Financial Stability Report and Record - July 2019

• Increased Brexit uncertainties have put additional downward pressure on UK forward interest rates and led to a decline in the sterling exchange rate and an underperformance of UK-focused equities. In markets that are particularly dependent on foreign investors – notably commercial real estate and leveraged lending - investment into the UK was much weaker in 2019 Q1 than in recent years.  

Even after a stress larger than the crisis, banks would still have more capital than in 2007.

• Actions by businesses and authorities since November have resulted in some improvement in the preparedness of the UK economy for a no-deal Brexit. However, material risks of economic disruption remain.
• The FPC continues to judge that its 2018 stress test of major UK banks was sufficiently severe to encompass the wide range of UK economic and financial shocks that could be associated with Brexit. Overall, the stress scenario was more severe than the global financial crisis.
• Major UK banks demonstrated their resilience to that stress scenario. Since the stress test they have maintained Tier 1 capital levels of around 17% of risk-weighted assets – more than three times higher than before the global financial crisis.

• The underlying vulnerabilities (excluding Brexit) that can amplify economic shocks have not changed materially since November and remain at a standard level overall in the UK. Despite continued signs of strong risk appetite from creditors and lenders, total UK private non-financial sector credit growth has not been rapid and debt servicing burdens remain low.
• The FPC stands ready to move the UK countercyclical capital buffer (CCyB) rate in either direction as economic conditions and the overall risk environment evolve. If a major economic stress were to materialise, the FPC is prepared to cut the UK CCyB rate, as it did in July 2016. In the absence of such a stress, the FPC remains vigilant to developments, particularly in the domestic credit environment.

• Extensive legislative and other preparations made by UK authorities and firms ahead of March will apply at the end of October. UK households and businesses will be able to use existing and new services from EU financial institutions.
• UK-based firms have made further preparations to be able to serve EU clients since the extension in March. It is important that they continue to do so to reduce further the risks of disruption.
• However, in the absence of further action by EU authorities, some disruption to cross-border financial services is possible. Although such disruption would primarily affect EU households and businesses, it could amplify volatility and spill back to the UK in ways that cannot be fully anticipated or mitigated.

• In a disorderly Brexit, a range of UK asset prices – including the sterling exchange rate, equities, corporate and government debt and bank funding costs – would be expected to adjust sharply, tightening financial conditions for UK households and businesses.  
• With over £1 trillion of high-quality liquid assets, major UK banks are able to meet their maturing obligations for many months without accessing wholesale funding or foreign exchange markets. As a further prudent precaution, the Bank of England maintains operations to lend in all major currencies on a weekly basis.

• Rising trade tensions have resulted in declining business confidence and pose material downside risks to global output growth.

• Credit growth in China continues to outpace nominal income growth and debt is more than 200% of GDP.  Some emerging market economies with large current account deficits or high levels of debt denominated in foreign currencies remain vulnerable to renewed capital outflows.  
• In global financial markets, risk-free interest rates have fallen markedly and are consistent with more pessimistic expectations of economic growth. In contrast, measures of compensation for credit risk in corporate bond and loan markets appear to factor in a relatively benign economic outlook.  
• US corporate debt is above pre-crisis levels as a share of GDP and, in part reflecting rapid growth of leveraged lending, the share of debt owed by highly leveraged US companies has reached pre-crisis levels of above 40%. 

Trade tensions could materially slow global growth, but UK banks have shown they could lend through a significantly more severe stress

• Major UK banks were subjected to a severe scenario for the global economy in the 2018 stress test that reflected these underlying vulnerabilities. World GDP contracted by 2.4% over the first year of that scenario and Chinese GDP contracted by 1.2%. Banks were assumed to lose more than 10% of their exposures to large non-investment grade US and UK companies.  Major UK banks showed they were resilient to that scenario.
• This test on global exposures was of a severity that encompassed a worst-case scenario for global trade tensions.  All implemented and contemplated tariff measures, combined with a severe business confidence shock and a sharp tightening in global financial conditions, could slow global GDP growth materially but would be unlikely to cause the outright fall in global output that banks were tested against.
• Even if a protectionist-driven global slowdown were to spill over to the UK at the same time as a worst-case disorderly Brexit, the FPC judges that the core UK banking system would be strong enough to absorb, rather than amplify, the resulting economic shocks. 

• Assess developments in the scope and nature of regulation for payments and other innovative financial services to ensure the approach reflects their systemic importance.
• Assess risks to the UK financial system associated with the use of tokens and other assets used to facilitate new payment options and appropriate safeguards for their use to maintain financial stability and the supply of finance to the economy.  
• Review the Bank's proposals on the appropriate level of access to its payments infrastructure and balance sheet in order to ensure that access supports fully the stability and resilience of the system while also allowing innovation in payments.  

• Financial stability risks from climate change arise both from the physical risks associated with the increased frequency of extreme weather events and from the transition to a carbon-neutral economy.
• This exercise will integrate climate scenarios with macroeconomic and financial system models. It will motivate firms to address data gaps and to develop cutting-edge risk management consistent with a range of possible climate pathways: ranging from early and orderly to late and disruptive. 
• The discussion paper will cover issues such as the coverage of the test, the nature of scenarios considered, the appropriate time horizon and disclosure of results. This will allow the Bank to develop the scenarios in consultation with risk specialists from across the financial sector, climate scientists, other industry experts, and other informed stakeholder groups.   

• Many funds offer daily redemptions while investing in assets that can take weeks or months to sell in an orderly way. They offer redeeming investors a price linked to the market price of the funds’ assets despite having a redemption period much shorter than would be needed to realise those market prices, particularly in stress.  
• This can create an incentive for investors to redeem when they expect others to do so. This self-reinforcing dynamic can lead to so many investors rushing to redeem that funds have no choice but to suspend all redemptions. Furthermore, fear of possible suspension reinforces the incentive to redeem.
• In 2015, the FPC highlighted vulnerabilities associated with funds’ liquidity mismatch. These go beyond any single market or fund type.  Large-scale redemptions from funds could test markets’ ability to absorb asset sales, amplifying price moves, transmitting stress to other parts of the financial system, and disrupting the availability of finance in the real economy. Although to date these vulnerabilities have not created financial instability, they could do so under severe stress and are likely to become more important if more funds expand into less liquid assets.

• This is a global issue.  For that reason the FPC supported the Financial Stability Board’s 2017 recommendation that funds’ assets and investment strategies should be consistent with their redemption terms. However, subsequent work by the International Organization of Securities Commissions did not prescribe how this should be achieved.  
• Although funds are not permitted in general to favour one group of investors over another, there are no well-defined requirements for how this should be done. The Bank and FCA review will examine the costs and benefits of aligning redemption terms, including pricing and notice periods, with the typical time it takes to realise market prices for funds’ assets in normal and stressed market conditions.
• The review will also assess the effectiveness of measures that are already used to deal with misalignment of redemption terms and asset liquidity, such as swing and fair value pricing and suspensions.

The stock of Libor-linked sterling derivatives has increased

• The smoothest transition will be one in which market participants: cease new issuance of Libor-linked contracts; identify all existing contracts without appropriate fallback clauses and rectify this to the greatest extent possible; and actively reduce legacy exposures by negotiating their transition to new rates.
• It is not in firms’ own interests to have a large stock of legacy contracts that will become subject to significant legal uncertainty beyond 2021. There are advantages to re-negotiating contracts to refer to alternative reference rates well in advance of end-2021.
• Well-managed firms are expected to lead the transition. All firms that responded to the PRA’s and FCA’s Dear CEO letter have now appointed a Senior Manager accountable for overseeing the transition.

• This exercise will not set new liquidity standards for banks. Banks hold regulatory liquidity buffers that the FPC expects to be used in a stress.  
• The exercise will explore how the reactions of banks and authorities to the stress would shape its impact on the broader financial system and the UK economy. It will help to guide the PRA's approach to supervision and the Bank’s provision of liquidity in stressed conditions.
• The Bank intends to publish the results of the exploratory exercise in mid-2020.