Last Thursday's Financial Stability Report (FSR) re-examines the banking system's possible loan losses based on the Monetary Policy Committee's (MPC) latest central economic projection. In May the MPC projected a 14 per cent fall in GDP, which has now been revised down to a still significant but less impactful 5.4 per cent fall. This is coupled with a 7.5 per cent unemployment rate, lower than the May projection. As a result of the May desktop stress test the Financial Policy Committee expected loan losses of £80 billion, which banks could cover with their ample capital buffers over and above the regulatory capita minimum. This figure has now been revised down to ?less than £80 billion? based on the improved economic outlook causing fewer customers to default on their loans.

However, the FSR describes the results of a ?Reverse Stress Test? which is different from the May stress test. A reverse stress test asks a different question, not ?how bad could it get?? based on a posited economic scenario but instead ?how much worse would it have to be?? in this case for banks? capital ratios to fall by 5.2 per cent, which is the level of capital depletion that banks were tested against in the 2019 Annual Concurrent Stress test.

The results of the Reverse Stress Test suggest that even if credit losses of £120 billion did materialise, causing them to burn through 5.2 per cent of their capital, major UK banks would still have buffers of four per cent  above their minimum requirements. Only if cumulative losses exceeded £200 billion, two and a half times the current expectation, would banks breach their minimum capital requirements.

The FPC's Reverse Stress Test ?reverses out? two alternative pathways for the economy, either of which could generate £120 billion in credit losses.

Each of the two pathways is dependent on how the Covid-19 outbreak develops in the UK and beyond up to the end of 2022. One suggests a gradual but slow and steady recovery, the other suggests that further lockdowns at the end of this year will cause a second fall in economic activity which would then pick up more quickly. The paths are extremely severe - much more impactful than experienced in previous economic downturns - and more so than the MPC's revised central economic projection.

It is important to understand that the reverse stress test is not a prediction of what could happen, but rather a means for understanding how banks might fare if the UK economy did encounter one of the pathways.

While it is comforting to know that UK banks can absorb further shocks before depleting all their capital buffers, reading the FSR reminds us that economic activity is the sum of a huge range of individual choices. Every member of society can play their part in ensuring that the Covid-19 reverse stress test scenarios do not become a reality. And the best way we can do that is by following government advice - staying alert, controlling the virus and saving lives.