Banks have been told they have to be able to cope with a 35 per cent crash in house prices, a 3.5 per cent fall in GDP and unemployment of almost 12 per cent if they want to avoid further pressure from the Bank of England.
These type of stresses have all happened in recent history, but for such a cataclysmic chain of events to occur so soon after the Great Recession would be the worst series of economic events since the First World War.
It is not something the Bank of England expects, but the aim is to make sure banks remain tough on risks even as the economy grows strongly.
In the stress test, unveiled this afternoon, the eight biggest banks (with one building society, Nationwide) with have to run the fictional crash through their books.
If the meltdown would chop down their capital buffers to less than 4.5 per cent of risk-weighted assets, the regulator is expected to tell them to take action, which could include raising capital, cutting dividends or suspending bonuses.
But even if the banks hit the 4.5 per cent target, the Bank of England could take action if it feels there are still some risks.
In the Bank of England’s fictional story, productivity and economic growth start to disappoint in early 2014, sending sterling down and imported inflation up.
The surge in inflation is shown in this graph, where it is compared with the Bank’s actual forecast for prices.
As a result the Bank of England would hike interest rates from 0.5 per cent to nearly four per cent, a shock to the economy.
Growth would dive as a result. The red line on this chart shows unemployment soaring, compared with the Bank of England’s actual forecast for a fall in joblessness.
Those two factors would exacerbate the fall in growth, turing it into a full blown recession.
This chart shows how GDP would dive in this scenario – even before the economy had fully recovered from the Great Recession, a very unusual set of events.
Those are the disasters banks have to be able to withstand – soaring unemployment causing house prices to fall by 35 per cent.
Some of the numbers individually look like the recessions in the 1980s and 1990s, which the Bank of England has then combined with current risks to bring this picture together.
Such a catastrophe is very unlikely to occur, but from now on banks will be forced each year to prove they are ready for the next crash, in a bid to make sure the risks are reduced and the banks are better prepared.