Britain’s banks are facing a real-life stress test

In 2014, the Bank of England’s economic Stephen Kings started dreaming up dastardly economic horrors for Britain’s banks. They called this “stress testing”.

With a real-life one unfolding before our eyes, we could be about to see just how effective the regime has been when it comes to making sure the industry can cope with a shock.

The idea, and it was a very good one, emerged from the toxic sludge of the financial crisis at a time when memories were still fresh and people were crying “never again”.

Some of the bankers I talked to privately groused about the tests, arguing that the scenarios thrown at them were too horrific to be realistic.

But the industry’s dirty secret was that, at least in the early days, they didn't always get passing grades.

The bank won’t thank me for characterising it this way. However, it indulged them, just a bit, by allowing them to cheat.

Its charges were allowed to say well, see here, we were already planning to do this and this and this to raise capital later in the year and we would have passed if we’d had these measures in place at the time of the test.

You can see the problem with that, can’t you. It's not something you can necessarily rely on being able to do in the midst of a real-life economic shock.

This happening wasn’t all that unusual in the tests’ early days, when there were some very obviously struggling smaller banks (such as Co-op) and some rather bigger “systemically significant” ones (such as RBS) that got caught short.

The bank’s outgoing governor Mark Carney, on whose watch the tests emerged, deserves the fulsome thanks of those that were granted a certain amount of leeway to get through the exercise. I hope they’ll be sending him a nice card at the very least.

Last time around they all passed, and for the third year in a row, partly through relying on their ability to cut dividends and bankers’ bonuses to cope with the scenario.

The bank told them to increase the amount of cash held back through what’s known as the “countercyclical capital buffer” all the same. Today that looks smart.

We aren’t yet in an extreme economic scenario, but we are in an unusual and rather scary one with a novel virus stalking the Earth, stock markets crashing, and economists furiously downgrading their global growth forecasts.

Britain’s economy spluttered in January. Official figures showed it recorded zero growth against an expectation of 0.2 per cent, with manufacturing in a bad way and the dominant services sector also struggling.

Needless to say, this is how extreme scenarios get started.

Out of its regular cycle of meetings, the bank cut 0.5 points off base rates, which now stand at a historically low 0.25 per cent. Banks will find it harder to make money as a result through squeezed margins.

Lenders are also going to be asked, or rather told, to be gentle with businesses that have taken a hit from people changing their habits in response to Covid-19, by staying indoors for example. Some are going to start to struggle to repay their loans. Some firms will inevitably go to the wall. You can expect a rise in bad debt to follow.

There’s a bigger worry, however, and it is what’s happening in Italy, where the outbreak is far more serious than it is here, and that is how its banks will cope with a nation in quarantine. They aren’t among Europe’s stronger ones and as the last nasty proved, it only takes a domino or two. They needn’t even be big ones. Remember what happened when Northern Rock fell over?

Carney’s legacy will be much discussed by economic historians. If Britain’s banks ultimately pass the real-life stress test that’s currently unfolding, the ones that started in 2014 will serve to burnish it.