LONDON—U.K. bank regulators are launching a new type of "stress test" that forces banks to consider unlikely but potentially disastrous scenarios like a flu pandemic or disruptions to the country's food-supply chain.
Disaster Planning
Scenarios U.K. banks are evaluating under new FSA 'stress tests'
It is a far cry from the comparatively quaint variables, bursting property bubbles and economic downturns, that regulators traditionally have used to gauge banks' financial health.
The latest exercise, which the U.K.'s Financial Services Authority instructed banks to start conducting in mid-December, is dubbed a "reverse stress test." It requires banks to identify potentially fatal events and then to work backward to find ways to revamp their businesses so they would be better prepared to withstand such shocks.
After being caught flat-footed by the financial crisis that nearly toppled two of the U.K.'s largest banks, the FSA sees the tests as part of prudent contingency planning. The agency last year told banks that the exercise is designed to spur them to "explore more fully the vulnerabilities of their current and future business plans."
Bankers call it the latest example of regulatory overkill. Executives protest that they are wasting countless hours dreaming up outlandish doomsday scenarios.
The chief executive of a major U.K. bank said the tests are predicated on "a massive confluence [of] absurd scenarios" in which executives passively watch events unfold rather than trying to stabilize the situation.
Bankers are especially worried that the process could result in them being forced to hold more capital. The FSA said in a planning document that the tests "may result indirectly in changes to the levels of capital held by firms" if the exercise "identifies business model vulnerabilities that have not previously been considered."
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An FSA spokeswoman defended the exercise. "It might seem outlandish to them, but the point is that it pushes the business model to the point it collapses," the spokeswoman said. She said the banks also should be evaluating relatively mundane situations like what they would do in the event of a major internal fraud.
The U.K. arms of foreign banks, including U.S. investment banks, also are subject to the tests, although they face a more gradual timetable than British lenders for conducting the exams. One Wall Street bank's London unit is likely to look at how it would fare in a global liquidity crisis, said a person familiar with the matter.
Meanwhile, the man likely to be Ireland's next prime minister said the government should wait until a round of stress tests on the country's banks has been completed before recapitalizing them.
In an interview Thursday, Enda Kenny said it would be "prudent and realistic" to wait "to see if there is another black hole in the banks" before they receive any new capital injections.
Under the terms of the roughly €67 billion ($92 billion) bailout it negotiated for Ireland late last year, the government had been due to inject up to €10 billion into Bank of Ireland, Allied Irish Banks and EBS Building Society by the end of this month.
But the departing finance minister, Brian Lenihan, postponed the plan Wednesday until after the election, scheduled for Feb. 25, effectively leaving the decision to the next government.
In the U.K., the griping about the reverse stress tests comes as bankers mount a counteroffensive against what they perceive as overzealous U.K. regulation, especially when it comes to the amounts of capital and funding they are required to keep on hand.
Barclays PLC Chairman Marcus Agius complained in a letter last month to Treasury chief George Osborne that the situation is "resulting in a nonlevel playing field." Mr. Agius attached an eight-page report listing examples, including the reverse stress tests, of the FSA outpacing other regulators and international rules.
The new testing process highlights the lengths to which regulators are going to guard against a repeat of the global financial crisis, in which a confluence of events crippled banks around the world and sent many economies into recession.
In November 2008, the FSA pioneered the use of stress tests to determine how much more capital banks would need to weather a variety of unpleasant but plausible economic environments. The U.S. adopted that model in 2009 to help ease its banking crisis.
The European Union last year conducted stress tests of 91 banks, but they were widely panned for giving passing marks to almost all banks, including some that subsequently required taxpayer bailouts.
European officials now are negotiating the variables they will use in a second round of tests this spring. Those variables include factors such as economic growth rates and real-estate values.
Those exams are tame compared with the reverse stress tests getting under way at U.K. banks and other financial institutions.
In those, bank executives are supposed to run simulations of a series of scenarios and then take steps to fortify their companies to withstand such crises. Such steps could include drawing up new contingency plans, restructuring business lines or beefing up cash reserves.
The FSA doesn't dictate the terms of the exams, leaving it up to banks to choose the catastrophes that they prepare for. But those situations are subject to FSA vetting and, in at least some recent cases, agency officials have told executives they aren't looking at sufficiently severe events, according to people familiar with the matter. The FSA has insisted those banks take into account more-extreme possibilities.
The banks appear to be "having difficulty thinking of something that will satisfy the regulators," said Irving Henry, a director at the British Bankers' Association who specializes in regulatory issues.
As a result, bankers are evaluating some seemingly far-fetched possibilities, according to people involved in the process.
For example, they are calculating what would happen if a swine-flu pandemic wiped out most of their employees, contemplating questions regarding how the bank continues to operate and even who would restock cash machines.
Another scenario posed involves the potential for a Latin American coup that would knock out the bank's local operations, potentially trapping large sums of money thousands of miles away.
And at least one bank was asked to asses the impact of a full-fledged trade war between the U.S. and China.
Some scenarios are easier to imagine. Last spring, an Icelandic volcano erupted, sending a big ash cloud floating over the U.K. and other parts of Western Europe. What if a future eruption prevented air travel for months rather than weeks?
The banks maintain that they would be doing this type of contingency planning without prodding from the FSA. Having regulators looking over their shoulders, demanding clear-cut answers and the completion of hundreds of spreadsheets, is simply making the process more cumbersome, bank officials said. It is "risk planning gone mad," one bank executive said.
—Guy Chazan contributed to this article.Write to David Enrich at david.enrich@wsj.com
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