A shoulder to spy on

The Bank of England is about to peer further over bank bosses’ shoulders. Not content with monitoring its charges’ solvency, the central bank said on Monday that future stress tests would look into whether lenders’ earnings will exceed the cost of equity. It’s not usual for a regulator to muscle in on what is normally a matter for investors, but it makes sense.

The lack of economic profit at the seven banks in question is worth fretting about. On average the lenders, which include Barclays and Royal Bank of Scotland, have a cost of equity of 12 percent, says a person familiar with the central bank’s thinking. Their average 2016 return on equity was just 5 percent, even on a generous underlying basis that ignores one-off expenses.

Subjecting these meagre returns to a long-term stressed scenario carries dangers. It could force lenders to take more risk than is sensible in order to create a return in excess of what shareholders demand. And it could bring free-marketers out in a rash. Setting strategy for Barclays and Lloyds Banking Group from Threadneedle Street sounds problematic. Imagine if a nervy Bank of England winds up vetoing a legitimate business decision.

Still, UK lenders’ levels of capital, the bank’s usual focus, are largely under control. The regulator could even consider loosening requirements should an accounting change known as IFRS 9 or global Basel capital rules prove onerous. Lowly returns are potentially a bigger problem.

The so-called Biennial Exploratory Scenario will happen only once every two years, and the results will not be made public. Properly handled, it should give the regulator a helpful sense of banks’ increasingly creative attempts to generate a decent return. The risk that these go awry justifies trampling on a few banker toes.

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