Financial Policy Summary and Record - October 2021

Our Financial Policy Committee (FPC) meets to identify risks to financial stability and agree policy actions aimed at safeguarding the resilience of the UK financial system.
Published on 08 October 2021

The Financial Policy Committee (FPC) aims 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

Support for the economy during the recovery

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 alongside the exceptional policy responses of the UK authorities.

UK GDP is projected to recover further over the remainder of the year towards its pre-pandemic level, although the outlook for the economy remains uncertain. The pace of recovery has slowed recently, and inflationary pressures have risen.

Households and businesses are likely to need continuing support from the financial system as the economy recovers and the Government’s support measures continue to unwind. 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 in the August Monetary Policy Report.

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 support viable, productive businesses, rather than seek to defend capital ratios by restricting lending.

To support bank lending to households and businesses as the economy recovers, the FPC is maintaining the UK Countercyclical Capital Buffer (CCyB) rate at 0%. The FPC has previously stated that it expects to maintain a 0% UK CCyB rate until at least December 2021. It will re-evaluate the appropriate level of the UK CCyB rate in light of the risk environment at that time. In line with the standard implementation period, any subsequent increase would not be expected to take effect until the end of 2022 at the earliest.

The FPC will also consult on a proposal to change the metric used to determine Other Systemically Important Institutions (O-SII) buffer rates to exclude central bank reserves, effective from the 2023 Prudential Regulation Authority (PRA) assessment of individual firm buffer rates. The FPC also welcomes the PRA’s intention to continue to freeze O-SII buffer rates until that point. This will ensure that the increase in central bank reserves since the start of the pandemic will not result in higher regulatory capital buffers for banks before the FPC’s proposals can come into effect.

Domestic debt vulnerabilities

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

UK house price growth has reached levels last seen before the global financial crisis and housing market activity has been strong, reflecting a mix of temporary policy support and factors that could prove more persistent. Strength in the housing market has historically been associated with riskier lending practices. However, there is little evidence so far of a deterioration in lending standards or a material increase in the number of highly indebted households.

The FPC has Recommendations in place which limit a deterioration in mortgage underwriting standards or a rapid build-up in the share of highly indebted households. The FPC is due to finalise its review of the calibration of its mortgage market Recommendations in December 2021.

The FPC judges that UK corporate debt vulnerabilities have increased moderately over the Covid pandemic so far. The increase in indebtedness has not been large in aggregate, and debt-servicing remains affordable for most UK businesses. Large increases in interest rates or severe earnings shocks would be needed to impair businesses’ ability to service their debt in aggregate.

The increase in debt in the UK corporate sector has been concentrated in some sectors and types of businesses, in particular in small and medium-sized enterprises (SMEs). Many of these SMEs had not previously borrowed and some would not have previously met lenders’ lending criteria. The increase in debt - though moderate in aggregate - has likely led to increases in the number and scale of more vulnerable businesses. As the economy recovers and Government support, including restrictions on winding up orders, falls away, business insolvencies are expected to increase from historically low levels.

The FPC continues to judge that the UK financial system is resilient to risks from the UK corporate and household sectors. The FPC will monitor the evolution of vulnerabilities as the economy recovers and remains vigilant to risks building up over the medium-term.

Global debt vulnerabilities

Debt vulnerabilities globally have also increased during the pandemic. Across advanced economies, corporate debt-to-GDP ratios have increased in aggregate by 10 percentage points since the end of 2019. Higher leverage and greater risk-taking abroad could directly increase the risk of losses for UK institutions on their foreign exposures. UK banks, however, have limited direct exposures to the most vulnerable sectors and so far debt servicing generally remains affordable. Corporate debt vulnerabilities in other countries could have more indirect spillovers to the UK.

Concerns about the ability of Evergrande Group, one of China’s largest property developers, to meet its financial obligations have been associated with recent volatility in international markets, and could pose risks to the wider property sector in China with potential spillovers internationally. The FPC has previously highlighted the risks associated with the rapid rise in debt more broadly in China and continues to monitor any of these potential risks to UK financial stability. While there is uncertainty as to how these risks might crystallise, the interim results of the 2021 Solvency Stress Test (SST) indicate that the UK banking system is resilient to the direct effects of a severe downturn in China and Hong Kong, and sharp adjustments in global asset prices.

Increased risk taking in global financial markets

The FPC judges there is evidence that risk-taking remains elevated in a number of markets relative to historic levels.

Following the Covid shock, central banks cut interest rates and undertook asset purchases to support economic activity and prevent an unwarranted tightening of financial conditions for corporates and households. Since then, risky asset prices have increased and, in a number of markets, asset valuations appear elevated relative to historical norms. This partly reflects the improved economic outlook, but may also reflect a ‘search for yield’ and higher risk‐taking in a low interest rate environment.

Asset valuations could correct sharply if, for example, market participants re‐evaluate the prospects for growth, inflation or interest rates. Any such correction could be amplified by vulnerabilities in market‐based finance that were exposed in March 2020. This could have consequences for market functioning and financial conditions, and hence the real economy.

Risks in leveraged loan markets globally continue to build. There are signs of continued loosening in underwriting standards and increased risk-taking in some investment banking businesses. These risks can affect UK financial stability through the direct impact on banks and the indirect impact of losses spreading through other parts of the global financial system. The core UK banking system is resilient to direct losses associated with leveraged lending, as demonstrated by the interim results of the 2021 SST.

Building the resilience of the financial system

Market-based finance

The March 2020 stress exposed a number of vulnerabilities in market-based finance. The FPC set out the next steps needed to enhance the resilience of market-based finance in July, and strongly supports the current work, co-ordinated internationally by the Financial Stability Board (FSB), to assess and remediate the underlying vulnerabilities. Such work is necessarily a global endeavour, reflecting the international nature of these markets and their interconnectedness. The Bank, the Financial Conduct Authority (FCA) and HM Treasury are fully engaged in this work programme, and the G20 will be updated on progress in October.

Until this work results in an increase in the resilience of non-bank financial institutions, the financial stability risks exposed in March 2020 will remain. And 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 internationally co-ordinated reforms that enhance the resilience of the non-bank financial sector.

Cryptoasset and associated markets and services continue to grow and to develop rapidly. Such assets are becoming increasingly integrated into the financial system. The FPC judges that direct risks to the stability of the UK financial system from cryptoassets are currently limited. However, regulatory and law enforcement frameworks, both domestically and at a global level, need to keep pace with developments in these fast-growing markets in order to manage risks and to maintain broader trust and integrity in the financial system.

The FPC will continue to pay close attention to developments, including the relationship between cryptoassets and the UK financial system, and thereby seek to ensure resilience to systemic risks that may arise from further developments in cryptoasset markets. The FPC considers that financial institutions should take a cautious and prudent approach to any adoption of these assets.

Productive finance to support the economic recovery

The supply of finance including for productive investment is important both for financial stability and long-term growth and can help to support the recovery from the pandemic. The FPC welcomes the Productive Finance Working Group’s final report, which sets out the case for long-term investment via a ‘Long-Term Asset Fund’ (LTAF) vehicle, and recommendations to help make progress on removing barriers to investment in less liquid assets.

Understanding how the provision of finance to SMEs is developing is important for the FPC’s understanding of the vulnerabilities associated with SME indebtedness and for the FPC’s secondary objective, but is impaired by data gaps. The FPC welcomes the upcoming Bank survey on UK businesses’ financing decisions, which will seek to address some of these gaps.

Libor transition

Most Libor benchmarks, as well as new use of any continuing Libor benchmarks, are due to stop by the end of 2021. The FPC welcomes the progress that has been made so far in transitioning away from Libor and the marked increases in use of risk-free rates over recent months, in particular the recent positive progress in the transition to the Secured Overnight Financing Rate (SOFR) in USD markets. SOFR-based rates provide more robust alternatives than the credit sensitive rates that have begun to be used in some USD markets. 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.

Critical third parties

The increasing reliance by the financial system on critical third parties (CTPs), including cloud service providers, can bring benefits to the financial sector, including improved operational resilience. However, the increasing criticality of the services that CTPs provide, alongside concentration in a small number of providers, pose a threat to financial stability in the absence of greater direct regulatory oversight.

Regulated firms will continue to have primary responsibility for managing risks stemming from their outsourcing and third-party dependencies. However, additional policy measures, some requiring legislative change, are likely to be needed to mitigate the financial stability risks stemming from concentration in the provision of some third-party services. These policy measures should include: an appropriate framework to designate certain third-party service providers as critical; resilience standards; and resilience testing. The FPC supports the intention of the Bank, PRA and FCA to publish a joint Discussion Paper in 2022 on these issues.

The FPC strongly supports UK financial authorities’ continued engagement with initiatives by the UK Government to strengthen cross-sectoral oversight of third-party service providers to multiple parts of the UK’s critical infrastructure, as well as in international workstreams at the FSB and other bodies, and with overseas financial regulators.