Financial Policy Summary and Record - July 2021

The outlook for financial stability

Support for the economy during the pandemic

The UK financial system has provided support to households and businesses to weather the economic disruption from the Covid pandemic, reflecting the resilience that has been built up since the global financial crisis, and the exceptional policy responses of the UK authorities.

In recent months, the rapid rollout of the UK’s vaccination programme has led to an improvement in the UK economic outlook. But risks to the recovery remain. Households and businesses are likely to need continuing support from the financial system as the economy recovers and the Government’s support measures unwind over the coming months.

The UK banking system has the capacity to continue to provide that support. The FPC continues to judge that the banking sector remains resilient to outcomes for the economy that are much more severe than the Monetary Policy Committee’s central forecast. This judgement is supported by the interim results of the 2021 solvency stress test.

The FPC expects banks to use all elements of their capital buffers as necessary to support the economy through the recovery. It is in banks’ collective interest to continue to support viable, productive businesses, rather than seek to defend capital ratios by cutting lending, which could have an adverse effect on the economy and, consequently, on banks’ capital ratios. To support this, the FPC expects to maintain the UK countercyclical capital buffer rate at 0% until at least December 2021. Due to the usual 12‐month implementation lag, any subsequent increase would therefore not be expected to take effect until the end of 2022 at the earliest.

The FPC supports the Prudential Regulation Committee’s (PRC’s) decision that extraordinary guardrails on shareholder distributions are no longer necessary, consistent with the return to the Prudential Regulation Authority’s (PRA’s) standard approach to capital‐setting and shareholder distributions through 2021. The FPC judges that the interim results of the 2021 solvency stress test, together with the central outlook, are consistent with the PRC’s decision.

Debt vulnerabilities

As the economy recovers, the FPC will continue to remain vigilant to debt vulnerabilities in the financial system that could amplify risks to financial stability.

The FPC judges that UK corporate debt vulnerabilities have increased modestly. The increase in indebtedness has not been large in aggregate, but has been more substantial in some sectors and among small and medium‐sized enterprises (SMEs). UK businesses’ aggregate interest payments as a proportion of earnings did not increase over 2020, and are around historic lows. And a large part of the additional debt taken on by companies has been issued at relatively low interest rates via government‐sponsored loan schemes. Support from the financial system and the Government has helped to keep business insolvencies relatively low. However, companies with weaker balance sheets, particularly in sectors most affected by restrictions on economic activity and SMEs, may be more vulnerable to increases in financing costs.

The share of households with high debt‐servicing burdens has increased slightly during the course of the pandemic, but remains significantly below its pre‐global financial crisis level. House price growth and housing market activity during 2021 H1 were at their highest levels in over a decade, reflecting a mix of temporary policy support and structural factors. However, so far, there has only been a small increase in mortgage borrowing relative to income in aggregate, and debt‐servicing ratios remain low. The FPC’s mortgage market measures are in place and aim to limit any rapid build‐up in aggregate indebtedness and in the share of highly indebted households. The FPC is continuing its review of the calibration of its mortgage market measures.

Increased risk‐taking in global financial markets

Risky asset prices have continued to increase, and in some markets asset valuations appear elevated relative to historical norms. This partly reflects the improved economic outlook, but may also reflect a ‘search for yield’ in a low interest rate environment, and higher risk‐taking.

The proportion of corporate bonds issued that are high‐yield is currently at its highest level in the past decade, and there is evidence of loosening underwriting standards, especially in leveraged loan markets. This could increase potential losses in a future stress, and highly leveraged firms have also been shown to amplify downturns in the real economy.

Asset valuations could correct sharply if, for example, market participants re‐evaluate the prospects for growth or inflation, and therefore interest rates. Any such correction could be amplified by vulnerabilities in market‐based finance, and risks tightening financial conditions for households and businesses.

Building the resilience of the financial system

Market‐based finance

It is important that market‐based finance is resilient to, and does not amplify, shocks. The FPC has previously identified a number of vulnerabilities in the sector. In March 2020, these vulnerabilities amplified the initial market reaction to the pandemic to create a severe liquidity shock (the ‘dash for cash’). This disrupted market functioning and threatened to harm the wider economy. Significant policy action from central banks was needed to restore market functioning.

The FPC strongly supports the work, co‐ordinated internationally by the Financial Stability Board (FSB), to assess and, where necessary, remediate the underlying vulnerabilities associated with the March 2020 ‘dash for cash’. Such work is necessarily a global endeavour, reflecting the international nature of these markets and their interconnectedness.

To reduce the likelihood and impact of disruptions to market‐based finance in the future, the FPC has identified the following areas of focus: reducing the demand from the non‐bank financial system for liquidity in stress, ensuring the resilience of the supply of liquidity in stress, and potential additional central bank liquidity backstops for market functioning. In particular:

• To address vulnerabilities in the global money market fund sector, a robust and coherent package of international reforms needs to be developed. The FPC welcomes the publication of a consultation paper by the FSB, which sets out policy proposals to enhance the resilience of Money Market Funds.
• The FPC supports the international work, co‐ordinated by the FSB, to understand the role of leveraged investors in government bond markets.
• The FPC supports international work to assess whether there was more procyclicality in margin calls than was warranted, whether market participants were prepared for margin calls in a stress, and any consequent need for policy in light of this, without compromising the benefits of the post‐global financial crisis margining reforms.
• The FPC judges that there would be value in exploring ways to enhance the capacity of markets to intermediate in a stress, without compromising on the resilience of dealers.
• In order for central banks to deal effectively with financial instability caused by market dysfunction, the FPC supports examining whether new tools are needed specifically for this purpose. Any tools would need to be both effective and minimise any incentives for excessive risk‐taking in the future through appropriate pricing and accompanying regulatory requirements.

The FPC supports the development of international standards through the FSB work and, consistent with its statutory responsibilities, remains committed to the implementation of robust standards in the UK. The FPC will continue to undertake its own assessment of the resilience of market‐based finance on a regular basis, and in light of the FSB’s work, will consider whether there may be a need for additional policy responses in the UK.

The joint Bank‐Financial Conduct Authority review of open‐ended investment funds

As the FPC has noted previously, the mismatch between redemption terms and the liquidity of some funds’ assets means there is an incentive for investors to redeem ahead of others, particularly in a stress. This first‐ mover advantage has the potential to become a systemic risk by creating run dynamics. It could result in forced asset sales by funds, further amplifying asset price moves and, by testing markets’ ability to absorb sales, contributing to dysfunction in markets of the sort observed in March 2020. This could impair the issuance of new securities and thereby disrupt the supply of credit to the real economy.

As part of its domestic work to identify and reduce vulnerabilities in market‐based finance, the Bank and Financial Conduct Authority (FCA) have concluded their joint review into risks in open‐ended funds. In doing so, the Bank and FCA have developed a possible framework for:

• how an effective liquidity classification framework for open‐ended funds could be designed — consistent and realistic classification of the liquidity of funds’ assets is an essential step to ensuring funds can address mismatches between asset liquidity and redemption terms; and
• the calculation and use of swing pricing such that pricing adjustments more accurately represent, where possible, the cost of exiting a fund over the specified redemption period.

The FPC fully endorses this framework and views it as an important contribution to the international work currently in train. The FPC judges that this framework for liquidity classification and swing pricing could reduce the risks arising from the liquidity mismatch in certain funds.

The FPC emphasises the importance of addressing these issues internationally, given the global nature of asset management and of key markets.

The FPC recognises that further work is needed to consider how these principles could be applied, and a number of operational challenges will need to be addressed before any final policy is designed and implemented.

Funds that hold highly illiquid, infrequently traded assets, such as commercial real estate, may not be able to implement swing pricing effectively in practice. In these cases, longer redemption notice periods can address the first‐mover advantage and financial stability risks that may otherwise arise. More generally, the development of funds with longer notice periods could help to increase the supply of productive finance to the economy. The FPC welcomes the FCA’s consultation on a Long‐Term Asset Fund structure.

The transition to robust alternative benchmarks to Libor

Most new use of Libor is due to stop by the end of 2021. The FPC emphasises that market participants should use the most robust alternative benchmarks available in transitioning away from use of Libor to minimise future risks to financial stability.

It is the FPC’s view that recently created credit sensitive rates – such as those being used in some US dollar markets – are not robust or suitable for widespread use as a benchmark, and the FPC considers these rates to have the potential to reintroduce many of the financial stability risks associated with Libor. The FPC welcomes recent remarks made by members at the US Financial Stability Oversight Council, warning that widespread use of these credit sensitive benchmarks may replicate many of Libor’s shortcomings, and calling for the use of robust risk‐free rates. These credit sensitive rates would not appear to be in compliance with the IOSCO Principles for Financial Benchmarks if their use became widespread.

Cloud service providers

The FPC has previously highlighted that the market for cloud services is highly concentrated among a few cloud service providers (CSPs), which could pose risks to financial stability. Since the start of 2020, financial institutions have accelerated their plans to scale up their reliance on CSPs. Although the PRA and FCA have recently strengthened the regulation of firms’ operational resilience and third party risk management, the increasing reliance on a small number of CSPs and other critical third parties could increase financial stability risks without greater direct regulatory oversight of the resilience of the services they provide.

The FPC is of the view that additional policy measures to mitigate financial stability risks in this area are needed, and welcomes the engagement between the Bank, FCA and HM Treasury on how to tackle these risks. The FPC recognises that absent a cross‐sectoral regulatory framework, and cross‐border co‐operation where appropriate, there are limits to the extent to which financial regulators alone can mitigate these risks effectively.

Review of the UK leverage ratio framework

The FPC considers leverage requirements, including the scope of the regime, to be an essential part of the framework of capital requirements for the UK banking system. It has conducted a comprehensive review of the UK leverage ratio framework in light of revised international standards and its ongoing commitment to review its policy approach and agreed a number of proposed changes on which it is consulting. The FPC welcomes the approach set out by the PRA to implementing those changes, which are now also being consulted on.