Financial Policy Summary, 2023 Q3
The Financial Policy Committee (FPC) seeks to ensure the UK financial system is prepared for, and resilient to, the wide range of risks it could face – so that the system is able to absorb rather than amplify shocks and serve UK households and businesses
The overall risk environment
The overall risk environment continues to be challenging and near-term global growth prospects remain subdued. Long-term interest rates, particularly in the US, have risen to materially higher levels. Some parts of the global banking system and financial markets remain vulnerable to stress from increased interest rates, and are subject to significant uncertainty, reflecting risks to the outlook for growth and inflation, and from geopolitical tensions.
Financial market developments
Since the July Financial Stability Report (FSR), risk-free interest rates in advanced economies have risen further, and market participants are now firmer in their expectations that many policy makers will need to maintain high rates for a prolonged period. 10-year US government bond yields have risen to around 4.75%, their highest level since 2007. Euro area and UK long-term interest rates have also risen. In the UK, market pricing implies a lower peak Bank Rate than had been anticipated at the time of the July FSR, reflecting downside news on inflation and the near-term outlook for growth.
Given the impact of higher interest rates, and uncertainties associated with inflation and growth, some risky asset valuations appear stretched. Stretched risky asset valuations increase the likelihood of a greater correction in prices if downside risks to growth materialise. This would have a direct impact on the cost and availability of finance for corporates globally, and would affect riskier borrowers in particular.
Further material increases in risk-free interest rates, or a significant re-appraisal of credit risk globally, could also be amplified by vulnerabilities elsewhere in the system of market-based finance, with a broader potential impact on financial stability.
Higher interest rates continue to weigh on the ability of households and businesses in advanced economies to service and refinance their debts. Some banks in a number of jurisdictions will have been impacted by recent increases in long-term interest rates. Residential property prices have fallen and further falls are likely in many economies, and indicators suggest that CRE prices in many countries are decreasing significantly.
Longstanding vulnerabilities in the Chinese property market have crystallised further, and significant downside risks remain. Activity and prices have weakened in recent months and a number of developers have faced tightening financing conditions and liquidity pressures as sales have fallen. Chinese authorities have put in place measures to provide some support, aimed at limiting spillovers from losses being borne by creditors. A further deterioration in activity and prices could pose risks to the Chinese economy and its financial sector, which could impact the UK and other jurisdictions via trade or financial spillovers, including through disorderly asset price adjustments.
In common with mainland China, Hong Kong also has high private sector debt levels and elevated property prices, and UK banks’ exposures to Hong Kong are larger than those to mainland China. At present, however, there are limited signs of stress in Hong Kong property markets and there is greater security and seniority on Hong Kong exposures relative to Chinese exposures. Nevertheless, despite differences between the risk profiles of the two property sectors, should current challenges in China’s property sector lead to a significant downturn in the broader Chinese economy, spillovers to Hong Kong’s property market could be material.
The 2022/23 Annual Cyclical Scenario (ACS) stress test indicated that major UK banks were resilient to the direct effects of a severe downturn in mainland China and Hong Kong, including a very large shock to property prices in both markets. The FPC will continue to monitor closely developments in these property markets, and the potential for spillovers to UK financial stability.
Markets reacted in an orderly manner to the announcement by the Bank of Japan in July that it would conduct its yield curve control policy with greater flexibility. However, there is a risk that further policy changes could trigger larger or more volatile price adjustments, for example if they led to reallocations of government bond holdings across jurisdictions, or some Japanese banks incurring losses on their domestic government bond holdings.
UK household and corporate debt vulnerabilities
In the UK, household finances remain under pressure, and the full impact of higher interest rates has not yet passed through to all borrowers. The share of households with high debt servicing ratios – after accounting for the higher cost of living – is rising, and is expected to continue to do so through 2024. But the FPC continues to judge that it is likely to stay below the historic peak reached in 2007. In part, this reflects the FPC’s mortgage market measures, introduced in 2014 – including its loan to income flow limit on lending to borrowers with high loan to income ratios at or above 4.5 – and the FCA’s responsible lending requirements, which have limited the build-up of household indebtedness.
Owner-occupier arrears are low in historical terms, though there has been a modest increase. Some borrowers facing higher interest rates have taken out mortgages with longer-terms, and a small number have moved to interest only. There has, for example, been a notable increase in the proportion of borrowers taking out mortgages with 35 year or above terms, although this remains a small share of total mortgages. Such lending will be bound by FCA responsible lending rules requiring lenders to take account of future changes to income and expenditure, such as the borrower retiring, where that is expected to happen during the mortgage term.
UK banks remain in a strong position to support borrowers should they face difficulties servicing their debts.
Buy-to-let mortgagors are experiencing increases in mortgage interest payments in addition to some structural factors likely to put pressure on incomes from residential property. This could lead some landlords to sell, putting downward pressure on house prices, although net sales by landlords have not been significant so far. Buy-to-let landlords may seek to continue to pass on higher costs to renters, adding to other cost of living pressures.
There is evidence that some households are increasing the use of consumer credit in response to cost of living pressures and higher debt servicing costs, which could lead to greater debt vulnerability for households in the near-term.
A significant rise in unemployment would increase the likelihood of UK household debt vulnerabilities crystallising. UK unemployment remains low by historical standards at 4.3%, although employment indicators are generally softening with subdued economic activity.
Overall, the UK corporate sector is expected to remain broadly resilient to higher interest rates and weak growth. However, the full impact of higher financing costs has not yet passed through to all corporate borrowers, and will be felt unevenly, with some smaller or highly leveraged UK firms under pressure. Corporate insolvency rates have continued to rise, albeit from very low levels.
Larger corporates were in a stronger position going into this period of rising interest rates relative to previous tightening cycles. The bulk of outstanding fixed-rate UK corporate debt matures in or after 2025. As a result, refinancing needs for larger firms are likely to be limited in the near-term, and firms have some time to adjust their business plans, which should help to limit risks associated with re-financing and higher debt servicing costs.
The UK CRE sector continues to face a number of challenges, both from higher interest rates and structural factors. CRE prices in the UK have reacted more quickly to market developments, having fallen further than in some other jurisdictions, such as the US and Europe. UK banks have reduced their exposures to UK CRE over recent years, and arrears on their exposures are still low by historical standards.
UK banking sector resilience
The UK banking system is well capitalised, supported by strong recent profitability, and has high levels of liquidity.
There is a wide range of business models amongst smaller and medium-sized UK banks, some of which are specialised in particular activities or serve particular sectors. A more challenging environment can affect these business models in different ways.
The FPC continues to judge that the UK banking system is resilient to the current economic outlook and has the ability to support households and businesses even if economic and financial conditions were to be substantially worse than expected.
Expected increases in credit losses related to the challenges facing UK households and corporates are well within the levels of losses projected in the 2022/23 ACS stress test. The ACS indicated that major UK banks could withstand a severe macroeconomic downturn whilst continuing to support UK households and businesses.
Forward looking indicators of UK banks’ asset quality remain relatively stable overall, though arrears have started to increase from historically very low levels and are expected to rise further. Recent weakness in lending appears to reflect weaker demand and previous tightening in banks’ risk appetite. The FPC continues to judge that the tightening in UK credit conditions has reflected changes to the macroeconomic outlook rather than defensive actions by banks to protect their capital positions.
The UK countercyclical capital buffer rate decision
In light of its assessment of financial vulnerabilities and the resilience of the UK banking system, the FPC has decided to maintain the UK CCyB rate at 2%. The FPC will continue to monitor developments closely and stands ready to vary the UK CCyB rate, in either direction, in line with the evolution of economic and financial conditions, underlying vulnerabilities, and the overall risk environment.
To support the FPC’s and Prudential Regulation Authority’s (PRA) monitoring and assessment of the resilience of the UK banking system to potential downside risks, the Bank intends to run a desk-based stress test exercise, rather than an ACS, in 2024. The desk-based exercise will use Bank models and expertise to test the resilience of the UK banking system. A key benefit of a desk-based exercise will be to allow for that resilience to be tested to more than one adverse macroeconomic scenario. The Bank currently intends to return to a concurrent exercise involving firm submissions of stressed projections in 2025.
The Bank will also take stock of, and update, its framework for concurrent bank stress testing in 2024, drawing on lessons learnt from its first decade of concurrent stress testing.
Alongside the desk-based stress test exercise, the Bank is currently carrying out a system-wide exploratory scenario (SWES), launched in June, which aims to improve understanding of the behaviours of banks and non-bank financial institutions in stressed financial market conditions. The participating firms in this exercise are representative of markets that are core to UK financial stability. The initial stress scenario will be published in 2023 Q4.
The resilience of market-based finance
Vulnerabilities in market-based finance (MBF) remain. The FPC judges that the scale of these is broadly unchanged since the July FSR. Should such vulnerabilities crystallise in the context of sharp movements in asset prices, they could amplify any tightening in credit conditions, and so affect households and businesses.
Hedge funds continue to maintain material leveraged positions in US Treasuries, including in the cash-futures basis trades that had contributed to dysfunction in the US Treasury market in March 2020. The FPC will continue to monitor risks to core market functioning and broader financial stability posed by leveraged trades in government bond markets, and welcomes the PRA’s recent ‘Dear CRO’ letter following the PRA’s thematic review of regulated banks’ liquid fixed income financing businesses.
A Financial Stability in Focus released today sets out the FPC’s approach to identifying, assessing, monitoring and mitigating vulnerabilities in MBF. As the FPC has previously stated, there is an urgent need to address these vulnerabilities. Market-based finance comprises a broad and complex universe of very different firms and business models connected by a range of financial market infrastructures, both within and between jurisdictions. Policy work to reduce vulnerabilities and improve resilience therefore needs to happen at an international level and involve a range of regulatory authorities. Alongside international policy work led by the Financial Stability Board, the UK authorities are also working to reduce vulnerabilities domestically where it is effective and practical.
The FPC’s resilience framework for liability-driven investment (LDI) funds introduced in 2023 Q1 has been functioning broadly as intended in an environment of higher market interest rates. Funds have maintained overall levels of resilience consistent with the minimum levels recommended and have initiated recapitalisation at higher levels of resilience than previously, although there remain some areas for improvement. It is important that work to put in place a monitoring and enforcement framework for pooled funds by the FCA and relevant international regulators continues.
The Bank is continuing to work with other UK authorities to improve the resilience of money market funds (MMFs). The UK authorities will publish a consultation paper on MMF regulation later this year. Significantly more liquid assets than currently required is likely to be the most effective way to increase MMF resilience and so reduce risks to financial stability, since higher levels of liquidity increase the range of stresses MMFs are resilient to. Bank staff analysis suggests that weekly liquid asset levels in the region of 50-60% of assets would give a high level of assurance that sterling denominated MMFs would be resilient to severe but plausible stresses.