Financial Policy Summary and Record – March 2022

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 can serve UK households and businesses in bad times as well as good.

The outlook for UK financial stability

UK financial stability and the Russian invasion of Ukraine

The Bank of England condemns Russia’s unprovoked invasion and the suffering inflicted on Ukraine. The Bank is working closely with the Government to support its response in coordination with the FCA and other UK and international authorities. The FPC supports this condemnation and welcomes these actions. In addition, the FPC welcomes international coordination to ensure alignment of financial sanctions, as well as industry engagement, to minimise the potential for unintended operational consequences.

Global financial markets, particularly for commodities, have been volatile and uncertainty over the economic outlook has increased significantly. Consistent with its remit, the FPC’s role is to assess the impact of these developments on UK financial stability and take action as appropriate.

The UK’s direct linkages to Russia are limited; trade links and the direct exposures of UK banks to Russia are low. There are, however, indirect channels through which the invasion could potentially pose risks to the UK financial system, and disruption to global supply chains could continue to affect activity and the economic outlook in the UK and elsewhere.

Major UK banks’ capital and liquidity positions remain strong. Their aggregate Common Equity Tier 1 capital ratio stood at 16.3% at end-2021. The FPC has tested the resilience of the UK banking system against a range of severe economic scenarios, and remains of the view that major UK banks are able to withstand severe market and economic disruption.

Financial markets have in general continued to function despite the high volatility, although bid-offer spreads have widened in certain bond markets, suggesting that market liquidity has been impacted. Risky asset prices have fallen, and global financial conditions have tightened with, for example, materially lower primary issuance in corporate debt and leveraged loan markets in recent weeks. Energy prices have risen sharply, as have the prices of other commodities where Russia and Ukraine are important producers, and volatility has been exceptionally high.

Given the need to safeguard against counterparty credit risks for both regulated and unregulated entities, and consistent with these moves, margin calls on derivatives positions in over-the-counter and exchange-traded markets rose significantly. The invasion has led to significant stress in a range of commodity markets. In particular, the London Metal Exchange had temporarily suspended trading in the nickel market and cancelled trades over a short time period following a sharp spike in prices.

Market dynamics have reflected both a ‘flight to safety’ in response to a deterioration in the geopolitical and economic outlook, as well as concerns about rising inflation, leading to portfolio adjustments and a repricing of risks. A key uncertainty is whether interconnections within the financial system – for example between energy and other commodity markets, wider financial markets and the real economy – might create feedback loops and amplification mechanisms across the financial system more broadly.

The economic implications of the invasion could also interact with risks associated with high levels of global debt. Sustained increases in energy prices resulting from the conflict are likely to put further pressure on real incomes and earnings for households and businesses.

There is heightened risk from cyber threats. The FPC welcomes the National Cyber Security Centre’s actions to ensure the UK financial system is well prepared for such attacks. The Bank and Prudential Regulation Authority (PRA) use a range of approaches to assess the cyber resilience of firms. Cyber stress testing tests firms’ abilities to restore vital financial services after a hypothetical cyber incident. Other tests and exercises such as CBEST (threat-led penetration tests) and SIMEX (sector cyber simulation exercises), as well as industry exercises and engagement with international partners, form a part of the overall toolkit to assess the cyber resilience of firms.

There is considerable uncertainty about future developments in Ukraine and Russia. Further geopolitical developments could pose additional risks. As discussed by the Monetary Policy Committee (MPC) at its March meeting, the global economic outlook has deteriorated significantly, and global inflationary pressures will strengthen considerably over the coming months. The possibility of further second-order spillover effects impacting upon the UK financial system cannot be discounted.

The FPC will continue to monitor developments closely and stands ready to take any measures necessary to help ensure UK financial stability, in line with its statutory responsibilities.

The resilience of the UK financial system to other domestic and global vulnerabilities

Domestic debt vulnerabilities

Prior to the Russian invasion of Ukraine, UK and global economic activity had returned to their pre-pandemic levels, despite the ongoing impact of Covid. Since then, the global economic outlook has deteriorated significantly, although, at present, domestic resilience has not been materially affected.

While UK house price inflation has continued to be strong, there is little evidence so far of a deterioration in lending standards or a material increase in the number of highly indebted households. Aggregate household debt relative to income has remained broadly flat, following slight increases earlier in the pandemic. And the share of households with a mortgage debt-servicing ratio at or above 40% – a level beyond which households are typically much more likely to experience repayment difficulties – remains broadly in line with 2017–19 averages and significantly below levels seen just prior to the global financial crisis.

However, an increase in the cost of living, partly due to rising energy and other import prices, is likely to affect household resilience across the income distribution, with a larger impact on lower income households that spend a greater share of their income on energy and other essential items. Although these price rises are unlikely to significantly affect the ability of mortgagors to make debt repayments, they will increase the pressure on household balance sheets, particularly if there is a larger than expected impact on growth.

There had been little reported need by UK corporates for additional liquidity or widespread distress as a result of the impact of Omicron. Quarterly insolvencies returned to pre-Covid levels in 2021 Q4, but cumulative insolvencies remain significantly below what might have been expected over the pandemic. Debt-servicing remains affordable for most UK businesses.

Following the Russian invasion of Ukraine, uncertainty around, and downside risks to, the economic outlook have increased, with implications for corporate earnings. Small and medium sized enterprises, which were disproportionally impacted by the pandemic, have increased their debt more than larger companies and are more vulnerable than they were pre-Covid. Companies in sectors most affected by rising energy prices will also face a greater cost shock. Nonetheless, as the FPC has noted previously, it would take large increases in borrowing costs or severe shocks to earnings to impair businesses’ ability to service their debt in aggregate.

Global vulnerabilities

The global economic outlook has deteriorated significantly following Russia’s invasion of Ukraine, and the associated material increase in the prices of energy and raw materials. The impact is likely to be especially felt in Europe where, for example, some countries are particularly reliant on Russian energy. Disruptions to global supply chains could also affect a wide range of countries given the significant role of Russia and Ukraine in the production of commodities including metals and wheat. Although risks remain, there has been little sign of financial market contagion to other emerging markets outside of Europe so far.

In addition, there remain a number of other vulnerabilities in the global economy that could further amplify shocks. As the FPC has previously highlighted, long-standing vulnerabilities in the Chinese property sector have re-emerged, amidst high and rising debt levels in China and Hong Kong. Restrictions to contain further Covid outbreaks, including in China given its zero-Covid policy, could further disrupt global supply chains and impact corporate earnings. Risks in leveraged loan markets globally also remain high.

Against the backdrop of a tightening in global financial conditions in recent months, and in light of recent events, a sharper increase in the financing costs facing households and businesses could pose risks given existing global debt vulnerabilities. In addition, tighter overseas credit conditions could affect UK businesses’ ability to raise or roll over finance in both overseas and domestic markets.

The UK Countercyclical Capital Buffer (CCyB) rate decision

The FPC is maintaining the UK Countercyclical Capital Buffer (CCyB) rate at 1%. The rate will come into effect from 13 December 2022 in line with the 12-month implementation period.

The Committee stated in December that if the UK outlook proceeded broadly in line with the MPC’s central projections in the November Monetary Policy Report, and absent a material change in the outlook for UK financial stability, the FPC would expect to increase the rate further to 2% in 2022 Q2.

While domestic vulnerabilities that could amplify economic shocks have not changed materially since the December 2021 Financial Stability Report, uncertainty around, and downside risks to, the economic outlook have increased significantly following Russia’s invasion of Ukraine.

Given this uncertainty, the Committee will continue to monitor the situation closely and stands ready to vary the UK CCyB rate – in either direction – in line with evolution of economic conditions, underlying vulnerabilities and the overall risk environment. When taking its Q2 UK CCyB rate decision, the FPC will consider a full evaluation of the economic outlook, including the MPC’s projections in the May 2022 Monetary Policy Report.

Building the resilience of the financial system

The resilience of market-based finance

Despite the recent falls seen in risky asset prices, some asset valuations remain vulnerable to a further re-assessment of economic prospects and potential rises in risk-free rates. Corrections in asset prices and volatility in markets could be amplified by existing vulnerabilities in market‐based finance that were highlighted in March 2020, and risk further tightening financial conditions for households and businesses.

The FPC strongly supports the ongoing international work to address vulnerabilities in market-based finance, led and coordinated by the Financial Stability Board (FSB). The work planned by the FSB this year represents an important opportunity to develop policies to address these vulnerabilities. Absent implementation of those policy measures and an increase in the resilience of non-bank financial institutions, the financial stability risks exposed in March 2020 remain.

Stress testing the UK banking system: the 2022 annual cyclical scenario

The Bank will return to its annual cyclical scenario (ACS) stress testing framework in 2022, following two years of Covid pandemic crisis-related stress testing. The 2022 ACS will test the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, large falls in asset prices and higher global interest rates, and a separate stress of misconduct costs. In light of uncertainty related to the Russian invasion of Ukraine, and in order to help lenders focus on managing the ongoing financial markets disruption associated with the invasion, the FPC and the Prudential Regulation Committee (PRC) will delay the launch of the 2022 ACS. The FPC and the PRC intend to announce a revised timeline, which accounts for this delay, during Q2 2022.

Risks from cryptoassets and decentralised finance

The underlying technologies behind cryptoassets and decentralised finance could bring a number of benefits including lower transaction costs, higher payment system interoperability and more choice for users. These benefits can only be realised and innovation can only be sustainable if it is undertaken safely and accompanied by effective public policy frameworks that mitigate risks and maintain broader trust and integrity in the financial system.

Since the start of the Russian invasion of Ukraine, there has been heightened activity in cryptoasset markets. While cryptoassets are unlikely to provide a feasible way to circumvent sanctions at scale currently, the possibility of such behaviour underscores the importance of ensuring innovation in cryptoassets is accompanied by effective public policy frameworks to mitigate risks to consumer protection, market integrity, money laundering and terrorist financing, and maintain broader trust and integrity in the financial system. The FPC welcomes the joint statement by UK financial regulation authorities regarding the application of sanctions to cryptoassets.

As set out in the accompanying Financial Stability in Focus, the FPC is monitoring a number of channels through which risks to financial stability could arise from cryptoassets and decentralised finance. These include: risks to systemic financial institutions; risks to core financial markets, including through the use of leverage; risks to the ability to make payments; and the impact on real economy balance sheets.

The FPC continues to judge that direct risks to the stability of the UK financial system from cryptoassets are currently limited, reflecting their limited size and interconnectedness with the wider financial system. However if the pace of growth seen in recent years continues, and as these assets become more interconnected with the wider financial system, cryptoassets will present a number of financial stability risks in the future.

Enhanced regulatory and law enforcement frameworks are needed, both domestically and at a global level, to address developments in these markets and activities. Where crypto technology is performing an equivalent economic function to one performed in the traditional financial sector, the FPC judges that this should take place within existing regulatory arrangements, and that the regulatory perimeter be adapted as necessary to ensure an equivalent regulatory outcome. This would likely require the expansion of the role of existing macro and microprudential, conduct, and market integrity regulators, and close co-ordination amongst them. The FPC will, where necessary, make Recommendations to HM Treasury regarding gaps in the regulatory perimeter, consistent with its statutory responsibilities; decisions on adapting the regulatory perimeter would be for the Government to take.

The FPC supports the work of the FSB as it coordinates the international approach to unbacked cryptoassets. Domestically, the FPC supports the work of the HM Treasury-FCA- Bank Cryptoassets Taskforce on assessing the regulatory approach to unbacked cryptoassets and their associated markets. The FPC also welcomes the Dear CEO letter issued by the PRA reminding banks of their obligations with respect to cryptoasset exposures, and the FCA statement reminding firms of their obligations when interacting with or exposed to cryptoassets. Such actions are important given the pace of growth in this area.

The FPC will continue to pay close attention to developments and will seek to ensure that the UK financial system is resilient to risks that may arise from cryptoassets.

Systemic stablecoins

Stablecoins are digital tokens that claim to maintain a stable value at all times, primarily in relation to existing national currencies. They could provide benefits to users but will be adopted widely and become successful as a means of payment only if they meet appropriate standards and confidence in their value is assured.

The FPC has previously set out its expectation that stablecoins used in systemic payments systems should meet equivalent standards to those that apply for commercial bank money. The FPC noted HM Treasury’s proposal for a regulatory regime for stablecoins, including bringing systemic stablecoins into the Bank’s regulatory remit.

The Bank has published a summary of responses to its Discussion Paper (DP) on new forms of digital money, and is currently considering the possible regulatory models discussed in light of these responses. With this in mind, the FPC has considered how a non-bank stablecoin could meet its expectations in the absence of a ‘backstop’ to compensate depositors in the event of failure. For banks, backstops include a resolution regime and the Financial Services Compensation Scheme (FSCS) deposit guarantee scheme, but such arrangements are generally not available for non-banks.

In the absence of such a backstop, regulatory safeguards will be needed for a non-bank systemic stablecoin to ensure that the coin issuance is fully backed with high quality and liquid assets, alongside loss absorbing capital as necessary, to compensate coinholders in the event that the stablecoin fails. In addition, the regulatory regime will need to mitigate operational risks (such as fraud or technological failure). These risks could result in a shortfall of backing assets relative to the coins in issuance, or prevent funds from being returned rapidly to coinholders.

On balance, the FPC judges that a systemic stablecoin issued by a non-bank without a resolution regime and deposit guarantee scheme could meet its expectations, provided the Bank applies a regulatory framework that is designed to mitigate these risks to financial stability.

It is likely some non-systemic stablecoin issuers will adopt a model in which coins are backed with deposits at a commercial bank. This model poses significant financial stability risks if pursued at scale. The FPC judges that a systemic stablecoin that is backed by a deposit with a commercial bank would introduce undesirable financial stability risks. The Bank and FCA intend to carry out further work on the regulatory framework for stablecoins, and subject to the outcome of HM Treasury’s consultation, the Bank intends to consult on its proposed regulatory model for systemic stablecoins in 2023.


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