Financial Stability Report - December 2023

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.

Risk outlook

Conditions remain challenging, given increased geopolitical tensions and uncertainties over growth, inflation and interest rates.

Households and businesses

UK households and businesses continue to face higher borrowing costs, as interest rates are expected to remain higher for longer.

Bank resilience

The UK banking system is strong enough to support households and businesses, even if the economy does worse than expected.

Non-bank finance

Risks from non-bank finance remain. These are being tackled in the UK and globally.

Published on 06 December 2023

The Financial Policy Committee (FPC) works to ensure the UK has a stable financial system.

The UK’s financial system enables households and businesses to make payments, manage their savings, borrow money, and insure themselves against risks. A stable financial system is one that can absorb shocks, such as economic downturns, rather than make them worse.

The FPC works in two main ways. First, it seeks to identify weaknesses in the UK’s financial system. Second, it takes action so that the system is able to absorb negative shocks.

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Non-technical summary

Conditions remain challenging, given increased geopolitical tensions and uncertainties over growth, inflation and interest rates. 

The outlook for global economic growth remains subdued. A number of risks could weaken growth further, including persistent inflation, higher interest rates, and increased geopolitical tensions.

Currently, financial markets are not expecting further increases in Bank Rate; although interest rates will likely need to stay high for some time to make sure inflation continues to fall. Interest rates on are back to where they were before the global financial crisis (see Chart 1). These interest rates act as a benchmark for other types of borrowing. So, when rates on government bonds are higher, it often leads to higher interest rates faced by households and businesses.

The prices of houses and commercial property, such as offices and retail premises, are falling in many countries. However, the results from our 2022/23 stress test on major UK banks suggested that they would be resilient to a global recession, including severe stresses to property prices.

Chart 1: In advanced economies long-term bond yields have risen significantly

Yields on UK, US and German 30-year government bonds (between 2003-2023)

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Footnotes

  • Sources and notes: See Section 1 of the Financial Stability Report – December 2023.

UK households and businesses remain under pressure from higher borrowing costs, as interest rates are expected to remain higher for longer.

Many households continue to face pressures from recent increases in the cost of living, and as higher interest rates continue to feed through to their borrowing costs (see Chart 2). Around 45% of fixed-rate mortgage deals agreed before the end of December 2021 (when Bank Rate started increasing) are yet to renew.

Since July, however, household income has been a bit stronger than expected and new mortgage rates have fallen slightly. This means the share of households spending a high proportion of their income on mortgage payments is expected to be lower in future than we had previously thought (see Chart 3). 

The overall share of households who are behind in paying their mortgages has risen slightly, but this remains low by historical standards. Some borrowers are taking action to limit their monthly repayments, for example through taking out longer-term loans, and UK banks are in a strong position to support customers facing difficulties. Approximately 90% of mortgage lenders have signed up to the Mortgage Charter, which aims to provide support to borrowers. As yet, the take-up by borrowers has been limited. 

We expect UK businesses to be resilient overall to higher interest rates and weak growth. The most recent data, showing a strong growth in business earnings, supports that view. But some firms are likely to struggle more with borrowing costs. This includes firms in parts of the economy most exposed to a slowdown, or with a large amount of debt.

The number of firms going out of business has continued to rise, albeit from low levels. So far, these have mainly been small firms. Not all businesses with debt have felt the full impact of recent interest rates rises yet. But many businesses will not have to renew their fixed-rate loans or other debt before 2025. This will give firms more time to adjust their plans, to account for higher borrowing costs. 

Both UK households and businesses have been broadly resilient to the impact of higher interest rates so far. We will continue to monitor developments.

Chart 2: Mortgage payments will increase for many households

Number of owner-occupier mortgages which will experience increases in monthly mortgage costs, for end-2024 and end-2026

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Footnotes

  • Source and notes: See Section 3.2 of the Financial Stability Report – December 2023.

Chart 3: The proportion of households with the highest mortgage repayments relative to their incomes decreased slightly in Q3, and is projected to increase by less than previously expected

The share of households with high cost of living adjusted DSRs

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Footnotes

  • Source and notes: See Section 3.2 of the Financial Stability Report – December 2023.

The UK banking system is strong enough to support households and businesses, even if the economy does worse than expected.

Higher interest payments on loans mean some households and businesses may not be able to make their payments. This increases the risks that banks may face losses on their lending. The UK banking system has large to absorb any potential losses, or outflows of cash (see Chart 4). Because of these resources, UK banks are strong enough to support households and businesses, even if economic and financial conditions are worse than expected. 

The amount of new lending by banks remains at low levels. This is mostly due to reduced demand for loans, given borrowing costs remain high. But as the economy has weakened, some households and businesses have also become riskier to lend to. This has led to a reduction in the availability of lending for certain types of borrowers. But banks do not appear to be cutting the availability of credit in a way that is out of line with changes in borrowers’ creditworthiness.

We set the UK countercyclical capital buffer (CCyB) rate each quarter. This provides banks with an additional ‘rainy day’ buffer they can use to withstand potential losses without restricting lending to the wider economy. The CCyB decision is based on the FPC’s assessment of economic and , and risks. In light of this assessment, the FPC decided to maintain the UK CCyB at its neutral setting (of 2%). 

Chart 4: Both larger and smaller UK banks have robust capital ratios

Aggregate CET1 ratio of UK banks and building societies

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Footnotes

  • Source and notes: See Section 4 of the Financial Stability Report – December 2023.

Risks from non-bank finance remain. These are being tackled in the UK and globally. 

Non-bank finance, also known as , is an important source of funding for UK firms alongside traditional bank loans. It has many benefits, such as allowing businesses to diversify their sources of finance. But, in part because of the way different markets are heavily connected, it also carries some risks. Vulnerabilities within market-based finance mean that shocks can be amplified. This could increase the cost and reduce the availability of loans to UK businesses and households. 

The system of market-based finance is complex, with interconnections across the globe. We are working with other UK authorities and globally to reduce risks and build resilience. 

To help us understand risks in the system as a whole, we have launched a system-wide exploratory scenario (‘SWES’) exercise. It is designed to help us better understand how banks and non-banks might act during very severe shocks in financial markets, and how their responses might interact to make things worse. 

Financial Policy Summary

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.

The overall risk environment

The overall risk environment remains challenging, reflecting subdued economic activity, further risks to the outlook for global growth and inflation, and increased geopolitical tensions. Long-term interest rates in the UK and US are now around their pre-2008 levels. The full effect of higher interest rates has yet to come through, posing ongoing challenges to households, businesses and governments, which could be amplified by vulnerabilities in the system of market-based finance. So far, and while the FPC continues to monitor developments, UK borrowers and the financial system have been broadly resilient to the impact of higher and more volatile interest rates.

Financial market developments

Current market pricing suggests that policy rates in the US, UK and euro area are at or near their peaks, and central banks have emphasised that they expect rates will need to remain at these levels for an extended period, in order to continue to address inflationary pressures. Returning inflation to target sustainably supports the FPC’s objective of protecting and enhancing UK financial stability.

Long-term interest rates are high and remain volatile in major advanced economies. Despite falling back somewhat since Q3, US long-dated government bond yields have risen since the July Financial Stability Report (FSR), with UK, euro area and Japanese long-term government bond yields following a similar pattern. Most of the recent upward move in US long-dated yields can be attributed to estimated term premia – the additional compensation that investors require to hold longer term rather than short-term bonds – which have increased from previously low levels. A number of factors could explain the rise in term premia across major advanced economies, including increased uncertainty around the longer-term economic outlook and interest rates, as well as evolving investor expectations of future supply and demand in government bond markets.

The full impact of higher interest rates will take time to come through. Given the impact of higher and more volatile rates, and uncertainties associated with inflation and growth, some risky asset valuations continue to appear stretched. Credit spreads are broadly unchanged since Q3, with the exception of leveraged loan spreads which have widened a little. Some measures of equity risk premia remain compressed, particularly in the US.

Global vulnerabilities

The adjustment to higher interest rates continues to make it more challenging for households and businesses in advanced economies to service their debts. Riskier corporate borrowing in financial markets, such as private credit and leveraged lending, appears particularly vulnerable. Although there are few signs of stress in these markets so far, a worsening macroeconomic outlook, for example, could cause sharp revaluations of credit risk. Higher defaults could also reduce investor risk appetite in financial markets and reduce access to financing, including for UK businesses.

Some banks in a number of jurisdictions have been impacted by higher interest rates. They also remain exposed to property markets, including commercial real estate where prices in some countries have fallen significantly.

High public debt levels in major economies could have consequences for UK financial stability, especially if market perceptions for the path of public sector debt worsen. The FPC will take into account the potential for these to crystallise other financial vulnerabilities and amplify shocks when making its assessment of the overall risk environment.

Vulnerabilities in the mainland China property market have continued to crystallise, and significant downside risks remain. This could lead to broader stresses in other sectors of the mainland Chinese economy, and materially affect Hong Kong. The results of the 2022/23 annual cyclical scenario indicated that major UK banks would be resilient to a severe global recession that included very significant falls in real estate prices in mainland China and Hong Kong.

Geopolitical risks have increased following the events in the Middle East, increasing uncertainty around the economic outlook, particularly with respect to energy prices. If these risks crystallised, resulting in significant shocks to energy prices, for example, this could impact on the macroeconomic outlook in the UK and globally, as well as increasing financial market volatility.

UK household and corporate debt vulnerabilities

Since the July FSR, household income growth has been greater than expected. This has reduced the share of households with high cost of living adjusted debt-servicing ratios, and a lower expected path for Bank Rate has reduced the extent to which that share is projected to rise. Nevertheless, household finances remain stretched by increased living costs and higher interest rates, some of which has yet to be reflected in higher mortgage repayments. Arrears for secured and unsecured credit remain low but are rising as the impact of higher repayments is felt by borrowers.

In aggregate, UK corporates’ ability to service their debts has improved due to strong earnings growth and the sector is expected to remain broadly resilient to higher interest rates and weak growth. But the full impact of higher financing costs has not yet passed through to all corporate borrowers, and will be felt unevenly, with some smaller or highly leveraged UK firms likely to remain under pressure. Corporate insolvency rates have risen further but remain low.

UK banking sector resilience

The UK banking system is well capitalised and has high levels of liquidity. It has the capacity to support households and businesses even if economic and financial conditions were to be substantially worse than expected. The overall risk environment remains challenging, however, and asset performance deteriorated among some loan portfolios in Q3. Some forms of lending, such as to finance commercial real estate investments, buy-to-let, and highly leveraged lending to corporates – as well as lenders that are more concentrated in those assets – are more exposed to credit losses as borrowing costs rise.

Aggregate net lending remains subdued, driven by reduced demand for credit and a tightening in banks’ risk appetites. The tightening in credit conditions over the past two years appears to have reflected the impact of changes to the macroeconomic outlook, rather than defensive actions by banks to protect their capital positions.

There is some evidence that net interest margins (NIMs) have peaked. The aggregate profitability of the major UK banks is nevertheless expected to remain robust, with NIMs expected to remain higher than in recent years when Bank Rate had been close to the effective lower bound, and similar to levels seen before the global financial crisis when Bank Rate was comparable to its current level.

Alongside the higher risk-free interest rate environment, a number of system-wide factors are likely to affect funding and liquidity conditions in the UK banking sector over the coming years, including as central banks normalise their balance sheets. Those factors will affect sources of bank funding and could affect their cost – for example through continued competition for deposits and greater use of some forms of wholesale funding. Banks will need to factor these system-wide trends into their liquidity management and planning over the coming years.

The impact on individual banks will depend, amongst other things, on their funding structure and business model. Banks have a range of ways in which they can adjust to changing trends in funding and liquidity, including through their mix of funding and liquid assets, and through the nature, quantity, and pricing of lending they undertake.

The FPC will monitor the implications of these trends for financial stability.

The UK countercyclical capital buffer rate decision

The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at its neutral setting of 2%. The FPC will continue to monitor developments closely and stands ready to vary the UK CCyB rate, in either direction, in line with the evolution of economic and financial conditions, underlying vulnerabilities, and the overall risk environment.

The resilience of market-based finance

Vulnerabilities in certain parts of market-based finance remain significant, and in some sectors have increased since the July FSR. Funds investing in riskier corporate credit have seen outflows. Hedge fund net short positioning and asset managers’ leveraged net long positions in US Treasury futures have also increased further, which could contribute to market volatility if hedge funds needed to unwind their positions rapidly. While the financial system has so far been broadly resilient to the higher interest rate environment, vulnerabilities in market-based finance could crystallise in the context of higher and more volatile interest rates or sharp movements in asset prices, leading to dysfunction in core markets and amplifying any tightening in credit conditions.

Alongside international policy work led by the Financial Stability Board, the UK authorities are also working to reduce vulnerabilities domestically where this is effective and practical. The FPC welcomes proposals by UK authorities to increase the resilience of UK-based money market funds, which have been published today.

In November, the Bank released the hypothetical scenario for its system-wide exploratory scenario (SWES) exercise. The SWES will assess the behaviours of banks and non-bank financial institutions during stressed financial market conditions, and how they might interact to amplify shocks to markets core to UK financial stability. Under the stress scenario, participating firms will model the impact of a shock that is faster, wider ranging and more persistent than those observed in recent events in financial markets.

1: Developments in financial markets

  • Current market pricing suggests that policy rates in the US, UK and euro area are at or near their peaks, and central banks have emphasised that they expect them to remain elevated for an extended period in order to continue to address inflationary pressures.
  • There has been arise in estimated term premia on long-term government bonds, and volatility in rates markets remains elevated.
  • Given the impact of higher and more volatile rates, and uncertainties associated with inflation and growth, some risky asset valuations, particularly in the US, continue to appear stretched. Credit spreads are broadly unchanged since July, although there has been a recent widening of leveraged loan spreads. Some measures of equity risk premia remain compressed, particularly in the US.
  • Should growth weaken or additional risks crystallise, a reduction in investor risk appetite could further impact riskier borrowers in advanced economies when they refinance their debts, especially if signs of a slowdown in private credit and private equity financing persist.
  • A sharp reduction in asset prices could also directly affect the financial system by reducing the value of collateral securing existing loans, or by creating sharp increases in the demand for liquidity. Any such moves could be amplified by vulnerabilities in market-based finance (MBF), potentially tightening financial conditions for UK households and businesses.

Current market pricing suggests that policy rates in the US, UK and euro area are now at or near their peaks, and central banks have emphasised that they expect them to remain elevated for an extended period.

In the UK, Bank Rate is currently 5.25%. While at the time of the July FSR the expectation was for Bank Rate to peak at 6.2%, current market pricing now implies that market participants are not expecting further rises. This reduction in short-term expectations for peak policy rates has been reflected in a slight decline in yields on UK government bonds of maturities out to 10 years. In the US and the euro area, market pricing similarly implies that market participants expect that policy rates have broadly peaked.

Central banks have emphasised that they expect rates to remain at these levels for an extended period, in order to continue to address inflationary pressures. Returning inflation to target sustainably supports the FPC’s objective of protecting and enhancing UK financial stability. Globally, potential sources of further inflationary pressures remain. In particular, recent events in the Middle East have increased uncertainty around future oil prices (see Section 2). In addition, US growth projections have been revised up since July, with the economy expected to expand by around 2¼% in 2023, although the outlook for global growth generally remains subdued.

Some longer-term interest rates have continued to rise since the July FSR…

Yields on 30-year government bonds are now close to 4.6% in both the UK and the US, which is around their levels prior to the global financial crisis (GFC) (Chart 1.1, left panel). Since July, the upward shift has been most pronounced in the US, with the UK and other advanced economies following a broadly similar pattern (Chart 1.1, right panel).

Chart 1.1: In advanced economies long-term bond yields have risen significantly

Yields on UK, US and German 30-year government bonds

Line chart showing changes in 30 year government bond yields for the UK, US and Germany, since 2003. The chart highlights the recent changes, with all three lines rising across 2023, meaning that they reach levels previously seen prior to the global financial crisis.

Footnotes

  • Source: Bloomberg Finance L.P.

Long-term interest rates in part reflect market expectations of future policy rates. For example, current market pricing implies that Bank Rate in ten years’ time is expected to be around 4%, up from around 3.5% at the end of Q2. This means that financing costs for households, businesses and governments could remain higher further into the future than had been previously anticipated (see Section 3). It is possible that market perceptions of the equilibrium real interest rate have risen.

…in part reflecting an increase in term premia.

Interest rates on long-term government bonds can also be affected by the amount of additional compensation that investors require to hold these instruments rather than rolling over short-term assets. This compensation, referred to as ‘term premia’, cannot be observed directly and estimates are sensitive to the model used. Model estimates indicate that the roughly 60 basis point increase since the July FSR in the 10-year US Treasury bond yield – a globally important benchmark – is attributable to an increase in the term premium (Chart 1.2). Although the term premium has increased, it remains low relative to its long-run average level. The term premium is also estimated to have risen on 10-year UK gilts since July. A number of factors could explain the rise in term premia, including increased uncertainty around the longer-term economic outlook and interest rates, and evolving investor expectations of future supply and demand in government bond markets (because, other things equal, increased net supply of government debt can increase term premia).

Chart 1.2: Term premia have pushed up interest rates on some long-term government bonds

Decomposition of changes in the 10-year US Treasury bond yield into expected rates and term premium

Line chart showing the term premia and expected rates components of changes in nominal 10-year US Treasury bond yields since 30 June 2023. Term premia are the dominant factor in the upward shift across the period.

Footnotes

  • Sources: Federal Reserve Bank of New York and Bank calculations.

Volatility in core rates markets remains elevated, but they are functioning normally.

Volatility in rates markets has been elevated by historical standards during 2023. For example, the MOVE index of implied volatility in US Treasury markets is in the top quartile of its historical range. Market volatility, if severe enough, can cause a deterioration in market functioning and interact with vulnerabilities in market-based finance to create risks to financial stability. But market contacts and liquidity metrics, such as bid-offer spreads (Chart 1.3), suggest that liquidity in core markets is within a normal range. Nonetheless, liquidity conditions could deteriorate quickly, especially if market volatility were to increase further, or if vulnerabilities in MBF were to crystalise.

Chart 1.3: Core market liquidity is within its normal historical range

Bid-offer spread versus realised volatility for the 10-year benchmark gilt, since 2019 (a)

Scatter plot showing realised 10-day volatility against 10-day bid-off spread, since 2019. The latest data point is highlighted. It sits in the lower half of the distribution for both measures.

Footnotes

  • Sources: Bloomberg Finance L.P. and Bank calculations.
  • (a) Realised volatility is calculated as the 10-day average of the high-low intraday range in the 10-year benchmark gilt yield.

Despite rising interest rates, corporate credit spreads are broadly unchanged since July…

Rising yields on government debt have fed through into higher yields on riskier lending to corporates. Higher yields push up refinancing costs, increasing pressure on corporates. However, the additional yield – the ‘spread’ that investors demand in return for credit risk – has been broadly unchanged for investment grade and high-yield bonds since the July FSR (Chart 1.4). These spreads are slightly wider than their long-run average levels in the UK, and slightly tighter in the US.

Chart 1.4: Credit spreads are broadly unchanged since July

Investment grade and high-yield bond spreads over risk-free rates

Line chart showing credit spreads for investment grade and high yield bonds, for both US dollar and pound sterling denominated debt, since January 2020. The chart shows that levels have recently been broadly flat.

Footnotes

  • Sources: ICE BofA USD High Yield Index (Ticker: H0A0), USD Investment Grade Index (Ticker: C0A0), GBP High Yield Index (Ticker: HL00), GBP Investment Grade (Ticker: UR00).

For leveraged lending, spreads have widened a little over recent months. In the UK, they are around 550 basis points, broadly in line with their 10-year historical average. See Box B for further discussion of leveraged lending.

Market intelligence suggests that market participants are in general relatively sanguine about credit risk, in part because the perceived likelihood of recession has reduced since the start of the tightening cycle, and because of a perception that corporates have generally been proactive with their refinancing needs. And while default rates on riskier credit have recently increased, in particular for leveraged loans, they remain well below their GFC peaks. Nonetheless, the relative stability in credit valuations has taken place against a backdrop of elevated and more volatile interest rates and uncertainty over their impact on borrowers and on the macroeconomy.

…and US equity valuations appear stretched…

The FPC judges that given the impact of higher interest rates, and uncertainties associated with inflation and growth, the valuations of some risky assets continue to appear stretched, particularly in the US. Since the July FSR, the US, UK and European stock markets have been broadly flat. However, in the context of rising long-term interest rates, the excess cyclically adjusted price-to-earnings (CAPE) yield – a measure of the excess return that investors expect from equities relative to government bond yields – on US equities has continued to fall, and is approaching its lowest level since around the time of the dotcom crash in the early 2000s (Chart 1.5). This could imply that US equity valuations have become more stretched.

Chart 1.5: US equity valuations are high relative to risk-free alternatives

Excess cyclically adjusted price-to-earnings yield (excess CAPE) for the S&P 500

Line chart showing the Excess CAPE yield for the S&P 500 since 1994. The current level is below the series average, and approaches levels seen prior to the dotcom crash in the early 2000s.

Footnotes

  • Sources: Bloomberg Finance L.P., Federal Reserve Bank of St Louis and Bank calculations.

.…increasing the risk of sharp reductions in asset prices, and an associated tightening of financial conditions for households and businesses.

Should growth weaken or other risks crystallise, a reduction in investor risk appetite could trigger a revaluation of assets, particularly since a deterioration in demand or corporate earnings would negatively impact debt servicing capacity. Sharp decreases in asset prices could further tighten financial conditions, especially for riskier borrowers when they refinance their debts and if signs of a slowdown in private markets (such as private credit and private equity) persist (see Box B). This could impair businesses’ ability to raise finance, by increasing the cost of bond and equity issuance.

A sharp reduction in asset values could also directly affect the financial system – for example through direct losses on asset holdings, by reducing the value of collateral securing existing loans, or by creating sharp increases in the demand for liquidity. Any such moves could be amplified by vulnerabilities in MBF, potentially tightening financial conditions for UK households and businesses (Section 5).

Box A: Developments in cryptoasset markets

The FPC conducts regular horizon scanning to identify emerging risks to the financial system. As part of this, the Committee has been monitoring risks from cryptoassets and associated activities. Cryptoassets are a digital representation of value or contractual rights that can be transferred, stored or traded electronically, and which typically use cryptography, distributed ledger technology or similar technology.

In March 2022, the FPC judged that direct risks to the stability of the UK financial system from cryptoassets and associated markets and activities, including decentralised finance (DeFi) were limited, but that risks would emerge if cryptoasset activity and its interconnectedness with the wider financial system developed.

That assessment reflected their small size and limited interconnectedness with the wider financial system. The FPC stated that it was monitoring risks to financial stability that could arise through four risk channels: risks to systemic institutions; risks to core financial markets; risks to the ability to make payments; and the impact on real economy balance sheets.

The FPC also judged that enhanced regulatory frameworks, both domestically and at a global level, were needed to address developments related to cryptoassets.

In accordance with the principle of ‘same risk, same regulatory outcome’, the FPC judged that where cryptoasset technology is performing an equivalent economic function to one performed in the traditional financial sector, this should take place within existing regulatory frameworks, and that the regulatory perimeter should be adapted as necessary to ensure an equivalent regulatory outcome. Innovation from cryptoassets and DeFi can only be sustainable if undertaken safely and accompanied by effective regulation that mitigate risks.

The FPC stated that it would pay close attention to developments in cryptoasset markets to ensure the UK financial system was resilient to systemic risks that might arise. The rest of this box outlines the developments in cryptoassets and associated markets and activities since the March 2022 Financial Stability in Focus, including an update on financial stability risks, and on the development of regulatory frameworks to address these.

The systemic risks that the FPC previously said could arise in future from cryptoasset activities have not materialised thus far.

The market capitalisation of the cryptoasset ecosystem declined by more than 70% from a peak of around US$3 trillion in November 2021 to US$800 billion in November 2022, before increasing to around US$1.4 trillion in November 2023 – (Chart A). This remains very small in the context of global capital markets: by way of comparison, the market capitalisation of the global equity market is estimated to be just above US$100 trillion, and outstanding global fixed-income securities around US$130 trillion in 2023.

Associated cryptoasset markets and activities have also declined over the same period: the total monetary value locked in the smart contracts of DeFi protocols has declined by 74% from its peak in November 2021 to US$47 billion; the average (mean) daily trading volume of bitcoin on exchanges in October 2023 was 44% of the daily average in November 2021; and the market capitalisation of stablecoins has declined from a peak of around US$180 billion in April 2022 to US$125 billion at present (Chart A).

Chart A: The size of the cryptoasset ecosystem has declined since March 2022

Market capitalisation of: all cryptoassets (a) and stablecoins (b)

The chart shows two time series plots: the market capitalisation of stablecoins; and the market capitalisation of all cryptoassets between 2013 and the present date. The total market capitalisation of cryptoassets peaks at around 3 trillion dollars in late 2021, before falling by more than two-thirds, and then recovering to roughly half of its original peak by late 2023. The market capitalisation of stablecoins rose quickly between early 2020 and early 2022, but has declined steadily thereafter to roughly two-thirds of its peak.

Footnotes

  • Sources: Coinmarketcap and Bank Calculations.
  • (a) Total crypto market capitalisation.
  • (b) Market capitalisation of 11 of the largest stablecoins currently accounting for around 99% of total stablecoin market capitalisation.

Events since November 2021 have also illustrated the need to bring cryptoassets and their associated activities within the regulatory perimeter.

The bankruptcies of the cryptoasset exchange FTX and cryptoasset lending firms such as Celsius, BlockFi and Voyager Digital have demonstrated that cryptoasset institutions are prone to a number of vulnerabilities that regulation in the conventional financial system is designed to avoid. For example, a number of centralised crypto trading platforms operate as conglomerates, bundling products and functions within one firm, whereas in conventional finance these functions are either separated into different entities or managed with tight controls and ring-fences and independent governance. The collapse of the algorithmic stablecoin TerraUSD, and the temporary depegging of the largest fiat-backed stablecoins USD Coin and Tether, have demonstrated risks in existing stablecoin arrangements. And to date, no so-called stablecoin has been able to maintain parity with its peg at all times.footnote [1]

Systemic financial institutions’ involvement in cryptoassets remains very limited, but may grow in future.

A survey of wholesale banks conducted by the FCA in February 2023 found that around three quarters of survey respondents did not conduct any activities in relation to cryptoassets at that time, nor did they intend to conduct any activities in the future. Among those firms that indicated some involvement in cryptoasset markets, dealing – particularly as an agent – was by far the most common activity. A small number of firms not currently offering cryptoasset services plan on acting as dealers, offering custodial services, or issuing a stablecoin in future. The PRA reminded firms of their obligations with respect to cryptoasset exposures in March 2022, and clarified its expectations of deposit takers with respect to new forms of digital money in November 2023 in ‘Dear CEO’ letters.

Banks are more positive about the use of cryptoasset technologies (eg programmable ledgers and smart contracts) for the tokenisation of money and assets. Current applications are very limited in scope, and a significant share of projects are taking place on permissioned ledgers that do not involve the use of cryptoassets. However, some projects are also taking place on public blockchains. The growth of asset tokenisation on public blockchains could contribute to greater systemic risks from stablecoins and unbacked cryptoassets: it could increase the size of the cryptoasset ecosystem (eg by increasing the demand for cryptoassets to pay blockchain transaction fees, or stablecoins to act as a settlement asset); increase the interconnectedness of markets for cryptoassets and traditional financial assets (since they are represented on the same ledger); and create direct exposures for systemic institutions.

Risks to core financial markets from cryptoassets and associated market activities remain limited by the degree of institutional cryptoasset adoption. But this adoption could accelerate as regulatory frameworks and market infrastructures develop.

Institutional adoption of cryptoassets and associated derivatives remains small. In the market for Chicago Mercantile Exchange (CME) bitcoin futures (an institutional market owing to its relatively large contract size and regulated nature) the number of contracts held by market participants reached an all-time high in November 2023. However, the notional value at US$3.8 billion remains very low. By comparison, CME E-MINI S&P 500 futures contracts have an outstanding notional value of around US$490 billion.

According to market intelligence, the largest barriers to investment in cryptoassets for institutional investors include: price volatility; lack of fundamentals for valuation; regulatory challenges; challenges around security (eg adequate custody solutions); and market manipulation. However, developments in regulation and market infrastructure may catalyse greater institutional investment in cryptoassets in future.

Use of cryptoassets for payments in the UK remains very small, but this could change if a sterling-denominated stablecoin used for retail payments emerges.

There is currently no widely used sterling denominated stablecoin used for payments or in the cryptoasset ecosystem, and the use of cryptoassets for payments is extremely low. However, payment companies with large established networks have the potential to accelerate the adoption of stablecoins for payments quickly. Some payment service providers (eg PayPal) have recently launched services supporting stablecoins. The Bank will continue to monitor payment activities in relation to cryptoassets and stablecoins.

UK households’ cryptoasset holdings remain limited but are increasing.

An FCA consumer survey conducted in August 2022 found that 9% of UK adults owned cryptoassets at that time, up from 4.4% in 2021. While the mean holding was around £1,600, 40% of owners held less than £100 of cryptoassets.

Against this backdrop, the UK authorities have taken important steps towards putting in place a regulatory regime for the sector.footnote [2]

The FCA has introduced money laundering and counter-terrorism financing rules for cryptoassets businesses in the UK (January 2020 and September 2023). In October 2023, the FCA put into place a regime for the marketing of crypto to UK consumers, ensuring that any marketing to retail consumers is clear, fair, not misleading and subject to approval by a regulated firm. The rules for marketing cryptoassets are aligned with existing rules for other high-risk investments. The FPC has urged investors to take a cautious approach to cryptoassets.footnote [3]

In November 2023, the Bank and the FCA published discussion papers on their proposed approach to regulating stablecoins, which will support safe innovation in retail payments. HM Treasury (HMT) now intends to bring forward secondary legislation to bring stablecoins into the regulatory perimeter by early 2024.

HMT has also set out its approach to regulating broader cryptoasset activities and the FCA will develop the regulatory regime.

Beyond the proposals to regulate stablecoins, HMT recently finalised its proposals to regulate a number of trading and investment activities related to cryptoassets, which were set out in a February 2023 consultation paper. Secondary legislation and FCA rules will be required to implement the regime. The FPC noted that while this regime would not achieve the outcome of market integrity to the same degree as in traditional securities markets, it considered the consultation to be an important step in developing a regulatory regime, with further work anticipated as cryptoasset markets evolved and international standards were developed.

The high degree of interconnectedness and cross-border activity associated with cryptoassets mean that global risks are most effectively addressed through internationally co-ordinated reforms.

Many cryptoasset service providers, such as wallets and exchanges, as well as some issuers, operate from offshore jurisdictions while providing services globally.footnote [4] International co-ordination can reduce the risks of cross-border spillovers, regulatory arbitrage, and market fragmentation.

Internationally, standard setters have made good progress in developing a global baseline for regulating cryptoassets.

This has been in line with the principle of ‘same risk, same regulatory outcome’. In July 2023, the Financial Stability Board (FSB) finalised its global regulatory framework for cryptoassets and stablecoins, focused on addressing risks to financial stability. Alongside this overarching framework, standard setters are establishing sectoral standards on market integrity and investor protection, on systemically important stablecoin arrangements, and on the treatment of banks’ exposures to cryptoassets.

Ensuring a wide and timely implementation of the international regulatory baseline will be key to mitigating the financial stability risks from cryptoassets.

The FSB will conduct a review of the implementation of its recommendations by end-2025. Given the cross-border nature of these markets, it will be important to ensure that both the FSB recommendations and sectoral international standards are implemented by the widest possible set of jurisdictions particularly those markets with the largest cryptoasset activity. Given the risks of regulatory arbitrage, this should include jurisdictions with currently limited regulation and jurisdictions with large crypto activity.

The FPC welcomes these developments and will seek to ensure that the UK financial system is resilient to systemic risks that may arise from cryptoassets and associated activities.

2: Global vulnerabilities

  • The outlook for global growth remains subdued and long-term interest rates have risen further. Geopolitical risks have increased following events in the Middle East.
  • Higher interest rates in advanced economies continue to pose challenges to UK financial stability through their impact on households, businesses, sovereigns and financial institutions.
  • Riskier corporate borrowing, such as private credit and leverage lending appears particularly vulnerable.
  • Some overseas banks could also be vulnerable to higher interest rates, including through their exposures to property markets, including commercial real estate, where prices in some countries have fallen significantly.
  • Vulnerabilities in the mainland China property market have continued to crystallise since the July 2023 FSR.
  • Major UK banks could experience spillovers from a materialisation of global risks, including in China. The results of the 2022/23 ACS indicated that major UK banks can continue to serve the UK economy in a severe global stress with elevated interest rates and very significant falls in real estate prices in mainland China and Hong Kong.

2.1: The global economic outlook

The outlook for global growth remains subdued, partly reflecting higher interest rates.

Projections in the November Monetary Policy Report (MPR) indicate that global growth over the next year is expected to remain below its 2010–19 average, reflecting tighter monetary and financial conditions. However, US growth projections have been revised upwards since July, with the economy expected to expand by around 2¼% in 2023.

Headline inflation remains elevated in advanced economies, but is declining. This largely reflects lower energy price inflation, although food and goods price inflation have also declined, particularly in the US. Global services inflation, however, remains elevated.

The paths for policy rates implied by current financial market pricing suggest rates are now expected to be at or near their peaks in the UK, US and euro area. Central banks have emphasised that they will need to remain high for an extended period in order to continue to address inflationary pressures. Long-term interest rates in advanced economies have increased since the July FSR, particularly in the US, where yields on 30-year government bonds are now around pre-GFC levels (see Section 1).

Geopolitical developments continue to add uncertainty to the economic outlook, and can pose risks to UK financial stability through a number of channels.

Geopolitical risks have increased following events in the Middle East. These events led to a relatively limited rise in energy prices, which has since retraced. However, uncertainty around future oil prices has increased. Further escalation of geopolitical tensions in the region could cause disruption to oil and gas markets and trade flows. A larger shock to energy prices would lead to higher inflation and increased cost of living pressures on households and businesses.

Other geopolitical risks remain. For example, in 2022, following Russia’s invasion of Ukraine, there was significant volatility in commodity markets, as well as increased volatility and risk aversion in financial markets more generally. And tensions between the US and China could disrupt global trade. Further escalation of geopolitical risks would increase the likelihood of vulnerabilities crystallising, which could impact the macroeconomic outlook in the UK and globally through trade and other channels, increase financial market volatility, and could particularly affect the UK’s internationally focused banks. Geopolitical developments are consistently cited by market participants as one of the biggest sources of risk to the UK financial system in the Bank’s Systemic Risk Survey.

2.2: The impact of higher interest rates on the global financial system

The adjustment to higher interest rates in advanced economies continues to pose challenges to UK financial stability.

As set out in Financial Stability in Focus: Interest rate risk in the economy and financial system, and in Figure 2.1, higher interest rates (and associated weaker global growth) could impact UK financial stability in a number of ways.

  • Banks could incur losses in the event of an increase in global risk aversion and falls in asset prices (including property prices), and UK financial conditions could tighten in response. The US banking stress earlier in the year illustrated how contagion could spread across borders even where there are no direct connections between institutions.
  • Increases in debt-servicing costs for foreign borrowers could increase defaults. UK banks could therefore also incur losses on their lending to non-UK borrowers.
  • A reversal in risk appetite among global investors can increase the cost or reduce the availability of market-based finance for UK institutions (see Section 1).
  • More broadly, global vulnerabilities can also amplify economic shocks in foreign economies and lead to spillovers to the UK, for example through lower demand for UK exports.

If rates remain higher for longer, it will pose particular refinancing challenges for highly leveraged corporates (see Box B).

Figure 2.1: Global shocks can affect UK financial stability in a number of ways