Today, the Prudential Regulation Authority, the Bank of England’s regulator, announced the results of its health check of UK banks, the findings of which have been eagerly awaited by City analysts and traders alike.
Much like the European Central Bank’s stress tests conducted earlier this year, the PRA’s test was designed to test whether or not the banks tested could survive a simulated period under stress. Specifically, the test assessed whether or not the banks in question would still be able to function after a 35% fall in house prices, a spike in interest rates and a surge in unemployment to 12%.
The tests revealed that during this period of simulated stress, the aggregate common equity Tier 1 ratio across the UK’s eight main banks would fall to an average of 7.3% to 2015, from an average of 10% during 2013. In total, the PRA’s tests revealed that this stress scenario would cause £13bn of cumulative losses at these eight major banks, with a further £70bn of impairment charges to account for.
Of the eight banks tested, five did not display any sign of capital inadequacy. Co-op Bank failed, while Lloyds (LSE: LLOY) and Royal Bank of Scotland (LSE: RBS) just passed thank to last-minute plans to strengthen their balance sheets.
Unfortunately, with the PRA testing for a 35% fall in house prices, domestic banks were penalised for their lack of overseas exposure. Lloyds suffered more than most.
Indeed, Lloyds has been trying to scale back its international operations for several years now. The bank currently operates in less than ten countries around the world.
Nevertheless, Lloyds managed to scrape through the test. The group’s Common Equity Tier 1 capital threshold — capital cushion — fell to a low of 5% after the simulated period of stress, just above the 4.5% minimum threshold. Even though the bank passed the test (although only just) the PRA still found the group to be lacking adequate capital resources.
However, before today’s announcement Lloyds submitted revised capital plan to the PRA, outlining plans boost its balance sheet. These plans were found to be adequate.
Moreover, Lloyds’ management noted, alongside the release of these results that the group has generated a 1.9% increase in its CET1 ratio during 2014 — not reflected in the stress test — and further contingent capital is available to the bank, which if trigged would boost its CET1 by 2%.
Work to do
On the other hand, RBS has some work to do.
While the bank did pass the test, with a minimum stressed capital ratio of 4.6%, the PRA found the bank to be short of capital based on 2013’s figures. But just like Lloyds, RBS pre-emptively submitted a revised capital plan to boost its balance sheet, which was considered sufficient by the PRA.
As part of this revised capital plan, RBS announced this morning that the bank was selling a portfolio of Irish home loans to hedge fund Cerberus, for which it will receive up to £1.1bn in cash.
Management will be glad to shift these loans off RBS’s balance sheet. Last year the assets generated a loss for the bank of £800m, mostly due to impairments.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.