Co-op Bank fails stress test; Lloyds and RBS raise concerns

THE Co-operative Bank has failed a Bank of England test to see how lenders would cope with severe economic stress, which also raised concerns about state-backed Lloyds Banking Group and Royal Bank of Scotland.

Co-operative Bank was ordered to shore up its balance sheet by axing £5.5 billion in loans after it failed a Bank of England stress test.

The troubled Co-op must cut its loan book by £5.5 billion while RBS is to issue £2 billion worth of convertible bonds.

The Bank found that a severe downturn with house prices plunging 35% would wipe out the Co-op’s capital because of the effect on its risky commercial property and sub-prime home loans.

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The test, using the position of banks and building societies at the end of 2013, also found RBS and Lloyds would be susceptible to such a crisis but improvements and changes to their plans this year meant only the Co-op was required to submit a new plan.

The test examined how lenders’ balance sheets would stand up to a potential Doomsday scenario of economic crisis by calculating the ratio of capital against loan assets on their balance sheets in such an event.

It judged that Lloyds, 25% owned by the taxpayer, would fall to a capital ratio of 5% under such a scenario, though by taking severe actions such as cost-cutting this would be 5.3%. It compares with a minimum benchmark set by the Bank of 4.5%.

The group, which includes the Halifax and is heavily exposed to the UK housing market, “remains susceptible to a severe economic downturn”, the test found.

But it said that, in light of the measures it already had in train, it did not require Lloyds to submit a revised capital plan.

The results did not comment on whether the test would affect Lloyds’ ability to pay a dividend next year, though it assumed that payouts would not be made in the stress scenario.

For RBS, 80% owned by the state, the capital ratio would fall to 4.6% in the stress scenario, or 5.2% after “strategic management actions” which could include cost-cutting.

The Bank said it would ordinarily have required RBS to submit a revised capital plan but, given the progress already made and the capital strengthening actions in its updated plans, this would not be necessary.

These included the issue of £2 billion worth of “Coco” bonds that RBS plans to issue in 2015, which would convert into shares as a failsafe to boost the bank’s capital ratio should it fall to 7%.

The Co-op has already admitted that it would be “no surprise” if it failed to pass the test as it was still undergoing a rebuilding process after its near collapse last year.

But the Bank’s assessment means the lender has been required to go further and reduce its risk-weighted assets by £5.5 billion by the end of 2018.

It is the latest challenge for the Co-op after a £1.5 billion hole was found in its balance sheet last year and it slipped out of the control of the wider Co-op group, and is now majority controlled by investors including US hedge funds.

Five other lenders passed the test with no judgment by the Bank’s Prudential Regulation Authority that they needed to strengthen their balance sheet further.

Allowing for emergency “management actions”, Barclays would see its capital ratio fall to 7.5% under the scenario with HSBC scoring 8.7%, Nationwide 6.7%, Santander UK 7.9% and Standard Chartered 8.1%.

The Co-op would fall to a theoretical minus 2.6%.

HSBC and Standard Chartered, which have a major focus on Asia, are less exposed to a UK housing crisis than some of their rivals.

The RBS result comes after it suffered embarrassment following a European stress test exercise earlier this year. It initially appeared to pass with ease but later had to admit it got its sums wrong and had only scraped through.

Bank of England governor Mark Carney said following today’s exercise: “This was a demanding test.

“The results show that the core of the banking system is significantly more resilient, that it has the strength to continue to serve the real economy even in a severe stress, and that growing confidence in the system is merited.”

The Bank said it would review the exercise and set out plans next year for developing the stress testing framework further. Details for a 2015 test scenario will be announced next year.

With the Co-op in the early stages of its turnaround plan, chief executive Niall Booker said it was “no surprise” that the bank failed the stress test.

He added: “The bank is much stronger than a year ago. As the regulator notes today, we have achieved the target of building our capital base and the actions we have taken during the first year of our business plan have made the bank more secure for the benefit of all stakeholders.”

The Co-op is not required to raise additional capital due to the test failure but has agreed to accelerate the reduction in risk-weighted assets, particularly those residential mortgage assets susceptible to severe stress, by 2018.

The test results were published at the same time as the Bank’s Financial Stability Report, which highlighted how weakness in the global economy could affect the outlook for stability in the UK.

It said the recent sharp fall in the oil price should support growth but also pose risks to stability.

The report also raised concerns about an increase in the risks from the UK housing market, saying this increase had not so far happened but that household debt levels remained high, supporting the Bank’s decision six months ago to take measures to prevent an overheating housing market.

It also said changes were needed in the way banks were run following a series of scandals - which was most recently highlighted by the foreign exchange-rigging affair.

The report said: “Recent misconduct and other operational failings have highlighted that rebuilding confidence in the banking system requires more than financial resilience.

“That, and changes to the banks’ business models in response to commercial and regulatory developments, make it important for banks to continue to enhance the effectiveness of their governance arrangements.”

Shares in the UK’s major banks were all higher after the stress test results.

Lloyds’ price rose slightly amid hopes that it remains on track to restart dividend payments in the next year, subject to the approval of the Prudential Regulatory Authority.

Chief executive Antonio Horta-Osorio said: “These results are a clear demonstration of the progress the group has made over the first two full years of our strategic plan, which was announced in June 2011.

“The stress test was based on our balance sheet as at the end of 2013 and since then we have made further significant progress in strengthening our capital position and delivering on our strategy.”