Bank of EnglandJun 17 2019

Bank warns of risk management issues at challenger banks

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Bank warns of risk management issues at challenger banks

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.

On top of this the firms showed weaknesses in the underwriting of commercial loans and the review found instances of weak financial analysis, limited evidence of challenge and high levels of lending outside of policy.

Ms Beaman wrote: "[Firms] need to ensure they are prepared to react quickly in the event that credit conditions change."

Further investigations into fast growing firms’ funding and lending analysis re-enforced earlier findings that many challenger banks were reliant on easy access to retail funding and were in "pursuit of aggressive balance sheet growth targets".

Ms Beaman concluded that the findings warranted a general reminder of the importance for all firms to ensure their governance and risk management remained aligned with their business model risk profile and appetite.

The BoE also pointed out that the review provided reassurance about the overall resilience of the sector and that "some weaknesses is not unexpected" given the early stage of development of many fast growing firms.

Commenting on the letter, UK Finance, the bank trade body, said these types of lender provided a valuable source of finance for small businesses and consumers while "helping drive competition and innovation in the marketplace".

The spokesperson added: "The regulator’s feedback is helpful in supporting an improvement in the resilience of these kind of businesses as they grow.

"UK Finance will continue to support its members and liaise with the regulator to ensure this important part of the market continues to work effectively."

imogen.tew@ft.com

What do you think about the issues raised by this story? Email us on fa.letters@ft.com to let us know.