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UK heading for new financial crisis 'on grander scale than 2008' with Bank of England 'asleep at the wheel', says Adam Smith Institute

Kevin Dowd, professor of finance and economics at Durham University, argues the Bank’s tests, which model various adverse economic scenarios, have a series of 'fatal flaws'

Published 03/08/2016

Kevin Dowd, professor of finance and economics at Durham University, argues the Bank’s tests, which model various adverse economic scenarios, have a series of 'fatal flaws'
Kevin Dowd, professor of finance and economics at Durham University, argues the Bank’s tests, which model various adverse economic scenarios, have a series of 'fatal flaws'

The Bank of England’s annual stress tests of the UK’s banks, designed to ensure Britain’s lenders will not be at the heart of another destructive financial crisis, have been branded “worse than useless”, by a new report.

Kevin Dowd, professor of finance and economics at Durham University, argues in a paper published today by the Adam Smith Institute that the Bank’s tests, which model various adverse economic scenarios each year such as a major fall in UK house prices or a Chinese property crash, have a series of “fatal flaws” and that the central bank is “asleep at the wheel”.

 “The purpose of the stress-testing programme should be to highlight the vulnerability of our banking system and the need to rebuild it. Instead, it has achieved the exact opposite, portraying a weak banking system as strong".

Professor Dowd warns that the eurozone banking system is on the precipice of another crisis, which will also engulf the UK’s major lenders.

“Once contagion spreads from Italy to Germany and then to the UK, we will have a new banking crisis but on a much grander scale than 2007-08” he said.

“The Bank of England is asleep at the wheel again, and we will be back to beleaguered banksters begging for bailouts – and the taxpayer will be ripped off yet again, but bigger this time.”

Among the flaws in the Bank’s testing exercise identified by Professor Dowd are the fact that the stress tests rely on analytical “risk weights” for banks’ assets, which have been much criticised for potentially underplaying the true riskiness of various assets such as mortgages and sovereign debt.

Professor Dowd also cites the use of questionable estimates of the scale of banks' true exposures and the fact that the Bank of England, unrealistically, only models a single stress scenario at a time.

In addition, he says the Bank’s tests are less rigorous than those of the US central bank, and that if UK lenders were tested by the Federal Reserve all of them would fail.

Other former regulators have raised questions about the Bank’s reliance on stress tests to gauge the resilience of UK banks.

In a speech last year Robert Jenkins, a former member of the Bank’s Financial Policy Committee and now a senior fellow at Better Markets, said: “For stress testing to be effective regulators must know which risks to stress and by what degree to do so. However hardworking and intelligent they may be they are also human. They, like the bankers they regulate will at some point get it wrong.”

Mr Jenkins, along with Professor Dowd, argues that regulators’ efforts should be focused on requiring banks to raise considerably larger equity cushions to protect them against future risks that are simply unforeseeable to regulators today.

In relation to their total assets regulators such as the Bank of England are only requiring private banks to have equity cushions of up to 5 per cent. This would imply that if their assets fell by just 5 per cent they would be insolvent and, potentially, need a public bailout.

The European Banking Authority – a separate regulator – published the results of its own latest stress test exercise for 51 or the continent’s largest banks last Friday, including the Royal Bank of Scotland, Barclays, HSBC and Lloyds.

This found that in an “adverse” scenario HSBC’s capital cushion falls to 8.7 per cent, RBS to 8 per cent and Barclays to 7.3 per cent – all well above the level at which they would have been pressured to raise more equity.

Two previous EBA stress tests in 2011 and 2014 have been roundly criticised for giving a host of eurozone lenders, which subsequently needed to be rescued, a clean bill of health.

European bank stocks have fallen sharply this week, suggesting that investors are unconvinced by the latest EBA results too.

In its own latest stress test scenario for 2016 the Bank of England is modelling a fall in the price of oil to $20 a barrel, a 33 per cent slide in global property prices and a 4.3 per cent fall in UK GDP. The results are due to be published in the final quarter of this year.

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