Financial Policy Summary and Record – March 2023

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.

Global economic and financial market developments

The outlook for global activity remains uncertain, despite support from lower energy prices since the December Financial Stability Report (FSR). Material geopolitical risks remain, as does the risk that inflationary pressures are more persistent than anticipated.

The global financial system is continuing to adjust to higher interest rates and tighter financial conditions. In March 2023, this contributed to severe stress in some banks. Investor risk appetite fell sharply and volatility in financial markets increased. These events followed the severe stress in liability-driven investment (LDI) funds in autumn 2022. Financial markets remain focused on whether other vulnerabilities related to higher interest rates might crystallise.

The UK banking system maintains robust capital and strong liquidity positions. It is well placed to continue supporting the economy throughout a wide range of economic scenarios, including in a period of higher interest rates.

Banking sector resilience

Recent weeks have seen a number of banks fail or come under severe stress.

Silicon Valley Bank (SVB), the 16th biggest US bank, failed following a rapid and very large withdrawal of uninsured deposits. Over previous quarters, higher interest rates had led to significant falls in the value of unhedged long-dated bonds held at cost. These significant depositor withdrawals led to a need to sell assets quickly, at losses greater than the bank’s capital could absorb. Problems with the US parent led to a loss of confidence in Silicon Valley Bank UK (SVB UK), and the Bank of England used its resolution powers for stabilising failing banks to write-down the firm’s AT1 and Tier 2 capital instruments, and transfer the shares in SVB UK to a private sector purchaser, HSBC UK Bank plc. The smaller US-based Signature Bank was also forced to close by the US authorities following SVB’s failure. Some other regional US banks continue to be under stress.

Over the autumn, unrelated to the problems facing SVB, Credit Suisse had been experiencing a liquidity stress and significant outflows of client funds. These were associated with long-running concerns about the bank’s risk management and profitability. When this liquidity stress and client outflows intensified in March, it led to an agreed takeover by UBS, following an intervention by the Swiss authorities.

The FPC has been closely monitoring these events and judges that the UK banking system remains resilient.

Since the global financial crisis of 2008, international authorities have established significantly more robust regulatory standards, including for bank capital and liquidity. The UK authorities have put in place a range of robust prudential standards, designed to ensure levels of resilience which are at least as great as those required by international baseline standards. These include a liquidity framework and capital requirements that are calibrated to the risks faced by individual firms. They apply to all UK banks.

The Prudential Regulation Authority (PRA) assesses all UK banks on their resilience to interest rate risk. This includes their need to hold capital against interest rate risks on banking book assets, including any net open bond positions – regardless of whether they are held at cost or fair value. Capital requirements associated with this risk are calibrated using large shocks to the interest rate yield curve. Many UK banks also actively manage their interest rate risk – taking into account the maturity and variability of interest rates on their funding and assets as a whole – using derivatives such as interest rate swaps.

The UK banking system is well capitalised. The aggregate Common Equity Tier 1 (CET1) ratio for major UK banks stands at 14.6%, and smaller lenders have an aggregate CET1 ratio of around 18%. Asset quality is stronger now than in the run up to the global financial crisis. And stress tests have shown that the banking system is resilient to a wide range of severe economic outcomes, including in a period of higher interest rates.

Major UK banks have large liquid asset buffers, around two-thirds of which are currently either in the form of cash or central bank reserves. And net stable funding requirements ensure that banks maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.

The profitability of UK banks has increased recently, reflecting higher net interest income as interest rates have increased. UK banks are not exposed to material direct losses associated with the failure of SVB and takeover of Credit Suisse, and they have very limited direct exposure to regional US banks.

The UK banking system therefore has the capacity to support the economy in a period of higher interest rates even if economic conditions are worse than expected.

The FPC will continue to monitor developments closely, in particular for the risk that indirect spillovers impact the wider UK financial system. There remain channels through which UK economic conditions could be affected by recent and possible future strains from banks outside the UK. These include any lasting impact on bank funding costs, which increased moderately following recent events, and the potential for that to raise the cost and reduce the availability of borrowing for UK households and businesses. Tighter credit conditions overseas could also weigh on economic activity abroad, impacting UK banks’ foreign assets and UK trade.

Global and UK debt vulnerabilities

Tighter financial conditions continue to weigh on the ability of households, businesses and governments globally to service their debts, with the full impact taking time to feed through for many borrowers. Heightened geopolitical risks increase the likelihood of financial vulnerabilities crystallising. Higher debt servicing costs could lead to credit losses for banks, including in the UK.

Riskier corporate borrowing in financial markets is likely to be particularly vulnerable to tighter financial conditions. In aggregate, the global high-yield bond, leveraged loan and private credit markets have almost doubled in size over the past decade. Within that, estimates suggest that private credit has tripled in size over the same period. The opacity of the private credit market complicates the assessment of potential risks for both regulators and market participants.

Leveraged loan and private credit default rates are currently low compared to historical levels. Signs of stress in these markets could cause a rapid re-assessment of risks by investors, potentially resulting in sharp revaluations; this occurred, for example, when high-yield corporate bond spreads rose sharply following the failure of SVB and in the run up to the agreed takeover of Credit Suisse. While near term refinancing needs appear limited, a severe reduction in investor risk appetite could result in refinancing challenges for riskier corporates over time, including in the UK.

Commercial real estate remains a potentially vulnerable sector globally, as higher interest rates reduce property values along with borrowers’ ability to service debt.

In aggregate, UK businesses remain resilient. The proportion of large to mid-sized businesses with high interest coverage ratios is low, and is expected to stay well below previous peaks. Smaller businesses are more exposed to rising debt servicing costs, though a significant share of debt extended since the start of 2020 has been Government guaranteed, with relatively low fixed interest rates.

UK household finances are still being stretched by increased living costs and mortgage payments. However, fewer households are projected to have high cost-of-living adjusted debt service ratios than was expected at the time of the December 2022 FSR, mainly because of lower energy prices and an improvement in the outlook for UK unemployment.

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

UK Countercyclical Capital Buffer rate decision

The FPC is maintaining the UK Countercyclical Capital Buffer (CCyB) rate at 2%. Vulnerabilities that could amplify future economic shocks remain. A ‘neutral’ setting of the UK CCyB rate in the region of 2% helps to ensure that banks have sufficient capacity to absorb unexpected future shocks without unduly restricting lending.

Given the considerable uncertainty around the outlook, the FPC 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 and financial conditions, underlying vulnerabilities and the overall risk environment.

The resilience of market-based-finance

There remain vulnerabilities in certain parts of market-based finance (MBF), which could crystallise should there be further volatility or sharp movements in asset prices, amplifying any tightening in credit conditions. And interlinkages within the system of MBF mean that actions taken in particular sectors can materially increase stress across the system as a whole. For example, having increased their positioning in US rates markets prior to March, some hedge funds subsequently experienced material losses as yields fell sharply and volatility rose. Actions taken by hedge funds to reduce these exposures appear to have amplified recent interest rate market volatility.

There is an urgent need to increase resilience in market-based finance. Alongside international policy work led by the Financial Stability Board, the UK authorities are working to reduce vulnerabilities domestically where effective and practical.

Liability Driven Investment funds

In late 2022, a rapid and unprecedented increase in UK gilt yields exposed vulnerabilities in LDI funds in which many pension schemes invest. These led to a vicious spiral of collateral calls and forced gilt sales that risked further market dysfunction and a material risk to UK financial stability. In response, the Bank took temporary and targeted action to restore market functioning and give LDI funds time to build their resilience to future volatility in the gilt market. Gilts purchased by the Bank as part of this action have since been sold.

Following this episode, the FPC recommended that The Pensions Regulator (TPR), in coordination with the Financial Conduct Authority (FCA) and overseas regulators, put in place arrangements to ensure that LDI funds maintain the levels of resilience they had built up and that appropriate steady-state minimum levels of resilience for LDI funds be put into place.

LDI funds should be able to: withstand severe but plausible stresses in the gilt market; meet margin and collateral calls without engaging in asset sales that could trigger feedback loops; and improve their operational processes to meet margin and collateral calls swiftly when needed. LDI funds should be resilient to stresses which account for both historical volatility in gilt yields, and the potential for their forced sales to amplify market stress and disrupt gilt market functioning. If LDI funds were not resilient to such a shock, their defensive actions could tighten credit conditions for UK households and businesses.

The FPC recommends that TPR takes action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest. The FPC judges that these factors imply that LDI funds should be resilient to a yield shock of around 250 basis points, at a minimum, in addition to the resilience required to manage other risks and day-to-day movements in yields.

In making this recommendation, the FPC noted that TPR should continue its effective collaboration with other domestic and overseas regulators. Until this framework is put in place, TPR, in coordination with the FCA and other overseas regulators, should continue to ensure that LDI funds maintain the resilience that has been built up, as set out in the FPC’s 2022 Q4 recommendation.

To better allow TPR to implement and enforce guidance on LDI resilience over the long term, and in the context of TPR’s other objectives, the FPC recommends that TPR should have the remit to take into account financial stability considerations on a continuing basis. This might be achieved, for example, by including a requirement to have regard to financial stability in its objectives, which should be given equal weight alongside other factors to which TPR is required to have regard. The FPC noted that in order to achieve this, TPR would need appropriate capacity and capability.

For further information on the FPC’s recommendations regarding LDI funds see the 2023 Q1 FPC Record and Bank staff paper: LDI minimum resilience – recommendation and explainer.

Money market funds

Increasing the resilience of money market funds (MMFs) is necessary to reduce systemic risk in the UK and global financial system. The UK authorities will launch a consultation paper on MMF regulation later this year.

The FPC judges that MMFs should be able to withstand severe but plausible levels of investor outflows without amplifying stress and increasing risks to financial stability. MMFs should be resilient to outflows at least as large as those seen in the dash for cash and LDI stress events, when central bank actions also helped to limit outflows. Such central bank interventions increase risks to public funds and should not be relied upon.

MMF redemption policies should be consistent with the liquidity of the underlying assets held by a fund, and redeeming investors should bear the full liquidity costs of any asset sales needed to meet redemptions. As MMFs generally hold assets to maturity, significantly more liquid assets are an effective way to increase MMF resilience and so reduce risks to financial stability. The forthcoming consultation should explore these issues.

System-wide exploratory scenario

The Bank’s system-wide exploratory scenario will investigate the behaviours of banks and non-bank financial institutions following a severe but plausible stress to financial markets. It will consider both what drives these behaviours and their consequences, and will focus on the potential for these actions to interact and to amplify shocks in ways that might cause adverse outcomes in UK financial markets core to UK financial stability.

This will be an exploratory exercise focused on market resilience and its importance for financial stability; it will not be a test of individual firms’ resilience.

The Bank will ask a range of institutions whose activity it judges to be most relevant to core UK financial markets to participate in this exercise. Firms approached to participate are strongly encouraged to prioritise this work, which will improve understanding and contribute towards the remediation of vulnerabilities that continue to pose risks to UK financial stability. The Bank will publish more detailed information on the exercise in Q2.

Operational resilience and the 2022 cyber stress test

The FPC has updated its impact tolerance for critical payments, based in part on the findings of the 2022 cyber stress test. In March 2021, the FPC set its impact tolerance: that the financial system should be able to make payments on the date they are due (i.e. by the end of the ‘value date’).

However, the FPC also acknowledged that there might be instances where the disruption caused by an incident was such that, despite prior planning, attempting to recover by the end of the value date could have a more adverse impact on financial stability than failing to do so. Findings from the 2022 cyber stress test reinforced this view. The test also indicated that there might be scenarios where it is not possible for firms to restore their services before recovery of a third party (e.g. where a financial market infrastructure is disrupted). The FPC impact tolerance has therefore been updated to factor in both these situations.

Firms should plan, prepare and test for such situations, and invest so that their response can effectively mitigate any impact on financial stability until service delivery is restored.

The FPC has also set its impact tolerance with regard to all operational disruptions to firms’ ability to make critical payments, whether they arise from a cyber incident or otherwise.

Firms that are required to consider risks to UK financial stability under Bank, PRA and FCA operational resilience policies should consider the FPC’s impact tolerance for critical payments when formulating their own payment impact tolerances, alongside other applicable requirements.

The Bank, PRA and FCA will continue to engage with firms on their ability to respond to and recover from operational incidents through their supervisory work, and will consider the lessons from this test to inform future work.


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