5 August 2019

Another downturn is looming – and UK banks are nowhere near ready

By Kevin Dowd

The Bank of England’s latest round of bank stress tests in November 2018 painted a reassuring picture of bank resilience. The message was that the UK banking system is now so strong that it can come through another crisis that is more severe than the last one and still be in good shape.

How do we know this? Because the stress tests tell us, claims the Bank. However, the truth is that the Bank’s stress tests are useless at detecting bank fragility. And how do we know that? Because this fragility is apparent from banks’ leverage. So do you believe the results of the stress tests or do you believe the leverage numbers?

The centrepiece of the Bank of England’s oft-repeated narrative about the banking system is that bank capital ratios are high and still rising. The banks are strong.

The measure the Bank relies on is the ‘CET1 ratio’, the ratio of Common Equity Tier 1 (CET1) capital to Risk Weighted Assets (RWAs). As of the third quarter of 2018, the average CET1 ratio across the big five UK banks was 14.7%. This number looks impressive until one realises that the denominator is meaningless, because it is highly gameable and the banks are expert at this game. We should throw this ratio into the bin.

A better measure is bank leverage. Leverage is total assets divided by (CET1) equity.

What is bank leverage?

As of the third quarter of 2018, the average leverage across the big five was 20.7. This number is book value, however, and a more accurate measure is market-value leverage, which is 34.4.

That means the big banks have issued over £34 of debt for every £1 in equity. That is an enormous level of leverage.

But weren’t we told that excessive leverage was a key driver of the severity of the financial crisis? Quite.

Bank leverage is also increasing. A year earlier, it was under 28. In market-value terms, bank leverage is higher than it was before the crisis.

The banks’ average price-to-book ratio (the ratio of share price to book share value) at the same date was 67%. These ratios suggest that the markets think that banks are still seriously impaired. The markets don’t believe the Bank of England’s narrative about the banks being fixed. And if the markets don’t believe the Bank, why should anyone else?

That combination, of high and increasing leverage and low price-to-book, is the sow’s ear that the Bank of England’s stress tests portray as a silk purse.

Like their predecessors, the central purpose of the stress tests is to persuade us that the banking system is strong when the evidence indicates it is not. The stress tests themselves are fatally flawed: they are undermined by conflicted objectives, inadequate scenarios, reliance on discredited metrics, low pass standards and woefully inadequate loss modelling. The stress test programme should be scrapped.

The banking system is weak now, before any ‘worse than financial crisis’ stress scenario, not strong after one.

All the stress tests provide is employment for modellers and false risk comfort for the public. False risk comfort is never good, however. It is about as useful as a cancer test that doesn’t work. If the banking system is weak, the public need to know.

The next downturn is only a matter of time and the UK banking system is nowhere prepared for it.

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Kevin Dowd is professor of finance and economics at the University of Durham. “No Stress IV – The flaws in the Bank of England’s 2018 stress tests” by Kevin Dowd is published today by the Adam Smith Institute.