Financial Policy Summary, 2024 Q2
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.