The COVID-19 crisis could be a very severe stress event for the nation’s bank, one even more so than the severe scenario in the Federal Reserve’s recent stress tests. At least, there’s a pretty fat tail out there, and the banks need to be resilient to that fat tail. They need to have enough resources to continue lending, to keep credit flowing, to reduce the scarring—a lot of which will happen anyway, but even more of it will if the banks don’t continue to lend. I think conserving that bank capital, building the capital, is key.
I want to make two points.
One, is there a regime built around the dynamic resilience? Yes, there is in the U.K., and I’ve been part of it as a member of the Financial Policy Committee. I also think that the U.S. capital regime was moving in the wrong direction before this stress event. Capital requirements from the stress test had fallen. The framework was becoming less countercyclical, and I’ll explain why I think that, and have a recommendation for it.
So, what have we been doing in the U.K.? For 5 years or so, we had a countercyclical counter buffer (CCyB) that was set at one percentage point in a standard risk environment. Last year we decided we wanted to make it two percentage points in a standard risk environment. We did it in part by looking, as Michael Blank, Samuel Hanson, Jeremy Stein, and Adi Sunderam do in their working paper, at the global financial crisis, and we could see that the buildup of capital before that crisis to make banks resilient would have had to be much larger than one or two percentage points. We questioned whether, if we had started from one, we could have gotten the CCyB up to the three and a half to five that the staff estimated we would have needed. We might have trouble even starting from two, say, in 2003 or 2004, but at least we would have a better chance of getting it to where it needed to be to make the banking system resilient. Going from one to two in a steady state would add a little bit to tier one capital requirements—about a quarter of a percentage point. It wasn’t a big increase, but a little increase in the quantity and quality of capital.
Our stress test helps the Financial Policy Committee decide on what the CCyB should be. As in the U.S., we make the test countercyclical. So the lower the unemployment rate is, the bigger the increase in the unemployment rate. The higher the property prices, the greater the fall in property prices are. We also look at the stress environment or the financial environment, the risk environment globally; in the past couple of years, our stress test has produced larger drawdowns in U.K. capital, importantly because of our perception of rising global risk, including leverage in U.S. businesses and leverages in China. We also believe releasing the CCyB can be an effective macroprudential tool to enable and encourage…
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