Our analysis indicates that the Covid-19 economic shock could see banks face higher losses on unsecured debt than on mortgages. This analysis helps us understand the potential impact of Covid-19 on financial stability. Three factors explain our findings. To varying extents, all three factors have been at play in past recessions too.
First, lower income households, whose finances have come under pressure during this shock, are more likely to hold unsecured debt — such as credit cards and personal loans — and not mortgages (Chart A).
Chart A Lower income households are more likely to hold unsecured debt than mortgages
FootnotesSources: Understanding Society Covid-19 Survey and Bank calculations.
Compared to higher earning households, lower income households are more likely to spend a higher share of their income on repaying unsecured debt and are more likely to go into arrears on this debt. During the Covid-19 shock, lower income households have had to draw on savings and have been less able to cut their spending. This is because they spend a larger share of their income on essentials — eg food or utilities.
Second, unsecured debt losses tend to increase when the unemployment rate rises. So the projected rise in unemployment in the August Monetary Policy Report could result in higher losses on unsecured debt.
Finally, bank losses on unsecured debt can exceed those on mortgage debt, even though the amount of mortgage debt in the UK is far higher than unsecured debt. This is because households are more likely to default on unsecured debt, and lenders do not have collateral to help absorb losses. From 2017, the Financial Policy Committee (FPC) has tested the major UK banks against much higher loss rates on unsecured debt. The results of these tests inform the size of the capital buffers we expect them to hold.
This potential for large unsecured debt losses has implications for the resilience of the UK banking sector.
Our ‘reverse stress test’ determined how much economic conditions would need to deteriorate before banks used up their capital buffers.
Based on this analysis, in August the FPC judged the major UK banks and building societies to be resilient to a very wide range of possible outcomes. These included scenarios — much more severe than the Monetary Policy Committee’s August central projection — where unemployment reaches around 15%, and total losses on unsecured debt exceeded £30 billion.
This post has been prepared with the help of Victoria Monro and Gabija Zemaityte.
This analysis was presented to the FPC in July 2020.
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