17 February 2020

Bank of England: How would banks cut their distributions in a period of economic stress?

Banks pay out many types of distributions, including dividends and bonuses. If their capital position deteriorates, banks can cut their distributions. These latest stress-test results show that banks would cut their distributions by £41 billion in a stress scenario.

Bank of England (BoE) carries out stress tests to see if banks have enough capital to cope with a range of hypothetical economic situations. Each year, BoE assesses banks based on a stress scenario that reflects the risks they face. BoE published the results of its latest stress test in its December 2019 Financial Stability Report.

The stress test shows if banks have enough capital to keep lending during a period of economic stress. Banks must show us that their capital and leverage ratios would remain above the hurdle rates BoE sets for them, even in the stress scenario.

Banks can reduce costs in a period of stress by cutting the amount of retained earnings they pay out as distributions. This includes dividends, variable remuneration and coupons on their additional Tier 1 (AT1) capital instruments. These capital instruments can be converted into shares during a stress so they form part of a bank’s supply of capital, rather than an outstanding bond.

These latest stress-test results show that banks project paying out around £48 billion of distributions before the end of 2020 in the baseline scenario. However, in the stress scenario, banks would only pay out £6.8 billion.

Cuts to dividends account for 61% of the projected £41 billion reduction in distributions. Cuts to variable remuneration and coupons on banks’ AT1 capital instruments account for the remainder of the reduction in distributions.

During a period of economic stress, as banks use up their capital buffers, they face mandatory restrictions on how much of their retained earnings they can pay out as distributions. These latest stress-test results show that the majority of distribution cuts in the stress scenario relate to mandatory restrictions.

The rest of the projected cuts are voluntary, either in line with banks’ policies or at the discretion of their boards. It is important that investors know that banks could make these cuts during a period of stress.

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