Outlook for UK financial stability and the UK countercyclical capital buffer rate decision
The FPC continues to judge that, apart from those related to Brexit, domestic risks remain standard overall, and that risks from global vulnerabilities remain material.
While the outlook for global growth has strengthened further, there are material risks associated with interest rate volatility. The principal risks are in debt markets. Across major markets, spreads between corporate and sovereign bond yields remain compressed, particularly for high-yield corporate bonds.
Against that market backdrop, risks stemming from corporate debt in the United States have continued to build. Financial vulnerabilities in China remain elevated.
In the United Kingdom, aggregate private (non-financial sector) debt has increased only a little faster than GDP over the past couple of years and, relative to incomes, remains well below pre-crisis levels. Debt-servicing costs, for both households and companies, are low.
However, the Committee noted some signs of rising domestic risk appetite in recent quarters. Gross issuance of leveraged loans and high-yield bonds by UK companies increased in 2017. Valuations in some segments of the UK commercial real estate sector appear stretched. In the mortgage market, the proportion of new owner-occupier mortgages at high loan-to-income ratios, including just below 4.5 (the level at which the FPC’s limit on the flow of new mortgages applies), has increased, and spreads between mortgage rates and risk-free rates have tightened.
In addition, the United Kingdom’s current account deficit remains large by international standards. And over recent quarters this deficit has been increasingly funded by capital inflows (rather than sales of foreign assets by UK residents), thus increasing the UK’s reliance on the confidence of foreign investors.
Balancing all these factors, the FPC is setting the UK countercyclical capital buffer (CCyB) rate at 1%, unchanged from November. The Committee will reconsider the adequacy of the 1% CCyB rate in June with a particular focus on the evolution of domestic risk appetite.
Risks to UK financial stability from Brexit
Consistent with its statutory duties, the FPC continues to identify and monitor UK financial stability risks associated with Brexit so that preparations can be made and actions taken to mitigate them.
The FPC continues to judge that the 2017 stress test encompassed a wide range of UK macroeconomic outcomes that could be associated with Brexit. The UK banking system could continue to support the real economy through a disorderly Brexit.
As the FPC noted in November 2017, the combination of a disorderly Brexit and a severe global recession and stressed misconduct costs could, however, result in more severe conditions than in the stress test. At the time, the FPC judged that the likelihood of this combination occurring simultaneously could be seen as extremely remote. Reflecting the resilience of major UK banks, which have an aggregate Tier 1 capital ratio of 16.8%, the FPC judged that Brexit risks did not warrant additional capital buffers for banks. Developments since November have not changed this assessment.
Brexit could also disrupt the financial system directly. The November Financial Stability Report outlined the main cross-cutting issues and a checklist of actions that would mitigate risks of disruption to important financial services used by households and businesses.
Since November, in the United Kingdom, progress has been made towards mitigating risks of disruption to the availability of financial services. Nonetheless, material risks remain, particularly in areas where actions would be needed by both the UK and EU authorities – as set out in Annex 1. The FPC re-emphasises the importance that preparations continue to be made and actions taken by relevant authorities to tackle these risks.
The Committee recognises the potential benefits of the technologies underlying crypto-assets and of their potential to create a more distributed and diverse payments system. It welcomes the work of the Bank and other authorities to explore ways of achieving these benefits in a robust and efficient manner.
The FPC judges that existing crypto-assets do not currently pose a material risk to UK financial stability – as set out in Annex 2. The FPC will act to ensure the core of the UK financial system remains resilient if linkages between crypto-assets and systemically important financial institutions or markets were to grow significantly. In the event that one or more crypto-assets were likely to become widely used for payments, or as an asset intended to store value, the FPC would require current financial stability standards to be applied to relevant payments and exchanges.
The 2018 stress test of major UK banks
The 2018 stress test scenario will be the same as that used in 2017. It is therefore more severe than the global financial crisis. The use of the same stress scenario will allow the Bank to isolate, as far as possible, the impact on the stress test results of the new accounting standard which came into effect on 1 January 2018 (International Financial Reporting Standard 9, or IFRS 9). The consistency of the scenario also recognises the deployment of resources both within the Bank and at private institutions in 2018 to prepare for Brexit and the introduction of ring-fencing requirements on 1 January 2019. The calibration of the stress scenario remains appropriate given the current risk environment. In 2019 the stress test scenario will be updated in line with the Bank’s usual approach.
The hurdle rates for the 2018 test will evolve from those used in earlier years. The Bank will hold banks of greater systemic importance to higher standards: each participating bank will now be assessed against single risk-weighted capital and leverage hurdle rates that incorporate any buffers to reflect their systemic importance. These will now include, for the first time, capital buffers for domestic, as well as global, systemic importance. In addition, adjustments will be made to hurdle rates to reflect the increased loss absorbency that will result from higher provisions in stress under the new IFRS 9 accounting standard.
These changes are set out in Stress testing the UK banking system: key elements of the 2018 stress test