Challenger banks are not managing risk effectively as they are aggressively growing their balance sheets and have adopted an "overly optimistic" view of stress scenarios, the Bank of England has found.
In a Dear CEO letter to ‘fast growing firms’ published last week (June 12), a senior regulator said the bank’s review of such firms, aimed to test their financial resilience, had found widespread weaknesses in their risk management.
The review used the BoE’s stress test scenario — the same applied to major banks — which is more severe than the latest global financial crisis and encompasses outcomes associated with the UK’s withdrawal from the EU.
It tested 20 unnamed firms which exhibited faster asset growth than the market as a whole.
The bank tested their resilience to a fall in GDP of 4.7 per cent, residential property and commercial property prices dropping by 33 per cent and 40 per cent respectively, a bank rate rise to 4 per cent and unemployment rising to 9.5 per cent.
In the assessment, the bank found that many new lenders were "overly optimistic" about the impact such a stress scenario would have on their business.
According to the letter, fast growing firms were exceedingly hopeful about their ability to raise capital, dispose of parts of their business and widen their margins in the context of a market-wide stress.
Many were unable to demonstrate an "understanding of the stress drivers for their business" or to explain the assumptions made in their stress testing models, while management plans related to stress testing were "poorly defined and lacked any clear trigger points" for action.
The review also showed that many fast growing firms had ambitious growth plans and therefore expected the additional income from new business to offset impairment charges on previous business in a stress scenario.
The central bank said while some firms could possibly capitalise on opportunities in a market-wide stress context, it was not "appropriate" to "assume significant growth would be available in falling markets".
These weaknesses were more prevalent due to the fact challenger banks tended to have a riskier loan book, the letter stated.
Melanie Beaman, the BoE’s senior supervisor, wrote: "Our overall concern was that fast growing firms could be underestimating the potential losses that could arise in their loan portfolios under the given scenario.
"This finding may reflect the fact that [challenger banks] have only existed during relatively benign credit conditions and have not experienced a downturn."
Ms Beaman went on to say that few fast growing firms explicitly took account of the average impairment rates published by the central bank, despite working in "higher-risk market segments" which were "more vulnerable to risk and stress".
A second part of the review, based on asset quality, showed that many of the firms investigated had risk appetite frameworks that were still evolving.
It found many statements did "not fully capture risk" or enable the level of risk to be "adequately" monitored.