Financial Stability Report - July 2016

The Financial Stability Report sets out our Financial Policy Committee's view on the stability of the UK financial system and what it is doing to remove or reduce any risks to it.
Published on 05 July 2016
  • Summary

    It is the statutory responsibility of the Financial Policy Committee (FPC) to identify, monitor and take action to remove or reduce systemic risks, with a view to protecting and enhancing the resilience of the UK financial system. By fulfilling this responsibility, the FPC ensures that risks to financial stability are addressed. Transparency about risks is essential to strengthen resilience and for plans to be put in place to manage those risks should they crystallise.

    Consistent with its remit, the FPC identified in March the risks around the referendum on the United Kingdom’s membership of the European Union as the most significant near-term domestic risks to financial stability.

    The Committee had identified the following channels through which the referendum could increase risks to financial stability:

    • the financing of the United Kingdom’s large current account deficit, which relied on continuing material inflows of portfolio and foreign direct investment;
    • the UK commercial real estate (CRE) market, which had experienced particularly strong inflows of capital from overseas and where valuations in some segments of the market had become stretched;
    • the high level of UK household indebtedness, the vulnerability to higher unemployment and borrowing costs of the capacity of some households to service debts, and the potential for buy-to-let investors to behave procyclically, amplifying movements in the housing market;
    • subdued growth in the global economy, including the euro area, which could be exacerbated by a prolonged period of heightened uncertainty; and
    • fragilities in financial market functioning, which could be tested during a period of elevated market activity and volatility.

    The FPC has monitored these channels of risk closely. There is evidence that some risks have begun to crystallise. The current outlook for UK financial stability is challenging.

    There will be a period of uncertainty and adjustment following the result of the referendum. It will take time for the United Kingdom to establish new relationships with the European Union and the rest of the world. Some market and economic volatility is to be expected as this process unfolds.

    The degree of uncertainty and nature of adjustment is evident in financial market prices, which have moved sharply following the referendum. Between 23 June and 1 July, the sterling exchange rate index fell by 9% and short-term volatility of sterling against the dollar rose to its highest level in the post-Bretton Woods
    era. Equity prices of UK banks have fallen on average by 20%, with UK-focused banks experiencing the largest falls. Equity prices of domestically focused companies have fallen by 10%. The ten-year UK government bond yield fell by 52 basis points. These moves reflect an increase in risk premia on UK assets, a perceived weaker growth outlook, and anticipation of some future deterioration in the United Kingdom’s terms of trade and supply capacity.

    Rises in funding spreads for investment-grade borrowers and banks have been more than offset by falls in risk-free interest rates. Between 23 June and 1 July, investment-grade corporate bond yields fell by around 25 basis points. Wholesale debt funding costs for the major UK banks fell by a similar amount. Overall bank funding costs — taking into account any increase in the cost of equity and the change in wholesale debt funding costs — are broadly unchanged since the referendum.

    During this period of uncertainty and adjustment, the resilience of the UK financial system, upon which financial stability depends, is grounded on:

    • substantial capital and liquidity buffers, which have been shown in repeated stress tests to enable banks to absorb extremely severe economic and market shocks without amplifying those shocks;
    • the regulatory framework of the United Kingdom that allows capital and liquidity buffers to be drawn on, as needed, to allow the system to cushion shocks and maintain the provision of financial services to the real economy; and
    • an institutional framework that promotes co-ordinated, evidence-based responses to risks. This framework was used to develop and implement extensive contingency plans by UK authorities and firms in advance of the referendum. The Bank of England and HM Treasury co-ordinated with international authorities.

    The FPC is focused on promoting a financial system that dampens, rather than amplifies, the impact of uncertainty and adjustment on the real economy. This means reducing any pressure on firms to restrict the provision of financial services, including the supply of credit and support for market functioning.

    The FPC is monitoring closely the risks of: further deterioration in investor appetite for UK assets; adjustments in CRE markets leading to tighter credit conditions for businesses; increasing numbers of vulnerable households and procyclical behaviour of buy-to-let investors; the outlook for the global economy; and reduced and fragile liquidity in core financial markets.

    Having consistently built over recent years the resilience that is necessary for the system to face this challenging outlook, the FPC stands ready to take actions that will ensure that capital and liquidity buffers can be drawn on, as needed, to support the supply of credit and in support of market functioning. At policy meetings on 28 June and 1 July:

    • The FPC reduced the UK countercyclical capital buffer rate from 0.5% to 0% of banks’ UK exposures with immediate effect (see Box 1). Absent any material change in the outlook, and given the need to give banks the clarity necessary to facilitate their capital planning, the FPC expects to maintain a 0% UK countercyclical capital buffer rate until at least June 2017. This action reinforces the FPC’s expectation that all elements of the substantial capital and liquidity buffers that have been built up by banks are able to be drawn on, as necessary. It will reduce regulatory capital buffers by £5.7 billion, raising banks’ capacity for lending to UK households and businesses by up to £150 billion.
    • The FPC welcomed the Bank of England’s announcement that it will continue to offer indexed long-term repo operations on a weekly basis until end-September 2016. This is a precautionary step to provide additional flexibility in the Bank’s provision of liquidity insurance, further reinforcing the ability of firms to draw on their own liquidity buffers.
    • The FPC supported the position of the Prudential Regulation Authority (PRA) to allow insurance companies to use the flexibility in Solvency II regulations to recalculate transitional measures. These measures smooth the impact of those regulations. Without them, the regulations, which came into force in January, would tighten regulatory constraints on insurance companies following sharp falls in market interest rates. At the margin, the recalculation of transitional measures is likely to reduce immediate pressure on insurance companies to sell corporate securities and other risky assets. As the outlook evolves, the FPC stands ready to take any further actions deemed appropriate to support financial stability.

    As the outlook evolves, the FPC stands ready to take any further actions deemed appropriate to support financial stability

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