UK banks earn lower capital requirements with stress test results

After solid stress test results from UK insurers last week, on Tuesday it was the banks’ turn as the Bank of England (BoE) published its 2025 stress test results along with December’s Financial Stability Report.

The fact that stress test results seldom make front page news these days is testament to the ongoing healthy fundamentals of the UK banking sector. The two main headlines were the resilience of the system in the face of a severe hypothetical shock, and the reduction in what the regulator deems to be an appropriate capital level for UK banks.

Starting with the results of the stress test, entities partaking this year represented close to 75% of all lending activity in the economy and they include the largest banks and building societies. The report’s assumptions included a toxic cocktail of supply chain disruptions and geopolitical tensions that lead to rising energy and commodity prices, driving a severe surge in inflation. In response, the BoE is forced to raise rates to 8%, resulting in UK GDP falling by 5% and unemployment jumping to 8.5%. World GDP falls by 2%, worse than 2009 but not quite 2020, house prices collapse, the government’s fiscal concerns put pressure on Gilt yields, Santa crashes his uninsured sleigh into the London Eye, and the list goes on.

In the stress test, the banking sector showed remarkable resilience to this scenario. The starting point for Common Equity Tier 1 (CET1) and the leverage ratio was 14.5% and 5.3%, falling to 11% and 4.7% respectively. All banks and building societies involved are comfortably above their individual requirements in both ratios. We do note though that this scenario of a severe shock to GDP and a significant increase in rates has some perhaps counterintuitive outcomes. On their own, loan impairments and traded risk losses account for a 5.6% fall in the CET1 ratio. However, with monetary policy rates increasing to 8%, so too does net interest income. After accounting for higher operational expenses, higher rates in isolation increase CET1 by 3.3%. Increases in risk-weighted assets, taxes and others subtract 1.9%, while management actions add 0.8%. The end result is the aforementioned decline from 14.5% to 11%.

The scenario arguably resembles what could be an escalation of the Russian invasion of Ukraine into a full-blown war. It is obviously an open question how this could develop, but we really struggle to see monetary policy rates at 8% while the UK’s GDP falls by 5%. Nevertheless, while lower rates would translate into lower net interest income benefits, they would also mean the economic contraction would likely be less severe.

The second interesting headline was the revision to what the regulator considers to be an appropriate benchmark for the system-wide level of Tier 1 capital requirements. The new figure is 100bp lower at 13%, which implies a CET1 ratio of 11%. The report states that “banks should have greater certainty and confidence in using their capital resources to lend to UK households and businesses”. In explaining its reasoning, the BoE discusses how banks are carrying less risk on the asset side of their balance sheet, some banks have decreased in systemic importance and therefore some systemic buffers should be lower, and that the implementation of Basel 3.1 in January 2027 “will improve risk measurement, allowing the Prudential Regulation Authority (PRA) to reduce Pillar 2A minimum requirements by around ½ percentage point”. There were also comments that the leverage ratio requirements might be revised as these requirements are stricter in the UK than in other jurisdictions. There was also talk of revising how different capital buffers interact with each other.

While questions remain on the implementation of some of these measures, we take the view that this is a long overdue mark-to-market of some capital requirements rather than a sea change in the regulator’s attitudes towards how much and what type of capital banks should hold in the UK. It is likely that banks reduce their capital targets and keep management’s headroom targets the same. The market reaction was consistent with the headlines not being perceived as a significant change in the regulatory framework. UK bank equities performed well, with Barclays and Lloyds up 1.4% and 1.9% respectively, while UK banks’ spreads were well supported but we would not say there was any notable performance deviation from the broader market.

Financial institutions in the UK, both banks and insurance companies, continue to exhibit remarkable resilience and good results. We take comfort in the strong fundamental picture and their ability to withstand shocks. That goes for the extreme variety imagined by the stress tests and less severe shocks such as more political turmoil in the UK or worsening losses in lending. While spreads across all credit markets are tight, we continue to find attractive opportunities in the UK financials space.