'Armageddon' Test Hits Co-op, Lloyds And RBS

Britain's eight biggest lenders would accumulate losses of £13bn during an 'Armageddon'-style recession in which the Co-operative Bank would see its capital reserves exhausted and the two state-backed banks severely tested.

The Bank of England (BoE) published on Tuesday the results of its inaugural annual stress tests, which concluded that Lloyds Banking Group and Royal Bank of Scotland (LSE: RBS.L - news) (RBS) were among the worst performers six years after their huge taxpayer bailouts.

Lloyds and RBS, which is 80%-owned by taxpayers, were judged by the BoE to need to strengthen their capital based on their positions at the end of last year.

Under the test, which examined the banks' balance sheets during a hypothetical three-year period in which the UK slumped into its deepest recession for decades, RBS only just remained above a 4.5% capital 'hurdle rate' set by the BoE's Prudential Regulation Authority (PRA).

But both it and Lloyds were told by regulators that based on improvements made this year and future plans, neither would be required to submit revised blueprints for strengthening their balance sheets.

RBS announced on Tuesday the issuance of billions of pounds-worth of bonds which convert into shares in the event of its capital reserves falling below a specific level.

The BoE tested banks' resilience in the face of a situation under which interest rates rose to 4.2%, unemployment soared to 12%, house prices slumped by 35%, commercial real estate prices fell by 30%, and GDP crashed by 3.5%.

Those factors amounted to what would be a brutal UK recession, with approximately one-third of mortgage-owners projected to be in negative equity.

Data produced by the BoE showed that Lloyds would be projected to take £12bn of impairment charges on its UK mortgage lending during the hypothetical recession, well over half of the £21.9bn projected across the entire industry.

In total, the authorities forecast that between them, the banks would accumulate roughly £70bn of additional impairments under the stress scenario, approximately £46bn of which would relate to UK household and commercial real estate lending.

Regulators said the tests highlighted a positive overall picture of the British banking system, adding that it would "have the capacity to maintain its core functions" despite the huge losses forecast.

They said the Financial Policy Committee, which has powers to rein in mortgage lending and impose other restrictions on the industry, "judged that no system-wide, macroprudential actions were needed in response to the stress test".

The only lender to effectively fail the test and be ordered to submit a revised capital plan was the Co-operative Bank, which was saved from collapse last year after a rescue led by US hedge funds.

The Co-op Bank, which would see its capital exhausted by the BoE stress scenario, has proposed slashing the size of its business in the wake of huge losses on its commercial real estate lending.

The BoE disallowed any effort by banks to shrink their loan-books as part of the exercise, insisting that their role supporting the real economy by continuing to lend to homeowners and businesses remained unimpaired.

However, banks' ability to pay dividends could be jeopardised.

While neither Lloyds, which is 25%-owned by taxpayers, nor RBS has paid a dividend since their bail-outs in 2008, the BoE was explicit that they could be prohibited from doing so under conditions similar to those modelled in the test.

Of the eight lenders examined by the BoE, Barclays (LSE: BARC.L - news) , HSBC, Nationwide, Santander UK (LSE: 44RS.L - news) and Standard Chartered (HKSE: 2888.HK - news) produced widely varying results in the test, but the trough of each of their capital positions remained well above the BoE's 4.5% minimum requirement.

Standard Chartered was excluded from the calculation of UK loan losses because it undertakes minimal lending in the UK.

The UK test followed a similar exercise conducted by European regulators earlier this year.

Mark Carney, the Bank of England Governor, said the exercise had been "demanding" but insisted it painted a positive picture of the rebuilding of Britain's banking sector.

"The results show that the core of the banking system is significantly more resilient, that it has the strength to continue to serve the real economy even in a severe stress, and that the growing confidence in the system is merited."

The Bank reiterated on Tuesday that the stress scenario was hypothetical and did not reflect a forecast for economic conditions in the UK.

Ewen Stevenson, RBS chief financial officer, said: "We have made good progress during 2014 in both strengthening our capital ratios and reducing higher risk exposures.

"However, we recognise that there is still much work to be done to improve the resilience of our balance sheet."