Financial Policy Summary and Record - December 2021

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 can serve UK households and businesses in bad times as well as good.

The outlook for financial stability

The UK and global economies have continued to recover from the effects of the pandemic. But uncertainty over risks to public health and the economic outlook remains. For example, there are near-term pressures on supply and inflation, and there could be a greater impact from Covid on activity, especially given uncertainties about whether new variants of the virus reduce vaccine efficacy.

Bank resilience

UK banks’ capital and liquidity positions remain strong, and they have sufficient resources to continue to support lending to the economy.

The FPC continues to judge that the UK banking system remains resilient to outcomes for the economy that are much more severe than the Monetary Policy Committee’s (MPC’s) central forecast. This judgement is supported by the final results of the 2021 solvency stress test (SST).

The FPC has tested the resilience of the UK banking system against a much more severe evolution of the pandemic and consequent economic shock. In the SST, major UK banks’ and building societies’ (banks) aggregate Common Equity Tier 1 (CET1) capital ratio falls by 5.5 percentage points to a low point of 10.5%. This low point compares with a 7.6% reference rate, comprising banks’ minimum requirements and systemic buffers.¹ The aggregate Tier 1 leverage ratio low point of 4.8% is also above the reference rate of 3.7%. All eight participating banks remain above their reference rates for both CET1 capital ratios and Tier 1 leverage ratios in the exercise.

As previously indicated, the aim of the SST has been to update and refine the FPC’s assessment of banks’ resilience and their ability to lend in a very severe intensification of the macroeconomic shock arising from the pandemic. Consistent with the nature of the exercise, the FPC and Prudential Regulation Committee will therefore not use the test as a direct input for setting capital buffers for UK banks. For 2022, the Bank intends to revert to the annual cyclical scenario stress-testing framework and will publish further details on this in 2022 Q1.

Debt vulnerabilities

The FPC remains vigilant to debt vulnerabilities in the economy that could amplify risks to financial stability.

UK household and corporate debt

The FPC judges that domestic debt vulnerabilities have not increased materially over the course of the pandemic.

So far, UK households’ finances have remained resilient as Covid-related support measures – such as the furlough scheme and the ability to take a payment deferral on mortgages and consumer credit – have ended. Although house prices in the UK have grown in recent months at their fastest annual rate since the global financial crisis, aggregate mortgage debt relative to income has remained broadly stable since 2009. And the share of households with a mortgage debt-servicing ratio (debt servicing costs as a proportion of income) at or above 40% – a level beyond which households are typically much more likely to experience repayment difficulties – remains broadly in line with 2017–19 averages and significantly below levels seen just prior to the global financial crisis. With all other factors, such as income, held constant, mortgage interest rates would need to increase by around 150 basis points for that share to reach its pre-global financial crisis average.

UK corporate debt vulnerabilities have increased relatively moderately over the pandemic so far. As the economy has recovered and government support has been withdrawn, business insolvencies have increased somewhat, but remain below pre-Covid levels. The increase in indebtedness has been moderate in aggregate, and larger corporates have repaid a significant proportion of the debt that they took on. Debt servicing remains affordable for most UK businesses. It would take large increases in borrowing costs or severe shocks to earnings to impair businesses’ ability to service their debt in aggregate.

The increase in debt has likely led to increases in the number and scale of more vulnerable businesses. It has been concentrated in some sectors and types of businesses, in particular in small and medium-sized enterprises (SMEs). For some of these SMEs, borrowing has been precautionary. Many SMEs, however, had not previously borrowed and some would not have previously met lenders’ lending criteria. Most of this new bank lending is guaranteed by the Government, which will limit risks to lenders, and was issued at low interest rates and with repayment flexibility which will limit the impact on borrowers.

Global vulnerabilities

Global debt vulnerabilities remain material. Government and central bank policy support in advanced economies has helped to limit the size of the disruption from the pandemic. However, across advanced and emerging market economies, corporate debt to GDP ratios have generally increased, and residential property price growth in many countries has been strong. Higher leverage abroad could increase the risk of losses for UK institutions, including on their foreign exposures.

Long-standing vulnerabilities in the Chinese property sector have re-emerged, against a backdrop of high and rising debt levels in China. A serious downturn in China could have a significant impact on the UK economy. While there is uncertainty as to how these risks might crystallise, the results of the 2021 SST indicate that the UK banking system is resilient to the direct effects of a severe downturn in China and Hong Kong, as well as indirect effects through sharp adjustments in global asset prices.

Risk-taking in global financial markets

Risk-taking in certain financial markets remains high relative to historical levels, notwithstanding recent market volatility. Low compensation for risk in some markets could be evidence of investors’ ‘search for yield’ behaviour, which could reflect the continued low interest rate environment and higher risk-taking. This creates a vulnerability to a sharp correction in asset prices – if for example market participants re-evaluated materially the prospects for growth, inflation or interest rates – that could be amplified by existing vulnerabilities in market‐based finance.

Risks in leveraged loan markets globally continue to increase. The post-global financial crisis trends of increased leveraged loan issuance and loosening in underwriting standards in these markets have continued. For example, the share of new lending with few financial maintenance covenants (so-called ‘covenant-lite’ lending) in these markets is at a record high globally.

The UK countercyclical capital buffer rate

The FPC judges that vulnerabilities that can amplify economic shocks are at a standard level overall, as was the case just before the pandemic. This would be consistent with the UK countercyclical capital buffer (CCyB) rate returning to the region of 2%. However, there continues to be uncertainty about the evolution of the pandemic and the economic outlook. Should downside risks crystallise, the economy could require more support from the financial system.

The FPC is therefore increasing the UK CCyB rate from 0% to 1%. This rate will come into effect from 13 December 2022 in line with the usual 12-month implementation period.

If the UK economic recovery proceeds broadly in line with the MPC’s central projections in the November Monetary Policy Report, and absent a material change in the outlook for UK financial stability, the FPC would expect to increase the rate further to 2% in 2022 Q2. That subsequent increase would be expected to take effect after the usual 12-month implementation period.

The FPC’s mortgage market Recommendations

An excessive build-up of mortgage debt, often associated with rapid increases in house prices, has historically been an important source of risk to the UK financial system and to the economy. The FPC therefore introduced two Recommendations in 2014 to guard against a loosening in mortgage underwriting standards, which could lead to a material increase in aggregate household debt and the number of highly indebted households: the ‘flow limit’ which limits the number of mortgages that can be extended at loan to income (LTI) ratios higher than 4.5; and the ‘affordability test’ which specifies a stress interest rate for lenders when assessing prospective borrowers’ ability to repay a mortgage.

In its latest review of the Recommendations, the FPC has concluded that these measures in aggregate continue to guard against a loosening in underwriting standards and a material increase in household indebtedness, which could amplify an economic downturn and financial stability risks.

Since the measures have been introduced, mortgage debt to income has been broadly stable. In the recent period of high house price growth, there has been little evidence of a deterioration in lending standards, a material increase in aggregate household debt or the number of highly indebted households.

The Committee judges that there is no strong evidence that the structural fall in long-term interest rates that has continued since the measures were put in place has reduced the overall level of risk associated with household debt.

Although interest rates are expected to remain low for longer – which, other things equal, implies a reduction in debt-servicing costs for households – both the causes and consequence of the fall in long-term interest rates imply an offsetting increase in risks. In particular, part of the decline in long-term rates since 2014 reflects weaker growth prospects, which are likely to lower household income growth, and so increase the risk from household debt because debt burdens relative to income decline more slowly over time. And if interest rates remain low for longer, there is less scope for them to fall in response to shocks, making indebted households more vulnerable. Furthermore, evidence suggests that, despite the large falls in mortgage interest rates in the recession following the global financial crisis, highly indebted households cut their consumption by more, thereby amplifying the downturn.

The FPC has therefore concluded that the structural decline in interest rates does not, by itself, justify a change in the overall calibration of its mortgage market measures.

In addition, the FPC’s analysis suggests that the measures have relatively little impact on mortgage market access, and that raising a deposit remains the most significant barrier to access, particularly for first-time buyers. In aggregate, there remains a significant degree of headroom below the LTI flow limit.

As part of the review, the FPC also considered how its two measures have operated since they were put in place. The LTI flow limit has played the role intended. However, the FPC notes that the stress rate in the affordability test has remained broadly static, reflecting stickiness in reversion rates despite falls in quoted mortgage rates. There is considerable uncertainty about how the stress rate might move in the future.

The FPC’s analysis suggests that the LTI flow limit is likely to play a stronger role than the affordability test in guarding against an increase in aggregate household indebtedness and the number of highly indebted households when house prices rise rapidly. A framework without the FPC’s affordability test would therefore be simpler and more predictable. It would also reduce the impact on a small proportion of borrowers.

Reflecting these factors, the FPC judges that, on current evidence, the LTI flow limit, without its affordability test but alongside the FCA’s affordability testing under its Mortgage Conduct of Business framework, ought to deliver an appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way.

The FPC therefore intends to maintain the LTI flow limit Recommendation, but consult, in the first half of 2022, on withdrawing its affordability test.

Building the resilience of the financial system

International progress in building the resilience of market-based finance

In March 2020, vulnerabilities in the system of market-based finance amplified the initial market reaction to the pandemic, contributing to a severe liquidity shock (the ‘dash for cash’), which 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 international work, led and co-ordinated by the Financial Stability Board (FSB), to assess and develop policy responses to address the underlying vulnerabilities in market-based finance that amplified the dash for cash. The FPC welcomes the FSB’s analysis of these vulnerabilities, and it endorses the FSB’s policy recommendations for money market funds, which now need to be implemented by all jurisdictions. In the FPC’s view, further policy measures are needed to enhance the resilience of market-based finance in other areas including open-ended funds, margin, the liquidity structure and resilience of core markets, and leveraged investors and their prime brokers.

Absent an increase in the resilience of market-based finance, financial stability risks, including those exposed in March 2020, remain. The work planned by the FSB next year therefore represents an important opportunity to develop policies to address those vulnerabilities. The FPC will continue to monitor progress.

Making progress on mitigating these vulnerabilities is also vital to ensure that interventions by central banks in stress episodes are truly backstops and potential negative side effects to the financial system are effectively mitigated. While central banks may need new and more targeted tools to deal effectively with financial instability caused by market dysfunction, central bank interventions cannot be a substitute for the primary obligation of market participants to manage their own risk, or for internationally co-ordinated reforms that enhance the resilience of the non-bank financial sector.

Risks from cryptoassets

Cryptoassets and their associated markets and activities, including decentralised finance, continue to grow and to develop rapidly. The market capitalisation of cryptoassets has grown tenfold since early 2020 to around US$2.6 trillion in November 2021, representing around 1% of global financial assets. The vast majority of this market (around 95%) is made up of ‘unbacked’ cryptoassets which have no underlying assets. Such cryptoassets have no intrinsic value, are vulnerable to major price corrections and so investors may lose all their investment.

Innovation can bring a number of benefits, including reduced frictions and inefficiencies in financial services. These benefits can only be realised and innovation can only be sustainable if undertaken safely and accompanied by effective public policy frameworks that mitigate risks.

As the FPC has noted, direct risks to the stability of the UK financial system from cryptoassets are currently limited. However, at the current rapid pace of growth, and as these assets become more interconnected with the wider financial system, cryptoassets will present a number of financial stability risks. For example, a large fall in cryptoasset valuations may cause institutional investors to sell other financial assets and potentially transmit shocks through the financial system. The use of leverage can amplify such spillovers further.

Enhanced regulatory and law enforcement frameworks, both domestically and at a global level, are needed to influence developments in these fast-growing markets in order to manage risks, encourage sustainable innovation and maintain broader trust and integrity in the financial system. The FPC welcomes international work on these issues.

Domestically, the FPC supports the work of the HM Treasury-FCA-Bank Cryptoassets Taskforce on assessing the regulatory approach to unbacked cryptoassets and their associated markets and activities, in order to shape developments in this space and support safe innovation.

The FPC also welcomes HM Treasury’s proposal for a regulatory regime for ‘stablecoins’, a type of backed cryptoasset, used as a means of payment. This includes bringing systemic stablecoins into the Bank’s regulatory remit.

The FPC will continue to pay close attention to the developments in this area, and will seek to ensure that the UK financial system is resilient to systemic risks that may arise from cryptoassets. Any future regulatory regime should aim to balance risk mitigation with supporting innovation and competition. The FPC considers that financial institutions should take an especially cautious and prudent approach to any adoption of these assets until such a regime is in place.

1. See The results of the 2021 solvency stress test of the UK banking system for further information on how the reference rate is calculated.