The Bank of England (BoE) gave a press conference to present its latest financial stability report and explain its bank stress tests. The Bank’s governor, Mark Carney, shed some light on the UK’s financial stability and how the country will be affected by significant changes caused by Brexit and the Trump trade wars. Carney emphasised how the UK is “the investment banker for Europe,” since more than half the equity and debt raised comes from firms and investors in the UK. This is why transitioning into the Brexit reality needs to happen smoothly by offering those services continued access to the single market.

Bank Stress Test

A bank stress test is an analysis of a bank’s financial health conducted under critical economic situations. Bank stress tests have become more regular after the 2008 financial crisis in order to determine if a bank has the necessary capital to respond to adverse scenarios. Today, the BoE’s tests assessed how the banks will deal with a recession, a housing crash and a halving of the oil price.

On bank stress tests, Carney said that the Financial Policy Committee (FPC)—a Committee of the Bank of England whose role is to identify, monitor and take action to control risks and protect the UK’s financial system—found that the banking system is “capitalised to support the real economy even under a broad severe … scenario” and that no actions on bank capital were needed. 

In other words, the entire banking system seems to be strong enough to endure the five-year scenario in which £44bn of capital is wiped out in the first two years, and another £48bn is directed towards paying fines and legal costs.

RBS fails BoE’s stress test

After the news that the RBS failed today’s stress tests and needs to strengthen its capital position, its shares have fallen 2.7% in the City. The stress tests by the BoE were tougher than previous years.

Carney said that the Royal Bank of Scotland has progressed a lot, but its challenges lie in its legacy issues: misconduct costs, impaired assets, and non-core assets on which is making some progress. He said: “It lost its way over a number of years and did a number of other things...not particularly well.”

Misconduct costs: bad assets. For example, the bank could have to pay the US Department of Justice up to £9bn fine in the next few months for mis-selling mortgage backed bonds.

Impaired assets: assets whose market price is lower than the listed one on the bank’s balance sheet.

Non-core assets: not important for the bank, but can be sold for cash when the bank needs money.

Financial stability reports determine the health of a central bank or a financial regulator’s banking, financial and payments systems. Such reports seek to give information on the structure of financial systems, trends in banking and finance, and how global economy affects local markets. This is a valuable tool for policy makers to explain to the public their concerns about the financial system, to establish standards for tracing risks in a country, or to present alternatives to financial regulations.

Global threats to UK’s financial stability

In the press conference, Carney commented on Britain’s financial system and how well it responded to this year’s vote to leave the EU. But he stressed that there are global threats that could shake the current financial landscape. The emerging economy of China, for example, whose growth is increasingly relying on borrowing, might pose a significant risk for the UK. He warned that: “There are signs that capital outflows from China and other emerging economies have begun to pick up in recent months and may accelerate further depending on the degree and pace of increases in US market interest rates." 

Eurozone economy and the threat of Brexit

Carney explained that the Eurozone is still facing vulnerability because of “higher borrowing costs and weaker growth prospects” associated with “trade or political risks.” Brexit poses an additional risk to the euro area: 

“Banks located in the UK supply over half of debt and equity issuance by continental firms, and account for over three quarters of foreign exchange and derivatives activity in the EU. If these UK-based firms have to adjust their activities in a short time frame, there could be a greater risk of disruption to services provided to the European real economy, some of which could spill back to the UK economy through trade and financial linkages."

Carney stressed that UK firms want “clarity” and to “know as much as possible about the desired endpoint, what type of relationship would be there, and as much as possible, as early as possible, about the potential path to that endpoint." This will help to “promote a smooth and orderly transition.”

How the UK might be affected by the world’s largest economy?

Carney warned that, while the UK might not be directly affected by a slowdown in world trade due to US policy initiatives, “if it slows the pace of global growth - and we're an open trading nation one of the most open nations in the world - it's going to have a knock-on effect through this economy. This is more of a slow burn issue, sand in the gears, headwind for the global economy as oppose to a sharper shock if any of it were to actually materialise."

When Carney was asked whether the BoE would be less concerned if Hillary Clinton won the US election, he smiled and said: “We’ll never know, so it’s impossible to speculate.”

What we do know, is that the banking sector can withstand critical economic situations and that Brexit has to be a smooth transition, ensuring that UK firms retain their access to the single market.