Impact of Stress Tests on RBS: A Financial Risk Analysis Report

This report critically evaluates the implications of stress tests on the Royal Bank of Scotland (RBS), focusing on its stock and bond values in both the short and long term. It explains the concept of stress tests, their implications on banks and financial institutions, and how the results impact RBS's ability to raise capital. The report also analyzes the concepts behind mortgage-backed securities (MBSs) and how risk was diversified to secure lending, examining the exposure of banking institutions to the subprime mortgage crisis. Furthermore, it explores the role of MBS in subprime mortgage crisis and discusses the exposure of banking institutions to the crisis, including an analysis of the causes and consequences of the crisis. The report concludes with potential actions RBS management can take to resolve the situation, including using unclaimed deposits, monetizing investments, and implementing structural improvements.

FINANCIAL RISK MANAGEMENT
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QUESTION 1:
Part 1:
Critically evaluate what implications will the stress tests have on the MPS's stock and bond
values in the short and long term.
The concept of Stress Test
The banking and financial sector may be construed to be the backbone of an economy. Because
of its extreme importance in maintaining the efficiency of the economy and financial liquidity
and performance, regulators have found it useful to have a follow-up and control mechanism on
the banks and other financial institutions operations. As a result, the concept of stress test has
been conceived. As per the opinion of Banulescu, Hansen, Huang and Matei (2018), the stress
test primarily measures the position of the banks and other financial houses in the crisis period of
the economy, like recession, depression and also the political turmoil etc. The resilience of banks
and financial houses are critical for a successful economy as the policymakers may accordingly
need to formulate strategies to control and regulate the economic functioning in the country in
the most efficient manner. Therefore, it becomes very critical for the regulators including
Government to undertake such tests where the banks operational and strategic flexibility may be
tested to the tune of national policy and market trends (Bankofengland.co.uk, 2019).
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Figure 1: Bank’s Stress Test
(Source: Fields, 2018, pp. 123)
Generally, as mentioned earlier, the test is conducted by assuming a hypothetical scenario of the
acute financial crisis, for example, recession. The banks are provided with such scenario where
the scenario incorporates various economic and market linked variables that may need to be
addressed by the banks in a most efficient manner without hampering the liquidity and credit
policy (Liu, 2018). Different models and techniques are used by the regulators to conduct such
tests to check the impact of a given scenario on the bank's financials for a given period.
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Implications of Stress Test on Banks and Financial Institutions
Stress Test may be of two different types from the user's point of view. The first type of test is
being conducted by the regulators where the banks and other financial institutions relative
strategic and financial resilience may be checked. The second type of test is carried out by the
banks itself to assess the flexibility of individual customers or the borrowers. For the purpose of
the discussion in this paper, the first type of test will be analysed and evaluated herein
(Fieldhouse, Mertens and Ravn, 2018).
Stress test generally involves assessment and evaluation of qualitative vulnerability and also a
thorough review of the regulatory and crisis management frameworks within a national policy
framework. Until the subprime mortgage crisis, there were concurrent stresses testing carried out
by the regulators. However, Hesse, Hofmann and Weber (2018) mentioned that the same did not
yield any quantifiable result in terms of an insight into the potential risk implication of the banks
in emergencies. The figure below shows the entire conceptual framework concurrent stress test
which may be divided into four parts. The first part identifies a stress scenario. The second part
prepares the model and presents the scenario including variables. The third stage shows various
projections based on stress scenario and the fourth part covers the results of the given test.
The stress test focuses on profitability scenario to check the profit generation is not affected by
the fiancé costs. Also, the change in traded risk scenario may adversely affect the bank’s
financial health and balance sheet to a certain extent which gets captured in the stress test.
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Figure 2: An Illustration of a Concurrent Stress Test
(Source: Fletcher, Paudyal and Santoso, 2019, pp. 11)
However, the post-crisis, the regulators including the Government decided to conduct a detailed
stress test on a periodic basis which helped the regulator to assess the potential flexibility and
relative financial position of banks and financial sectors of the country. In this context, it may be
noted that the concept of stress testing requires a projection for future based on present capacity
and financial health of the banks. There are different approaches that may be undertaken by the
regulators to conduct such projection (Banulescu, Hansen, Huang and Matei, 2018). On the other
hand, banks, at times, also conduct such study and present the result to the regulators for their
subsequent assessment. The results are evaluated by the regulators on a forward-looking basis
and necessary actions may be undertaken in terms of the imposition of restrictions or bars on
bank's activities or giving relaxation from complying the statutory norms of liquidity reserve and
so on.
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Part 2:
Explain and analyse how will the stress test results impact the bank’s ability to raise capital
and what actions can RBS’s management take to resolve the situation.
Stress tests will significantly affect the bank’s ability to raise capital. If a bank is found to be
disqualified on the basis of stress test results, the same amount to significant bar and restrictions
imposed by the regulators on the bank’s lending operations (Aguilera‐Caracuel and Guerrero‐
Villegas, 2018). Therefore, it becomes critical for banks to pass the test with sufficient liquidity
provision.
Stress test result:
The result of the stress test would focus on credit risk, market risk, and liquidity risk in order to
assess banks' financial condition even in the crisis situation. In the words of Fligstein and
Roehrkasse (2016), two types of stress test are conducted to assess the financial condition. After
the stress test, the RBS would publish the results. As per the stress test result in FY 2017 & 2018,
RBS failed to fulfil the requirement and RBS has a greater value of the non-performing asset
(NPA) (Ospina and Uhlig, 2018). However, the Bank of England had asked RBS to submit a
plan that contains steps to improve the financial condition of RBS. Therefore, after the present
stress test, RBS needs to submit a plan to describe the financial status and action plan.
Impact of stress test and challenges:
 The results of the stress test should be published to the public and all stakeholders
 RBS should release the report on how the bank will handle a major crisis.
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 If RBS fails to pass the stress test, the Company needs to follow new regulations such as
cutting the dividend payouts and share buybacks to the preserve capitals.
 RBS could also get a conditional pass value of the stress test conducted by the Bank of
England.
 After signing to the conditional pass of the stress test, RBS would resubmit the action
plan
 If RBS again fails in the consideration test, all stakeholders would be informed and
would be considered as the bad bank to the public based on the threat of financial
catastrophe.
With the failure of the stress test, RBS would face the challenge to meet the overall structural
change as compared to the cyclical change. Supporting this fact, Hirtle (2018) stated that RBS
would experience a significant drop in demand for cross-border finance and increased
competition in financial services. The Fintech disruption warning would employ easy switch of
customer accounts into other banks that are financially more stable than RBS. Thus, RBS needs
to look into the overall cost structure as it would drive the consumers to keep the accounts with
RBS in the future.
Under the stress scenario, unlike Santander UK Plc, HSBC, Lloyds, RBS has not paid a dividend
from the financial crisis and the bank would continue the same throughout the stress scenario. On
the contrary, Nationwide would continue to make distributions on core capote deferred shares. In
addition, as the participating bank, RBS was covered to pay out £26 billion in dividends in FY
2017 and 2018, based on the stress test results. Moreover, RBS would stop coupon payments on
AT1 bonds under the financial stress along with the dramatic fall in the bonus and other
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distribution as compared to previous financial years. RBS will not pay any bonuses during the
stress test scenario.
Mitigating the challenges:
Using unclaimed deposits:
The unclaimed deposits such as balances in the frozen or inoperative accounts can be used and
transferred to the government with the future claim provisions.
The monetisation of RBS's investments:
RBS’s investment in insurance, mutual fund, housing finance, etc can be monetized and the same
can be explored with the markets lapping up the recent issuances (Fabozzi, 2016). Moreover,
RBS could create more value by auctioning the assurance partnership as compared to running an
insurance firm to avoid the blocking of its precious capital.
Structural improvement:
RBS’s banking system needs to be truly governed by the structure of the board. Thus, the
compensation structure also needs to be revised to attract other private capital. The structural
reform of RBS could make the system more robust and a greater degree of economic growth can
be attained by RBS (Altavilla, Pagano and Simonelli, 2017).
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QUESTION 2:
Part 1:
Critically analyse concepts behind MBSs and how risk was diversified to secure lending.
Analyse, what exposure did the banking institutions have to the subprime mortgage crisis.
Concepts of MBS
A mortgage-backed security (hereinafter may be referred to as "MBS" or the security, as the case
may be) is a kind of asset-backed security that is being secured by a mortgage or range of
mortgages. These mortgages are generally sold out to the individuals or business houses which
securitize the loans together and then sell off to the investors as a package for the investment of
later parties. These MBSs may be residential or commercial. However, in the USA, the MBSs
are issued by Government-sponsored agencies or investment houses. MBSs may be of different
types like Collateralized Debt Obligations (CDO) or Collateralized Mortgage Obligations
(CMO) etc (Glasserman and Tangirala, 2015).
In this context, it may be noted that the concept of MBS is closely linked with that of the process
of securitization which is complex in its own way. Generally, the process is undertaken in four
basic steps as shown herein:
 Mortgage notes are bought from banks, financial institutions or Government-sponsored
agencies.
 Such notes are assigned to a Special Purpose Vehicle (SPV).
 The SPV assembles these loans or notes and creates a “pool” of assets.
 Thereafter, these pools are securitized by using various kinds of MBSs.
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Importance of MBS in Risk Diversification
The securitization has been significantly important in diversifying the portfolio risks of the
investors. First of all, MBSs helped to introduce more fund in the capital market during the time
of inflation. Since the securities are from different and diverse sectors, the investment in such
pool of securities automatically assured risk diversification to a great extent.
It may be observed that the MBSs are primarily sold to individual investors and financial
institutions including the Government. The proceeds are used to offer other borrowers a number
of loans and as a result, it may be conceived that MBS is comparatively a liquid product which
provides liquidity and cash support to the investors when needed. This way the investors may
diversify their portfolio in terms of a cash crunch and liquidity related issues (Adrian and
Ashcraft, 2016).
In addition, it may also be stated that MBSs contributes towards the sharing of consumption risk
which further enables the banking and financial sectors of the country to provide credit even
during the crisis period. Such process, if continued, effectuates the normalisation of interest rate
and thereby diversification of risk across the economy (ROSS, 2017).
Role of MBS in Subprime Mortgage Crisis
Though MBSs provide liquidity within the economy and helps the banking sectors to reduce the
interest rate to an extent, the product is extremely unsafe in terms of its offering and hidden
systematic risks. In this context, it will be worth to mention about the subprime mortgage crisis
that occurred not only in the USA but almost throughout the world during the year 2007 to 2009
(Adelino, Schoar and Severino, 2016). The crisis happened after the radical decrease in home
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prices which further led to the closure of securities linked to the housing prices and thereby
devaluation of those securities and erosion of a large amount of capital of the investors.
The primary reason for such crisis may be attributable to the MBSs which used to offer a high
amount of interests along with high return expectations a well. However, when the signs of the
crisis were visible and prominent in the housing market, lots of financial institutions and credit
rating agencies were forced to close down their operations and the economy worldwide
experienced a significant amount of disruption in the credit flow which led to the global
recession in the year 2008 (Kolasinski and Yang, 2018). There were lots of investors with high
credit rating who also failed to pay and defaulted like other small investors (Guilford, 2017)
In addition, subprime lending played a crucial role here. Principally, subprime lending is those
loans which are offered to the borrowers having a lower credit rating and higher amount of risks
of non-payment. The delinquent borrowers are therefore priced loan with a higher amount of
interest rate and collateral support. During the period, lots of subprime loans were packaged and
sold in the market as MBSs that eventually defaulted (Usatoday30.usatoday.com, 2019).
Another viewpoint suggests that the banks and financial sectors provided lots of loans to the
house building owners or buyers without sufficiently judging their individual creditworthiness.
As a result, when the value of MBSs fell drastically and consistently, the borrowers also had no
money left at their disposal to pay out the debt obligations and even the bear the finance costs.
Therefore, the financial sectors experienced an acute liquidity crisis.
In this context, it may also be noted that MBSs may suffer from prepayment risks where the
borrowers may end up paying more than their debts, in terms of monthly instalment payments.
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Such a scenario is clearly detrimental to the interest rate and hence the rate reduces leading to
imbalance within the economy.
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