Financial Policy Summary and Record - October 2019

The core of the UK financial system, including banks, broker dealers and insurance companies, is resilient to, and prepared for, the wide range of risks it could face, including a worst case disorderly Brexit.

The resilience of the UK financial system to Brexit

Entrenched Brexit uncertainties, particularly in an environment of weaker global growth, continue to weigh on economic activity in the UK.

• Brexit uncertainty is weighing on business investment, the prices of UK assets and flows of foreign capital into the UK, most notably in commercial property and leveraged lending markets.
• Although actions by businesses and authorities have resulted in some improvement in the preparedness of the UK economy for a no-deal Brexit, material risks of economic disruption remain.

The core of the UK financial system including banks, broker dealers and insurance companies is resilient to and prepared for the wide range of risks it could face, including a worst-case disorderly Brexit.

Major UK banks could absorb the impact of our 2018 stress test, which encompassed a disorderly Brexit, and still have significantly more capital than in 2007

• Major UK banks have maintained Tier 1 capital levels of around 17% of risk-weighted assets – more than three times higher than before the global financial crisis.
• The FPC continues to judge that its 2018 stress test of major UK banks was sufficiently severe to encompass a worst-case disorderly Brexit. The core UK banking system demonstrated its resilience to – and capacity to keep lending in – that stress scenario.
• Post-crisis reforms have made broker dealers, on which some markets rely, more resilient.  This has reduced the risk that market-making losses could lead to their distress or failure. Insurance companies, whose behaviour can dampen market shocks, have sufficient surplus capital to withstand very sharp falls in property and equity prices.

The FPC is maintaining the UK countercyclical capital buffer rate at 1%.

• Underlying domestic vulnerabilities (excluding Brexit) that can amplify economic shocks have not changed materially since July and remain at a standard level overall. Despite continued signs of strong risk appetite from creditors and lenders, credit growth to UK households and businesses remains modest and debt-servicing burdens remain low.
• The FPC stands ready to move the UK countercyclical capital buffer (CCyB) rate in either direction as economic conditions and the overall risk environment evolve. If a major economic stress were to materialise, the FPC is prepared to cut the UK CCyB rate, as it did in July 2016. In the absence of such a stress, the FPC remains vigilant to developments, particularly in the domestic credit environment. 

Reflecting extensive preparations made by UK authorities and the private sector, most risks to UK financial stability that could arise from disruption to cross-border financial services in a no-deal Brexit have been mitigated.

• Legislation, temporary permissions and other preparations have been made by UK authorities to ensure that UK households and businesses will be able to use existing and new services from EU financial institutions.
• However, in the absence of further action by EU authorities, some disruption to cross-border financial services in the event of a no-deal Brexit is possible. Such disruption would primarily affect EU households and businesses, but it could amplify volatility or spill back to the UK in ways that cannot be fully anticipated or mitigated.

Financial stability is not the same as market stability. Significant further asset price volatility is to be expected in a disorderly Brexit.

• In a disorderly Brexit, demand for UK assets could be expected to fall sharply, depreciating sterling and tightening financial conditions for UK households and businesses through adjustments in equity prices and corporate and bank funding costs.
• With over £1 trillion of high-quality liquid assets, major UK banks can meet their maturing obligations without any need to access wholesale funding for many months. They can also withstand an unprecedented loss of access to foreign currency markets. As a further precaution, the Bank of England is maintaining operations to lend in all major currencies on a weekly basis.

Irrespective of the particular form of the UK’s future relationship with the EU, and consistent with its statutory responsibilities, the FPC will remain committed to the implementation of robust prudential standards in the UK. This will require maintaining a level of resilience that is at least as great as that currently planned, which itself exceeds that required by international baseline standards, as well as maintaining UK authorities’ ability to manage UK financial stability risks.

The resilience of the UK financial system to global risks

The intensified trade war between the United States and China has weighed on global growth and poses the biggest near-term risk to the global economy.

Global growth has slowed, but not by as much as in our 2018 stress test

• Following the latest announcements, average bilateral tariffs between the United States and China are around 20 percentage points higher than at the start of 2018. These tariffs – and the uncertainty associated with intensifying trade tensions – have contributed to slowing global growth and are likely to weigh on global growth in the coming quarters.
• The trade war has also increased downside risks to the global outlook. Global growth could slow more sharply if the trade war were to lead to a tightening of financial conditions or to further reductions in business confidence and investment. A broadening of the trade war beyond tariff measures to restrictions on technology and capital, and to other jurisdictions, would magnify global risks and fragment the global economy.
• Even if a protectionist-driven global slowdown were to spill over to the UK at the same time as a worst-case disorderly Brexit, the FPC judges that the core UK banking system would be strong enough to absorb, rather than amplify, the resulting economic shocks.

Future shocks to the global economy could be amplified by material debt vulnerabilities, some structural illiquidity in financial markets and reduced space for some monetary authorities to respond.

• The growth rate of debt in mainland China is rising again. The debt to GDP ratio exceeds 200%, having risen by around 90 percentage points since 2008.
• In Hong Kong, corporate and household debt levels are also high. Recent political protests have been accompanied by slowing growth and falling asset prices. ong Kong’s position as a major financial centre increases the risk of spillovers.
• US corporate debt is close to pre-crisis levels as a percentage of GDP and credit quality has continued to deteriorate. In recent years, there has been a significant increase in the share of BBB-rated bonds, which could drop to a sub-investment grade rating in the event of a negative economic shock.
• In global financial markets, the trade war has put further downward pressure on risk-free interest rates. In the face of weakening growth, some authorities have reduced official interest rates. Lower rates are likely to support global growth, but these moves have further reduced space for some monetary authorities to respond in the event of a shock to the global outlook.
• US repo market rates were highly volatile for a period in mid-September. A number of factors appeared to have pushed up repo rates. The subsequent actions of the Federal Reserve Bank of New York served to stabilise the market.  However, the volatility could point to a more general tendency for markets to jump to illiquidity under stress. This could impair the ability of global markets to absorb future shocks while still functioning effectively. 

The core of the UK banking system remains resilient to severe global and market stress.

• UK banks have substantial exposures to mainland China and Hong Kong, of around 230% of their common equity Tier 1 (CET1) capital base. Exposures of UK banks to the United States and the euro area are around 325% and 240% of CET1 capital respectively.
• The international exposures of major UK banks were tested against a global scenario more severe than the financial crisis in the 2018 stress test. That scenario included recessions in mainland China, Hong Kong, the euro area and the United States. It also included sharp falls in the price of a range of financial assets.
• Major UK banks with international and trading exposures were assessed to be resilient to that scenario. The results of the 2019 stress test will be published in December.

Tackling vulnerabilities in open-ended funds

The FPC continues to judge that the mismatch between redemption terms and the liquidity of some funds’ assets has the potential to become a systemic risk.

• This mismatch creates incentives for investors to redeem ahead of others, which can lead to forced asset sales by funds and amplify asset price movements. Sharp falls in asset prices could increase the cost of finance to companies, leading to lower investment and output in the economy. These incentives should be reduced through greater consistency in the design of funds between:

• The liquidity of a fund’s assets, which determines the price that can be achieved during the redemption period;
• The price offered to redeeming investors for their share of the fund; and
• The redemption frequency or length of notice periods.

• The Bank and the Financial Conduct Authority (FCA) are undertaking a joint review to assess how funds’ redemption terms might be better aligned with the liquidity of their assets in order to minimise financial stability risks without compromising the supply of productive finance. The progress of this review will be reported in the December Financial Stability Report (FSR).

Ensuring that payment systems support financial stability

The FPC has agreed a set of principles that will guide its assessment of how prudential regulation and supervision should adjust to fast-moving developments in payments activities, which are currently a focal point for innovation in financial services.

• These principles are that regulation and supervision should:

• Reflect the financial stability risk, rather than the legal form, of payments activities;
• Ensure end-to-end operational and financial resilience across payment chains that are critical for the smooth functioning of the economy; and
• Ensure that sufficient information is available to monitor payments activities so that emerging risks to financial stability can be identified and addressed appropriately.

• HM Treasury is leading a review of the payments landscape to support choice, competition and resilience and to ensure that regulation and infrastructure keep pace with innovation. These principles could usefully inform any assessment of existing payments regulation in that review.
• Libra has the potential to become a systemically important payment system. The FPC judges that such a system would need to meet the highest standards of resilience and be subject to appropriate supervisory oversight, consistent with the principles set out above. The terms of engagement for innovations such as Libra must be adopted in advance of any launch.  UK authorities should use their powers accordingly.
• The FPC encourages exploration of alternative solutions to improve the efficiency of domestic and cross-border payments.

The transition away from Libor to alternative benchmark rates

The continued reliance of global financial markets on Libor poses risks to financial stability that can be reduced only through a transition to alternative benchmark rates by end-2021.

Firms continue to write new Libor contracts despite clear risks to its existence after end-2021
Total value of contracts referencing GBP Libor cleared through LCH

There is no justification for firms continuing to increase their exposures to Libor. The pace of market participants’ transition efforts to alternative benchmark rates now needs to accelerate and the FPC will continue to monitor progress closely.

• The FPC welcomes measures taken by the Prudential Regulation Authority (PRA) and the FCA to step up their monitoring of regulated firms’ exposures to Libor and firms’ transition plans for reducing those exposures.
• In Q4, the FPC will consider further potential policy and supervisory tools that could be deployed by authorities to reduce the stock of legacy Libor contracts to an irreducible minimum ahead of end-2021.

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