Bank of England 'stress test' for banks explained: What it all means

The Bank of England has just unveiled its 2015 stress test for banks in the UK, to make sure they are in a secure financial position.

Using a modelled scenario, the Bank of England scrutinises a bank's ability to cope with shocks, like a sudden recession or a spike in interest rates. Then it assess whether the bank passes or fails the stress test. If it passes, then all is well. If it fails, the Bank of England will tell the bank that it needs to increase its capital as a "buffer" to protect itself from any unforeseen shocks. This is about making sure banks are funding more of what they do through capital rather than debt. Before the financial crisis, banks were highly leveraged with debt, meaning they funded a lot of what they did by borrowing money. This created significant risk because when the financial crisis hit, a lot of banks struggled to cope with the level of debt they had built up. Some even had to be rescued by governments.

There are a lot of people who would agree and who say we shouldn't have rescued the likes of RBS and Lloyds during the financial crisis, instead letting them fail and protecting depositors instead. By rescuing them, the argument goes, the "moral hazard" of taking excessive risk - such as debt-funded purchases of assets - is blunted because banks know they will be saved in the end anyway. And its taxpayers who always lose out.

But to let RBS collapse in 2008, when at the time it was the world's largest bank by assets owned and heavily indebted, threatened not just the UK financial system, but the entire global financial system. It had the potential to be a catastrophic economic disaster, far worse than the crisis we ended up experiencing, painful though it was.

In order to prevent the government from having to bail banks out again, one of the strategies has been to tighten regulation. One facet of this is to demand that banks hold a certain amount of capital as a buffer to absorb losses, so that they are able to stay afloat themselves without the need for a bailout. Or at least, are able to wind themselves down in an orderly way, rather than abruptly collapse.

So, every year, the Bank of England runs these stress tests to determine whether or not the banks' capital buffers are sufficient.

The scenarios change each year to reflect the risks present in the global economy. This is so the modelling is as realistic as possible in the face of the uncertain. Those scenarios are agreed by the two arms of the Bank of England responsibly for banking regulation: The Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).

For 2015, the scenario involves disappointing global economic growth and deflationary threats. The appetite for risk weakens, meaning firms hoard their capital in the form of high-quality assets, such as US bonds, rather than invest it. Market liquidity seizes up - just like what happened during the financial crisis - and all of this is intensified by a weakening Chinese economy, which in turn hurts other emerging markets. Moreover, the eurozone economy sours further because of deflation. All of this filters down to the UK economy, which enters recession as its exports fall sharply.

That's just a summary, but it gives the gist of the stress test applied to banks.

"Last year's stress tests demonstrated how much stronger the core of the UK financial system has become since the financial crisis," said Mark Carney, governor of the Bank of England.

"The results showed that the post crisis reforms have put the UK banking system on a stronger footing and made it better able to support the real economy even in the face of a major domestic shock.

"This year's test will have a different focus and is equally important. By assessing the resilience of the UK banking system against a major external shock, we will improve further our ability to identify vulnerabilities and we will ensure that banks have plans in place to address a wider range of possible stresses."

Here's where it gets a little more technical. The capital buffer is formed of different tiers and measured in ratios. But the ones we are interested in, and the ones being assessed by the Bank of England's stress test, are the Common Equity Tier One (CET1) capital ratio and the Tier 1 leverage ratio.

To be considered "adequately capitalised" by the Bank of England, a bank must hold CET1 capital worth at least 4.5% of its assets (loans, like mortgages or credit for small businesses), which are weighted in the calculation depending on how risky they are.

CET1 includes capital raised from the sale of equity in the firm, or shares. So when a bank wants to raise money, it can issue shares which are bought up by investors seeking dividend payments. What would happen in the event of a shock is the first to absorb the losses would be the equity holders who fall under the CET1 category. Their shares would be wiped out. Included in CET1 is also capital reserves, such as retained profits, which would be used to absorb losses.

The Bank of England also demands at least a 3% Tier 1 leverage ratio. That ratio shows how much Tier 1 capital - which includes quality capital such as shareholder equity, UK gilts, retained profits, and so on - a bank holds against its loan assets. For example, for every £100 a bank lends, it must hold £3 in Tier 1 capital.

Essentially, how much decent capital a bank has that can act as a buffer to absorb losses from loans that go bad, or aid an orderly winding down of the institution if things got really bad. Banks can improve their capital positions by retaining profits, issuing more shares, selling off riskier assets and reducing debt.