capital Conservation Buffer, it is required to be held in the form of CET1 capital.

With the final Basel III reform due to be implemented in mid-2025 in the UK, the expectation is that overall Risk Weighted Assets (RWAs) will increase and, by extension, capital requirements.  At the time of publication of the PRA’s consultation around the UK’s implementation of the rules, the PRA were forecasting an expected increase of 3.1% of capital in the UK, with this figure being net of any corresponding reductions to Pillar 2 capital as a consequence.

The purpose of performing capital stress testing

Recognising the importance of holding sufficient capital, the purpose of capital stress testing is to assess whether the capital position of an institution (or the entire sector, from the perspective of the regulator) would be sufficient to withstand adverse and severe, yet plausible scenarios. 

In the UK, for the largest institutions, the regulator has traditionally run a co-ordinated annual stress test exercise, the Annual Cyclical Scenario (ACS).  This exercise has been based upon a hypothetical adverse economic scenario developed by the Prudential Risk Authority (PRA) and this scenario may consider how factors such as the country’s GDP, unemployment, property prices, interest rates and other factors would all be impacted under the scenario.  For participating institutions, they are required to integrate the scenario with their own business models to analyse the impact to their profitability and capital position under the scenario, reporting these results to the PRA.

In late-2023 the Bank of England (BoE) had announced it’s intention to cancel the 2024 ACS exercise – alternatively running a ‘desk-based’ exercise –but intending to return to a concurrent exercise in 2025 following a review of their stress testing programme.

For institutions that do not fall within the scope of the ACS, capital stress testing still remains a regulatory requirement as documented under the ICAAP section of the PRA Rulebook.  Institutions are expected to perform scenario analyses in proportion to their complexity and levels of risk they face.

These institutions are required to develop their own scenarios that should consider an adverse  event over a prolonged period as well as sudden and severe events as well as considering a potential combination of both.  To support such institutions, the PRA will periodically publish scenarios to serve as a guide and a starting point that can be tailored by each institution to prepare a scenario that will present a strong challenge to the institution.

During the assessment of performance under a capital stress test, institutions should be concerned with how the scenario would impact their profitability and the impact of any losses or other impairment to their capital position: are they able to maintain their required capital ratios and / or would they be forced to drawn down on their regulatory buffers to remain within their compliance limits.  Institutions should also be conscious that the ‘human behavioural’ element can also add further complexity to a situation.

Key considerations when performing capital stress testing

The value to be gained from running capital stress testing simulations is very much dependent on realistic design and execution of the scenarios as well as the integration into the wider risk management framework:  

Key considerations to running these effectively should include:

• Buy-in: capital stress testing should not be seen as a regulatory, tick-box exercise.  Whilst the regulator holds a vested interest, capital stress testing is equally an internal opportunity to identify and mitigate vulnerabilities.  Without genuine buy-in from the board down and across all counterparts of the exercise will minimise the potential effectiveness of the exercise.
• Risk modelling: using risk modelling techniques to accurately model the impact of a scenario across the institution.
• Data synergy: typically data will be required from across the business and commonly there is no single golden source for this information.  As inputs and assumptions are assessed at pace, this can result in poorly calibrated inputs impacting on accuracy or requiring substantial manual involvement to validate and reconcile the inputs, assumptions and outputs.
• Scenario Scope: there is undoubted value in measuring resiliency to severe yet plausible or likely scenarios, however in reality crises do arise from the unexpected and due consideration should be given to reverse stress testing to understand what would be required to happen for an institution to become below capital requirements or become insolvent.
• Assumption risk: both building and impact assessing the scenario will require high levels of assumption.  Assumptions should be suitably challenged and, where possible, validated.
• Resource requirements: capital stress testing can become highly resource intensive, demanding coordinated expertise from across the business.  Ensuring that the appropriate resources are identified and engaged throughout the exercise, in addition to the exercise having the suitable focus and priority at a senior level should ensure that lack of resource or expertise doesn’t act as a bottleneck.

Capital stress testing has existed in the financial sector for over a decade, following the learnings from the 2007 – 2008 financial crises.  Results from the most recent ACS show a strong resiliency in the UK financial sector to perceived potential scenarios, yet complacency cannot be afforded given the myriad of interwoven political, geopolitical, economic and social factors that can all combine in a way that could put sudden or unexpected strain on the financial sector and wider economy, both domestically and internationally.

About the Author

Stuart Fairley is Head of Client Experience at ALMIS International and works closely with clients in his role.  Prior to joining ALMIS in 2019, Stuart had spent most of his career working in the bank and building society sector and holding a number of finance and project roles.  Stuart is also a member of the Chartered Institute of Management Accountants (CIMA).

Market leading experts in controlling risk, ALMIS International has been successfully delivering solutions in Asset Liability Management, Regulatory Reporting, Treasury Management and Hedge Accounting for over three decades . If you want to find out more about our latest products book a demo.