Financial Policy Summary and Record – July 2023

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. 

Key developments since the December 2022 FSR

Since the December 2022 Financial Stability Report, global interest rates have risen further, reflecting actual and expected increases in central bank policy rates in response to continued inflationary pressure. Returning inflation to target sustainably will support the FPC’s objective of protecting and enhancing UK financial stability. 

The sharp transition to significantly higher interest rates and greater market volatility over the past 18 months has, however, created stress in the financial system through a number of channels. The failure of three mid-sized US banks – and the failure of a global systemically important bank (G-SIB), Credit Suisse, due to long-running concerns about its risk management and profitability – caused a material rise in financial market risk premia and volatility earlier this year. The impact on the UK banking system through lower bank equity prices and increases in funding costs was limited, and market risk sentiment has stabilised since then. Nonetheless, elements of the global banking system and financial markets remain vulnerable to stress from increased interest rates, and remain subject to significant uncertainty, reflecting risks to the outlook for growth and inflation, and from geopolitical tensions.

In the UK, given the prevalence of variable-rate and short-term fixed-rate mortgages and other loans, the impact of higher interest rates is relatively lower in the financial system than in the real economy, compared to some other jurisdictions.

The UK economy has so far been resilient to interest rate risk, though it will take time for the full impact of higher interest rates to come through. In the financial system, interest rate risks crystallised in Autumn 2022, with stress in liability-driven investment (LDI) funds requiring a temporary and targeted intervention by the Bank. The ability of those funds to absorb shocks has since been reinforced through the setting of new standards, and the rest of the UK financial system has so far been resilient to higher interest rates. This is partly due to the range of regulatory measures introduced after the global financial crisis to manage interest rate risk and to build resilience into the financial system more generally. 

The impact of higher interest rates on UK household and corporate debt vulnerabilities

Higher interest rates increase debt-servicing costs facing household and business borrowers. This makes them more likely to cut back on spending, worsening the economic environment, and increases the risk that they will default on loans. Both these factors increase credit risks for lenders.

In the UK, more households are being affected by higher interest rates as fixed-rate mortgage deals expire. The proportion of households with high debt service ratios, after accounting for the higher cost of living, has increased and is expected to continue to do so through 2023. But it is projected to remain some way below the historic peak reached in 2007. 

There are several factors that should limit the impact of higher interest rates on mortgage defaults. Given robust capital and profitability, UK banks have options to offer forbearance and limit the increase in repayments faced by borrowers, including by allowing borrowers to vary the terms of their loans. There are now stricter regulatory conduct standards for lenders with respect to supporting households in payment difficulties. And on 23 June, the principal mortgage lenders, the Chancellor and the Financial Conduct Authority (FCA) agreed new support measures for mortgage holders. 

The FPC’s mortgage market measures, introduced in 2014 – including its loan to income flow limit on lending to borrowers with high loan to income ratios at or above 4.5 – and the FCA’s responsible lending requirements, have limited the build-up of household indebtedness in the mortgage market. This has increased borrower resilience and played a role in reducing payment difficulties for residential mortgagors.

Buy-to-let mortgagors are also experiencing increases in mortgage interest payments, and other structural factors are also likely to put pressure on their incomes. This could cause landlords to sell, putting downward pressure on house prices. Alternatively, they may seek to continue to pass on higher costs to renters. Similar to other forms of borrowing, buy-to-let mortgages are subject to affordability testing. In 2016, the PRA issued a supervisory statement outlining its expectations for underwriting standards in the buy-to-let market to safeguard against a deterioration in such standards. 

The overall number of mortgages in arrears increased slightly over the first quarter of 2023 but remained low by historical standards. It will take time for the full impact of higher interest rates to come through. 

The UK corporate sector is expected to remain broadly resilient to higher interest rates and weak growth. Nevertheless, higher financing costs are likely to put pressure on some smaller or highly leveraged firms. The debt-weighted proportion of medium and large corporates with low interest coverage ratios is projected to continue to increase throughout 2023 as debts are refinanced at higher rates, although it is expected to remain some way below previous peak levels. 

While corporate insolvency rates have risen above pre-Covid rates, they remain low relative to longer-term average levels. The large majority of the increase in insolvencies has been among very small firms that hold little debt, and a high proportion of the debt they do hold is fixed at low rates and government guaranteed. More broadly, the corporate sector has been repaying debt and its near-term refinancing needs appear limited. 

UK banking sector resilience in the context of higher interest rates

The UK banking system is well capitalised and maintains large liquidity buffers. Asset quality overall remains relatively strong, with higher interest rates having had a limited impact on credit risk so far. However, the overall risk environment is challenging. Some forms of lending, such as to finance commercial real estate investments, buy-to-let, and highly leveraged lending to corporates – as well as lenders that are more concentrated in those assets – are more exposed to credit losses as borrowing costs rise. 

Major UK banks’ capital and liquidity positions remain robust and profitability has increased, which enables them both to improve their capital positions and to support their customers. 

In aggregate, smaller lenders are also well capitalised and maintain strong liquidity positions. These lenders typically hold greater amounts of capital as a share of their risk-weighted assets, relative to regulatory requirements, than larger firms and maintain significant liquidity buffers. 

The results of the 2022/23 stress test indicate that the major UK banks are resilient to a severe stress scenario that incorporates persistently higher advanced economy inflation, increasing global interest rates, deep simultaneous recessions in the UK and global economies with materially higher unemployment, and sharp falls in asset prices. The stress test scenario is not a forecast of macroeconomic and financial conditions in the UK or abroad. Rather, it represents a ‘tail risk’ scenario designed to be severe and broad enough to assess the resilience of UK banks to a range of adverse shocks.

The rise in interest rates from a low level has increased bank net interest margins in aggregate. But the fact that higher rates also reduce the market value of banks’ fixed-rate assets can present risks to all banks. UK banks manage these risks through their hedging practices within a regulatory framework that includes rules designed to ensure that UK banks have capital against interest rate risks in their banking book, the maintenance of substantial liquid asset buffers, supervision by the PRA, and regular stress testing. 

The FPC continues to judge that the UK banking system is resilient, and has the capacity to support households and businesses through a period of higher interest rates, even if economic and financial conditions were to be substantially worse than expected. 

The FPC judges that the tightening of lending standards seen over recent quarters does not reflect banks restricting lending primarily to protect their capital positions. The FPC will continue to monitor UK credit conditions for signs of tightening that are not warranted by changes in the macroeconomic outlook.

The FPC agreed to maintain the UK countercyclical capital buffer (CCyB) rate at 2%. This will help to ensure that banks have sufficient capacity to absorb future shocks without unduly restricting lending. The FPC 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 impact of higher interest rates on global vulnerabilities

Higher interest rates have affected households and businesses in other advanced economies in similar ways. Jurisdictions where long-term fixed-rate mortgages are more prevalent are likely to have financial sectors that are more naturally exposed to interest rate risk. Riskier corporate borrowing in financial markets – such as private credit and leveraged lending – appears particularly vulnerable, and global commercial real estate markets face a number of short and longer-term headwinds that are pushing down on prices and making refinancing challenging. 

Lessons from the recent global banking sector stress

The UK’s regulatory and institutional framework has supported UK financial stability through recent stresses in parts of the global banking system, underlining the importance of maintaining robust macroprudential, regulatory and supervisory standards. Nevertheless, the FPC will draw lessons from the episode. 

For example, the impact of the stress underscored how contagion can spread across and within jurisdictions, even where smaller institutions are involved. It also highlighted that while an individual institution may not be considered systemic, if a risk is common – or perceived to be common – among similar institutions, the collective impact can pose a systemic risk. 

The stress highlighted the need for all banks to be adequately capitalised against the risks they are exposed to, including interest rate risk. This is consistent with the PRA’s current regulatory frameworks, as well as its initiative to maintain the resilience of the smallest UK banks while considering measures to simplify regulatory requirements for these lenders, known as ‘Strong and Simple’.

Deposit outflows at some regional US banks were large and rapid, with digital banking technology and social media playing a role in increasing the speed at which information was shared and deposits withdrawn. The Bank will contribute to relevant international work to consider whether lessons can be learnt for the liquidity framework for banks, or components of it, in the light of the size and pace of outflows witnessed in recent events.

These events also showed the importance of being able to resolve firms effectively and of maintaining confidence in resolution frameworks. In co-ordination with HM Treasury, the Bank is seeking to ensure that for small banks, which do not need to hold additional resources to meet the minimum requirement for own funds and eligible liabilities (MREL), there are resolution options that improve continuity of access to deposits and so outcomes for depositors. The FPC supports this work. The stress also demonstrated the importance of international authorities’ commitment to ensuring that the resolution framework and plans for G-SIBs, in line with Financial Stability Board (FSB) standards, remain credible.

The resilience of market-based finance

Vulnerabilities in certain parts of market-based finance (MBF) remain. These could crystallise in the context of the current interest rate volatility, amplifying any tightening in financial conditions. 

Although the business models of some non-bank financial institutions (NBFIs), such as pension funds and insurance companies, mean that they can benefit from the impact of higher interest rates, the use of derivatives to hedge their interest rate exposures can create material liquidity risk. Liquidity risks also arise when NBFIs use derivatives and repo to create leverage. These liquidity risks must be managed, as evidenced by the LDI stress seen in September 2022. 

The risks from higher interest rates can also be amplified by NBFIs deleveraging and rebalancing their portfolios. The FPC will continue to develop its approach to monitoring such risks as the financial system adjusts to higher interest rates.

There continues to be an urgent need to increase resilience in MBF globally. Alongside international policy work led by the FSB, the UK authorities are also working to reduce vulnerabilities domestically where it is effective and practical. 

For example, in March 2023, the FPC recommended that The Pensions Regulator (TPR) take 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. Since then, both the FCA and TPR have published detailed guidance on LDI resilience. The FPC welcomes this guidance and the steps taken by TPR and the FCA to ensure the continued resilience of LDI funds. In recent months as interest rates have risen further, funds have in general maintained levels of resilience consistent with the minimum levels recommended by the FPC in March, and have initiated recapitalisation at higher levels of resilience than previously. The Bank will continue working with the FCA, TPR and overseas regulators to monitor the resilience of LDI funds closely. 

The Bank has recently launched its system-wide exploratory scenario (SWES) exercise, which will be the first exercise of its kind. It aims to improve understanding of the behaviours of banks and non-bank financial institutions in stressed financial market conditions. It will explore how these behaviours might interact to amplify shocks in financial markets that are core to UK financial stability. In bringing together information from various parts of the financial system to develop system-wide (and sector-specific) insights, it will be able to account for interactions and amplification effects within and across the financial system that individual financial institutions working alone cannot assess. The FPC supports the SWES and considers it an important contribution to understanding and addressing vulnerabilities in market-based finance.


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