Financial Stability Report - December 2022
Current risk outlook
Global economic growth is slowing and borrowing costs have gone up.
Household and business finances
UK household and business finances are under growing pressure.
UK banks are strong enough to support households and businesses.
In 2023, there is a need for urgent international action to reduce risks in non-bank finance.
Global economic growth is slowing and borrowing costs have gone up
Since our July Financial Stability Report (FSR), the outlook for growth and unemployment in the UK and globally has deteriorated further. Prices have continued to rise rapidly, in considerable part reflecting steep increases in energy and food prices.
In response to these price rises, central banks around the world, including the Bank of England, have been increasing interest rates. These rate rises, and the expectation that they will rise further, have caused the cost of borrowing to rise for households and businesses.
There have been large and rapid moves in financial market asset prices. The price of certain assets – such as risky corporate bonds – have fallen. These trends are due to a combination of the worsening global economic outlook and the potential for further adverse geopolitical developments, including from Russia’s invasion of Ukraine. This has increased uncertainty.
UK household and business finances are under growing pressure
Globally, the challenging economic outlook is making it harder for households, businesses and governments to service their debt.
In the UK, monthly payments on around 4 million owner occupied mortgages are expected to increase over the next year. Households may also find it harder to repay other types of debt (eg credit cards and loans), particularly given rising food and energy prices. People are in a better position to manage these changes than they were in previous periods of stress and UK unemployment remains very low by historical standards, although it is expected to rise.
UK businesses have seen their earnings rise and debt fall as the effects of the Covid pandemic have receded. But higher costs, lower demand, rising interest rates, and continued disruption to supply chains are putting pressures on earnings for some businesses. Those most affected may find it harder to repay debts.
UK banks are strong enough to support households and businesses
The UK banking sector is resilient to an economic downturn much worse than the one currently expected. That reflects the large financial buffers they have built up since the 2008 global financial crisis.
We run regular stress tests to ensure major UK banks have big enough buffers to absorb large losses, even during severe downturns. Banks will adjust their lending in an economic downturn given what that means for debt affordability. But their strong position means they are able to support creditworthy households and businesses through the current downturn.
We set the UK countercyclical capital buffer (CCyB) rate each quarter. The CCyB provides banks with an additional ‘rainy day’ buffer making sure they can absorb potential future losses without restricting lending to those that are able to repay. The UK CCyB rate will be maintained at 2% with effect from July 2023. We are able to release this buffer if needed to make it easier for the banks to lend to UK households and businesses.
In 2023, there is a need for urgent international action to reduce risks in non-bank finance
Today, more business lending and other financial services come from financial institutions other than banks (ie non-bank financial institutions). This sector includes different types of firms, operating from many countries other than the UK.
We have previously highlighted the need to strengthen the resilience of this sector. In 2023, there is a need for urgent international action to reduce risks in non-bank finance. We will also begin an exploratory scenario exercise focused on non-bank financial institutions. This will help us better understand and reduce the risks associated with them.
At the end of September 2022, rapid and large moves in the interest rates on UK government debt exposed weaknesses in liability driven investment – LDI – funds which are used by UK pension schemes. This weakness threatened UK financial stability and the Bank of England had to intervene temporarily in government debt markets so that the funds could increase their resilience. Had we not acted, the stress would have significantly affected households’ and businesses’ ability to access credit.
The resilience of this sector needs to be improved in a number of ways to make it more robust. This includes the need for regulatory action to ensure LDI funds keep their higher levels of resilience. Some steps have already been taken, and further work will be done next year.
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.
Financial market developments and global debt vulnerabilities
The global economic outlook has deteriorated further since the July 2022 Financial Stability Report and financial conditions have tightened significantly. Monetary authorities have been responding to high levels of inflation, driven by higher and more volatile energy prices, domestic inflationary pressures and global supply chain issues following the pandemic. Higher central bank policy rates, alongside expectations of further rises, have led to very material and rapid increases in yields on long-term government bonds globally.
The deterioration in the global economic outlook, together with heightened uncertainty and the potential for further adverse geopolitical developments, has also led to falls in risky asset prices and a reduction in investor risk appetite. Financing conditions for households and businesses have tightened significantly. Financial market volatility has been elevated. Overall, moves in risky asset prices have been generally orderly, but the risk of sharp adjustments from further developments in the outlook remains.
Sharp increases in prices, including of energy, tighter financial conditions, and the worsening outlook for growth and unemployment will continue to weigh on debt affordability for households, businesses and governments globally. The FPC judges that the risks of global debt vulnerabilities crystallising have increased.
In the current environment, the FPC is monitoring geopolitical and other risks very closely and taking them into account when assessing the resilience of the UK financial system, including in the context of the 2022 annual cyclical scenario (ACS) stress test. It will work with other authorities at home and abroad, including the Prudential Regulation Authority (PRA), to consider whether any further action is required to enhance the resilience of UK banks to such risks.
UK household and corporate debt vulnerabilities
Household finances are being stretched by increased living costs and rising mortgage payments. Households are adjusting spending behaviour as real income is squeezed, although widespread signs of financial difficulty among UK households with debt have yet to emerge. The risk that indebted households default on loans, or sharply reduce their spending, has increased.
Pressures on household finances will increase over 2023. In total around half of owner occupier mortgages (around 4 million) will be exposed to rate rises over the next year. Falling real incomes, increases in mortgage costs and higher unemployment will place significant pressure on household finances. The share of households with high cost of living adjusted mortgage debt-servicing ratios would increase over 2023 to 2.4%, assuming current market pricing of Bank Rate, but remain lower than in the global financial crisis (GFC). Households are also experiencing increased pressure on their ability to service other types of consumer debt, such as credit cards and personal loans.
While pressures will increase, the FPC judges that households are more resilient now than in the run-up to the GFC in 2007 and the recession in the early 1990s. Households are in aggregate less indebted compared to the peak that preceded the GFC. And the proportion of disposable income spent on mortgage payments in aggregate is projected to rise but remain below the peak levels during the GFC and the 1990s recession. The core UK banking system is also more resilient, in part due to lower risk lending to households. The greater resilience of banks, and the higher standards around conduct, also means they are expected to offer a greater range of forbearance options. As such, the increased pressure on UK households is not expected to challenge directly the resilience of the UK banking system.
In aggregate, UK businesses are entering the period of stress in a broadly resilient position, but are under increased pressure from economic and financial developments. Earnings have risen and leverage has fallen in 2022 as the effects of the Covid pandemic have abated. But within the aggregate, there are a number of vulnerable companies with low liquidity, weak profitability, or high leverage. And some businesses are facing other pressures from higher costs of servicing debt, weaker earnings, and continued supply chain disruption. These pressures are expected to continue to increase over 2023, especially for smaller companies that are less able to insulate themselves against higher rates.
Increased pressure on the corporate sector is not expected to pose material risks to the resilience of the UK banking system, but will leave businesses more vulnerable to future shocks. There are some emerging signs of stress among corporate borrowers. Corporate insolvencies have increased, in particular among small and medium-sized enterprises. Financing conditions have tightened, particularly for risky firms, with some funding markets closed. But businesses are not yet showing signs of reducing employment or investment sharply in response to the economic downturn.
UK external balance sheet vulnerabilities
Reflecting its position as one of the most financially open economies in the world, many UK assets are held by overseas investors, meaning the UK is exposed to external financing risks. The UK’s external liabilities are significantly higher than for other G7 economies. The size of these liabilities means that the behaviour of foreign investors, and their perceptions of the UK macroeconomic policy framework, can have a material impact on UK financial conditions.
There were signs that foreign investor demand for UK assets weakened in September and early October, but this has since reversed. Over the second half of 2022 as a whole, UK asset prices have moved broadly in line with euro-area equivalents. Any future UK-specific shock to investor appetite for UK assets would likely reduce their prices. Some of the impact of such a move on the UK’s external balance sheet could be offset by moves in the exchange rate. This is in part because the UK’s external assets at current market value are estimated to be worth significantly more than its liabilities.
A particularly large and rapid fall in foreign investor demand for UK assets could pose a more acute risk to UK financial stability if it led to difficulties refinancing UK external liabilities, but the FPC judges that this risk at present is low. UK banks have robust foreign currency liquidity positions in aggregate and liquidity regulations require greater liquidity buffers for greater exposures to refinancing risk.
UK bank resilience
The FPC continues to judge that the UK banking system is resilient to the current economic outlook and has capacity to support lending, even if economic conditions are worse than forecast. Major UK banks’ capital and liquidity positions remain strong and pre-provision profitability has increased. They are therefore well placed to absorb shocks and continue meeting the credit needs of households and businesses. In aggregate smaller lenders are also well capitalised and have strong liquidity positions.
Asset quality remains relatively strong – although some forms of lending, such as buy-to-let, higher loan to value and higher loan to income mortgage lending, and lending to lower rated and highly leveraged corporates, are more exposed to losses – as are those lenders that are more concentrated in those assets.
There is evidence that the major UK banks are tightening their lending standards by adjusting their appetite for lending to riskier borrowers as risks have increased, consistent with the worsening macroeconomic outlook. Excessive restrictions on lending would prevent creditworthy households and businesses from accessing funding. This would be counterproductive, harming both the wider economy and ultimately the banks themselves. The FPC will continue to monitor UK credit conditions for signs of unwarranted tightening.
The FPC has previously judged that the UK banking system is resilient to a wide range of severe economic outcomes, and is assessing major UK banks against a further severe shock in the 2022 ACS. The results will be published in Summer 2023.
The UK countercyclical capital buffer rate
The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 2%, due to come into effect on 5 July 2023. The global and UK economic outlooks have deteriorated and financial conditions have tightened. The FPC judges that the UK banking system can absorb the impact of the expected weakening in the economic situation while continuing to meet credit demand from creditworthy households and businesses.
Vulnerabilities that could amplify future economic shocks remain. Maintaining a neutral setting of the UK CCyB rate in the region of 2% helps to ensure that banks continue to have sufficient capacity to absorb further unexpected shocks without restricting lending in a counterproductive way.
Cryptoasset prices have continued to decline sharply. The sudden failure of FTX – a large conglomerate offering cryptoasset trading and other associated services – has highlighted a number of vulnerabilities. The FPC continues to judge that direct risks to UK financial stability from cryptoassets remain limited. But these events have highlighted how systemic risks could emerge if cryptoasset activity and interconnectedness with the wider financial system increase. They underscore the need for enhanced regulatory and law enforcement frameworks to address developments in crypto markets and activities. Financial institutions and investors should take an especially cautious and prudent approach to any adoption of these assets until the necessary regulatory regimes are in place.
The resilience of market-based finance
Tightening financing conditions and greater volatility, alongside a number of economic shocks, have caused long-standing vulnerabilities in market-based finance (MBF) to crystallise in a number of areas over the past three years.
These episodes underline the need to develop and adopt policy reforms to increase resilience across the system of MBF. The Financial Stability Board (FSB) has a comprehensive international work programme in train focused on increasing the resilience of money market funds and open-ended funds, improving margin practices and understanding drivers of illiquidity in core funding markets, including non-bank financial institution (NBFI) leverage.
The FPC welcomes the FSB’s recent progress report to G20 leaders and the proposed work plan for 2023, which includes developing policy recommendations that seek to address vulnerabilities. The Bank and FPC continue to support strongly this programme of international work. In 2023 international and domestic regulators urgently need to develop and implement appropriate policy responses to address the risks from MBF. Absent an increase in resilience, the sharp transition to higher interest rates and currently high volatility increases the likelihood that MBF vulnerabilities crystallise and pose risks to financial stability.
Alongside this international work, the Bank will continue to work to reduce vulnerabilities domestically where it is effective and practical. To support this, there is a need to develop stress-testing approaches to understand better the resilience of NBFIs to shocks and their interconnections with banks and core markets. The Bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches. Further details will be set out in the first half of 2023.
The resilience of liability-driven investment funds
In late September, UK financial assets saw severe repricing, particularly affecting long-dated UK government debt. The rapid and unprecedented increase in yields exposed vulnerabilities associated with 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. In response to this threat to UK financial stability, the FPC recommended that action be taken, and welcomed the Bank’s plans for a temporary and targeted programme of purchases of long-dated UK government bonds to restore market functioning and give LDI funds time to build their resilience to future volatility in the gilt market.
This episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient, and that buffers were too low and less usable in practice than expected, particularly given the concentrated nature of the positions held in the long-dated gilt market. While it might not be reasonable to expect market participants to insure against the most extreme market outcomes, it is important that shortcomings are identified and action taken to ensure financial stability risks can be avoided in future. There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding.
The FPC is of the view that LDI funds should maintain financial and operational resilience to withstand severe but plausible market moves, including those experienced during the recent period of volatility. This should include robust risk management of any liquidity relied upon outside LDI funds, including in money market funds. The FPC welcomes, as a first step, the recent guidance published by The Pensions Regulator (TPR) in this regard. The FPC also welcomes the recent statements by the Financial Conduct Authority (FCA) and overseas regulators on the resilience of LDI funds.
Given the identified shortcomings in previous levels of resilience and the challenging macroeconomic outlook, the FPC recommends that regulatory action be taken, as an interim measure, by TPR, in co-ordination with the FCA and overseas regulators, to ensure LDI funds remain resilient to the higher level of interest rates that they can now withstand and defined benefit pension scheme trustees and advisers ensure these levels are met in their LDI arrangements.
Following this, regulators should set out appropriate steady-state minimum levels of resilience for LDI funds including in relation to operational and governance processes and risks associated with different fund structures and market concentration. Further steps will also need to be taken to ensure regulatory and supervisory gaps are filled, so as to strengthen the resilience of the sector. The Bank will continue to work closely with domestic and international regulators so that LDI vulnerabilities are monitored and tackled.
Banks, as providers of funding to the LDI sector, should apply a prudent approach when providing finance to LDI funds, taking into account the resilience standards set out by regulators and likely market dynamics in relevant stressed conditions. The FPC supports further work by the PRA and FCA to understand the roles of firms that they regulate in the recent stress, focusing particularly on their risk management, and to investigate lessons learned.
1: Developments in financial markets and global debt vulnerabilities
The global economic outlook has deteriorated further since the July 2022 Financial Stability Report (FSR) and financial conditions have tightened significantly. Monetary authorities have been responding to high levels of inflation, driven by higher and more volatile energy prices, domestic inflationary pressures, and global supply chain issues following the pandemic. Higher central bank policy rates, alongside expectations of further interest rate rises, have led to very material and rapid increases in yields on long-term government bonds globally.
Following the UK Government’s announcement of a set of fiscal policy measures in September 2022, yields on long-dated UK government debt rose more sharply than on equivalent US and German government bonds. The speed and scale of the rise in gilt yields resulted in stress in the liability driven investment funds sector, which itself reinforced the upward pressure on gilt yields (see Section 5). This resulted in a material risk to UK financial stability. In response, the FPC recommended action be taken and welcomed the Bank’s plan for a temporary and targeted programme of purchases of long-dated UK government bonds to restore market functioning. Market functioning has since improved and overall, changes in gilt yields since July 2022 are now comparable with international peers, but liquidity conditions remain challenging.
The deterioration in the global economic outlook, together with heightened uncertainty and the potential for further adverse geopolitical developments, has also led to falls in risky asset prices and a reduction in investor risk appetite. Risky asset prices are materially below their 2021 levels, and financing conditions for households and businesses have tightened significantly. Volatility has been elevated across a range of asset classes, given the macroeconomic uncertainty and geopolitical backdrop. Overall, moves in risky asset prices have been generally orderly, but the risk of sharp adjustments from further developments in the outlook remains.
Sharp increases in prices (including of energy and food), tighter global financial conditions, and the worsening outlook for growth and unemployment will continue to weigh on debt affordability for households, businesses and governments globally. The Financial Policy Committee (FPC) judges that the risks of global debt vulnerabilities crystallising have increased, and that they continue to pose a material risk to UK financial stability through economic and financial spillovers.
In the current environment, the FPC is monitoring geopolitical and other risks very closely and taking them into account when assessing the resilience of the UK financial system, including in the context of the 2022 annual cyclical scenario (ACS) stress test. It will work with other authorities at home and abroad, including the Prudential Regulation Authority (PRA), to consider whether any further action is required to enhance the resilience of UK banks to such risks.
1.1: The global economic outlook
The global economic outlook has deteriorated further since the July 2022 FSR.
In the November 2022 Monetary Policy Report (MPR), the Monetary Policy Committee set out its projections for UK and global activity. These were materially weaker than its projections in the May 2022 MPR. Global activity is expected to continue growing but at a significantly slower rate than at the time of the May 2022 MPR.footnote  Monetary authorities have been raising interest rates in response to elevated inflation rates. This, alongside expectations of future interest rate rises, has led to a significant increase in long-term interest rates, and associated repricing of other financial market assets.
Global inflation rose sharply in 2021, with higher and more volatile energy prices in 2022 providing further upward pressure on inflation. Energy prices increased sharply in the immediate aftermath of Russia’s invasion of Ukraine. Although they have broadly decreased from their peaks, some energy prices have remained elevated and are expected to remain so in the long term. For example, prices across the UK natural gas futures curve are on average around 85% higher than they were before the start of the invasion.
Energy prices have also remained volatile. There have been large intraday swings in prices of energy futures contracts, and required levels of initial margin remain elevated compared to their pre-invasion levels. Activity and liquidity in these markets remains muted, as the total number of outstanding exchange traded European Union (EU) and UK gas derivatives contracts has fallen by around 50% compared to 2021.
There is a continuing risk that energy prices could be pushed higher, and that volatility in prices could increase further. This would have a significant knock on effect to financial markets and to UK and global activity. The Bank and HM Treasury put in place the Energy Market Financing Scheme in October 2022 to help avoid the risk that extraordinary market conditions could result in energy firms of good credit quality being unable to meet margin calls. The Scheme will support wider confidence in the market, and help to reduce eventual energy costs for consumers and businesses.
1.2: Recent financial market conditions
Policymakers’ responses to heightened inflationary pressures have led to a rapid and material tightening in financial conditions across a range of economies.
Policy rates across a range of jurisdictions have increased sharply in response to inflationary pressures. For example, the US federal funds rate has increased by 300 basis points since May 2022, the fastest six-month increase in over four decades. And the European Central Bank (ECB) deposit rate has increased by 200 basis points over the same period, its fastest six-month increase since the euro was introduced in 1999.
As a result, there have been very material and rapid increases in interest rates on long-term government debt globally, and financial conditions have tightened considerably. Since the start of 2022, yields on 10-year UK, US, and German government debt have all increased by over 200 basis points, and are now all around two times higher than their post global financial crisis averages. Between July and October 2022, the increases in yields on both UK and US government debt were the sharpest seen since the 1990s, although these increases were not as pronounced as in the US 1979 rate tightening episode. Government bond yields have subsequently fallen back a little, or remained broadly flat, whereas in other notable tightening episodes, interest rate rises have tended to persist over a longer period (Chart 1.1).
Chart 1.1: The tightening in 10-year UK and US government bond yields was particularly sharp, and in line with historical episodes back to the 1980s
- Sources: Bloomberg Finance L.P and Bank calculations.
- (a) Tightening episodes were identified by the largest three-month (US) and two-month (UK) moves in yields combined with other qualitative historical sources.
- (b) The minimum for each series, at which the series is indexed, represents the lowest yield within the time period spanned by an identified tightening period.
Amid broader market volatility, UK assets – particularly long-term UK government debt – saw a further severe repricing in late September. On 23 September, the UK government announced a set of fiscal policy measures. In the days that followed, gilt yields increased sharply. For instance, between 1 August and their peak on 14 October, yields on 30-year gilts rose significantly, briefly exceeding 5% – a more than 270 basis point increase. During this period, yields on 30-year US Treasuries and German bunds peaked at around 150 basis points higher than their starting points, respectively. The increase in gilt yields during this episode was more than twice the size of that seen during the March 2020 ‘dash for cash’, which itself was the largest increase since 2000.
The speed and scale of the rise in gilt yields resulted in stress in the liability driven investment funds sector, which itself reinforced the upward pressure on gilt yields (see Section 5). This risked leading to further market dysfunction, creating a material risk to UK financial stability. In response, the FPC recommended action be taken and welcomed the Bank’s plans for a temporary and targeted programme of purchases of long-dated UK government bonds to restore market functioning. Since this episode, gilt yields have fallen, such that since July the overall change in gilt yields is in line with global peers and gilt market functioning has improved.
Gilt market liquidity is yet to fully recover. One commonly used headline measure of market liquidity is the bid-offer spread; the difference between the price at which an asset can be sold by a client (the bid) and that which it can be purchased (the offer). As reflected in the spike in bid-offer spreads in September, liquidity conditions in gilt markets have been exceptionally challenging since the July 2022 FSR. And despite improving over recent weeks, bid-offer spreads on 10-year gilts remain elevated compared to equivalent US and German government bonds (Chart 1.2). Should liquidity conditions remain challenging, there is a higher risk of future shocks resulting in sharp moves in yields.
Chart 1.2: Bid-offer spreads remain particularly elevated in the 10-year gilt market
Bid-offer spreads on 10-year government bonds
- Sources: Refinitiv Eikon from LSEG and Bank calculations.
In September and early October, during the period of heightened volatility and severe repricing in UK markets, there were signs that foreign investor demand for UK assets weakened. While this has since reversed, foreign investor appetite for UK assets could be vulnerable to future shocks (see Box A).
The deterioration of expected global growth, together with heightened uncertainty, has led to sharp falls in risky asset prices, a reduction in investor risk appetite, and elevated financial market volatility.
There is evidence of weaker risk appetite across financial markets. Against the backdrop of higher interest rates and the weakening macroeconomic outlook, risky asset prices have decreased sharply and are materially below their 2021 levels. Since the start of 2022, major equity indices in the US and euro area, and those most exposed to the deteriorating UK economic outlook, have fallen by around 10%–20%. Investment-grade corporate bond spreads have widened by around 45–90 basis points. Overall, movements in risky asset prices have been generally orderly, but the risk of sharp adjustments from further developments in the economic outlook remains, for example from potential further adverse geopolitical developments. These could be amplified by existing vulnerabilities in the system of market-based finance and continued challenging market liquidity conditions.
Market volatility has remained elevated, reflecting uncertainty around the macroeconomic outlook and geopolitical developments. For example, the equity volatility index (VIX) has been nearly two thirds higher than its post global financial crisis average since July 2022, but around half the peak level observed during the ‘dash for cash’. Volatility in the bond market has also been heightened; since July 2022 the Merrill Lynch options volatility estimate (MOVE) index has on average been roughly double its post-crisis average and higher than its level observed during the ‘dash for cash’.
Weaker risk appetite is also reflected in primary credit markets, both in the higher cost of issuing corporate debt, as well as in subdued primary debt issuance volumes. Issuance has been particularly weak for some riskier borrowers. For example, there has been no issuance of sterling high-yield debt since April 2022, the longest period without issuance since 2011. More broadly, year-to-date issuance of advanced economy high-yield corporate bonds is between 10%–35% of its five-year average level. Leveraged lending and collateralised loan obligation issuance have also slowed relative to historical averages, albeit to a lesser extent (Chart 1.3).
Chart 1.3: Year-to-date issuance of high-yield corporate bonds has been subdued, relative to average issuance in Q1–Q3 over the past five years
Year-to-date issuance in corporate financing markets as a proportion of averages over Q1–Q3 in the past five years
- Sources: Leveraged Commentary & Data, Refinitive Eikon from LSE and Bank calculations.
The recent financial market volatility, and in particular the recent dysfunction in the long-dated gilt market, further highlights previously identified vulnerabilities in the system of market-based finance. Going forward, the adjustment to an environment of higher interest rates and heightened market volatility could expose further risks to UK financial stability from this source (see Section 4).
Cryptoasset prices have continued to decline sharply and the sudden failure of FTX has highlighted a number of vulnerabilities. But the FPC continues to judge that direct risks to UK financial stability from cryptoassets remain limited.
Cryptoasset prices have declined more sharply than other risky asset prices. The market capitalisation of cryptoassets has fallen to around US$800 billion, from a peak of almost US$3 trillion in late 2021. More recently, the sudden failure of FTX – a large conglomerate offering cryptoasset trading and other associated services – has highlighted a number of vulnerabilities within the cryptoasset ecosystem including:
- lack of requirements and transparency around corporate structures and the relationships between them;
- lack of controls to mitigate or prevent exposures to credit, liquidity, and market risk;
- high volatility associated with unbacked cryptoassets;
- the potential for extreme ‘wrong way’ risk when firms accept their own unbacked cryptoasset as collateral; and
- lack of client fund protection.
The FPC continues to judge that direct risks to UK financial stability from cryptoassets are limited, reflecting their current limited size and interconnectedness with the financial system (see March 2022 Financial Stability in Focus). Consistent with this, the sharp decline in cryptoasset prices and the recent collapse of FTX have not posed material risk to broader financial stability. However, given the speed of developments in this area it is important to be forward-looking. These events have highlighted how systemic risks could emerge, particularly if cryptoasset activity and interconnectedness with the wider financial system increase.
Recent events further underscore the need for enhanced regulatory and law enforcement frameworks to address developments in crypto markets and activity. Financial institutions and investors should take an especially cautious and prudent approach to any adoption of these assets until the necessary regulatory regimes are in place. In March, the Financial Conduct Authority issued a statement to all regulated firms highlighting certain risks such as financial crime and custody risks related to crypto activities.
1.3: Global debt vulnerabilities
The FPC judges that the risks of global debt vulnerabilities crystallising have increased in light of the weakening in the global economic outlook and the tightening financial conditions. Geopolitical tensions are also elevated and could increase further. These developments continue to pose a material risk to UK financial stability.
A deterioration in global growth prospects and a tightening in global financial conditions, like that observed, has the potential to affect UK financial stability through a number of channels.
As global financial conditions tighten, foreign borrowers may struggle to service their debts and defaults could increase. UK banks could incur material losses on their exposures to foreign borrowers, since around 45% of major UK banks’ outstanding lending was to non-UK borrowers as of June 2022. If the likelihood of foreign borrower default and global risk aversion increases further, risky asset prices may be vulnerable to further falls. Banks could therefore directly incur losses on their holdings of risky assets, and global financial conditions could tighten further. In turn, this could result in tightening UK financial conditions. More broadly, global debt vulnerabilities can also amplify economic shocks in foreign economies and lead to spillovers to the UK, for example through lower demand for UK exports (Figure 1.1).
Figure 1.1: Tightening global financial conditions can affect UK financial stability through numerous channels
The FPC continues to judge that global debt vulnerabilities pose material risks to UK financial stability through these channels and that they are now more likely to crystallise in light of the further weakening in the global economic outlook, and the material tightening in global financial conditions. Additionally, geopolitical tensions are elevated and there is potential for them to increase further.
Authorities in other jurisdictions have also noted vulnerabilities in their domestic financial systems. For instance, in September 2022 the European Systemic Risk Board issued a warning about pockets of vulnerability in the EU financial system, including risks that could be associated with a sharp adjustment in EU house prices.
Sharp increases in prices and tighter global financial conditions will continue to weigh on debt affordability for some businesses in advanced economies, particularly those with high leverage or high exposure to energy prices.
Increased prices, including energy prices, have reduced consumer demand and increased the cost of production for a range of businesses. This, along with the higher interest rate environment, is likely to weigh on debt affordability. In turn this could lead to both corporate borrowers defaulting on their debt, and a further weakening in the economic outlook due to a further contraction in demand. Similar to the UK, authorities in many jurisdictions have responded by introducing measures to mitigate the effect of high and volatile energy prices on corporate finances, as well as to support households. Corporates in energy intensive sectors may, however, still find that their finances are particularly squeezed.
The FPC has previously highlighted vulnerabilities from highly leveraged corporate borrowing, particularly in the US. The stock of outstanding leveraged lending in the US has increased from around US$2 trillion in 2017 to roughly US$3.5 trillion as of end-September 2022. This lending is typically floating rate and therefore sensitive to increasing interest rates.
The material tightening global financial conditions will also weigh on households’ ability to service their debt in some countries.
Tighter global financial conditions have led to tighter household credit conditions, and reduced activity in global housing markets. Mortgage rates have risen sharply in the United States. The average quoted rate on 30-year fixed-rate US mortgages has increased from around 3% in 2021 Q4 to around 7% in November 2022. Meanwhile the value of new US mortgage originations fell to around US$680 billion in 2022 Q2, which is just half the 2020 Q4 peak but still significantly higher than pre-pandemic. Moreover, during the summer, US house prices recorded their first month-on-month falls since February 2012. Euro-area mortgage market conditions have tightened too, but by less than in the US.
In the US, most households are likely to be shielded from increasing interest rates as most household debt is fixed rate, typically with long terms. Mortgage debt accounts for two thirds of US household debt and 80% was originated on fixed terms of more than 15 years. And nearly all outstanding mortgages are at loan to value ratios of 80% or less. As a result, most US households are likely to be able to absorb even a 20% fall in house prices before falling into negative equity and potential losses on defaulting US mortgages should therefore be limited.
A slowdown in the US housing market could have knock-on effects to the wider financial system. In line with moves in broader asset prices, prices of financial assets tied to the US housing market have fallen sharply. For example, over 2022 the S&P US mortgage-backed securities (MBS) index has fallen by 11%, and the Wilshire US real estate investment trust index has also fallen by 25%. UK investors’ holdings of these assets are relatively limited, as they hold significantly less than US$100 billion of US government agency backed MBS, for example (Chart 1.4). But US banks’ exposures to these assets are sizable, at US$3.2 trillion and non-bank financial institutions (NBFIs) exposures are also substantial. Should NBFIs need to liquidate their holdings quickly over a similar timeframe to one another, for example to raise liquidity to meet margin calls in other markets or as investors seek to reduce exposure to the US housing market, they could amplify price falls.
Chart 1.4: UK holdings of US mortgage-backed securities are relatively small
- Sources: Federal Reserve Bank of New York, Federal Reserve Board – Treasury International Capital reports, US Federal Reserve flow of funds, joint US Treasury and Bank calculations.
- (a) Each square represents 1% of the total holdings of US mortgaged-backed securities.
- (b) UK holdings are estimated based on June 2021 data.
- (c) Other includes US corporates, holding companies, and an accounting adjustment reflecting mismatches in the reporting of US agency assets and liabilities.
- (d) ‘Other foreign holdings’, and ‘UK’ could include both private and public sector holdings.
Although mortgage rates have increased by less in the euro area than the US, some euro-area borrowers are likely to be exposed to rising rates. Across the euro area, just under 25% of new mortgage lending in September 2022 was extended at either floating rates or with a fixed term of less than one year. There are also differences in the degree of exposure to rising mortgage rates within the euro area. The take up of floating rate products over the past 10 years has been proportionally greater in Spain and Italy than in France and Germany, for example. Analysis by the European Banking Authority shows that 17% of outstanding mortgages in the euro area were at loan to value ratios of 80% or higher in 2022 Q1, suggesting they may be at risk of falling into negative equity if euro-area house prices fall significantly.
Despite these potential vulnerabilities, analysis from euro-area and US authorities show their banking systems are likely to remain resilient to prospective increases in losses on lending. For example, the November 2022 ECB Financial Stability Review shows that the major euro-area banks have robust capital positions, with an average CET1 capital ratio of around 15% as of 2022 Q2. The November 2022 Federal Reserve Board Financial Stability Report notes that the US banking system maintains an aggregate capital position within its usual range over the previous decade, and the Federal Reserve Board’s 2022 stress test indicates that large US banks would maintain capital ratios well above minimum risk-based requirements during a substantial economic downturn.
Government support measures to mitigate the impact of high energy prices on households and businesses are likely to raise public debt levels, and vulnerabilities associated with high public debt levels could intensify in an environment of tightening financial conditions.
The support measures introduced in many jurisdictions to reduce pressures on households and businesses, particularly from heightened and more volatile energy prices, are likely to increase public debt levels. For instance, Germany is borrowing €200 billion (6% of its 2021 GDP) to implement a cap on gas and electricity prices.
The FPC has previously highlighted vulnerabilities created by high public debt levels in the euro area, including interlinkages between banks and sovereigns. Yields on euro-area government bonds have increased since July 2022. For example, yields on 10-year German bunds have increased by about 1.3 percentage points to around 2%. Following a widening in spreads to German bunds earlier in year, yields on 10-year Italian government debt had increased to over 4% in mid-October, but have decreased since. The spread against bunds remains narrower than its post financial crisis peak of around 500 basis points in November 2011. If this spread rises further, however, could increase the risk of previously identified euro-area vulnerabilities crystallising. The ECB’s Transmission Protection Instrument might help to mitigate this risk. It allows the ECB to make secondary market purchases of securities issued in jurisdictions that are experiencing a deterioration in financing conditions not warranted by country-specific fundamentals.
The Chinese economy is slowing down, reflecting an increase in the number of Covid cases, as well as debt vulnerabilities in the Chinese property market crystallising. A sharper slowdown could pose risks to UK financial stability.
A slowdown in the Chinese economy could impact UK financial stability through various trade and financial market channels, as well as UK banks’ direct exposures. This reflects the size of the Chinese economy, its trading links with a range of global economies including the UK, and the UK banks’ exposures to China, including indirectly via Hong Kong.
The Chinese economy has slowed, in part due to ongoing Covid restrictions as Covid cases have increased. In addition to the risks to public health associated with increases in Covid cases, further lockdowns are likely to weigh on economic activity. The slowdown has also been driven partly by debt vulnerabilities in the Chinese property sector crystallising. Property prices have continued to fall and are now on average 2.6% lower than their 2021 Q3 peak. Property investment also fell by around 16% in the year to October. But recently announced policy measures to support the property sector may reduce near-term risks to some extent. The likely effect of the current slowdown on UK financial stability appears limited, but a sharper or broader slowdown in China could have more significant spillovers to the UK.
Tighter financial conditions and the stronger US dollar will weigh on debt affordability in some non-China emerging market economies (NCEMEs), but this currently poses limited risk to UK financial stability.
High energy costs, tighter global financial conditions, and the stronger US dollar, will also weigh on debt serviceability in some NCEMEs. In particular, energy importers and those with high levels of dollar-denominated debt or large current account deficits are likely to be most exposed. Non-resident portfolio flows to NCEMEs have continued to be volatile, with a small cumulative inflow since the July 2022 FSR. There has been evidence of stress in some NCEMEs. For example, NCEME exchange rates have generally depreciated against the US dollar. Additionally, dollar-denominated government bonds of around 14 smaller NCEMEs are trading at ‘distressed levels’, indicating they are at a higher risk of default than other NCEMEs.footnote 
The larger and more established NCEMEs, such as Brazil and India, have been less affected so far. If a number of these larger NCEMEs were to enter into stress, there would likely be a significant negative effect on the global risk environment. Stress in larger and more established NCEMEs would therefore be more likely to impact negatively on UK financial stability.
There are signs that external vulnerabilities in some larger NCEMEs are increasing, as their current account deficits are rising while their foreign currency reserves are falling. A significant proportion of this decrease in reserves is related to valuation effects, which have likely been driven by falling US government bond prices. The tightening in external financing conditions has not, as yet, led to significant stresses in the larger NCEMEs, and as a result spillovers to the wider financial system have so far been limited. On average, the spreads over US government bonds for dollar denominated debt of a group of 12 larger NCEMEs have decreased by around 70 basis points since the July 2022 FSR.
In the current environment, the FPC is monitoring geopolitical and other risks very closely and taking them into account when assessing the resilience of the UK financial system, including in the context of the 2022 ACS stress test.
It will work with other authorities at home and abroad, including the PRA, to consider whether any further action is required to enhance the resilience of banks to such risks.
Box A: UK external balance sheet vulnerabilities
The UK has a large external balance sheet associated with large gross capital flows that exposes it to external financing risks.
The UK is one of the most financially open economies in the world. It has external liabilities (UK assets held by overseas residents) of over 550% of GDP (Chart A). This is significantly higher than other G7 economies, although lower than the level of the Netherlands and Switzerland. The size of these liabilities mean that the behaviour of foreign investors, and their perceptions of the UK’s macroeconomic policy framework and its long-term growth prospects, can have a material impact on UK financial conditions.
A decline in foreign investor appetite for UK assets, all else equal, could lead to large falls in UK asset prices and tighter domestic credit conditions, as well as a weaker sterling exchange rate.
Foreign investors’ perceptions about the riskiness of UK assets affect their willingness to hold them and the return they require. Foreign investors will demand a higher risk premium on UK assets when sterling exchange rate volatility is expected to be higher, for example. This can exacerbate falls in UK asset prices in response to shocks and ultimately contribute to tighter UK financial conditions.
Foreign investors’ decisions are likely to have a larger influence on prices in markets where they have a larger presence. Foreign investors are estimated to own around 50% of UK equity and private sector debt and around 30% of UK government bonds. They also typically account for over 40% of the value of UK CRE transactions in any given year.
Chart A: The UK has large external liabilities
UK gross external liabilities by type (a)
There were signs that foreign investor demand for UK assets weakened in September and early October, but this has since reversed. Over the second half of 2022 as whole UK asset prices have moved broadly in line with euro-area equivalents.
Based on an international comparison across financial market variables, it appears that foreign investor sentiment towards UK assets deteriorated markedly in September. This was related to increased uncertainty around the UK’s economic prospects including the UK’s fiscal position. For example, between the start of September and mid-October, UK government bond term premia and corporate bond spreads rose by more than their counterparts in the US and euro area. Since then, indicators of the perceived riskiness of UK assets have generally fallen back in line with euro-area economies.
Any future UK specific shock to investor appetite for UK assets would likely result in some combination of a weaker sterling exchange rate and lower UK asset prices. This would likely tighten domestic financing conditions (ie higher borrowing costs for the government, households and businesses), and lead to downward pressure on real incomes through higher domestic prices for goods and services related to a weaker value of sterling. Both of these factors would make it harder for indebted UK households and corporates to service their debt (see Section 2).
One potential shock could come in the form of a downgrade to the UK’s credit rating, after several rating agencies downgraded the outlook for the UK’s rating to negative in September and October. Although there is some uncertainty, the underlying effects of a one notch downgrade are already likely to be priced in to some extent. Forced selling, due to investment mandates which stipulate certain minimum credit ratings, for example, is not expected to be material.
Currency mismatches between the assets and liabilities of UK resident non-financial businesses can amplify external risks. Unlike the UK as a whole, non-financial businesses hold more foreign currency liabilities than assets because some choose to borrow in more liquid foreign currency corporate debt markets to fund sterling assets. They do this because it can be cheaper for them to raise finance in these markets and swap the proceeds back into sterling. For UK businesses with a currency mismatch, the cost of servicing foreign currency debt can rise when sterling depreciates without this being fully offset by a rise in their foreign currency revenues. This can affect their profitability or solvency. That said, large companies are generally able to hedge these risks.
A particularly large and rapid fall in foreign investor demand for UK assets could pose a more acute risk to UK financial stability if it led to difficulties refinancing UK external liabilities, but the Financial Policy Committee judges that this risk at present is low.
‘Other investment’ liabilities, mostly composed of currency, deposits and loans, account for around 35% of total external liabilities (Chart A). A significant portion of these could, in theory, be withdrawn at short notice. But this risk appears low. At least 35% of these ‘other investment’ liabilities are estimated to consist of intragroup bank transactions, and where that is the case, a sudden withdrawal in stress is much less likely. Direct risks to UK banks from this channel appear limited. While there is no regulatory requirement for individual banks to match their short-term foreign currency liabilities on a currency-by-currency basis, UK banks have robust foreign currency liquidity positions in aggregate. Furthermore, liquidity regulations stipulate that the more exposed they are to refinancing risk, the greater the liquidity buffer they are required to have in place. Overall, the risk of an acute increase in refinancing difficulties giving rise to an impact on UK financial stability remains low.
One feature of the UK’s external financing position is that the UK has run a persistent current account deficit over past decades. That necessitates consistent net inflows of capital from abroad. The UK’s ability to attract these inflows at current levels of sterling has been supported by the fact that the estimated value of UK external assets are significantly larger than the value of UK external liabilities.
The annual current account deficit has averaged around 3¼% of GDP since 2000, which has required net inflows of capital of the same magnitude. While these net inflows can be funded by UK residents selling foreign assets, ultimately their long-term sustainability will rely on foreign investors’ willingness to finance them.
The net value of the stock of the UK’s external assets and liabilities (the UK’s net international investment position (NIIP)) is estimated to be strongly positive (Chart B). This should support investor confidence when investing in UK assets. The strength of the UK’s NIIP is the result of a positive net rate of return on its external balance sheet over previous decades. This has more than offset the capital flows associated with funding its persistent current account deficit, which other things equal, would have eroded the UK’s NIIP over time.
The positive net rate of return on the UK’s NIIP has been partly due to compositional effects, although these may have lessened recently. Historically, the UK has had more equity and long-term debt assets than liabilities, which generated positive net returns. But this compositional feature has reversed over the past two decades.
The currency composition of the UK’s external balance sheet can also influence investors’ perceptions around the sustainability of net capital inflows to the UK. UK liabilities tend to be denominated in sterling and UK assets tend to be denominated in foreign currencies so that, other things equal, a sterling depreciation increases the value of the UK’s NIIP.
Chart B: The UK’s net international investment position has improved in recent years, in part due to a fall in the value of sterling
- Sources: Bloomberg Finance L.P., ONS and Bank calculations.
- (a) Data are not seasonally adjusted.
- (b) For details on how foreign direct investment estimates are adjusted for changes in market value, see footnote (3) on page 23 of the May 2014 Inflation Report.
- (c) The current account is cumulated from 1970.
- (d) The ONS NIIP re-evaluates portfolio debt and equity at regular intervals but it values FDI at purchase price.
2: UK household and corporate debt vulnerabilities
UK economic conditions have worsened and financial conditions have tightened over 2022. Household finances are being stretched by increased living costs and rising mortgage payments. Households are adjusting spending behaviour as real income is squeezed, although widespread signs of financial difficulty among UK households with debt have yet to emerge. The risk that indebted households default on loans, or sharply reduce their spending, has increased.
Pressures on household finances will increase over 2023. Falling real incomes, increases in mortgage costs and higher unemployment will place significant pressure on household finances. The FPC judges that households are more resilient now than in the run-up to the global financial crisis in 2007 and the recession in the early 1990s. In aggregate, the proportion of disposable income spent on mortgage payments is projected to rise but remains below the peak levels during the global financial crisis (GFC) and the 1990s recession.
The core UK banking system is also more resilient, in part due to lower risk lending to households. The greater resilience of banks, and higher standards around conduct, also mean they are expected to offer a greater range of forbearance options. As such, the increased pressure on UK households is not expected to challenge directly the resilience of the UK banking system.
In aggregate, UK businesses are entering the period of stress in a broadly resilient position. Earnings have risen and leverage has fallen in 2022 as the effects of the Covid pandemic have abated. But within the aggregate, there a number of vulnerable companies with low liquidity, weak profitability or high leverage. And some businesses are facing other pressures from higher costs of servicing debt, weaker earnings, and continued supply chain disruption. Pressures on businesses are expected to continue to increase over 2023, especially for smaller companies which are less able to insulate themselves against higher rates. The risks that firms default on debt, or cut employment or investment sharply, have increased.
There are emerging signs of some corporate borrowers facing difficulty. Corporate insolvencies have increased, driven in particular among micro and small and medium-sized enterprises (SMEs). Financing conditions have tightened, particularly for risky firms, with some funding markets closed. But businesses are not yet showing signs of reducing employment or investment sharply in response to the economic downturn. Increased pressure on the corporate sector is not expected to pose material risks to the resilience of the UK banking system, but will leave businesses more vulnerable to future shocks.
2.1: UK economic and financial market developments
Household and corporate indebtedness impact UK financial stability in two key ways.
Although borrowing helps households and businesses to smooth consumption and investment, high indebtedness can pose risks to UK financial and economic stability. The FPC has previously identified two main channels through which high levels of household or corporate debt can pose risks to the UK financial system or wider economy:
1. Lender resilience. Highly indebted households and businesses are more likely to face difficulties making debt repayments. If borrowers default, this can lead to losses for lenders and test their resilience.
2. Borrower resilience. In an economic downturn, more highly indebted and savings-constrained households may cut back more sharply on other spending to make debt repayments, and highly indebted corporates may reduce investment and employment by more than those with less debt. These behaviours can amplify macroeconomic downturns, further affecting household and corporate resilience, and potentially also increasing losses for lenders on other forms of lending (see Figure 2.1).
Figure 2.1: UK household and corporate debt vulnerabilities can affect UK financial stability
UK economic conditions have deteriorated and financial conditions have tightened significantly over 2022.
The outlook for the UK economy has worsened significantly since the July 2022 FSR. High food and energy costs continue to feed through into producer and consumer prices. CPI inflation rose to 11.1% in the 12 months to October 2022. Within this, food price inflation stood at 16%, and domestic energy price inflation was just under 90%. Domestic inflationary pressures are expected to remain strong over the next year. The MPC’s latest projections are for the UK economy to be in recession for a prolonged period.
There has been a significant increase in household and corporate borrowing costs (see Box B). Market interest rates, which underpin the cost of borrowing for households and businesses, have risen over 2022. This has been driven in large part by increases in Bank Rate, and market expectations that the MPC will continue to increase Bank Rate in order to meet the inflation target, in the context of persistently high global inflationary pressure. For example, the two-year overnight index swap rate has risen to around 4.4% from 0.9% in December 2021.
Rising mortgage rates are putting pressure on house prices, and house price growth has started to slow (see Box B). Changes in house prices affect the loan to value ratios on lenders’ mortgage portfolios, which are an important driver of the losses they would face if mortgagors were to default.
Economic and financial conditions are stretching household and corporate finances. Debt has become more difficult to obtain for some borrowers, and more costly to service. Higher input prices, labour market shortages and supply chain disruption are putting pressure on corporate balance sheets, and household finances are stretched by increases in costs of essential goods, especially energy and food. Pressures on household and corporate finances will increase over 2023.
2.2: UK household debt vulnerabilities
Household finances are being stretched by economic and financial developments.
Increased living costs and rising mortgage payments have made it harder for households to service debt. Households are adjusting spending behaviour as real income is squeezed, although widespread signs of financial difficulty among UK households with debt have yet to emerge.
One of the ways the FPC assesses household debt vulnerabilities is by considering how much of their income, adjusted for tax and essential spending,footnote  households need to spend on debt repayments. Specifically, the FPC monitors the proportion of households with cost of living adjusted mortgage debt-servicing ratios (COLA-DSRs) over 70%. Households with levels of COLA-DSRs above this point are more likely to face difficulties in meeting debt repayment costs, so are more likely to default, or cut back sharply on other consumption to manage repayments. The share of households with high mortgage COLA-DSRs has increased over 2022 H2, but currently remains around historic averages at 1.6%. One factor currently helping to limit household debt vulnerabilities is that the UK unemployment rate remains very low by historical standards, at 3.6%.
Pressures on household finances will increase over 2023, making it harder for households to service their debt.
Pressures on household finances will increase over 2023. The cost of essential goods is expected to remain high, and around half of owner-occupier mortgagors will experience increases in mortgage costs (see Box B). These factors will increase the proportion of households with high COLA-DSRs. The expected rise in unemployment should also increase the proportion of households under pressure from debt, though by a less significant amount. This is because unemployment is projected to remain well below levels seen in previous large recessions, and because mortgagors tend to be dual-income households so they are likely to still have some earnings if one earner becomes unemployed. For those in work, nominal wage growth will also help to offset some of the upward pressures on COLA-DSRs.
The share of households with high mortgage COLA-DSRs is projected to increase over 2023 to 2.4%, or around 670,000 households. These levels are significantly higher than those observed in recent years and are starting to approach levels comparable to the proportion of households with high debt-servicing burdens around the start of the GFC (Chart 2.1). In 2007, 2.8% of households (equating to around 710,000 households at that time) had high COLA-DSRs.
The overall COLA-DSR distribution is also projected to change in a way that signals that households will have greater difficulty servicing debt over 2023. The numbers of households with the lowest levels of COLA-DSRs is expected to fall, as households move into higher COLA-DSR groups. And the number of households with COLA-DSRs just below the threshold at which the FPC identifies a COLA-DSR as high, and therefore more likely to struggle to make payments on their debt, is projected to increase (Chart 2.1). Taken together, these expected changes imply that households will be more vulnerable to future shocks. But the proportion of households with high COLA-DSRs is expected to remain below the pre-GFC peak.
Chart 2.1: The share of households with high debt-servicing burdens is projected to increase over 2023
- Sources: British Household Panel Survey/Understanding Society (BHPS/US), Bank of England, NMG Consulting survey, ONS and Bank calculations.
- (a) The threshold of 70% is estimated by taking the threshold at which households become much more likely to experience repayment difficulties for gross DSRs (40%) and adjusting it to reflect the share of income spent on taxes and essentials (excluding housing costs) by households with mortgages. For more information on the gross threshold, see the August 2020 FSR. The impact of inflation is estimated by assuming the prices of essential goods rise in line with the November 2022 MPR projections and the extended Energy Price Guarantee, and households do not substitute away from this consumption.
- (b) Interest rate projections are applied based on market expectations for Bank Rate as at 25 November 2022. Projections are conditioned on announced fiscal policy for households over 2023 as at 25 November 2022. Proportions refer to number of households with respective COLA-DSR (excluding non-mortgagors) as a proportion of all households in the UK. A greater number of households had mortgages in 2007.
Households are also experiencing increased pressure on their ability to service other types of consumer debt, such as credit cards and personal loans. Relative to mortgage rates, interest rates on consumer credit products are typically higher but are not as sensitive to increases in Bank Rate, so interest rates on these products have not increased as sharply. That said, households’ ability to service consumer credit debts will also be affected by increases in the costs of essential goods and rises in unemployment. And households with both mortgages and consumer credit tend to default on consumer credit before they stop paying their mortgage. In response to affordability concerns, some banks have tightened lending criteria on consumer credit products.
Thus far, widespread signs of financial difficulty among UK households with debt have yet to emerge. While the major UK banks have reported an increase in arrears on some types of lending this year, mortgage arrears overall remain subdued by historic standards and lenders have not realised large losses or changed the levels of forbearance they have extended. The proportion of mortgages in arrears of six months or more is around 0.5%, which is comparable to pre-Covid levels and much lower than peaks of 3.5% in 1992 and 1.4% in 2009. The share of consumer credit loans which have not yet defaulted, but which have had impairments raised against them by banks due to a significant increase in credit risk, has picked up somewhat over 2022, but remains around pre-pandemic levels. And evidence from Citizens Advice suggests more households are seeking help with budgeting to cope with the cost of living, but does not yet point to a material increase in people struggling to access credit or service debts.
The risk that households default on debt, or sharply reduce their spending, has increased. But the increased pressure on UK households is not expected to challenge directly the resilience of the UK banking system.
Pressures on household finances will increase the risk that households default on debt, or sharply reduce their spending. Historically, some periods of household distress have resulted in significant losses for banks. For example, household finances were put under pressure by high levels of unemployment and interest rates in the early 1990s, resulting in material loss rates for banks. Loss rates on mortgages in this period peaked at 1.8% for UK banks and building societies, and up to 2.8% when taking into account losses incurred by the UK insurance industry on mortgage loans originated by banks and building societies.
Household finances were also put under pressure during the global financial crisis, but loss rates on mortgages were more contained, at 0.6%. This reflects the sharp fall in interest rates in response to the GFC that cushioned the impact on households, combined with a strong recovery in house prices in the period following the crisis.
There are several factors that are likely to mitigate the impacts of the current economic downturn on households and lenders. The FPC judges that households are more resilient now than in the run-up to the financial crisis in 2007 and the recession in the early 1990s. Households are in aggregate less indebted; the ratio of aggregate debt to income has been broadly stable over recent years at around 125%, well below the peak of around 150% preceding the GFC (but more than in the 1990s). In aggregate, the proportion of disposable income spent on mortgage payments (or DSR) is currently at 5.4%, compared to just below 9% and 10% in the periods preceding the 1990s recession and the GFC respectively. The aggregate DSR is projected to rise, but remain below historic peak levels (Chart 2.2). Unemployment levels, which are a strong indicator of household distress, are currently very low in historical terms at 3.6%, though the projection in the November 2022 MPR is for the unemployment rate to rise by around three percentage points by end-2025. And a greater proportion of households have fixed-rate mortgages than was the case going into previous periods of stress, meaning households have more time to adjust before rate rises start to affect their finances.
Chart 2.2: The aggregate household mortgage DSR is projected to remain below the peaks seen in previous crises
- Sources: Bank of England, Bloomberg Finance L.P., FCA Product Sales Data, ONS and Bank calculations.
- (a) Calculated as interest payments plus mortgage principal repayments as a proportion of nominal household post-tax income. Household income has been adjusted to take into account the effects of Financial Intermediation Services Indirectly Measured. Mortgage interest payments before 2000 are adjusted to remove the effect of mortgage interest relief at source.
- (b) For the illustrative projections to end-2025, projections for household post‑tax income consistent with the November 2022 MPR. Payment increases are projected using market expectations for Bank Rate based on the overnight index swap curve as at 25 November, take into account the distribution of fixed-deal terms from the FCA Product Sales Data and assume the aggregate mortgage debt to income ratio remains constant.
There are now higher standards for lenders around conduct with respect to supporting households. Other things equal, this should lead to lower household defaults and property repossessions than in previous downturns. Since 2021, lenders have been expected to give borrowers in financial difficulty appropriately tailored forbearance that is in their interests, and takes account of their individual circumstances. This could include extending terms on mortgages or moving households onto interest only repayments in times of stress. Lenders are also required to use repossessions only as a last resort, with the present repossession rate very low at less than 0.04%.footnote  The repossessions rate reached nearly 0.8% of all mortgages in the early 1990s, significantly higher than the historical average of around 0.2%.
Nevertheless, many households will find it challenging to manage higher interest rates alongside the ongoing rises in the cost of essentials, and pressures on UK households will increase. As household debt-servicing burdens continue to rise over the next year, arrears and defaults are likely to rise.
The FPC judges that the core UK banking system is more resilient than in historic downturns, even if the rise in household borrower defaults turns out to be greater than expected. Increased pressure on households is therefore not expected to challenge directly the resilience of the UK banking system. This is in part due to lower risk lending to households. The loan to value (LTV) profile of the major UK banks’ mortgage portfolios is very strong, following a long period of house price growth and prudent lending practices. For example, less than 10% of lenders’ current owner-occupier mortgage exposures are at LTVs of greater than 75%, compared to around 25% preceding the GFC. As such, very few existing borrowers are expected to be pushed into negative equity. This also reflects significantly stronger lending practices than those preceding historic crises; around 40% of new lending was at 90% LTV or above in 1991, compared to less than 20% over 2022.
Stronger lender resilience also, in part, reflects the impact of the FPC’s mortgage market Recommendations since their implementation in 2014. These Recommendations have guarded against a material loosening in underwriting standards and have dampened the build-up of household debt despite a prolonged period of recent house price growth.
However, the risk that households with the highest borrowing costs relative to incomes cut back on consumption by more than anticipated has increased. Some households, in particular those with lower income, fewer savings, or greater debt, may be forced to cut back on spending as their stretched finances mean they will not be able to maintain current levels of consumption.
Households might also increase precautionary savings in response to the economic downturn, which risks amplifying it. Should downside risks to businesses crystallise, this will have knock on effects for households through increased unemployment (see Section 2.3). Unemployment is expected to rise over the next year, but remain well below levels seen following the GFC or in the early 1990s.
There is evidence that households with debt have started to adjust spending behaviour as real income is squeezed. The latest NMG survey shows the number of households putting off spending due to debt concerns rose sharply over 2022, now standing at over a third of households with debt, compared to levels of around a quarter from 2015 to 2020. Furthermore, based on the November 2022 MPR forecast, the saving ratio is likely to rise over the next three years from around 7½% to 9%. If households reduced consumption by more than expected over 2023, this would act to amplify the current economic downturn. This would increase the pressures faced by businesses and households, and pose additional risks to lenders.
2.3: UK corporate debt vulnerabilities
In aggregate, UK businesses are in a broadly resilient position, but are under increased pressure from economic and financial developments.
In aggregate, UK businesses are entering the period of stress in a broadly resilient position. Corporate balance sheets have strengthened as stresses associated with the Covid pandemic have abated. Latest data at end-June 2022 show the aggregate corporate debt to earnings ratio for UK businesses had fallen to around 315% in 2022 Q2, below the pandemic peak of 345% and the GFC peak of nearly 370%. This reflects a fall in aggregate leverage and an increase in aggregate earnings over this year (Chart 2.3).
Chart 2.3: The aggregate corporate debt to earnings ratio has fallen slightly since the pandemic peak
Aggregate debt of UK corporates, split into bank and market-based debt (left axis) Aggregate debt to earnings ratio of UK corporates (right axis) (a)
- Sources: Association of British Insurers, Bank of England, Bayes CRE Lending Report (Bayes Business School (formerly Cass)), Deloitte, Financing & Leasing Association, firm public disclosures, Integer Advisors estimates, LCD an offering of S&P Global Market Intelligence, London Stock Exchange, ONS, Peer-to-Peer Finance Association, Eikon from Refinitiv and Bank calculations.
- (a) These data are for private non-financial corporates, which exclude public, financial and unincorporated businesses. Earnings are defined as businesses’ aggregate gross operating surplus, adjusting for financial intermediation services indirectly measured.
Within the aggregate, there are however a number of companies with low liquidity, weak profitability or high leverage. These indicators are associated with a greater probability of corporate distress, and firms with these characteristics may also find it more difficult to refinance debt.
In particular, SMEs have more debt than prior to the Covid pandemic and their liquidity positions have fallen back in recent months. Total outstanding SME debt has increased by around 20% since 2019, and high debt payments and rising costs have started to run down SME cash buffers. The share of SMEs with less than seven days turnover in cash has fallen back to pre-Covid levels as firms have drawn down on liquidity built up through pandemic-era borrowing.
The significant and rapid tightening in corporate borrowing conditions over 2022 is putting additional pressure on indebted corporates. Corporate funding costs have increased; the effective rate on new lending from banks to private non-financial corporations (PNFC) is currently 3.8%, up from 2.0% at end-2021, and the highest seen since 2008. Similarly, the cost of new SME bank debt rose to 4.7% from 2.5% at end-2021.
In aggregate, corporates are now more reliant on debt sourced from financial markets than on bank funding, with the share of outstanding market-based debt rising to 55% of total corporate debt, up from 40% before the GFC (Chart 2.4). But the volume of market-based finance extended to UK corporates has fallen over this year as volatility and risk aversion in financial markets has risen, and uncertainty over the economic outlook has increased. Net sterling corporate bond issuance over 2022 has been materially lower than historic averages for investment-grade bonds and there has been no new sterling high-yield bond issuance since April (see Section 1). Furthermore, there has been no new leveraged loan issuance this year from firms with more than six times debt to earnings before interest, tax, depreciation and amortisation (EBITDA), with these companies having constituted around 10% of new issuance over 2020 and 2021. Collateralised loan obligation issuance has also remained lower over 2022 at around 60% of averages seen over recent years. This suggests riskier firms are finding it harder to access finance at an affordable price.
A significant contraction in the supply of corporate finance from banks or from financial markets would amplify pressures on businesses. Capital market investor deleveraging or large increases in the cost of borrowing and issuance would challenge corporate resilience, and push down on investment and employment, should firms be unable to roll over or refinance existing debt or issue new finance as needed at an affordable price. This risk is heightened for firms which would find it harder to access other sources of lending, such as SMEs which tend to be more reliant on bank relationships.
Vulnerabilities in the system of market-based finance can amplify financial stability risks through corporates. For example, large negative shocks to asset values, or episodes of rapid repricing, can force lenders to sell assets to generate liquidity. This can push down the price of corporate bonds and equities, further amplifying shocks and affecting corporate valuations and access to finance (see Section 4). There is evidence that these channels may already be affecting some sectors, for instance, UK commercial real estate investment trusts are currently trading at around a 25% discount, which is much greater than recent averages of around 5%. And ‘fallen angels’ – businesses that lose their investment grade status – might pose risks if investors are forced to sell their holdings of many such downgraded bonds at the same time (eg due to investment mandates to only hold investment-grade debt, or higher capital charges associated with lower-rated bonds).
Pressure on corporates’ ability to service debt has risen, and is expected to continue to increase into 2023. Some sectors will be especially vulnerable.
Pressure on corporate earnings, combined with the rising cost of credit, will reduce companies’ ability to service debts. One of the ways that the FPC assesses corporate debt vulnerabilities is monitoring the debt-weighted proportion of companies with interest coverage ratios (ICRs) below 2.5, which is calculated by dividing a business’ earnings before interest and tax (EBIT) by its interest expense. Companies with ICRs below 2.5 are materially more likely to experience repayment difficulties. And as businesses experience distress, they are more likely to take defensive action such as cutting spending (eg investment or hiring). The aggregate debt-weighted share of corporates with ICRs of below 2.5 is estimated to have increased over 2022, primarily driven by increases in debt funding costs.
The deterioration in the UK macroeconomic outlook since the July 2022 FSR suggests that pressure on corporate earnings will continue into 2023 through increased input costs, reduced demand, and rising costs of servicing bank and market-based debt. More than 70% of corporate (including SME) bank loans are floating rate. This means that increases in Bank Rate are likely, on average, to flow through into corporate debt-servicing costs more quickly than for household debt, which over recent years has tended to be fixed rate. That said, larger corporates tend to be able to hedge against interest rate risk. Higher input costs and lower demand are expected to put further pressure on earnings for many businesses, especially those in sectors with large exposure to energy and fuel prices, or which provide non-essential household goods and services. Firms are able to mitigate these pressures by passing some cost increases through to consumers, but contacts of the Bank's Agents reported that companies saw reduced demand as a barrier to increasing prices further.
As a result, borrowers in the hardest hit sectors may have reduced capacity to repay loans. The share of corporates with low ICRs is expected to increase further into 2023, as credit conditions remain tight, input costs rise, and demand falls. Earnings and interest rate paths consistent with the November 2022 MPR imply that the debt-weighted share of corporates with ICRs below 2.5 could rise from 30% in 2022 to around 40% in 2023. This would remain, however, well below the GFC peak of over 50%.
The impacts of tightening financial conditions and higher input prices will be felt unevenly across sectors, bringing opportunities for some firms but putting significant financial pressure on others. Companies in the utilities and oil, gas and mining sectors have recorded strong increases in earnings, and the debt-weighted proportion of companies with low ICRs in these sectors is relatively low and projected to fall (see the purple bars in Chart 2.4). But companies in some other sectors will come under pressure. The fall in household real incomes could reduce demand significantly in sectors that provide non-essential household goods and services. And sectors with large exposures to energy or fuel prices, such as transport and manufacturing, could come under significant cost pressures. These factors will increase the share of firms with ICRs below 2.5 for firms in more vulnerable sectors.
Chart 2.4: Impact of increases in debt costs and earning shocks are felt unevenly across sectors
Debt weighted share of large firms with an ICR below 2.5 at end-2022 Q1, and projected share at end-2023 Q1, compared to GFC peaks (a)