Financial Stability Report - June 2024

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 broadly unchanged from Q1. Markets continue to price mostly for a benign central case outlook, and some risk premia have tightened even further, despite the global risk environment facing several challenges. Some of these challenges have become more concerning and proximate.

In aggregate, UK household and corporate borrowers have been resilient, although many remain under pressure. UK banks are in a strong position to support households and businesses, even if economic and financial conditions were substantially worse than expected.

The adjustment to the higher interest rate environment is continuing globally, including as businesses and households refinance their debt. Risks are crystalising in the US commercial real estate market and important vulnerabilities in market-based finance are yet to be addressed globally.

Developments in financial markets

The Monetary Policy Committee’s (MPC’s) central projection for UK GDP growth, unemployment and inflation has improved slightly further since Q1, and global growth is projected to rise in the medium term, although several risks to that outlook remain. Economic data news has pushed out market expectations on the timing of reductions in policy rates in the US and UK, although rate cuts have now begun in some jurisdictions. Markets responded to the announcement that French parliamentary elections would be held on 30 June and 7 July. For example, the spread between French and German 10-year government bond yields rose to its highest level since 2017.

Risk premia on US equities have been compressed for some time but have also fallen across a range of other markets this year and are now very low by historic standards, including for more leveraged borrowers. While there is some evidence of investors demanding higher risk premia on small pockets of the riskiest bonds, the widespread overall compression of risk premia, in an uncertain risk environment, suggests that investors are continuing to put less weight on risks to the macroeconomic outlook. Valuations and risk premia are therefore vulnerable to a shift in risk appetite that could be triggered by factors including a weakening of growth prospects, more persistent inflation, or a further deterioration in geopolitical conditions.

Although financial market asset valuations have so far been robust to large increases in interest rates and recent geopolitical events, the adjustment to the higher interest rate environment is not yet complete and market prices remain vulnerable to a sharp correction. This could adversely affect the cost and availability of finance to the real economy via two main channels. First, a sharp market correction would make it more costly and difficult for corporates to refinance maturing debt, including by reducing the value of collateral. This is particularly relevant given the large proportion of leveraged lending and high-yield market-based corporate debt that is due to mature by the end of 2025. Second, it could interact with vulnerabilities in market-based finance, which may amplify the correction. For example, it may cause large losses for leveraged market participants, which could further reduce risk appetite, or it may lead to a spike in liquidity demand and a deterioration in the functioning of core markets.

Global vulnerabilities

Global vulnerabilities remain material. US commercial real estate (CRE) borrowers have significant short-term refinancing needs and a number of overseas banks with large exposures to CRE, in the US and other jurisdictions, experienced significant falls in their equity prices earlier in the year. Stresses in global CRE markets could affect UK financial stability through several channels, including a reduction in overseas finance for the UK CRE sector.

Policy uncertainty associated with upcoming elections globally has increased. This could make the global economic outlook less certain and lead to financial market volatility. It could also increase existing sovereign debt pressures, geopolitical risks, and risks associated with global fragmentation, all of which are relevant to UK financial stability.

UK household and corporate debt vulnerabilities

In the context of strong nominal household income growth and continued low unemployment, the aggregate UK household debt to income ratio has continued to fall. That said, many UK households, including renters, remain under pressure from higher living costs and higher interest rates. The share of households spending a high proportion of their available income servicing their mortgages is expected to increase slightly over the next two years, but it is likely to remain well below pre-global financial crisis (GFC) levels. Mortgage arrears remain low by historical standards and are expected to remain well below their previous peaks.

Aggregate measures of UK corporate debt vulnerability have fallen further and corporates are likely to remain broadly resilient to the current economic outlook, including high interest rates. But there remain pockets of vulnerability among highly leveraged corporates. Despite strong issuance so far in 2024, a significant portion of market-based corporate debt is due to mature in the coming years, so risks associated with the need to refinance at higher interest rates remain. The most highly leveraged and lowest rated corporates, including those backed by private equity, are likely to be more exposed to this risk.

Private equity

The private equity (PE) sector grew rapidly during the period of low interest rates and plays a significant role in financing UK businesses. The long-term nature of capital investments into PE allows and incentivises fund managers to act less cyclically, which can reduce the volatility of financing flows in macroeconomic downturns. However, the widespread use of leverage within PE firms and their portfolio companies makes them particularly exposed to tighter financing conditions.

Although the sector has been resilient so far, it is facing challenges in the higher rate environment. These manifest in refinancing risk as debt matures, and an increased drag on performance from higher financing costs. Vulnerabilities from high leverage, opacity around valuations, and strong interconnections with riskier credit markets mean the sector has the potential to generate losses for banks and institutional investors, and cause market spillovers to highly correlated and interconnected markets such as leveraged loans and private credit – all of which could reduce investor confidence, further tightening financing conditions for businesses. Disruptions in international PE markets could also spill over to the UK, particularly from US markets given their size and importance, and because the majority of PE funds backing UK corporates are based in the US.

Improved transparency over valuation practices and overall levels of leverage would help to reduce the vulnerabilities in the sector. Risk management practices in some parts of the sector also need to improve, including among lenders to the sector such as banks. The FPC will consider the outcome of regulatory work by the Financial Conduct Authority and Prudential Regulation Authority to address some of these issues. Because of the interconnections between PE markets in different jurisdictions, international co-ordination will be important.

UK banking sector resilience

The UK banking system has the capacity to support households and businesses, even if economic and financial conditions were to be substantially worse than expected. The UK banking system is well capitalised and UK banks maintain strong liquidity positions. The return on equity of major UK banks in aggregate has risen to around their cost of equity, and asset quality remains strong.

The FPC judges that changes in credit conditions overall reflect changes to the macroeconomic outlook. Mortgage approvals have risen, in part in response to a fall in quoted mortgage rates since last summer. Overall credit conditions for corporates have remained broadly unchanged since the start of the year.

A number of system-wide factors are likely to affect bank funding and liquidity in the coming years, including as central banks normalise their balance sheets as the extraordinary measures put in place following the GFC and the Covid pandemic are unwound. The Bank of England is unwinding its holdings in its Asset Purchase Facility, as determined by the MPC, and the Term Funding Scheme with additional incentives for SMEs is coming to an end. It is important that banks factor these system-wide trends into their liquidity management and forward planning over the coming years. Banks have a number of ways in which they can manage their funding and liquidity, including use of the Bank of England’s facilities, such as the Short-Term Repo and Indexed Long-Term Repo facilities.

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 Bank’s 2024 desk-based stress test will further inform the FPC’s assessment of the resilience of the UK banking system to downside risks.

The resilience of market-based finance

There remain important vulnerabilities in market-based finance that the FPC has previously identified. In particular, leveraged positions, which have been a driver of a number of recent stress events, appear to be increasing among hedge funds. The work of international and domestic regulators to develop appropriate policy responses to address the risks of excessive leverage is therefore important. The FPC supports the Financial Stability Board’s international work programme on leverage in non-bank financial institutions, and encourages authorities globally to take action to reduce the vulnerabilities through internationally co-ordinated policy reforms.

Given the significant progress made on liability-driven investment (LDI) fund resilience across domestic and international authorities over the past 18 months, the FPC has closed its November 2022 and March 2023 Recommendations on LDI resilience. Its March 2023 Recommendation that The Pensions Regulator should have the remit to take into account financial stability considerations in its work on a continuing basis remains in place.

The FPC welcomes the launch of the second round of the Bank’s system-wide exploratory scenario (SWES) exercise. In the first round, the hypothetical SWES scenario led most participating non-bank financial institutions to report significant liquidity needs from margin calls. Many participants started the scenario with greater resilience than they had at the onset of recent market shocks. For example, the current level of resilience of money market funds is well above existing minimum requirements. This is also in part the result of recent regulatory actions, such as the LDI resilience standard recommended by the FPC. Participants therefore expected those liquidity needs could be mostly met by pledging assets. However, participants’ responses also implied that terms in the sterling repo market would tighten, and that there would be selling pressure in the sterling corporate bond market.

In the second round, the Bank is exploring the assumptions underpinning participants’ actions and how different assumptions might alter actions taken and lead to different outcomes in markets. The analysis has already provided important insights which demonstrate the value of system-wide exercises. The overall results of the exercise will be published in 2024 Q4.

1: Developments in financial markets

Market participants continue to expect policy rates to remain high for an extended period.

Economic data news has pushed out market expectations on the timing of reductions in policy rates in the US and UK, although rate cuts have now begun in some jurisdictions.

Markets continue to anticipate that policy rates will settle well above where they had been prior to 2021. For example, markets now expect Bank Rate to be around 3.8% in three years’ time, whereas Bank Rate had remained between 0.25% and 0.75% in the 10 years prior to 2021. Longer-term borrowing costs, for example 10-year government bond yields, remain broadly unchanged in the UK, euro area and US since December (Chart 1.1).

Markets responded to the unexpected announcement that French parliamentary elections would be held on 30 June and 7 July. For example, the spread between French and German 10-year government bond yields rose to its highest level since 2017.^{footnote [1]} Much of the widening in spreads reflected a fall in the yield for German bunds. Contacts indicated that while material uncertainty persists, markets remain orderly and the spread still sits well below the peak level reached in 2011 during the period of severe euro area stress. Other euro area sovereign spreads to German bunds widened by less and have shown signs of stabilising.

Chart 1.1: Longer-term borrowing costs remain high relative to post-global financial crisis levels, and are broadly unchanged since the December FSR

US, UK and German 10-year government bond yields

Footnotes

• Source: Bloomberg Finance L.P.

Core market functioning has improved as interest rate volatility has fallen back towards historical averages.

Core markets have functioned well since the previous FSR. Measures of liquidity across UK government bond markets has improved. Bid-ask spreads have narrowed. Sterling money markets have also operated well, with trading rates and volumes generally remaining within historical norms.

Market contacts suggest the global improvement in core market functioning has been driven by reduced interest rate volatility. The MOVE index, which tracks implied volatility in US Treasury markets, has continued to trend lower since December and is now around its average since 1990. Contacts attribute the fall to reduced perceived uncertainty over the global outlook.

Risk premia across a range of markets have fallen significantly since December and are now low by historical standards.

Prices of a range of risky assets – those which carry a degree of credit risk over government securities – have risen since the December FSR. With long-term interest rates remaining high, and the outlook for growth only improving slightly, this increase in prices has been primarily driven by falling risk premia. Measures of risk premia across a range of different asset classes, including equities and corporate debt, are now further below historical medians (Chart 1.2). Relative to the December FSR, risk premia for a broader set of asset classes now appear compressed.

Chart 1.2: Risk premia across many asset classes have fallen further and appear compressed relative to their historical distributions ^(a)

Current level of selected risk premia metrics as a percentile of historical distribution, compared to levels seen at the 2023 Q4 FPC policy meeting

Footnotes

• Sources: Bloomberg Finance L.P., Datastream from LSEG, ICE BofAML, Leveraged Commentary & Data (LCD), an offering of pitchbook and Bank calculations.
• (a) Risk premia data are a percentile of five-day rolling average (except for leveraged-loan (LL) spreads). Percentiles are calculated from 1998 for investment-grade spreads and high-yield bond spreads, 2008 for LL spreads and 2006 for excess cyclically-adjusted price-to-earnings (CAPE) yields. Data updated to 10 June 2024, except for LL spreads which are updated to 7 June 2024. Investment-grade spreads are adjusted for changes in credit quality and duration. All data is daily except for LL spreads which are weekly.

Equity price growth has been particularly strong for some time in the US, driven by the continued resilience of the US economy and optimism over future returns due to Artificial Intelligence and other technological developments. Prices have continued to increase since December and risk premia remain very low by historical standards. The excess cyclically adjusted price-to-earnings yield – a measure of the excess return that investors expect from equities relative to government bond yields – on US equities is at a similar level to the early 2000s. Equity indices have also risen in the UK and EU since the December FSR, notwithstanding a recent fall in French equities. The ratio of prices to earnings over the previous 12 months has increased across these markets but remains below early 2000s peaks.^{footnote [2]}

Corporate credit spreads to risk free rates have also tightened materially since December, with spreads falling across most types of corporate lending. This is particularly evident in the US, where corporate spreads are now nearing levels last seen pre-2008. Spreads on high-yield bonds and leveraged lending also appear historically compressed across jurisdictions, with the majority in or around the bottom quartile of their historical distribution (Chart 1.2).

The tightening of credit spreads has been driven by generally strong investor risk appetite, evident in robust primary market issuance. Corporate debt issuance has been strong in the year to date (Chart 1.3). Most market contacts are more optimistic about the global outlook and think aggregate corporate credit risk is receding. While defaults have been rising, most contacts believe default rates have peaked, consistent with ratings agency central case projections.

Chart 1.3: Corporate issuance in the year to date has been strong across most credit markets ^{(a) (b) (c)}

Year-to-date credit issuance compared to previous five-year average (2019–2023)

Footnotes

• Sources: Leveraged Commentary & Data (LCD), an offering of pitchbook, Refinitiv Eikon from LSEG and Bank calculations.
• (a) Monthly data as at 31 May 2024.
• (b) Yellow diamond data as at 31 May 2023.
• (c) Data for both columns and yellow diamonds are a percentage of the 2019–2023 year to date cumulative averages. For example, a percentage above 100 indicates above average issuance.

There remains some evidence of investors demanding higher risk premia in certain asset classes. Contacts report that demand for some of the riskiest debt has not recovered as much as for more highly rated corporates. This is reflected in the pricing of the lowest rated high-yield debt. For example, while overall euro-denominated high-yield spreads have fallen around 120 basis points since the previous FSR and are around the 15th percentile of their historical distribution, lower-rated euro-denominated high-yield spreads (rated CCC or lower) are around the 75th percentile. The divergence in pricing of the lowest rated bonds is also evident in the smaller sterling market, and in US dollar high-yield debt (Chart 1.4).

Chart 1.4: Risk premia on lower-rated high-yield bonds have not fallen by as much as those on other high-yield bonds, relative to their historical distributions ^(a)

US dollar and euro-denominated high-yield bond spreads, total index and CCC and lower rated, as a percentile of their historical distribution

Footnotes

• Sources: ICE BofAML and Bank calculations.
• (a) Percentiles calculated as five-day rolling average since 1999.

The widespread compression of risk premia has increased the risk of a sharp re-pricing across asset markets. Such a correction could impact financial stability via a number of channels.

Although financial market asset valuations have so far been robust to large increases in interest rates and recent geopolitical events, the adjustment to the higher interest rate environment is not yet complete. The FPC judges that risk premia and valuations remain particularly vulnerable to a shift in risk appetite. An adjustment could be triggered by factors including a weakening of growth prospects, more persistent inflation or a further deterioration in geopolitical conditions.

Should these downside risks materialise, a change in sentiment could lead to a sharp correction in market prices, adversely affecting financing to the real economy via two main channels. First, it would make it more costly and difficult for corporates to refinance maturing debt, including by reducing the value of collateral. This is particularly relevant given the large proportion of leveraged lending and high-yield market-based corporate debt that is due to mature by the end of 2025. Second, it could interact with vulnerabilities in market-based finance which may amplify the correction. For example, it may cause large losses for leveraged market participants, which could further reduce risk appetite and trigger further deleveraging. Or it may lead to a spike in liquidity demand and a deterioration in the functioning of core markets.

2: Global vulnerabilities

2.1: The global economic outlook

Global growth is expected to remain modest over the near term.

There were notable differences in growth across jurisdictions over 2023, with growth stronger in the US and weaker in the euro area. Over 2024, the projections in the May Monetary Policy Report (MPR) are for four-quarter growth to pick up in the euro area, and to moderate somewhat in the US, albeit from relatively high levels. Overall, global activity is expected to grow at moderate pace.

Inflationary pressures have moderated across many advanced economies, and headline and core inflation have fallen back from their peaks over the past year. The European Central Bank and the Bank of Canada both reduced policy rates in June, and market participants expect other central banks, including the Federal Reserve Bank and the Bank of England, to begin to reduce rates over the coming quarters. However, market participants expect short-term interest rates to remain higher for longer over 2024 than was expected at the time of the December FSR.

2.2: The continued impact of higher interest rates

Policy rates in advanced economies have increased significantly over recent years, and households, businesses, sovereigns and financial institutions continue to adjust. Higher interest rates, while necessary to reduce inflation, could impact UK financial stability in a number of ways (see Financial Stability in Focus: Interest rate risk in the economy and financial system for details).

Risks have started to crystallise in property markets globally.

CRE prices have continued to decline since the December FSR in many countries, and are below their pre-Covid levels in the UK and euro area (Chart 2.1). This reflects the continued effect of higher interest rates, as well as structural factors such as the shift to more remote working, and falls in the prices of some buildings driven by differences in energy efficiency. The continued impact of higher interest rates, increasing vacancy rates in certain parts of the sector, and tightening in CRE lending standards are likely to continue to drag on CRE prices globally.

CRE borrowers face large short-term refinancing needs, particularly in the US. Around US$1 trillion of US CRE debt is due to mature in 2024 and 2025, with around a quarter of all debt backed by offices or by industrial property estimated to mature in 2024. A portion of this debt had been due to mature in 2023, but has since been extended or otherwise modified. Of the US$1 trillion of US CRE debt maturing in 2024 and 2025, the International Monetary Fund (IMF) estimates the gap between demand for finance and the amount that lenders are willing to provide (the ‘refinancing gap’) to exceed US$300 billion, based on current pricing and prevailing CRE debt market conditions. This could lead to further sales of CRE assets if investors are unable to roll over or secure new financing, potentially amplifying falls in CRE prices.

Chart 2.1: CRE prices continue to fall across regions

Indexed CRE prices in the UK, euro area and US ^(a)

Footnotes

• Sources: European Central Bank, Federal Reserve Board, MSCI and Bank calculations.
• (a) Data used are latest available as at 10 June. More recent data are available for the UK than for the US or euro area.

Stress in global commercial property markets could spill over to the UK.

The global banking system has significant exposures to CRE. For instance, the IMF estimates that CRE debt accounts for about 18% of total US bank loans. Of the debt due to mature over 2024 and 2025, banks hold a larger proportion than other types of lenders. The non-performing loan ratio for CRE lending in the US and in the euro area increased over 2023, and the proportion of UK banks’ CRE loans considered credit impaired also increased. US CRE loans secured on office buildings in particular have seen marked increases in delinquencies over 2023 and 2024.

There are a number of small and mid-sized banks in jurisdictions such as the US, Germany and Japan with significant domestic and cross-country exposures to CRE. Some banks saw sharp falls in stock prices after announcing losses or provisions on CRE portfolios earlier this year, and one small US bank with large CRE exposures failed in April.

The results of the 2022/23 ACS stress test, which included very sharp falls in global property prices well beyond those seen to date, suggest that major UK banks are resilient to their direct exposures to commercial real estate globally. Losses on CRE exposures reduced aggregate CET1 ratios of major UK banks by 0.3 percentage points in the 2022/23 ACS. However, crystallisation of risks in global CRE markets could pass through to the UK financial system in other ways.

A significant share of global CRE debt and exposure to property markets is held outside the banking sector. Outflows from CRE funds have continued, though these have so far been orderly. There is less visibility on CRE debt held by non-bank financial institutions (NBFIs), but correlated exposures to overseas CRE markets for some groups of NBFIs could lead to concentrated losses in a stress.

Stresses in exposed non-banks, as well as in overseas banks, could affect UK financial stability through macroeconomic and financial market spillovers, contagion to funding conditions for UK banks, or a reduction in overseas finance for the UK CRE sector leading to further downward pressure on UK valuations. Stress could also interact with existing vulnerabilities in the system of non-bank finance.

Growing expected interest rate differentials with the US have generated moves in exchange rates and, in some places, increased financial pressures.

Policy rates in the US are now expected to remain higher for longer than at the time of the December FSR, and interest rate differentials between the US and a number of other countries have generated moves in exchange rates. For instance, the yen has depreciated to historic lows against the US dollar, prompting intervention in the foreign exchange markets by the Japanese authorities.

Non-China emerging market economies have experienced increased financial pressure from exchange rate differentials, but have generally continued to be resilient. If global financial conditions were to tighten sharply, non-China emerging market assets could be subject to a sudden repricing, which could have spillovers to the UK through financial markets.

Banks continue to adjust to higher interest rates across jurisdictions, but vulnerabilities remain.

US and euro-area bank profitability has generally been supported by higher interest rates. Deposits in smaller US banks have returned to levels seen before the March 2023 stress (Chart 2.2).

Chart 2.2: Smaller US banks’ deposit levels have returned to levels seen before March 2023

Deposit levels at US banks, seasonally adjusted

Footnotes

• Source: Refinitiv Eikon from LSEG.

However, a number of vulnerabilities remain, particularly among small and mid-sized US banks. Banks are still exposed to sectors such as CRE that are adjusting to a higher interest rate environment. In March, the Federal Reserve’s Bank Term Funding Program (BTFP) ceased extending new loans, though the Federal Reserve’s discount window lending programmes are still available to help banks manage liquidity risks. 95% of advances provided through the BTFP were given to smaller institutions.

Some banks across jurisdictions continue to face high unrealised losses on securities including bonds, brought about by the increase in interest rates. US banks’ total unrealised losses on securities were US$39 billion higher in 2024 Q1 than at the end of 2023, at US$517 billion. Further rises in foreign and domestic yields could also generate further unrealised losses on debt security holdings across some Japanese banks.

The overseas banking stress following the failure of Silicon Valley Bank in March 2023 showed that stress can spread across and within jurisdictions, even where smaller institutions are involved. It highlighted that, while an individual institution may not be considered systemic, if a risk is common – or perceived to be common – among similar institutions, the collective impact can pose a systemic risk. Further losses on CRE or other exposures could spill over to other markets if similar contagion dynamics were to occur, including through market or depositor sentiment.

Globally, corporate and household balance sheets have remained resilient in aggregate despite pressures from higher costs of servicing debt.

Higher interest rates continue to make it more challenging for households and businesses to service and refinance their debts, but corporate and household balance sheets have remained resilient in aggregate across advanced economies.

There are however some areas of increased vulnerability, including borrowing by highly leveraged corporates. Defaults on leveraged loans increased to a peak of 7.1% globally in February, and were at 6.8% in April, up from 5.0% this time last year. And as outlined in Section 6, private credit and leveraged loan markets are interconnected and shocks could be highly correlated, so disruptions in overseas markets could spill over to the UK.

Public debt-to-GDP levels have increased across a number of major economies, which could have consequences for UK financial stability.

Across jurisdictions, debt-to-GDP levels have increased over recent years, driven by increased government borrowing, particularly over the Covid pandemic. The current period of elevated geopolitical risk and uncertainty, as well as structural trends such as demographics, could place further pressure on debt-to-GDP levels and government finances.

The FPC has previously highlighted vulnerabilities created by high public debt levels in major economies, including through interlinkages between banks and sovereigns. Increases in global policy rates, combined with increasing indebtedness levels, have increased the costs of servicing government debt. And higher interest rates will further increase debt servicing costs over time as governments refinance.

High public debt levels in major economies could have consequences for UK financial stability and interact with other risks. A deterioration in market perceptions of the path of public debt globally could lead to market volatility and interact with vulnerabilities in market-based finance, potentially tightening credit conditions for households and businesses. Increased servicing costs for governments as debt is refinanced could also reduce their capacity to respond to future shocks. The FPC will continue to monitor these risks and take into account the potential for them to crystallise other financial vulnerabilities and amplify shocks.

2.3: Risks from developments in China

Property market vulnerabilities in mainland China have continued to crystallise.

Activity in the mainland Chinese residential property sector continues to decrease, and prices of new and existing homes have fallen over 2024 (Chart 2.3). Some large Chinese property developers have missed bond payments without agreed extensions. In response to property market developments, Chinese authorities have put in place measures to provide support and limit spillovers from the property sector to the broader economy, and further measures were announced in May to support housing demand and encourage state-owned enterprises to purchase unsold properties. Disorderly defaults by property developers have been avoided thus far.