- At its meeting on 20 September, the Financial Policy Committee (FPC) reviewed developments since its meeting on 21 June. The FPC assessed the outlook for UK financial stability by identifying the risks faced by the UK financial system and assessing the resilience of the system to them. In doing so, its aim is that the financial system can continue to provide essential services to the real economy, even in adverse circumstances.
- The FPC judges that overall risks to UK financial stability from the domestic environment are broadly unchanged at a standard level. However, there are signs in some markets, globally and domestically, of excessive weight being placed on recent benign conditions as an indicator of future risks. This behaviour encourages greater risk taking, potentially building up greater vulnerabilities.
Global economic and market risks
- In the global economy, risks from indebtedness remain material and geopolitical tensions have risen. Financial vulnerabilities in China remain pronounced. Corporate leverage in the United States has risen to new highs.
- Near-term global growth prospects have continued to improve and broaden, and expectations of inflation are subdued. Against that backdrop, long-term interest rates remain very low and market measures of volatility and uncertainty are at historic lows.
- Often in periods of low volatility, underlying risks can build up gradually. In recent years, financial covenants in riskier corporate lending markets have loosened materially. And global corporate bond spreads have narrowed to unusually low levels.
- Some asset valuations appear to factor in the low level of long-term market interest rates but may not be consistent with the pessimistic and uncertain economic outlook embodied in these rates. These asset prices are therefore vulnerable to a repricing, whether through an increase in long-term interest rates or adjustment of growth expectations, or both.
- The FPC is assessing the resilience of major banks to severe global and market shocks as part of the Bank’s 2017 annual cyclical stress test.
- In domestic credit markets, risk-taking is currently judged to be at a standard level overall. Domestic credit has grown broadly in line with nominal GDP over the past two years. Lending spreads on new owner-occupier mortgages are in line with their average since 1997. The share of households with mortgage debt-servicing costs exceeding 40% of their income (the percentage beyond which historical evidence suggests that households are materially more likely to experience repayment difficulties) is just 1%. And the aggregate debt-servicing ratio for UK non-financial corporations is below its average since 1999.
- In segments of the UK commercial property market, valuations appear to factor in the low level of long-term market interest rates but not necessarily the cash flows associated with the economic outlook embodied in these rates.
- Consistent with these judgements, its stated policy of moving gradually, and its June 2017 guidance; the FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 0.5%. Absent a material change in the outlook, the FPC expects to increase the rate to 1% at its November meeting, with binding effect a year after that.
- Within a benign overall domestic credit environment, there is a pocket of risk in the rapid growth of consumer credit. This is not a material risk to economic growth, as consumer credit represents only 11% of overall household debt. It is a risk to banks’ ability to withstand severe economic downturns, because this asset class is disproportionately more likely to default. Although the overall credit quality of consumer credit has improved significantly since the financial crisis, the FPC judges that lenders overall are placing too much weight on the recent performance of consumer lending in benign conditions as an indicator of underlying credit quality. As a result, they have been underestimating the losses they could incur in a downturn.
- The FPC has responded to this risk by accelerating its analysis of credit losses that banks could incur in the very deep recession encapsulated in the 2017 annual stress test scenario. The FPC and PRC judge that, in the first three years of that severe stress test scenario, the UK banking system would, in aggregate, incur UK consumer credit losses of around £30 billion, or 20% of UK consumer credit loans, representing 150 basis points of the aggregate common equity Tier 1 capital ratio of the UK banking system. This is just one element of the overall stress test and should not be used as a guide to lenders’ overall results, which will be published as planned on 28 November.
- Regulatory capital buffers for individual firms will be set following the full stress test results so that each bank can absorb its losses on consumer lending, alongside all the other effects of the stress scenario on its balance sheet. The FPC also expects that banks will begin to factor these market-wide levels of stressed losses on consumer credit into their overall lending and capital plans.
- The FPC continues to assess the risks of disruption to financial services arising from Brexit so that preparations can be made and action taken to mitigate them. The FPC is considering in particular risks arising from: discontinuity of cross-border contracts, in particular insurance and derivatives; restrictions on sharing of personal data between the European Union and United Kingdom; and restrictions after Brexit on cross-border banking, central clearing and asset management service provision.
- In areas where it would be complex and difficult for firms themselves to mitigate risks fully, such as the continuity of contracts between UK and EU27 counterparties, the FPC is exploring other mitigating actions. This applies most notably to uncleared derivative contracts between UK and EU27 counterparties, which account for around a quarter of outstanding contracts and involve tens of thousands of counterparties. It also applies to the cross-border sharing of personal data.
- Major UK banks have continued to build their resilience. The aggregate common equity Tier 1 capital ratio of major banks has increased to 14.3% of risk-weighted assets. In aggregate they have a capital ratio that is more than three times higher than it was ten years ago.
- On 1 January 2018, most banks in the United Kingdom will need to adhere to a new accounting standard called International Financial Reporting Standard 9 (IFRS 9). Under the new accounting standard, banks will set aside provisions for expected credit losses on all loans, not just where a loan is past due or has already fallen into default. Because provisions will be made in a more timely way, IFRS 9 accounting will support financial stability.
- The FPC’s judgement of the necessary level of loss absorbing capacity for the banking system is invariant to accounting standards. The change in accounting standard will not, by itself, change the cumulative losses banks incur during any given stress episode. The Committee’s judgement of the appropriate level of capital for the banking system was calibrated such that banks could absorb the cumulative losses in historical stress episodes and continue to provide essential services to the real economy, regardless of the timing of when those losses were actually measured.
- The FPC will take steps to ensure that the interaction of IFRS 9 accounting with its annual stress test does not result in a de facto increase in capital requirements. The FPC and Prudential Regulation Committee (PRC) encourage firms to use any internationally agreed transitional arrangements as they adjust to the new regime, provided the arrangements are broadly similar to those currently being considered. The FPC and PRC will respect firms’ choices in future capital assessments and stress tests.
- Following consultation, the FPC is confirming its recommendation to the Prudential Regulation Authority (PRA) to set the minimum leverage requirement at 3.25%, with central bank reserves removed from the leverage exposure measure. The PRA will shortly be publishing its rules on how this change will be implemented, alongside publication of the Record of the FPC’s meeting.