Stress Signals: What the 2025 Capital Test Means for Small- and Medium-sized Banks
With the Bank of England’s 2025 Bank Capital Stress Test now in motion, small and medium-sized banks should take note. While only the large banks participate directly, it is nonetheless of interest for other firms as they approach their next stress testing exercise. The latest publications bring stress parameters up to date from the 2024 Desk-based Stress Test, and some elements have changed. This article explores what banks can take away from the latest stress programme and how to reflect those developments in their own risk management processes.
Background
On 24 March 2025, the Bank of England (BoE) announced its latest stress testing exercise — the 2025 Bank Capital Stress Test (BCST). This comes on the back of the 2024 Desk-based Stress Test (DBST) - published 27 June 2024, in connection with which the Prudential Regulation Authority (PRA) announced the 2024 ICAAP Scenarios for non-systemic firms (read our earlier article here). Results are to be published by the BoE in Q4 2025.
The new BCST builds on the 2024 DBST/ICAAP Scenarios by focusing on a global aggregate supply shock that triggers recessions affecting both the UK and global economies, accompanied by rising interest rates and significant falls in asset prices.
While the BCST incorporates stressed levels of misconduct costs, many small- and medium-sized firms will assess these aspects separately within their idiosyncratic stress scenarios (and may combine them with market-wide aspects in an integrated combined stress). Accordingly, some firms might elect to carve out the conduct-related elements from the BCST, if they elect to use it for their market-wide stress.
The ICAAP scenarios published alongside the stresses for the larger banks are commonly used by small- and medium-sized firms in their own stress testing exercises: not only do the scenarios reflect the thinking of the UK’s central bankers and policymakers, but they also provide a useful severity benchmark that can offer management teams and Board members comfort when evaluating their own bank’s stress tests.
Beyond the relevance for their capital planning and stress testing initiatives, small- and medium-sized banks have an indirect interest in the outcome of the BCST at a broader level: the BoE previously indicated, in its Approach to Stress Testing the UK Banking System, that the Financial Policy Committee (FPC) would use the results of capital stress tests when evaluating the appropriateness of the countercyclical capital buffer (CCyB) rate for the UK as a whole. If results indicate that capital buffers are insufficient, it may act to raise the CCyB rate, which would have implications for the majority of firms.
Relevance of the New Scenario for Stress Testing
While the PRA’s ICAAP Scenarios are invaluable for small- and medium-sized banks, there can be challenges with implementing them as part of a modelling exercise — primarily this relates to timing.
Banks often deliberate on how to treat stress variables when their own stress tests begin at a different reference date or span a different time horizon. Firms may also debate how to address divergence between observed macroeconomic variables and the stressed projections: “Should we accelerate this variable to reach the low point sooner?”, “Under stress, this variable would immediately and sharply increase; however, in reality it has fallen over the last two quarters – what does this mean for our stress test?” In addition, the geopolitical environment is evolving rapidly, meaning that the specifics of earlier stress testing exercises may be overtaken by more immediate concerns.
Unlike in prior years — where concurrent stress testing exercises were accompanied by scenarios for smaller firms, such as the 2024 DBST and the 2022 Annual Concurrent Stress Test (ACS)– the BCST has not, as yet, been complemented with an equivalent set of stresses for non-systemic firms.
One may still be forthcoming; however, in the interim, we would encourage banks preparing for their next stress testing exercise to consider adopting the principles of the BCST.
We see three key benefits to doing so:
As highlighted above, the stress variables have been brought up to date with economic developments over 2024 and into 2025. This helps avoid the need to manage or adapt earlier-announced variables whose trajectories have since diverged. This is particularly relevant given that the 2024 ICAAP Scenarios are now somewhat dated, with stresses commencing in Q1 2024.
For firms seeking to stay abreast of evolving economic risks – particularly those that run stress testing exercises between formal ICAAP updates – the BCST offers the most up-to-date benchmarks available.
The BCST introduces a pragmatic simplification by focusing on a single macroeconomic stress, in contrast to the two scenarios featured in last year’s stresses (a demand shock (rates down) and a supply shock (rates up)). This may help to streamline the scenario selection process.
Updated Stress Parameters in the 2025 BCST
The BCST sees stress events commencing in Q1 2025, 12-months later than the scenarios used in 2024 ICAAP Scenarios. Naturally, this allows macroeconomic variables to be brought into line with prevailing economic conditions. While the scenario continues to reflect a supply-side shock, there are nonetheless some changes to the underlying parameters.
These evolving stress variables offer banks the opportunity to ensure their own stress testing remains as current and relevant as possible, and that scenarios are suitably aligned with emerging risks and geopolitical developments.
Below, we provide a comparison of selected parameters that are likely to be of relevance for small- and medium-sized firms. As many business plans are developed around a forward-looking 3-year horizon, we have focussed on the years 2025 to 2027 for the BCST (although the stress extends across a 5-year period). For comparison, we present the 2024 ICAAP Scenario – the supply shock variant – beginning in Q1 2024.
Bank Rate
There is a notable divergence in both the level and trajectory of policy rates. Under the BCST, Bank Rate peaks at a level 1pp below that of the 2024 ICAAP Scenario (a reduced peak of 8%). This high point is also reached more gradually, and immediately begins to fall the following quarter, but the return towards the baseline level occurs at a slower pace.
Source: Bank of England and Katalysys calculations
Inflation
With inflation having fallen since the 2024 parameters were set, the BCST starts from a level just under 2pp lower. The peak also tops out at 10%, approximately 2.3pp below that seen in the 2024 ICAAP Scenarios (supply shock variant).
Source: Bank of England and Katalysys calculations
Residential House Prices
Residential house prices follow an equivalent path under the BCST, troughing at 28% below the base case values, which is consistent with the 2024 ICAAP Scenarios. As firms typically focus on the net change, this represents no material divergence from the prior year’s assumptions.
Source: Bank of England and Katalysys calculations
Unemployment
The peak in UK unemployment remains unchanged, but now occurs 4 quarters later, in Q1 2027. Given the BCST begins a year after last year’s version, this timing shift is straightforward to rationalise.
Source: Bank of England and Katalysys calculations
Conclusion
While the BCST is aimed at the largest UK banks, for small- and medium-sized firms the scenario provides a valuable marker for aligning internal stress testing practices with current economic realities.
As firms look to update their ICAAPs or undertake an interim review of stress testing, the BCST (or at least drawing on its structure and assumptions) offers a timely opportunity and a useful benchmark. It also reflects the BoE’s latest thinking on potential vulnerabilities within the UK banking system, providing banks with a credible basis for evaluating their financial resilience.
How We Can Help
At Katalysys, we support banks in delivering robust, proportionate, and forward-looking ICAAP and ILAAP exercises, with a particular focus on effective stress testing. Whether it’s running Board and management workshops, selecting appropriate stress scenarios aligned with a bank’s unique risk profile, or building tailored capital and liquidity stress models, we work closely with our clients to ensure clarity and insightful analysis.
We help firms navigate changes in the macroeconomic environment and apply credible stress scenarios that reflect current risks. Our team of specialists is dedicated to demystifying the stress testing process, ensuring the stress testing framework is both fit-for-purpose and consistent with best practices.
From methodology to execution, we bring the knowledge and expertise to help firms build resilience and respond confidently to future challenges
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