The world economy recovered in 2010, following its largest post-war contraction. But the return to growth has been uneven. Developed countries, some burdened by high levels of private and public sector indebtedness, grew more slowly while rapid growth in Asia has created inflationary pressures in commodities markets. The UK economy recovered briskly in the first half of the year but slowed in the second half with output contracting in the final quarter of 2010. Deleveraging in the private sector picked up pace from the previous year, supported by government spending and a more favorable macroeconomic environment. The coalition government has set out plans for fiscal consolidation. With a continuing need for gradual deleveraging in parts of the household and corporate sectors, the impetus for growth will have to come from corporate investment and overseas trade, requiring steady growth in the world economy. Rebalancing of the UK economy and adjusting to more sustainable debt levels in the more leveraged sectors will take time.

In 2010 the major UK-owned banks were profitable in aggregate and made further progress in building capital. Since the 2008 crisis, the FSA has used an interim capital framework by which banks are expected to hold sufficient core tier 1 capital to enable them to absorb potential losses in a severe stress scenario and still have a core tier 1 ratio of at least 4%. This section includes a description of our updated ‘anchor’ stress test scenario for the period 2011-2015. Regulators internationally have agreed on new capital and liquidity standards for banks. These address the excessive leverage and over-reliance on short-term wholesale funding that lay behind the financial crisis. But the shift to a more stable banking system will take time and this is reflected in the extended transition periods agreed upon for implementing the new Basel III standards. Making a number of assumptions, we illustrate how the major UK banks should be able to reach the core tier 1 ratio significantly above Basel III levels by 2019, provided dividend payout rates are not excessive. Although major UK banks continue to target returns on equity of 12 to 15%, those may not be achievable in the future, even if economic growth remains on track. The logical corollary of higher equity capital requirements, which will reduce the riskiness of banks, is that shareholders should be willing to accept lower returns on equity.