Financial Policy Summary, 2024 Q1
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 overall risk environment
The overall risk environment remains challenging. While the central economic outlook has improved somewhat since the December 2023 Financial Stability Report (FSR), some risks to financial stability globally have increased. It is concerning that risk premia across a range of markets have fallen further and several are close to historical lows, despite the fact that the adjustment to higher interest rates continues to pose challenges, and geopolitical risks are heightened. So far, UK borrowers have been broadly resilient to the impact of higher interest rates. The UK banking system is well capitalised, with the ability to support households and businesses even if economic and financial conditions were to be substantially worse than expected.
Developments in financial markets
Expected policy rates and long-term government bond yields in advanced economies are both a little lower than at the time of the December 2023 FSR. Global GDP growth has remained subdued, although US growth in 2023 Q4 was stronger than anticipated. UK GDP is expected to start growing again during the first half of this year. But risks to the macroeconomic outlook remain, with market interest rate volatility still elevated by historical standards.
Asset valuations across a range of markets have continued to rise. This has pushed measures of risk premia further below historical averages across a number of asset classes (Chart 1). These moves, in a challenging risk environment, suggest that investors are putting less weight on risks to growth or to the path of interest rates necessary to bring inflation back to target sustainably. US equity risk premia remain particularly low, and corporate bond spreads – particularly for the riskiest companies – have tightened further, despite rising default rates. The risk of a sharp correction in a broad range of asset prices and a widening in credit spreads – for example due to the materialisation of downside risks to growth, interest rates remaining higher than expected, or a deterioration in geopolitical conditions – has therefore grown since 2023 Q4. Such a correction could crystallise longstanding vulnerabilities in market-based finance – which remain significant – potentially leading to dysfunction in core markets, amplifying any tightening in credit conditions.
Chart 1: Measures of risk premia across a range of asset classes have fallen and are compressed in historical terms
Current level of selected risk premia metrics as a percentile of historical values, compared to levels seen at 2023 Q4 FPC policy meeting (a)
Footnotes
- Sources: Bloomberg Finance L.P., Datastream from LSEG, ICE BofAML, LCD, an offering of S&P Global Market Intelligence, and Bank calculations.
- (a) Risk premia data are a percentile of five-day rolling average (except for leveraged-loan (LL) spreads). Percentiles are calculated from 1998 for investment-grade spreads and high-yield bond spreads, 2013 for LL spreads and 2006 for excess cyclically-adjusted price-to-earnings (CAPE) yields. Data updated to 13 March 2024, except for LL spreads which are updated to 8 March 2024. Investment-grade spreads are adjusted for changes in credit quality and duration. All data is daily except for LL spreads which are weekly.
Finance for riskier corporates could be particularly vulnerable to a significant deterioration in investor risk sentiment. The private equity sector, which is closely related to private credit and leveraged lending, plays an important role in channelling finance to the UK real economy. The sector has grown rapidly over the past decade when interest rates have been relatively low. More recently, higher interest rates have made it more difficult for private equity funds to raise investment, contributing to downward pressure on asset valuations, and default rates on debt linked to private equity have increased. The extent of transparency around asset valuations, overall levels of leverage, and the complexity and interconnectedness of the sector make assessing financial stability risks difficult and mean that risks need to be managed carefully, both by those in the sector and by their counterparties. The FPC will publish a further assessment of these risks in its June 2024 FSR.
Global vulnerabilities
Global risks have continued to increase and remain material, against the backdrop of heightened geopolitical tensions. Households, businesses and financial institutions overseas continue to adjust to higher interest rates. Some risks have already started to crystallise, most notably in commercial real estate (CRE) markets globally and in the mainland China property sector.
CRE prices have fallen sharply in many advanced economies and could fall further, leading to losses for creditors. A number of smaller banks with significant exposures to CRE, in jurisdictions such as the US, the EU and Japan, have seen large reductions in their equity prices. Stresses in exposed banks could affect UK financial stability through a number of channels, including macroeconomic and financial market spillovers, contagion to funding conditions for UK banks, and a reduction in overseas finance for the UK CRE sector leading to further downward pressure on UK valuations.
Financial stability spillovers from the adjustment in the mainland China property market have largely been limited so far, but significant downside risks remain. The Chinese authorities have provided support but the adjustment in the property sector, alongside broader structural trends, is likely to weigh on growth in China for some time. More widespread crystallisation of risks in mainland China could lead to more pronounced spillovers in Hong Kong. Spillovers could also affect the UK and other countries. The 2022/23 ACS results indicate that major UK banks would be resilient to very significant declines in property prices in mainland China and Hong Kong.
Some lenders to Chinese property developers, for example those active in offshore markets or via wealth management products, may be especially exposed to losses as these risks crystallise. This could represent another material potential channel of contagion if financial institutions have concentrated exposures to such lenders.
High public debt levels in major economies could have consequences for UK financial stability, particularly in an environment of tighter financial conditions. A deterioration in market perceptions of the path for public debt globally could lead to market volatility and interact with vulnerabilities in market-based finance, potentially tightening credit conditions for households and businesses. Increased debt servicing costs for governments as debt is refinanced could also reduce their capacity to respond to future shocks.
UK household and corporate debt vulnerabilities
While household finances remain under pressure from increased living costs and higher interest rates, the outlook for UK households has improved somewhat since 2023 Q4. The share of households spending a high proportion of their available income on servicing mortgage debt, taking into account the cost of essential items, is expected to increase marginally over the next two years but remain well below pre-global financial crisis (GFC) levels. Owner-occupier mortgage arrears have increased moderately but remain low, as strong nominal wage growth over recent quarters combined with low unemployment have helped to contain the rise. Mortgage arrears are likely to increase further but remain well below post-GFC levels, absent a very significant rise in unemployment.
In the UK, corporates remain broadly resilient to high interest rates and weak growth. But the full impact of higher financing costs has not yet been passed through to all borrowers, and will be felt unevenly. Some smaller or highly leveraged UK firms may struggle to service their debt and some borrowers may be more exposed to refinancing risk. Corporate insolvencies continued to rise over 2023 Q4, albeit from low levels. UK CRE continues to face pressures that are weighing on prices and making refinancing challenging, particularly in sectors most affected by structural challenges such as some offices and retail. The pace at which UK CRE prices are falling has slowed in recent quarters, although significant risks remain. The results of the 2022/23 ACS showed that major UK banks would be resilient to a much larger fall in CRE prices than those already observed.
UK banking sector resilience
The UK banking system has the capacity to support households and businesses even if economic and financial conditions were to be substantially worse than expected.
The UK banking system is well capitalised and UK banks maintain strong liquidity positions. The aggregate profitability of major UK banks is expected to remain robust. Nevertheless, indicators of the market value of major UK banks’ future profitability, such as their average price to tangible book ratios, remain subdued. The FPC will publish further analysis of UK banks’ price to book ratios in its June 2024 FSR.
Asset quality has been resilient, despite the challenging risk environment. While arrears continued to edge upwards across loan portfolios in 2023 Q4, this was broadly as banks expected, and their forward-looking indicators of asset quality improved over the quarter.
Some forms of lending, such as to finance CRE investments, buy-to-let, and highly leveraged lending to corporates are more exposed to credit losses as borrowing costs rise. There is a wide range of business models among smaller and medium-sized UK banks, some of which are specialised in particular activities or serve particular sectors. In a more challenging environment, these business models will be impacted by different risks in different ways.
UK credit conditions are broadly unchanged. Those households and businesses most impacted by the macroeconomic outlook continue to face tighter credit conditions than others. The FPC continues to judge that credit conditions overall reflect changes to the macroeconomic outlook rather than defensive actions by banks to protect their capital positions.
The UK countercyclical capital buffer rate decision
The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at its neutral setting of 2%. The FPC will continue to monitor developments 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 Bank’s desk-based stress test exercise this year will further inform the FPC’s monitoring and assessment of the resilience of the UK banking system to downside risks.
Operational resilience
The FPC has today published a Financial Stability in Focus on its approach to operational resilience. Alongside work by the Bank of England, Prudential Regulation Authority and the Financial Conduct Authority, this work aims to bridge the gap between firm-level and system-wide operational resilience.
Operational incidents pose an increasing risk to financial stability, given growing digitalisation and interconnectedness (including via greater outsourcing) in the financial system. Although individual firm-level operational resilience provides the essential foundation for operational resilience across the system, firms and Financial Market Infrastructures must also factor in the potential impacts on the wider financial system from weaknesses in their own operational resilience and actions they might take in response to incidents, as they take steps to build their resilience.
The FPC will continue to further its analysis of operational resilience. The Committee will also continue its programme of cyber stress testing, monitor the implementation and outcomes of the new critical third parties regime, and consider whether to set impact tolerances for additional vital services beyond payments. The FPC will start the next cyber stress test in Spring 2024, with the findings expected to be published in the first half of 2025.
