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.
Financial market developments and global debt vulnerabilities
The global economic outlook has deteriorated further since the July 2022 Financial Stability Report and financial conditions have tightened significantly. Monetary authorities have been responding to high levels of inflation, driven by higher and more volatile energy prices, domestic inflationary pressures and global supply chain issues following the pandemic. Higher central bank policy rates, alongside expectations of further rises, have led to very material and rapid increases in yields on long-term government bonds globally.
The deterioration in the global economic outlook, together with heightened uncertainty and the potential for further adverse geopolitical developments, has also led to falls in risky asset prices and a reduction in investor risk appetite. Financing conditions for households and businesses have tightened significantly. Financial market volatility has been elevated. Overall, moves in risky asset prices have been generally orderly, but the risk of sharp adjustments from further developments in the outlook remains.
Sharp increases in prices, including of energy, tighter financial conditions, and the worsening outlook for growth and unemployment will continue to weigh on debt affordability for households, businesses and governments globally. The FPC judges that the risks of global debt vulnerabilities crystallising have increased.
In the current environment, the FPC is monitoring geopolitical and other risks very closely and taking them into account when assessing the resilience of the UK financial system, including in the context of the 2022 annual cyclical scenario (ACS) stress test. It will work with other authorities at home and abroad, including the Prudential Regulation Authority (PRA), to consider whether any further action is required to enhance the resilience of UK banks to such risks.
UK household and corporate debt vulnerabilities
Household finances are being stretched by increased living costs and rising mortgage payments. Households are adjusting spending behaviour as real income is squeezed, although widespread signs of financial difficulty among UK households with debt have yet to emerge. The risk that indebted households default on loans, or sharply reduce their spending, has increased.
Pressures on household finances will increase over 2023. In total around half of owner occupier mortgages (around 4 million) will be exposed to rate rises over the next year. Falling real incomes, increases in mortgage costs and higher unemployment will place significant pressure on household finances. The share of households with high cost of living adjusted mortgage debt-servicing ratios would increase over 2023 to 2.4%, assuming current market pricing of Bank Rate, but remain lower than in the global financial crisis (GFC). Households are also experiencing increased pressure on their ability to service other types of consumer debt, such as credit cards and personal loans.
While pressures will increase, the FPC judges that households are more resilient now than in the run-up to the GFC in 2007 and the recession in the early 1990s. Households are in aggregate less indebted compared to the peak that preceded the GFC. And the proportion of disposable income spent on mortgage payments in aggregate is projected to rise but remain below the peak levels during the GFC and the 1990s recession. The core UK banking system is also more resilient, in part due to lower risk lending to households. The greater resilience of banks, and the higher standards around conduct, also means they are expected to offer a greater range of forbearance options. As such, the increased pressure on UK households is not expected to challenge directly the resilience of the UK banking system.
In aggregate, UK businesses are entering the period of stress in a broadly resilient position, but are under increased pressure from economic and financial developments. Earnings have risen and leverage has fallen in 2022 as the effects of the Covid pandemic have abated. But within the aggregate, there are a number of vulnerable companies with low liquidity, weak profitability, or high leverage. And some businesses are facing other pressures from higher costs of servicing debt, weaker earnings, and continued supply chain disruption. These pressures are expected to continue to increase over 2023, especially for smaller companies that are less able to insulate themselves against higher rates.
Increased pressure on the corporate sector is not expected to pose material risks to the resilience of the UK banking system, but will leave businesses more vulnerable to future shocks. There are some emerging signs of stress among corporate borrowers. Corporate insolvencies have increased, in particular among small and medium-sized enterprises. Financing conditions have tightened, particularly for risky firms, with some funding markets closed. But businesses are not yet showing signs of reducing employment or investment sharply in response to the economic downturn.
UK external balance sheet vulnerabilities
Reflecting its position as one of the most financially open economies in the world, many UK assets are held by overseas investors, meaning the UK is exposed to external financing risks. The UK’s external liabilities are significantly higher than for other G7 economies. The size of these liabilities means that the behaviour of foreign investors, and their perceptions of the UK macroeconomic policy framework, can have a material impact on UK financial conditions.
There were signs that foreign investor demand for UK assets weakened in September and early October, but this has since reversed. Over the second half of 2022 as a whole, UK asset prices have moved broadly in line with euro-area equivalents. Any future UK-specific shock to investor appetite for UK assets would likely reduce their prices. Some of the impact of such a move on the UK’s external balance sheet could be offset by moves in the exchange rate. This is in part because the UK’s external assets at current market value are estimated to be worth significantly more than its liabilities.
A particularly large and rapid fall in foreign investor demand for UK assets could pose a more acute risk to UK financial stability if it led to difficulties refinancing UK external liabilities, but the FPC judges that this risk at present is low. UK banks have robust foreign currency liquidity positions in aggregate and liquidity regulations require greater liquidity buffers for greater exposures to refinancing risk.
UK bank resilience
The FPC continues to judge that the UK banking system is resilient to the current economic outlook and has capacity to support lending, even if economic conditions are worse than forecast. Major UK banks’ capital and liquidity positions remain strong and pre-provision profitability has increased. They are therefore well placed to absorb shocks and continue meeting the credit needs of households and businesses. In aggregate smaller lenders are also well capitalised and have strong liquidity positions.
Asset quality remains relatively strong – although some forms of lending, such as buy-to-let, higher loan to value and higher loan to income mortgage lending, and lending to lower rated and highly leveraged corporates, are more exposed to losses – as are those lenders that are more concentrated in those assets.
There is evidence that the major UK banks are tightening their lending standards by adjusting their appetite for lending to riskier borrowers as risks have increased, consistent with the worsening macroeconomic outlook. Excessive restrictions on lending would prevent creditworthy households and businesses from accessing funding. This would be counterproductive, harming both the wider economy and ultimately the banks themselves. The FPC will continue to monitor UK credit conditions for signs of unwarranted tightening.
The FPC has previously judged that the UK banking system is resilient to a wide range of severe economic outcomes, and is assessing major UK banks against a further severe shock in the 2022 ACS. The results will be published in Summer 2023.
The UK countercyclical capital buffer rate
The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 2%, due to come into effect on 5 July 2023. The global and UK economic outlooks have deteriorated and financial conditions have tightened. The FPC judges that the UK banking system can absorb the impact of the expected weakening in the economic situation while continuing to meet credit demand from creditworthy households and businesses.
Vulnerabilities that could amplify future economic shocks remain. Maintaining a neutral setting of the UK CCyB rate in the region of 2% helps to ensure that banks continue to have sufficient capacity to absorb further unexpected shocks without restricting lending in a counterproductive way.
Cryptoassets
Cryptoasset prices have continued to decline sharply. The sudden failure of FTX – a large conglomerate offering cryptoasset trading and other associated services – has highlighted a number of vulnerabilities. The FPC continues to judge that direct risks to UK financial stability from cryptoassets remain limited. But these events have highlighted how systemic risks could emerge if cryptoasset activity and interconnectedness with the wider financial system increase. They underscore the need for enhanced regulatory and law enforcement frameworks to address developments in crypto markets and activities. Financial institutions and investors should take an especially cautious and prudent approach to any adoption of these assets until the necessary regulatory regimes are in place.
The resilience of market-based finance
Tightening financing conditions and greater volatility, alongside a number of economic shocks, have caused long-standing vulnerabilities in market-based finance (MBF) to crystallise in a number of areas over the past three years.
These episodes underline the need to develop and adopt policy reforms to increase resilience across the system of MBF. The Financial Stability Board (FSB) has a comprehensive international work programme in train focused on increasing the resilience of money market funds and open-ended funds, improving margin practices and understanding drivers of illiquidity in core funding markets, including non-bank financial institution (NBFI) leverage.
The FPC welcomes the FSB’s recent progress report to G20 leaders and the proposed work plan for 2023, which includes developing policy recommendations that seek to address vulnerabilities. The Bank and FPC continue to support strongly this programme of international work. In 2023 international and domestic regulators urgently need to develop and implement appropriate policy responses to address the risks from MBF. Absent an increase in resilience, the sharp transition to higher interest rates and currently high volatility increases the likelihood that MBF vulnerabilities crystallise and pose risks to financial stability.
Alongside this international work, the Bank will continue to work to reduce vulnerabilities domestically where it is effective and practical. To support this, there is a need to develop stress-testing approaches to understand better the resilience of NBFIs to shocks and their interconnections with banks and core markets. The Bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches. Further details will be set out in the first half of 2023.
The resilience of liability-driven investment funds
In late September, UK financial assets saw severe repricing, particularly affecting long-dated UK government debt. The rapid and unprecedented increase in yields exposed vulnerabilities associated with liability-driven investment (LDI) funds in which many defined benefit pension schemes invest. This led to a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to UK financial stability. This would have led to an unwarranted tightening of financing conditions and a reduction in the flow of credit to households and businesses. In response to this threat to UK financial stability, the FPC recommended that action be taken, and welcomed the Bank’s plans for a temporary and targeted programme of purchases of long-dated UK government bonds to restore market functioning and give LDI funds time to build their resilience to future volatility in the gilt market.
This episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient, and that buffers were too low and less usable in practice than expected, particularly given the concentrated nature of the positions held in the long-dated gilt market. While it might not be reasonable to expect market participants to insure against the most extreme market outcomes, it is important that shortcomings are identified and action taken to ensure financial stability risks can be avoided in future. There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding.
The FPC is of the view that LDI funds should maintain financial and operational resilience to withstand severe but plausible market moves, including those experienced during the recent period of volatility. This should include robust risk management of any liquidity relied upon outside LDI funds, including in money market funds. The FPC welcomes, as a first step, the recent guidance published by The Pensions Regulator (TPR) in this regard. The FPC also welcomes the recent statements by the Financial Conduct Authority (FCA) and overseas regulators on the resilience of LDI funds.
Given the identified shortcomings in previous levels of resilience and the challenging macroeconomic outlook, the FPC recommends that regulatory action be taken, as an interim measure, by TPR, in co-ordination with the FCA and overseas regulators, to ensure LDI funds remain resilient to the higher level of interest rates that they can now withstand and defined benefit pension scheme trustees and advisers ensure these levels are met in their LDI arrangements.
Following this, regulators should set out appropriate steady-state minimum levels of resilience for LDI funds including in relation to operational and governance processes and risks associated with different fund structures and market concentration. Further steps will also need to be taken to ensure regulatory and supervisory gaps are filled, so as to strengthen the resilience of the sector. The Bank will continue to work closely with domestic and international regulators so that LDI vulnerabilities are monitored and tackled.
Banks, as providers of funding to the LDI sector, should apply a prudent approach when providing finance to LDI funds, taking into account the resilience standards set out by regulators and likely market dynamics in relevant stressed conditions. The FPC supports further work by the PRA and FCA to understand the roles of firms that they regulate in the recent stress, focusing particularly on their risk management, and to investigate lessons learned.