Mark Carney, two years after taking charge at the Bank of England, was forced
to write a letter to the Chancellor explaining why inflation had climbed
above 3pc. By the end of 2014, it climbed above 6pc, and as output slumped,
it remained at that level for the next two years.

The Governor’s monthly inflation letters now arrived at Number 11, the
Chancellor mused, with the unhappy regularity of a gas bill.

As Britain threatened to fall back into recession, the Bank resisted raising
interest rates for as long as possible. The important thing, Mr Carney
maintained, was giving the economy the support it needed to get back on a
solid footing.

The Monetary Policy Committee quickly broke ranks, however. Once the newspaper
columnists began harping about Weimar Germany, it was clear that rate hikes
would have to start coming. In the winter of 2015, interest rates rose to
4pc. The Bank successfully prevented inflation hitting double digits, but
the effect on the rest of the economy was tremendous. By January 2016, GDP
in real terms had shrunk 3.5pc in two years.

Unemployment hit 12pc, a level the UK had not seen for 25 years. The housing
market, which at the start of 2014 had looked set to surpass 2008’s highs,
collapsed. Nobody could afford a mortgage in the new interest rate
environment. Defaults spiked.

Within two years, house prices were down by 35pc. London suffered even worse,
and commercial property prices collapsed too. As the Chancellor’s car headed
up to Threadneedle Street, he saw that even in the City of London – which at
one point appeared impervious to the wider economy – few lights were on.

If this picture sounds scary, it is supposed to be. But, according to the Bank
of England, the UK’s eight biggest banks must prove that they are ready for
it. On Tuesday, the Bank will release the results of its
inaugural stress tests, its examination of whether the banks would
still be afloat if interest rates spike, property prices collapse, and the
stock market goes haywire.

The financial crisis showed that the banking sector was woefully unprepared
for any downturn, resulting
in tens of billions of pounds of taxpayer money being used to bail it out.
As a result, the banks have been forced to shore up their finances.

Post-crisis, they are conforming to strict standards on capital, lending
standards and loss-absorbing debt. But, says the Bank, this is not enough.

“Just using the capital ratio and hoping for the best, that’s what we did
prior to 2008,” says Paul Sharma, the former deputy head of the Bank’s
Prudential Regulation Authority who now works at Alvarez Marsal, the
consultancy. “We want our major banks to be able to withstand a crash.”

In reality, the crisis being imagined would require a highly unlikely series
of events to occur. “[The stress scenario] is not a set of events that is
expected, nor likely, to materialise,” the
Bank has said. “Rather, it is a coherent, ‘tail-risk’ scenario that
is designed to assess the resilience of UK banks and building societies.”

The European Banking Authority, the EU’s banking supervisor, conducted
its own stress tests in October. The four British banks involved
passed, although some narrowly, and the UK test is seen as significantly
more difficult.

The eight banks will be measured on their response to 10 factors – GDP,
inflation, unemployment, interest rates, sterling, house prices, commercial
property prices, stock markets, wages and bond yields – all going the wrong
way. But there is one in particular that could see one or two lenders sail a
little close to the wind.

The 35pc decline in house prices being tested by the Bank compares with the
20pc fall the EBA stressed for. It is the UK’s major mortgage lenders that
are most in the spotlight this week.

“The stress test scenario is a more severe one, especially with respect to the
house price fall,” Mr Sharma says. “It’s a different and more severe stress
test.”

Over the past few months, Royal Bank of Scotland, Lloyds, HSBC, Barclays,
Standard Chartered, Santander UK, Nationwide and the Co-operative Bank have
been figuring out exactly how they would fare.

To pass, their sums, which will be checked by the Bank, must show that Common
Equity Tier 1 capital ratio – a bank’s key measure of financial safety –
would be above 4.5pc throughout the so-called “adverse scenario”. Should
they fail, they can in theory be forced to raise more capital, through
selling assets or shares.

Of the eight banks under the microscope, most are not seen as being at risk of
failing. Most of HSBC and Standard Chartered’s business occurs outside of
the UK, Barclays would not be as affected by a housing collapse as its
peers, and Nationwide and Santander are believed to be well-capitalised
enough.

RBS, out of the four banks to be subject to the EBA’s stress tests in October,
came closest to failing: The
bank embarrassingly admitted that it overstated its EU stress test results
last month, meaning it scraped through by just 0.2 percentage
points. It is expected to have fared better in the Bank of England tests,
which unlike the European ones take into account expected profits and asset
sales.

The two banks under most pressure on Tuesday are Lloyds and the Co-op Bank.
The former, as the UK’s biggest mortgage lender, is most exposed to the
interest rate spike, and subsequent plunge in house prices, envisaged by the
stress test.

Although the bank passed the EBA’s tests in October, it fared worse than
expected, sending shares falling the next day. Since the UK tests envisaging
a much harsher scenario for the housing market, a few worries have crept in.

“We see Lloyds most at risk [of the listed banks], due to its large exposure
to UK mortgages,” says Andrew Coombs, a banking analyst at Credit Suisse.

Ed Firth of Macquarie says that under his forecasts the bank fails, and rates
the chances of Lloyds passing at around 50-50.

The Co-op Bank is a different story. The lender has already admitted that it
is not robust enough and is widely assumed to have failed the tests. “Almost
70pc of our customer assets are residential mortgages and it has always been
clear to ourselves and the regulator that we are vulnerable to these tests
at this point in our turnaround,” Niall Booker, the bank’s chief executive
said this month. “It will come as no surprise if the bank does not meet the
desired capital ratios in the stress tests.”

The Co-op Bank, which was taken over by private equity groups last year after
a £1.5bn black hole emerged in its accounts, has already had
its capital raising proposals signed off by the Bank of England. But a
particularly poor result on Tuesday could mean the plan being tweaked.

Whatever Tuesday’s results are, this year’s stress tests will by no means
count as a clean bill of health for Britain’s banks. Another test will come
next year, and there will be regular ones after that.

Future versions of the test are expected to be tougher: the numbers may be
more closely scrutinised, for example, and other aspects such as banks’
leverage ratios – a measure of financial strength that is tougher on
mortgage providers – may be tested alongside capital ratios. UK subsidiaries
of foreign banks are also likely to be drawn into the tests.

For the companies involved, which have raised tens of billions of pounds in
capital in recent years, this is just another regulatory barrier to profits.
But if there is one solace granted to our fictional chancellor, it is that
his banks are likely to stay afloat for the foreseeable future.