What is the Bank of England's New Annual Stress Test?

Britain’s state-backed banks scraped through the Bank of England’s inaugural annual stress test, a test of how the sector can cope with another financial crisis or ‘doomsday scenario’.

The Co-operative Bank actually failed the test having nearly collapsed entirely last before being saved by bondholders.

Lloyds and RBS narrowly passed, but the result puts in doubt whether the former will be able to pay back the government a dividend for 2014. Indeed, the test put the two banks ‘at risk’ if another crash was to occur.

But what is the stress test all about?

Brought in by the Bank of England, led by Mark Carney, this year, the stress test is designed to evaluate or forecast what would happen to lenders if a similar sort of economic crisis was to occur again.

It adds a number of additional layers on top of those applied by European regulators in an EU-wide test of 123 banks in October, and is tougher on organisations with high exposures to UK mortgages, including Lloyds, RBS and Nationwide.

The test assumes the following doomsday scenario:

1. Sterling falls by around 30 percent
2. House prices fall by 35 percent
3. Bank rate rises to 4.2 percent
4. CPI inflation peaks at 6.6 percent
5. Unemployment rises to nearly 12 percent
6. GDP falls by 3.5 percent
7. Share prices fall by 30 percent

Under the stress scenario, RBS’s core capital ratio fell to just 4.6 percent, just above the 4.5 percent minimum required. Lloyds passed with five percent. It should be noted that these results do not take into account actions taken this year to strengthen balance sheets.

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Britain’s other large banks including HSBC, Standard Chartered, Santander UK and Barclays, scored comfortably in the test with pass rates of between seven and 8.7 percent.

Although the Bank of England says it does not expect this scenario to occur, it is a useful indicator in assessing whether financial institutions have learnt from the disaster of 2008, vital in rebuilding trust among the public and business arena alike.