Financial Policy Summary, 2022 Q3
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 is able to absorb rather than amplify shocks and serve UK households and businesses.
Global economic and financial market developments
Since the July 2022 Financial Stability Report (FSR), the global economic outlook has continued to deteriorate significantly, and by more than had been expected, while geopolitical risks have remained heightened. Inflationary pressures have intensified further, driven in part by a sharp reduction in gas supply from Russia to Europe. That followed steep rises in energy and other commodity prices after Russia’s illegal invasion of Ukraine in February 2022, which had already exacerbated inflationary pressures arising from the pandemic. Household real incomes and the profit margins of some businesses have fallen this year as a result.
Financial conditions have tightened further, and financial markets have remained volatile in recent months, with significant rises in government bond yields, large moves in exchange rates, and falls in risky asset prices. Overall, the adjustment in global market prices has been consistent with tighter monetary policy globally and the further deterioration in the economic outlook. While generally orderly so far, pressures have been observed in parts of the global financial system, including challenging liquidity conditions across some energy and fixed income markets, but without a widespread crystallisation of financial stability risks. Global financial markets were, however, affected by spillovers from dysfunction in the market for long-dated UK government debt in response to which the Bank announced measures to support UK financial stability.
Global debt vulnerabilities
Rapid increases in the prices of a range of goods, including energy, and tighter financial conditions will continue to weigh on debt affordability for households, businesses and governments in many countries. That increases the risks posed by global debt vulnerabilities to UK financial stability through economic and financial spillovers. Pressure on household and corporate balance sheets could lead to losses for banks, particularly in the euro area where energy prices have risen very sharply. While there are pockets of deteriorating asset quality, recent analysis by the European Central Bank suggests that the euro-area banking system as a whole is resilient to a severe downturn.
Government support measures in many countries will reduce the pressure on vulnerable households and businesses, but are also likely to increase public sector debt. The FPC has previously highlighted vulnerabilities created by high public debt levels, including in the euro area, where yields on public sector debt in some countries remain elevated. Spreads on ten-year Italian government bond yields over their German equivalents have increased significantly since the start of the year.
The FPC has also previously highlighted vulnerabilities associated with riskier corporate borrowing, particularly in the United States. The stock of outstanding leveraged lending and private credit in the United States has risen sharply in recent years. Companies with such debt are likely to be particularly vulnerable to tighter financial conditions and the weaker growth outlook.
Debt vulnerabilities in China’s property market appear to be crystallising. Housing investment and property prices have continued to fall, weighing on activity, alongside headwinds from Covid-related disruption. The tightening in global financial conditions, and the strengthening dollar, will also weigh on debt serviceability in non-China emerging market economies, particularly energy importers and those with high levels of dollar-denominated debt.
UK economic and financial market developments
The intensification of inflationary pressures, reflecting, in part, Russia’s reduction of gas supplies to Europe, and the associated tightening in global financial conditions since the July 2022 FSR have led to a further material deterioration in the UK economic outlook.
In response to cost-of-living pressures, the UK Government announced support measures for households and businesses, including an Energy Price Guarantee. Other proposals, relating to taxation and supply-side reforms, were also announced. The Energy Price Guarantee is likely to reduce the near-term peak in CPI inflation and, together with other Government measures, support demand. On the other hand, rapid increases in financing costs for mortgages and other borrowing will increasingly stretch UK household and business finances in coming months. As previously communicated, the Monetary Policy Committee will make a full assessment at its next scheduled meeting in November of the impact on demand and inflation from the Government’s announcements.
In late September, UK financial assets saw further significant repricing, particularly affecting long-dated UK government debt. The rapid and unprecedented increase in yields exposed vulnerabilities associated with the leveraged liability-driven investment (LDI) funds in which many defined benefit pension schemes invest. This led to a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to UK financial stability. This would have led to an unwarranted tightening of financing conditions and a reduction in the flow of credit to households and businesses.
On 28 September, the FPC assessed the risk to UK financial stability from dysfunction in the gilt market. It recommended that action be taken to address it and welcomed the Bank’s plan for temporary and targeted purchases in the gilt market on financial stability grounds at an urgent pace. The Bank announced a temporary programme of purchases of long-dated UK government bonds until 14 October, and other measures. Real and nominal gilt yields fell materially following the initial announcement, creating an environment where LDI funds could build resilience to future shocks. The Bank, The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) are closely monitoring the progress of LDI managers as they put their funds on a sustainable footing for whatever level of asset prices prevails when the Bank ceases purchasing gilts, and to ensure LDI funds are better prepared for future stresses given current market volatility. The Bank’s purchases will be unwound in a smooth and orderly fashion.
While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned from this episode and appropriate levels of resilience ensured. Although the PRA regulates bank counterparties of LDI funds, the Bank does not directly regulate pension schemes, LDI managers, or LDI funds. Pension schemes and LDI managers are regulated by TPR and the FCA. LDI funds themselves are typically based outside the UK. The Bank will work with TPR and the FCA domestically to ensure strengthened standards are put in place.
More generally, the vulnerabilities exposed by the gilt market dysfunction share characteristics with those in the non-bank financial system previously identified by the FPC that are being addressed by the Bank and Financial Stability Board’s (FSB) long-standing work programmes. The FPC judges it crucial that this work results in effective policy outcomes to improve the resilience of non-bank financial institutions globally to sharp reductions in asset prices and liquidity. Absent such an increase in resilience, the financial stability risks associated with core market dysfunction could resurface in other ways or in other parts of the financial system. The FPC looks forward to the FSB’s forthcoming report to the G20 on progress made in 2022. It is important that the report sets out clear priorities and expectations for international policy development in 2023.
UK debt vulnerabilities
In the UK, higher inflation and rising interest rates will weigh on households repaying debt. Rising interest rates will also increase debt-servicing costs for UK corporates, while higher input costs and lower household demand will impact business earnings.
The continued rise in living costs and interest rates will put increased pressure on UK household finances in coming months and make households more vulnerable to shocks. Overnight swap rates, which feed directly into mortgage interest rates, were, at the time of the FPC Policy meeting, priced to peak at around 6%. Assuming rates follow this market-implied path, the share of households with high cost-of-living adjusted mortgage debt-servicing ratios would increase by end-2023 to around the peak levels reached ahead of the global financial crisis (GFC).
However, households are in a stronger position than in the run-up to the GFC, so UK banks are less exposed to household vulnerabilities. In particular, the ratio of aggregate household debt (excluding student loans) to income is well below the pre-GFC peak and the share of outstanding mortgage debt at high loan-to-value ratios is much lower. The UK banking sector is also much better capitalised compared with the pre-GFC position, mitigating the risk that losses on loans cause lenders to reduce credit supply in order to preserve capital. In addition, lenders are now required to apply flexible approaches to repayments and only use repossessions as a last resort. Nevertheless, it will be challenging for some households to manage the projected rises in the cost of essentials alongside higher interest rates.
Higher input costs and lower demand will weigh on earnings for many businesses, especially those in sectors with large exposure to energy and fuel prices, or who provide non-essential household goods and services. This pressure on corporate earnings, combined with the rising cost of credit, will reduce companies’ ability to service their debts, which is likely to lead to some business failures and reduced corporate spending as some companies seek to deleverage. Based on the path implied by financial markets for market interest rates at the time of the FPC Policy meeting, the share of businesses with low interest coverage ratios is expected to increase materially, but remain below historical peak levels.
Larger companies have a relatively large share of fixed-rate debt and this will insulate them to some extent from the immediate effects of rising interest rates. In contrast, small and medium-sized enterprises (SMEs) are more exposed to rising borrower costs: the majority of UK SME debt is floating-rate lending by banks. Although SMEs make up a relatively small share of total corporate debt, and therefore pose limited direct risk to the UK financial sector in terms of bank losses, they represent a much larger share of employment.
UK external financing vulnerabilities
The UK has a large external balance sheet and a current account deficit financed by gross inflows of capital. The UK’s ability to continue financing its current account deficit is supported by a large, positive net international investment position (NIIP) when measured at market prices. In part, this reflects the fall in the value of sterling since 2015, which has boosted the NIIP because UK liabilities tend to be denominated in sterling and UK assets tend to be denominated in foreign currencies.
But the size and composition of the UK’s external balance sheet make it vulnerable to reductions in foreign investor appetite for UK assets, which can cause falls in UK asset prices and tighter credit conditions for UK households and businesses. The composition of the UK’s external liabilities may also make it vulnerable to refinancing risk. Both of these risks may be heightened in current circumstances. The FPC continues to monitor the nature of capital flows in and out of the UK, and risk premia on a range of UK assets.
UK bank resilience
The FPC continues to judge that major UK banks have considerable capacity to support lending to households and businesses even with the further deterioration in the economic outlook. Major UK banks’ capital and liquidity positions remain strong, and profitability has strengthened in aggregate. Capital ratios continued to fall slightly in 2022 Q2, but banks maintain headroom above their regulatory buffers. Looking forward, asset quality is likely to deteriorate in view of the worsening macroeconomic outlook, leading to increasing impairments and risk-weighted assets, although higher interest rates are likely to continue to have a positive effect on banks’ profitability overall.
Although downside risks present headwinds, the FPC judges that UK banks have capacity to weather the impact of severe economic outcomes. In such scenarios, banks are likely to manage prudently their lending activity, commensurate with changes in credit quality in the real economy. Setting lending terms to reflect the new risk environment is appropriate - to date, the observed marginal tightening in major banks’ risk appetites has been consistent with this. Restricting lending solely to defend capital ratios or capital buffers would be counterproductive and could prevent credit-worthy businesses and households from accessing funding. Such excessive tightening would harm the broader economy and ultimately the banks themselves. The FPC will continue to monitor banking sector resilience, including in the 2022 stress test, and banks’ risk appetite for lending.
The UK Countercyclical Capital Buffer rate
The FPC is maintaining the UK Countercyclical Capital Buffer (CCyB) rate at 2%. This rate will come into effect on 5 July 2023, in line with the generally required 12-month implementation period. While the global and UK economic outlooks have deteriorated significantly and financial conditions have continued to tighten, any signs of a persistent reduction in credit supply from UK banks are limited and the Government’s support measures will reduce the impact on domestic debt vulnerabilities from higher energy prices. As such, the FPC continues to judge that a UK CCyB rate of 2% is appropriate to ensure that banks have sufficient capacity to absorb shocks and are able to lend through downturns.
Given the considerable uncertainty around the outlook, the Committee will continue to monitor the situation closely and stands ready to vary the UK CCyB rate – in either direction – in line with the evolution of economic conditions, underlying vulnerabilities and the overall risk environment.
The 2022 annual cyclical scenario
To support the FPC’s monitoring and assessment of the resilience of banks to potential downside risks, the Bank commenced its annual cyclical scenario (ACS) stress test in September 2022. It tests the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, real income shocks, large falls in asset prices and higher global interest rates, as well as a separate stress of misconduct costs. Results will be published in Summer 2023.
The Future Regulatory Framework
On 20 July 2022, HM Government published the Financial Services and Markets (FSM) Bill. The FSM Bill will, among other things, implement the outcomes of the Future Regulatory Framework (FRF) Review, which was established by the previous Government to consider how the UK’s financial services regulatory framework should adapt for the future, and in particular to reflect the UK’s position outside the European Union.
The FPC continues to judge that UK financial stability will require levels of resilience at least as great as those put in place since the GFC and required by international baseline standards, and - recognising the importance of the United Kingdom as a global financial centre - in some cases greater. In this context, the Bill introduces new secondary objectives for the PRA and FCA to facilitate, subject to aligning with international standards, the international competitiveness of the UK economy and its growth in the medium to long-term. The FPC stresses the importance for UK financial stability of alignment with international standards within that objective. The FPC supports the FRF measures contained in the Bill introduced into Parliament.
Subsequently, the Bill passed its second reading on 7 September. During that reading, the Economic Secretary to the Treasury stated the Government’s intention to include an amendment to introduce an intervention power that would enable HM Treasury to direct a regulator to make, amend or revoke rules where there are matters of significant public interest.
The FPC considers that the operational independence of regulators is an essential part of the regulatory regime in support of both of its public interest objectives, namely to deliver UK financial stability and strong, sustainable and balanced growth. The FPC will continue to monitor closely the Bill’s progress through Parliament and will consider the implications of all amendments once details are available.
