Financial Policy Summary and Record – July 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 is able to absorb rather than amplify shocks, and serve UK households and businesses.

The economic outlook and UK financial stability

The economic outlook for the UK and globally has deteriorated materially. Following Russia’s illegal invasion of Ukraine, global inflationary pressures have intensified sharply. This largely reflects steep rises in energy and other commodity prices that have exacerbated inflationary pressures arising from the pandemic, and further disruption of supply chains. Household real incomes and the profit margins of some businesses have fallen as a result. Global financial conditions have also tightened significantly, in part as central banks across the world have tightened monetary policy. Market interest rates and corporate bond spreads have risen sharply, reflecting expectations of further policy tightening in response to renewed risks of more persistent elevated inflation and increasing credit risk.

The outlook is subject to considerable uncertainty and there are a number of downside risks that could adversely affect UK financial stability. Developments related to the Russian invasion of Ukraine are a key factor that will affect both the global and UK outlooks, particularly if energy and food prices rise further. Stronger or more persistent inflationary pressures than currently expected might lead to: weaker economic growth globally; a further sharp tightening in global financial conditions; and the potential for further volatility and stress in financial markets. Tighter conditions would increase the pressures already facing households and businesses and the serviceability of public sector debt in some countries, including in the euro area. And risks remain in China around the re-emergence of vulnerabilities in the property sector and potential restrictions to contain further Covid outbreaks.

Financial markets and the resilience of market-based finance

Reflecting these developments in the economic outlook, global financial markets have been volatile in recent months. Risky asset prices have fallen markedly since the beginning of the year, and government bond yields have risen. Risk-taking in financial markets has also fallen globally, and measures of risk premia no longer appear compressed relative to historical levels. In addition, cryptoasset valuations have fallen sharply, exposing a number of vulnerabilities within cryptoasset markets, but not posing risks to financial stability overall. Given downside risks from additional supply shocks, faster-than-expected monetary policy tightening and slower-than-expected economic growth, risky asset prices remain vulnerable to further sharp adjustments.

Amid high volatility, liquidity conditions deteriorated even in usually highly liquid markets such as US Treasuries, gilts and interest rate futures. Core UK financial markets have remained functional, with participants able to execute trades, albeit at a higher cost. However conditions could continue to deteriorate, especially if market volatility increases further.

In the event of further shocks, impaired liquidity conditions could be amplified by the vulnerabilities in the system of market-based finance previously identified by the FPC. There is an important programme of work, co-ordinated by the Financial Stability Board (FSB), to understand and, where necessary, remediate the vulnerabilities exposed in the March 2020 ‘dash for cash’, which is due to report its main findings and policy proposals in October. It is crucial that this work results in effective policy outcomes.

Increasing the resilience of Money Market Funds (MMFs) is an important step towards reducing the systemic risks that they pose to the UK and global financial system. In this context, and following agreement by FSB members to assess and address the vulnerabilities that MMFs pose in their jurisdictions, the FPC welcomes the recent publication of the joint UK authorities’ Discussion Paper on Resilience of Money Market Funds.

UK bank resilience

The FPC judges that major UK banks have considerable capacity to support lending to households and businesses even with the deterioration in the economic outlook. In line with expectations, capital ratios declined in 2022 Q1 and are expected to fall back slightly over coming quarters. Nevertheless, major UK banks’ capital and liquidity positions remain strong, and profitability has strengthened in aggregate.

Although downside risks will present headwinds, the FPC judges that UK banks have capacity to weather the impact of severe economic outcomes. In such scenarios, banks are likely to manage prudently their lending activity, commensurate with changes in credit quality in the real economy. Setting lending terms to reflect the new risk environment is appropriate. Restricting lending solely to defend capital ratios or capital buffers would be counterproductive and could prevent credit-worthy businesses and households from accessing funding. Such excessive tightening would harm the broader economy and ultimately the banks themselves.

Domestic debt vulnerabilities

Aggregate household debt relative to income has remained broadly flat in recent quarters, and there is little evidence of a deterioration in lending standards. However, the rise in living costs and interest rates will put increased pressure on UK household finances in coming months.

Despite this, the share of households with high debt-servicing ratios – those who are typically more likely to experience repayment difficulties – is not expected to increase substantially this year, in part because debt serviceability will be cushioned in the near term by fiscal support measures. This share is expected to increase above its historical average in 2023, as interest rate rises continue to pass through to households and unemployment rises, but it would remain significantly below the peaks seen ahead of the global financial crisis.

Debt-servicing remains affordable for most UK businesses. However, higher interest rates and input prices, weaker economic growth, and continued supply chain disruption are expected to weigh on corporate balance sheets. These effects will not fall evenly across businesses. Sectors with large exposures to energy or fuel prices (manufacturing and transport in particular) could face significant cost pressures. And the fall in household real incomes could reduce demand significantly in sectors such as non-essential household goods and services. While these pressures are likely to lead to some business failures, it would take large increases in borrowing costs or severe earnings shocks to impair businesses’ debt-servicing ability in aggregate.

UK small and medium-sized enterprises (SMEs) have more debt than prior to the Covid pandemic, although the vast majority of this new debt was issued at relatively low rates, and the majority was fixed for six years or longer. Despite this, at least 70% of the current stock of outstanding SME debt is estimated to have been issued outside government loan schemes, and a large proportion of this debt is exposed to Bank Rate increases within a year. SME cash buffers are also lower than during the pandemic. SMEs make up a relatively small share of total corporate debt, and therefore pose limited direct risk to the UK financial sector in terms of bank losses, but represent a much larger share of employment.

The FPC continues to judge that major UK banks are resilient to domestic debt vulnerabilities.

Global debt vulnerabilities

Tighter financial conditions and reduced real incomes will weigh on debt affordability for households, businesses and governments in many countries, increasing the risks from global debt vulnerabilities. These pose risks to UK financial stability through economic and financial spillovers.

Higher interest rates and increases in the price of essential goods such as food and energy will make servicing debt more difficult for households in some countries, and emerging market economies in particular.

The FPC has previously highlighted vulnerabilities associated with riskier corporate borrowing, including in the United States. Weaker demand and higher interest rates will stretch debt affordability for a wider range of businesses. If interest rates were to increase in line with market expectations, the share of listed US companies with low interest coverage ratios could increase significantly by the end of 2022, although it would remain below historical peaks.

Debt vulnerabilities in China remain elevated, particularly in the property market. The Chinese economy faces headwinds from continued Covid disruption, and a crystallisation of debt vulnerabilities would weigh further on activity.

A more severe downturn and tighter financial conditions could also put pressure on public sector debt in some countries, adding to the strains already caused by the pandemic. The FPC has previously highlighted vulnerabilities created by high public debt levels, including in Europe where yields on public sector debt in some countries have risen significantly during 2022.

The UK Countercyclical Capital Buffer (CCyB) rate decision

The FPC is increasing the UK Countercyclical Capital Buffer (CCyB) rate to 2%. This rate will come into effect on 5 July 2023, in line with the generally required 12-month implementation period. The FPC noted in December 2021 that since vulnerabilities that can amplify economic shocks had returned to pre-pandemic levels, and global and UK activity was expected soon to return to pre-pandemic levels, it was minded to return the UK CCyB rate to 2%, the level it was due to reach before the pandemic, in 2022 Q2. The global and UK economic outlook has deteriorated significantly since then, but domestic vulnerabilities that can amplify economic shocks remain broadly at their pre-pandemic level.

Given the considerable uncertainty around the outlook, the Committee will continue to monitor the situation closely and stands ready to vary the UK CCyB rate – in either direction – in line with the evolution of economic conditions, underlying vulnerabilities and the overall risk environment. In particular, if economic conditions deteriorate by significantly more than currently expected – in a manner that might otherwise lead banks to restrict lending – the FPC will be prepared to cut the UK CCyB rate as necessary.

The 2022 annual cyclical scenario

To support the FPC’s monitoring and assessment of the resilience of banks to potential downside risks, the Bank will commence its annual cyclical scenario (ACS) stress test in September 2022, having been delayed in March in light of the Russian invasion of Ukraine and to help lenders focus on managing the associated market disruption. It will test the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, real income shocks, large falls in asset prices and higher global interest rates, as well as a separate stress of misconduct costs. Results will be published in Summer 2023.

Commodity market vulnerabilities

Commodity price volatility following the Russian invasion of Ukraine has further exacerbated price pressures facing households and businesses, and has had implications for the financial system. The sharp spike in gas and other prices following the invasion led to steep increases in margin requirements, essential for reducing counterparty credit risk, which created challenges for some market participants to raise the liquidity to meet them. Banks faced significant calls on revolving credit facilities from clients to fund higher margin requirements.

Despite the volatility, commodity and wider financial markets have continued to function, although the London Metal Exchange temporarily suspended trading in nickel contracts and cancelled trades between 8 and 15 March after a specific set of circumstances contributed to a sharp spike in prices.

Heightened uncertainty following the Russian invasion means there is a significant risk of further disruption in commodity markets. Further increases in volatility could increase the credit needs of the commodity sector for a given level of activity. Banks have sufficient capital to continue to meet these needs, although there is uncertainty over the amount of credit that will be supplied since it is subject to banks’ judgements on risk management criteria and appetite.

The recent disruption has highlighted how vulnerabilities within commodity markets – and interconnections with the wider financial system – could propagate and amplify macroeconomic shocks.

Some of these are similar to vulnerabilities in the system of market-based finance. Due to opacity and lack of data in some markets, quantifying the size and scale of these fragilities and interconnections remains challenging, and addressing this globally should be a priority.

But some of these fragilities relate to physical markets, non-financial entities, or entities domiciled in other jurisdictions. Addressing them will thus require engagement from a broad range of financial and non-financial authorities, both domestic and global.

The FSB is undertaking in-depth analysis and assessment of vulnerabilities in commodity markets. Given the global nature of these markets, the FPC welcomes this work.


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