What to expect from UK bank stress test

British banks passed Eurozone stress tests back in October, and although the Bank of England's own risk assessment will be more stringent, most lenders are widely expected to pass with flying colours. Even Royal Bank of Scotland and Lloyds Banking Group are tipped to stay above the 4.5% hurdle rate if capital actions in 2014 are included. We'll find out first thing Tuesday morning.

As well as RBS and Lloyds, the central bank will test the ability of Barclays, HSBC, Standard Chartered, Co-operative Bank, Nationwide and Santander UK to withstand shocks to the financial system.

An EU-wide stress test of 123 banks, carried out by the European Banking Authority (EBA) in October, revealed EU banks' common equity ratio (CET1), or capital adequacy, falls by 260 basis points over three years from 2013-2016 to 8.5%.

But the UK central bank tests include additional scenarios for housing stress and interest rate shock. Using a dynamic balance sheet definition will also mean the size and composition of banks' balance sheets are allowed to vary over the time horizon.

"Our expectation remains that the UK stress test results on 16 December are likely to show that large UK banks under our coverage have made enough capital progress to absorb the tail risks outlined," says JP Morgan.

But some may struggle, especially the Co-op whose boss Niall Booker has already hinted his company, currently sitting on billions of pounds of sub-prime mortgages, could fail the test.

And the EBA test, which revealed largely lower-than-expected adverse stress test capital ratios for the UK banks, raised some concerns about the ability of both Lloyds and RBS to begin paying dividends again. However, JPM reckons Lloyds will restart its regular payout to shareholders at its full-year results. By 2016 it could boast a dividend yield of 6%. Says the broker:

In our view, the exercise is unlikely to provide full clarity on the required amount of capital for UK banks and hence some uncertainty over capital return could persist. However, we believe that regulators are likely to be supportive of banks paying dividends based on sustainable earnings and with Lloyds likely to report statutory profits in 2014 (EPS of 2.1p) with a CT1 of 12.2%, we expect a resumption of dividend payments with the FY'14 results.

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