Consultant Zone

Stress tests should apply to all lenders!

The Bank of England recently announced that the major UK banks would be resilient to a severe stress scenario. Re-assuring news, especially considering that their stress scenario was more severe than the downturn during the global financial crisis and significantly more severe than current economic forecasts. PRA regulated banks are of course used to considering these stress scenarios as part of their annual capital adequacy (ICAAP) process. However, robust stress testing should not be limited to PRA regulated banks.

While most of UK residential lending is originated by PRA regulated firms, there are another 18,000 firms that are subject to the prudential standards detailed in either the FCA handbook or European prudential legislation. To comply with FCA requirements these firms are also subject to an annual assessment of capital adequacy – ‘ICAAP lite’ in the absence of a formal label. Whilst the FCA as conduct regulator, clearly focuses on potential consumer harm arising from capital adequacy issues, the prudential aspects of these assessments are coming under wider scrutiny to protect against the systemic risks to the UK economy.

Mortgage borrowing has become more restrictive over the past decade, with stress testing prudence having created a more stable UK mortgage market. However, as economic headwinds gather, the affordability stress test – looking at whether borrowers could manage payments if rates rose beyond 3 percentage points – has already been eroded for many borrowers.

Funders and investors are now taking a more inquisitive approach, particularly with lenders outside the PRA process. They are demanding more detailed answers from their lender partners to better understand the potential stress shocks of those they fund. They include, but are not limited to, rising unemployment, falling house prices and higher interest rates. Additionally, more questions are being asked of lenders around early warning indicators (EWIs) for each stress, reporting processes and the planned resolutions when an EWI is triggered. It can be summed up easily; funders and investors are seeking greater reassurance that business models are robust and sustainable.

Rockstead, as many of our clients know, has years of experience carrying out funding line reviews. As risk consultants, we have seen widening in the breadth of scopes of work we undertake for funders. Historically, we have been required to focus on underwriting policies and procedures while ensuring that loans being originated comply with agreed terms of the funding arrangement. In recent scopes, we are also being asked to consider if new and expanding lenders are complying with FCA requirements, if their business models are robust and, most importantly if a business is sustainable in plausible stress scenarios. Give us a call to chat about stress tests, EWIs and business models in a ‘downturn’.