Financial Stability Report – June 2024

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 broadly unchanged from Q1. Markets continue to price mostly for a benign central case outlook, and some risk premia have tightened even further, despite the global risk environment facing several challenges. Some of these challenges have become more concerning and proximate.

In aggregate, UK household and corporate borrowers have been resilient, although many remain under pressure. UK banks are in a strong position to support households and businesses, even if economic and financial conditions were substantially worse than expected.

The adjustment to the higher interest rate environment is continuing globally, including as businesses and households refinance their debt. Risks are crystalising in the US commercial real estate market and important vulnerabilities in market-based finance are yet to be addressed globally.

Developments in financial markets

The Monetary Policy Committee’s (MPC’s) central projection for UK GDP growth, unemployment and inflation has improved slightly further since Q1, and global growth is projected to rise in the medium term, although several risks to that outlook remain. Economic data news has pushed out market expectations on the timing of reductions in policy rates in the US and UK, although rate cuts have now begun in some jurisdictions. Markets responded to the announcement that French parliamentary elections would be held on 30 June and 7 July. For example, the spread between French and German 10-year government bond yields rose to its highest level since 2017.

Risk premia on US equities have been compressed for some time but have also fallen across a range of other markets this year and are now very low by historic standards, including for more leveraged borrowers. While there is some evidence of investors demanding higher risk premia on small pockets of the riskiest bonds, the widespread overall compression of risk premia, in an uncertain risk environment, suggests that investors are continuing to put less weight on risks to the macroeconomic outlook. Valuations and risk premia are therefore vulnerable to a shift in risk appetite that could be triggered by factors including a weakening of growth prospects, more persistent inflation, or a further deterioration in geopolitical conditions.

Although financial market asset valuations have so far been robust to large increases in interest rates and recent geopolitical events, the adjustment to the higher interest rate environment is not yet complete and market prices remain vulnerable to a sharp correction. This could adversely affect the cost and availability of finance to the real economy via two main channels. First, a sharp market correction would make it more costly and difficult for corporates to refinance maturing debt, including by reducing the value of collateral. This is particularly relevant given the large proportion of leveraged lending and high-yield market-based corporate debt that is due to mature by the end of 2025. Second, it could interact with vulnerabilities in market-based finance, which may amplify the correction. For example, it may cause large losses for leveraged market participants, which could further reduce risk appetite, or it may lead to a spike in liquidity demand and a deterioration in the functioning of core markets.

Global vulnerabilities

Global vulnerabilities remain material. US commercial real estate (CRE) borrowers have significant short-term refinancing needs and a number of overseas banks with large exposures to CRE, in the US and other jurisdictions, experienced significant falls in their equity prices earlier in the year. Stresses in global CRE markets could affect UK financial stability through several channels, including a reduction in overseas finance for the UK CRE sector.

UK household and corporate debt vulnerabilities

In the context of strong nominal household income growth and continued low unemployment, the aggregate UK household debt to income ratio has continued to fall. That said, many UK households, including renters, remain under pressure from higher living costs and higher interest rates. The share of households spending a high proportion of their available income servicing their mortgages is expected to increase slightly over the next two years, but it is likely to remain well below pre-global financial crisis (GFC) levels. Mortgage arrears remain low by historical standards and are expected to remain well below their previous peaks.

Aggregate measures of UK corporate debt vulnerability have fallen further and corporates are likely to remain broadly resilient to the current economic outlook, including high interest rates. But there remain pockets of vulnerability among highly leveraged corporates. Despite strong issuance so far in 2024, a significant portion of market-based corporate debt is due to mature in the coming years, so risks associated with the need to refinance at higher interest rates remain. The most highly leveraged and lowest rated corporates, including those backed by private equity, are likely to be more exposed to this risk.

Private equity

Although the sector has been resilient so far, it is facing challenges in the higher rate environment. These manifest in refinancing risk as debt matures, and an increased drag on performance from higher financing costs. Vulnerabilities from high leverage, opacity around valuations, and strong interconnections with riskier credit markets mean the sector has the potential to generate losses for banks and institutional investors, and cause market spillovers to highly correlated and interconnected markets such as leveraged loans and private credit – all of which could reduce investor confidence, further tightening financing conditions for businesses. Disruptions in international PE markets could also spill over to the UK, particularly from US markets given their size and importance, and because the majority of PE funds backing UK corporates are based in the US.

Improved transparency over valuation practices and overall levels of leverage would help to reduce the vulnerabilities in the sector. Risk management practices in some parts of the sector also need to improve, including among lenders to the sector such as banks. The FPC will consider the outcome of regulatory work by the Financial Conduct Authority and Prudential Regulation Authority to address some of these issues. Because of the interconnections between PE markets in different jurisdictions, international co-ordination will be important.

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 return on equity of major UK banks in aggregate has risen to around their cost of equity, and asset quality remains strong.

The FPC judges that changes in credit conditions overall reflect changes to the macroeconomic outlook. Mortgage approvals have risen, in part in response to a fall in quoted mortgage rates since last summer. Overall credit conditions for corporates have remained broadly unchanged since the start of the year.

A number of system-wide factors are likely to affect bank funding and liquidity in the coming years, including as central banks normalise their balance sheets as the extraordinary measures put in place following the GFC and the Covid pandemic are unwound. The Bank of England is unwinding its holdings in its Asset Purchase Facility, as determined by the MPC, and the Term Funding Scheme with additional incentives for SMEs is coming to an end. It is important that banks factor these system-wide trends into their liquidity management and forward planning over the coming years. Banks have a number of ways in which they can manage their funding and liquidity, including use of the Bank of England’s facilities, such as the Short-Term Repo and Indexed Long-Term Repo facilities.

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 2024 desk-based stress test will further inform the FPC’s assessment of the resilience of the UK banking system to downside risks.

The resilience of market-based finance

There remain important vulnerabilities in market-based finance that the FPC has previously identified. In particular, leveraged positions, which have been a driver of a number of recent stress events, appear to be increasing among hedge funds. The work of international and domestic regulators to develop appropriate policy responses to address the risks of excessive leverage is therefore important. The FPC supports the Financial Stability Board’s international work programme on leverage in non-bank financial institutions, and encourages authorities globally to take action to reduce the vulnerabilities through internationally co-ordinated policy reforms.

Given the significant progress made on liability-driven investment (LDI) fund resilience across domestic and international authorities over the past 18 months, the FPC has closed its November 2022 and March 2023 Recommendations on LDI resilience. Its March 2023 Recommendation that The Pensions Regulator should have the remit to take into account financial stability considerations in its work on a continuing basis remains in place.

The FPC welcomes the launch of the second round of the Bank’s system-wide exploratory scenario (SWES) exercise. In the first round, the hypothetical SWES scenario led most participating non-bank financial institutions to report significant liquidity needs from margin calls. Many participants started the scenario with greater resilience than they had at the onset of recent market shocks. For example, the current level of resilience of money market funds is well above existing minimum requirements. This is also in part the result of recent regulatory actions, such as the LDI resilience standard recommended by the FPC. Participants therefore expected those liquidity needs could be mostly met by pledging assets. However, participants’ responses also implied that terms in the sterling repo market would tighten, and that there would be selling pressure in the sterling corporate bond market.

In the second round, the Bank is exploring the assumptions underpinning participants’ actions and how different assumptions might alter actions taken and lead to different outcomes in markets. The analysis has already provided important insights which demonstrate the value of system-wide exercises. The overall results of the exercise will be published in 2024 Q4.

1: Developments in financial markets

Market participants continue to expect policy rates to remain high for an extended period.

Economic data news has pushed out market expectations on the timing of reductions in policy rates in the US and UK, although rate cuts have now begun in some jurisdictions.

Markets continue to anticipate that policy rates will settle well above where they had been prior to 2021. For example, markets now expect Bank Rate to be around 3.8% in three years’ time, whereas Bank Rate had remained between 0.25% and 0.75% in the 10 years prior to 2021. Longer-term borrowing costs, for example 10-year government bond yields, remain broadly unchanged in the UK, euro area and US since December (Chart 1.1).

Market contacts suggest the global improvement in core market functioning has been driven by reduced interest rate volatility. The MOVE index, which tracks implied volatility in US Treasury markets, has continued to trend lower since December and is now around its average since 1990. Contacts attribute the fall to reduced perceived uncertainty over the global outlook.

Risk premia across a range of markets have fallen significantly since December and are now low by historical standards.

Prices of a range of risky assets – those which carry a degree of credit risk over government securities – have risen since the December FSR. With long-term interest rates remaining high, and the outlook for growth only improving slightly, this increase in prices has been primarily driven by falling risk premia. Measures of risk premia across a range of different asset classes, including equities and corporate debt, are now further below historical medians (Chart 1.2). Relative to the December FSR, risk premia for a broader set of asset classes now appear compressed.

There remains some evidence of investors demanding higher risk premia in certain asset classes. Contacts report that demand for some of the riskiest debt has not recovered as much as for more highly rated corporates. This is reflected in the pricing of the lowest rated high-yield debt. For example, while overall euro-denominated high-yield spreads have fallen around 120 basis points since the previous FSR and are around the 15th percentile of their historical distribution, lower-rated euro-denominated high-yield spreads (rated CCC or lower) are around the 75th percentile. The divergence in pricing of the lowest rated bonds is also evident in the smaller sterling market, and in US dollar high-yield debt (Chart 1.4).

The widespread compression of risk premia has increased the risk of a sharp re-pricing across asset markets. Such a correction could impact financial stability via a number of channels.

Should these downside risks materialise, a change in sentiment could lead to a sharp correction in market prices, adversely affecting financing to the real economy via two main channels. First, it would make it more costly and difficult for corporates to refinance maturing debt, including by reducing the value of collateral. This is particularly relevant given the large proportion of leveraged lending and high-yield market-based corporate debt that is due to mature by the end of 2025. Second, it could interact with vulnerabilities in market-based finance which may amplify the correction. For example, it may cause large losses for leveraged market participants, which could further reduce risk appetite and trigger further deleveraging. Or it may lead to a spike in liquidity demand and a deterioration in the functioning of core markets.

2.1: The global economic outlook

Global growth is expected to remain modest over the near term.

There were notable differences in growth across jurisdictions over 2023, with growth stronger in the US and weaker in the euro area. Over 2024, the projections in the May Monetary Policy Report (MPR) are for four-quarter growth to pick up in the euro area, and to moderate somewhat in the US, albeit from relatively high levels. Overall, global activity is expected to grow at moderate pace.

Inflationary pressures have moderated across many advanced economies, and headline and core inflation have fallen back from their peaks over the past year. The European Central Bank and the Bank of Canada both reduced policy rates in June, and market participants expect other central banks, including the Federal Reserve Bank and the Bank of England, to begin to reduce rates over the coming quarters. However, market participants expect short-term interest rates to remain higher for longer over 2024 than was expected at the time of the December FSR.

2.2: The continued impact of higher interest rates

The global banking system has significant exposures to CRE. For instance, the IMF estimates that CRE debt accounts for about 18% of total US bank loans. Of the debt due to mature over 2024 and 2025, banks hold a larger proportion than other types of lenders. The non-performing loan ratio for CRE lending in the US and in the euro area increased over 2023, and the proportion of UK banks’ CRE loans considered credit impaired also increased. US CRE loans secured on office buildings in particular have seen marked increases in delinquencies over 2023 and 2024.

There are a number of small and mid-sized banks in jurisdictions such as the US, Germany and Japan with significant domestic and cross-country exposures to CRE. Some banks saw sharp falls in stock prices after announcing losses or provisions on CRE portfolios earlier this year, and one small US bank with large CRE exposures failed in April.

Stresses in exposed non-banks, as well as in overseas banks, could affect UK financial stability through macroeconomic and financial market spillovers, contagion to funding conditions for UK banks, or a reduction in overseas finance for the UK CRE sector leading to further downward pressure on UK valuations. Stress could also interact with existing vulnerabilities in the system of non-bank finance.

Growing expected interest rate differentials with the US have generated moves in exchange rates and, in some places, increased financial pressures.

Policy rates in the US are now expected to remain higher for longer than at the time of the December FSR, and interest rate differentials between the US and a number of other countries have generated moves in exchange rates. For instance, the yen has depreciated to historic lows against the US dollar, prompting intervention in the foreign exchange markets by the Japanese authorities.

Non-China emerging market economies have experienced increased financial pressure from exchange rate differentials, but have generally continued to be resilient. If global financial conditions were to tighten sharply, non-China emerging market assets could be subject to a sudden repricing, which could have spillovers to the UK through financial markets.

Banks continue to adjust to higher interest rates across jurisdictions, but vulnerabilities remain.

US and euro-area bank profitability has generally been supported by higher interest rates. Deposits in smaller US banks have returned to levels seen before the March 2023 stress (Chart 2.2).

Chart 2.2: Smaller US banks’ deposit levels have returned to levels seen before March 2023

Deposit levels at US banks, seasonally adjusted

Footnotes

• Source: Refinitiv Eikon from LSEG.

However, a number of vulnerabilities remain, particularly among small and mid-sized US banks. Banks are still exposed to sectors such as CRE that are adjusting to a higher interest rate environment. In March, the Federal Reserve’s Bank Term Funding Program (BTFP) ceased extending new loans, though the Federal Reserve’s discount window lending programmes are still available to help banks manage liquidity risks. 95% of advances provided through the BTFP were given to smaller institutions.

Some banks across jurisdictions continue to face high unrealised losses on securities including bonds, brought about by the increase in interest rates. US banks’ total unrealised losses on securities were US$39 billion higher in 2024 Q1 than at the end of 2023, at US$517 billion. Further rises in foreign and domestic yields could also generate further unrealised losses on debt security holdings across some Japanese banks.

The overseas banking stress following the failure of Silicon Valley Bank in March 2023 showed that stress can spread across and within jurisdictions, even where smaller institutions are involved. It 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. Further losses on CRE or other exposures could spill over to other markets if similar contagion dynamics were to occur, including through market or depositor sentiment.

Globally, corporate and household balance sheets have remained resilient in aggregate despite pressures from higher costs of servicing debt.

Higher interest rates continue to make it more challenging for households and businesses to service and refinance their debts, but corporate and household balance sheets have remained resilient in aggregate across advanced economies.

There are however some areas of increased vulnerability, including borrowing by highly leveraged corporates. Defaults on leveraged loans increased to a peak of 7.1% globally in February, and were at 6.8% in April, up from 5.0% this time last year. And as outlined in Section 6, private credit and leveraged loan markets are interconnected and shocks could be highly correlated, so disruptions in overseas markets could spill over to the UK.

Public debt-to-GDP levels have increased across a number of major economies, which could have consequences for UK financial stability.

Across jurisdictions, debt-to-GDP levels have increased over recent years, driven by increased government borrowing, particularly over the Covid pandemic. The current period of elevated geopolitical risk and uncertainty, as well as structural trends such as demographics, could place further pressure on debt-to-GDP levels and government finances.

The FPC has previously highlighted vulnerabilities created by high public debt levels in major economies, including through interlinkages between banks and sovereigns. Increases in global policy rates, combined with increasing indebtedness levels, have increased the costs of servicing government debt. And higher interest rates will further increase debt servicing costs over time as governments refinance.

High public debt levels in major economies could have consequences for UK financial stability and interact with other risks. A deterioration in market perceptions of the path of 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 servicing costs for governments as debt is refinanced could also reduce their capacity to respond to future shocks. The FPC will continue to monitor these risks and take into account the potential for them to crystallise other financial vulnerabilities and amplify shocks.

2.3: Risks from developments in China

Property market vulnerabilities in mainland China have continued to crystallise.

There have been limited spillovers to the UK so far from the adjustment in mainland China’s property market. However, significant downside risks remain. More widespread crystallisation of risks in mainland China could lead to spillovers to the UK and other countries, and could be larger if the crystallisation of property sector vulnerabilities were to spread to other sectors in the Chinese economy. Risks could spill over to the UK financial system through channels including weaker trade, financial markets, and global risk sentiment.

2.4: Geopolitical risks

Policy uncertainty associated with upcoming elections globally has increased.

Policy uncertainty could increase existing sovereign debt pressures and interact with pressures on public sector debt levels in major economies, geopolitical risks, and risks associated with global fragmentation. These factors and their potential interaction make the economic outlook less certain and could lead to market volatility, including in sovereign debt markets, as already observed in response to the unexpected news of French parliamentary elections over the summer.

Geopolitical risks remain high and could impact the UK financial system through a number of channels.

The macroeconomic outlook has improved since the December FSR. But many households, including renters, and businesses remain under pressure from past increases in the cost of living, subdued demand and higher interest rates.

The aggregate household debt to income ratio continues to trend down.

But many mortgagors coming to the end of fixed-rate deals will see increased borrowing costs as they have yet to refinance onto higher rates.

Offsetting some of that refinancing pressure, market participants expect Bank Rate to start falling in 2024 H2. This would immediately benefit variable rate mortgagors, who account for around 18% of the total stock of mortgages. Current market pricing also suggests a growing number of fixed-rate mortgagors, who are already paying higher rates, may be able to refinance at a lower interest rate over the next two years (Chart 3.1). In response to higher mortgage rates, an increasing proportion of households are choosing to borrow over longer terms, which reduces monthly capital repayments in the near term but means they will have more debt to service further out.

Although debt-servicing ratios (DSRs) are increasing, mortgagors should remain broadly resilient to higher interest rates if unemployment remains low, as projected by the MPC.

The continuing adjustment to higher interest rates means that, in aggregate, the share of household income spent on mortgage repayments is likely to increase further, as it has done since the December FSR, albeit to a lesser extent than expected. The aggregate mortgage DSR is still projected to remain well below levels experienced in the global financial crisis (GFC) and the early 1990s recession (Chart 3.2). Borrowing rates would likely have to increase by around 400–500 basis points for mortgage DSRs to reach GFC levels.

Although the share of vulnerable corporates has increased slightly, it is projected to continue to remain well below past peaks.

But refinancing challenges remain, particularly for firms using riskier market-based finance markets, such as leveraged loans and high-yield bonds.

Given that most corporate debt is on floating interest rates (eg variable rate bank loans) that have already increased in line with Bank Rate, much of the debt-servicing pressure associated with past interest rate rises has already passed through to corporates in aggregate.

But a subset of corporates, largely those relying on market-based finance (or with interest rate hedges in place), have not yet felt the full impact of higher interest rates. Most UK corporate bonds have fixed repayments. Corporate bonds currently account for 25% of total UK corporate debt. Given the average tenor of UK corporate bonds is around 10 years, most of these bonds were issued before interest rates started to rise. Many bonds issued in 2014, when UK high-yield corporate bond interest rates were around 4.9% on average, may be reaching maturity in 2024 and if they need to be refinanced, it would be at around the current market average rate of around 8.9%.

While strong issuance in corporate debt markets over the past 12 months has supported refinancing (see Chart 1.3), around 25% of corporate bonds issued by UK companies are due to mature in the next two to three years.

More highly rated or less leveraged firms are likely to be more resilient to refinancing risks. They tend to have stronger balance sheets and more choice over sources of finance. Investment-grade bonds account for a relatively small proportion of maturing market-based debt over the coming years.

Near-term refinancing requirements are higher in markets for riskier borrowers, where terms tend to be shorter. Notably, around 16% of high-yield corporate bonds are due to mature by end-2025, and around 40% by end-2027 (Chart 3.6). Many of the firms considered to be most vulnerable to default that need to refinance over the coming years are private equity backed (see Section 6). In addition to needing to refinance at higher rates, these firms may also be particularly vulnerable to sharp moves in risk premia, or an upside shock to interest rate expectations.

For example, should currently low risk premia (see Section 1) increase back towards historical norms, or if policymakers keep interest rates higher than markets currently expect, refinancing would be more costly and difficult for firms with maturing debt. Businesses facing higher debt-servicing costs after refinancing, or difficulties in sourcing finance, may take defensive action by cutting back on investment and employment and may be more likely to default.

The headwinds continuing to face some parts of the UK commercial real estate (CRE) market also make refinancing challenging, in part due to the lower value of collateral. Office and retail CRE have been particularly impacted by factors including the post-pandemic shift to more remote working and the continuing shift from physical to online shopping. Cyclical pressures and the climate transition are also expected to continue to weigh on prices. Although UK CRE prices have fallen over 20% from their 2022 peaks, the pace of decline has slowed in recent quarters. The 2022/23 ACS stress test showed that the major UK banks would be resilient to a much larger fall in CRE prices than already observed.

The FPC continues to judge that, in aggregate, the UK corporate sector is expected to remain broadly resilient to the current economic outlook, including high interest rates.

Despite the potential refinancing challenges, it would take an interest rate increase of a further 600 basis points, all other things equal, for the share of firms with low ICRs to reach levels experienced in the GFC. But pockets of risk remain, including some highly leveraged businesses, including private equity backed businesses (see Section 6), and small and medium-sized enterprises (SMEs).

While the rise in SME arrears has slowed, SMEs are generally under more pressure than larger corporates.

The majority of lending to SMEs is advanced by banks on floating rates, so most SMEs have already experienced increased borrowing costs associated with higher interest rates. Consistent with this, arrears for commercial loans to SMEs remained broadly flat at 1.3% in January. But SMEs generally continue to be under more pressure than larger corporates.

4.1: Recent developments in banks’ resilience

The UK banking system is well capitalised and has high levels of liquidity.

Major UK banks and building societies (‘major UK banks’) remain well capitalised, with an aggregate Common Equity Tier 1 (CET1) capital ratio of 14.7% in 2024 Q1. This level is broadly unchanged since the December 2023 FSR, as strong pre-provision profits have been broadly offset by impairments and distributions to shareholders. Small and medium-sized UK banks and building societies (‘small and medium-sized UK banks’) have also maintained robust capital positions in aggregate with an overall CET1 ratio of 17.7% in 2024 Q1.

The UK banking system also maintains high levels of liquidity. Major UK banks’ aggregate three-month moving average Liquidity Coverage Ratio (LCR) is broadly unchanged since the December FSR, standing at 150% in April, and these banks maintained total high-quality liquid assets (HQLA) of around £1.3 trillion. The aggregate LCR for small and medium-sized UK banks was 260% in March and they had £160 billion of HQLA.

Strong earnings have supported a recent rise in major UK banks valuations.

Major UK banks reported robust earnings in 2024 Q1, with underlying return on tangible equity rising from 11% in the previous quarter to 14%, which is around the same level as their cost of equity (the compensation investors require for the perceived riskiness of those returns). Pre-provision profits rose a little on the quarter, to £16.4 billion, largely driven by non-interest income, though this was a little below their peak of £17.9 billion in 2023 Q1.

Reflecting strong results, UK banks’ share prices rose at the start of 2024, with the FTSE 350 bank index increasing by 17% since the start of the year. Higher valuations have been reflected in PtTB ratios, with the average UK bank PtTB ratio rising to around one, up from Covid-era lows of around 0.5. UK banks’ PtTB ratios are further discussed in Box A. Several acquisitions were also announced during this period, which would, if completed, lead to some consolidation within the UK banking sector.

Asset quality for major UK banks has remained strong since the December FSR.

The overall risk environment remains challenging as higher interest rates continue to put pressure on households and corporate borrowers, with refinancing at higher rates not yet complete. Since the December FSR, mortgage arrears have remained broadly flat and are expected to remain well below their historical peaks. Business insolvencies have risen slightly but remain well below their long-term average level (see Section 3). Certain global risks have continued to crystallise (see Section 2).

Some forms of lending – as well as lenders that are more concentrated in those assets – are more exposed to credit losses as borrowing costs rise or should economic conditions turn out worse than expected. This includes consumer credit, buy-to-let and commercial real estate lending, and lending to highly leveraged corporates. The global banking system has significant exposures to private equity-related activity, including via leveraged lending, and these are discussed (see Section 6).

On some measures, leveraged loan defaults globally have increased further since the December FSR, and vulnerabilities in mainland Chinese and Hong Kong property markets continue to crystallise (see Section 2). But leveraged loan defaults and property price declines in mainland China and Hong Kong remain significantly less severe than levels to which major UK banks were tested as part of the 2022/23 annual cyclical scenario bank stress test.

Major UK banks’ forward-looking indicators of asset quality have improved since the December FSR. The share of loans either for which there has been a significant increase in credit risk (International Financial Reporting Standard (IFRS) 9 ‘stage 2’ loans) or that are credit impaired (IFRS 9 ‘stage 3’ loans) are down, at 12.3% in 2024 Q1 compared with 13.4% in 2023 Q3. The decline has been driven by a fall in corporate loans in stage 2.

Overall, the UK banking system is resilient to the current economic outlook and has the capacity to support households and businesses even if economic and financial conditions were to be substantially worse than expected.

All else equal, the reduction of Bank of England reserves resulting from the normalisation of its balance sheet would put downward pressure on banks’ liquidity ratios. Aggregate Bank of England reserves have declined by around £200 billion since their peak in early 2022. The level of reserves supplied by the Bank of England to support UK financial stability will have to balance the rise in liquidity relative to the pre-GFC period, when the level of reserves was inadequate, against a desire not to over-supply reserves and impede the incentives for robust private sector liquidity management.

The impact of these system-wide factors on individual banks will depend on their funding structure and business models. It is important that banks incorporate them into their liquidity management and forward-planning over the coming years. The FPC will continue to monitor the implications of these trends for financial stability.

4.2: UK banks’ provision of credit

Annual net lending growth remained historically weak in the year to April, at 1%. In Q1, there was a modest increase in total gross lending, which was primarily driven by a small increase in mortgage lending (Chart 4.2), though the level of mortgage lending remains subdued compared with levels seen over 2015–19.

The FPC has previously identified several vulnerabilities in the system of MBF, which remain significant. These include:

• liquidity mismatch in money market funds (MMFs) and open-ended funds (OEFs); as seen in the global financial crisis (GFC) and the 2020 dash for cash;
• instances of concentrated leverage in NBFIs, for example in liability-driven investment (LDI) funds (where stress crystallised in late 2022), and in hedge funds;
• liquidity demands from margin calls in times of stress; as seen in the ‘dash for cash’ in March 2020; and
• the insufficient capacity of markets to intermediate in stress, so-called jump-to-illiquidity risk, as also seen in the ‘dash for cash’.

These vulnerabilities can lead to forced selling, the amplification of price moves, and the impairment of core market functioning, which may affect the cost and availability of finance for UK households and corporates.

Challenges associated with a higher and more volatile interest rate environment could trigger the crystallisation of these vulnerabilities. Risk premia have been falling across a number of asset classes since the December FSR and are compressed in historical terms (see Section 1). A sharp correction in a broad range of asset prices, including equities and certain credit markets could lead to a significant increase in liquidity demand among NBFIs, as well as significant losses for some investors. Given the known vulnerabilities and interconnections within MBF, this might lead to a broader stress in the system, which could ultimately reduce the availability or increase the cost of borrowing for UK households and businesses.

Liquidity mismatches can arise when assets are less liquid than liabilities, as is the case for many OEFs.

This liquidity mismatch creates a risk that investor outflows could overwhelm OEFs’ capacity to liquidate assets in an orderly manner, which may lead to forced selling and amplification of moves in asset prices.

Meanwhile, OEFs for euro and US dollar investment-grade bonds have seen large inflows. Investment appetite for OEFs for sterling investment-grade bonds has not picked up in the same way (Chart 5.1). A sharp widening in credit spreads from currently compressed levels, especially in the US, could trigger rapid outflows, with the large growth in IG funds increasing the scale of potential vulnerabilities in this part of the market.

Sterling Low Volatility Net Asset Value MMF resilience decreased in 2024 Q2. Weekly liquid asset holdings were 46%, below the post-‘dash for cash’ average of 50% (between 2020 Q2 and 2024 Q1).

There are further signs of increased hedge fund leverage, with some funds moving into more leveraged strategies.

As outlined in the December FSR, hedge funds play a role in intermediating between different types of market participants, helping to keep cash bonds and futures markets broadly aligned through ‘cash-futures basis trades’, thus improving market liquidity and efficiency. But this intermediation can amplify stress should hedge funds be forced to rapidly unwind their positions, especially as hedge funds use significant amounts of leverage, supported by short-term borrowing in the repo market.

These behaviours are particularly evident in US Treasury markets. Hedge funds’ net short positioning in US Treasury futures has increased since 2024 Q1 but is only slightly higher than at the time of the December 2023 FSR. Basis trade activity remains driven by structural demand from asset managers for exposures to US Treasuries and an increasing preference to source this exposure via the futures market.

Private equity, which is a significant source of finance for many UK companies, is facing challenges in an environment of higher interest rates, in part because of the high degree of leverage in the sector. The FPC has identified several vulnerabilities in the sector which could amplify the impact of shocks on the availability and cost of finance to corporates (see Section 6).

5.3: Improving the resilience of market-based finance

Given the potential for vulnerabilities in MBF to pose risks to UK financial stability, the FPC seeks to build the resilience of MBF. The high degree of interconnectedness in MBF, including across borders, means that vulnerabilities are most effectively addressed through internationally co-ordinated reforms. The FPC continues strongly to support international work to increase the resilience of MBF. The FPC also works to reduce vulnerabilities domestically where this is effective and practical.

Some progress has been made in addressing key vulnerabilities in the system of MBF, including since the December FSR (see Table 5.A). But vulnerabilities remain and could amplify any future shocks.

Vulnerabilities associated with concentrated leveraged positions and margining practices in over-the-counter markets, particularly in core markets (including repo markets), remain. The FSB is working on policies to enhance the monitoring of, and to address financial stability risks stemming from, leverage in NBFI.

The FPC has previously identified non-bank leverage as a vulnerability in market-based finance. It had an amplifying effect in the Archegos default in 2021, the March 2020 ‘dash for cash’, the commodities market shock in early 2022, and the LDI episode in late 2022.

NBFI leverage vulnerabilities can cause financial stability risks through two transmission channels: (i) via systemic markets, where deleveraging flows or liquidity demands to meet collateral or margin calls could lead to fire sales which amplify shocks, and (ii) via systemic institutions, where stress or default of a leveraged entity could propagate stress to its counterparties including banks. Macro-financial vulnerabilities such as concentration, interconnectedness and liquidity stress can further amplify these risks, causing them to become systemic.

LDI is an investment approach used by defined-benefit (DB) pension schemes to help ensure that the value of their assets (ie their investments) moves in line with the value of their liabilities (ie the pensions they have promised to pay in the future).

The FPC’s March 2023 Recommendation that TPR should have the remit to take into account financial stability considerations in its work on a continuing basis remains in place.

The FPC notes the importance of continued oversight of LDI resilience by TPR, the FCA, and international authorities.

While substantial progress has been made on operational processes in the LDI sector, it is important that these processes are maintained and tested on a regular basis. It is also important that authorities retain the ability to monitor LDI funds’ resilience in dynamic markets. The Bank is contributing to the work through its system-wide exploratory scenario (SWES), which includes pension schemes and LDI funds (see Box C).

It is first and foremost the responsibility of market participants to manage the risks they face and maintain appropriate levels of resilience. The FPC recognises it is vital that domestic and international regulators continue to develop and implement policies that mitigate vulnerabilities in the system of MBF to ensure that it can absorb and not amplify severe but plausible shocks.

But it is not feasible for non-banks to maintain a level of resilience that would insure against the most extreme system-wide liquidity stresses. In such circumstances, where reasonable levels of resilience in the market are likely to be exhausted, central bank tools can support financial stability by providing backstop liquidity. To strengthen its toolkit, the Bank is currently developing a new lending facility to provide liquidity directly to NBFIs in times of system-wide liquidity stress in the gilt market. It is preferable, where possible, to backstop gilt market functioning by lending directly to NBFIs against high quality collateral, rather than with asset purchases, as this presents less risk to public funds and less moral hazard.

The SWES exercise will aid the FPC’s understanding of how market-based finance behaves as an interconnected system.

The FPC welcomes the launch in June 2024 of Round 2 of the scenario phase of the SWES. The Bank has shared its observations from Round 1 submissions with participating banks and NBFIs. Participants have been asked to indicate how they would expect to act in light of these Round 1 observations and some accompanying updated assumptions. The Bank will analyse responses to understand the financial stability implications of interactions between participants’ actions (see Box C).

PE consists of funds which use pools of capital, largely from institutional investors, to invest primarily in non-publicly traded companies. Globally, assets under management in the PE sector have increased fourfold over the past 10 years, from around US$2 trillion in 2013 to around US$8 trillion in 2023.

PE-backed corporates account for around 5% of UK private sector revenues and around 10% of UK private sector employment, or over 2 million employees. PE has played an increasingly significant role in facilitating capital for UK corporates, helping to diversify their sources of finance. The long-term nature of capital investments into PE allows and incentivises fund managers to act less cyclically – for example by retaining assets when market valuations are impacted by a cyclical downturn. This means that PE investments can help reduce the volatility of financing flows in macroeconomic downturns. There was evidence of this during the global financial crisis (GFC) and the Covid pandemic.

However, the widespread use of leverage within PE firms and their portfolio companies makes them particularly exposed to tighter financing conditions.

Although the sector has been resilient so far, it is facing challenges in the higher rate environment. These manifest in refinancing risk as historic debt matures, and an increased drag on performance from higher financing costs.

As financing costs have risen, lenders and borrowers have increasingly turned to amend-and-extend agreements – where lenders agree to push back a loan’s maturity, often in return for a higher yield and tighter financial controls – and payment in kind agreements – where borrowers with low liquidity issue new debt in order to meet interest payments. Such actions reduce near-term debt pressures on PE-backed corporates but can create future refinancing risks.

In a higher-rate environment, higher financing costs create an increased drag on the performance of indebted PE-owned companies, which makes it challenging for PE sponsors to exit their investments in their portfolios. There have been limited initial public offerings and sale activity has been weak, resulting in PE firms increasing their holding periods of portfolio companies. Pressure on PE funds to return capital to end-investors has also resulted in funds increasingly turning to unconventional approaches such as continuation vehicles, which are typically used by funds to restructure and spin off the ownership of selected sponsored companies, thereby providing an exit opportunity on investments.

There is also evidence that PE funds have increasingly resorted to taking secured borrowing against the net assets of their funds, known as net asset value (NAV) financing. The NAV financing market globally is estimated to be around US$100 billion and is expected to grow further over the coming years. This type of debt is used to monetise assets and source liquidity. However, as the providers of NAV facilities have recourse to the assets of PE funds, and these assets are leveraged themselves (‘leverage on leverage’), this type of lending can increase the risk profile for lenders in the market.

These trends are particularly pronounced in the US, where fundraising and exit activity has fallen more sharply than in the UK.

Vulnerabilities in the PE ecosystem could amplify shocks and disrupt the stable provision of finance to the real economy.

First, the PE market has multiple financing structures, and layers of leverage, much of which are provided by banks. Layers of leverage expose lenders to risks at the portfolio company level, at the fund level, and at end-investor level. PE funds use leverage to increase returns for investors, fund deals, and manage cash flows. In the leveraged buyout space, PE-sponsored companies are typically highly leveraged corporates with floating-rate debt, and, unless hedged, are exposed to changes in interest rates. A lack of transparency to those outside the PE market makes it challenging to gauge the aggregate degree of leverage and interest rate exposure across the system. Leverage can also create liquidity demands despite the closed-end nature of funds.

Second, the PE sector is highly interconnected with the system of market-based finance (MBF) and the financial system more broadly. The PE ecosystem involves investors and lenders from different parts of the financial system, such as pension fund and insurance investors, as well as banks and private credit lenders. Globally, PE-sponsored activity is heavily associated with leveraged lending and private credit, with around 73% of leveraged loans and around 90% of private credit linked to PE-sponsored companies, according to Bank analysis.

In the UK, a large proportion of PE-backed companies’ debt is from risky credit markets (private credit, leveraged loans, and high-yield bonds). For example, over two thirds of market-based borrowing by UK PE-backed companies is from these higher-risk markets, compared to around one quarter for all firms (Chart 6.1).

A shock to highly indebted corporates or investor confidence could be amplified by the underlying vulnerabilities within the PE ecosystem through a number of channels, including through losses for banks…

The global banking system has significant exposure to PE activity. Such exposures could lead to credit losses for banks. In addition, opacity regarding exposures could result in a bank reducing lending to PE or other sectors by more than is warranted by macroeconomic conditions. This opacity could also have spillover effects, for example by amplifying changes in valuations, or through confidence channels.

Regulatory arbitrage opportunities in the insurance sector have incentivised some life insurers to reinsure their portfolios with offshore reinsurers. PE-connected offshore reinsurers – such as reinsurance companies, where PE companies have full or partial ownership, or a strategic partnership – often invest more in illiquid assets, potentially increasing risks. For example, PE-connected Bermudan reinsurers allocate about 20% of their investments into illiquid assets (including PE), compared to the median for global insurers, which is around 6%.

That said, structural features of PE markets help mitigate fire-sale risks in the underlying assets, limiting potential spillovers. PE funds are predominantly buy-and-hold closed-ended structures, with investors committing capital for long periods. Although it has grown over recent years, the secondary market for either limited partner shareholding interests or portfolio assets remains small relative to the size of the overall PE market.

…all of which could reduce investor confidence, triggering a widening in spreads from currently compressed levels, and further tightening financing conditions for businesses.

PE-backed companies account for around 15% of UK corporate debt in aggregate. They operate in a variety of sectors, with high concentration in finance, insurance, professional services, and information and communications. The high degree of sectoral concentration represents an additional vulnerability, which could amplify the impact of shocks in individual sectors. If a sector with a high concentration of PE-backed companies is undergoing a stress, it may be more likely to impact the PE sector more broadly.

PE backs a sizeable portion of highly leveraged vulnerable firms. Bank analysis suggests that since 2017, the share of liability-weighted PE-backed companies at higher risk of default has been larger than that of UK corporates in aggregate. But this share has been falling from its Covid peak, reflecting the recent strength in UK nominal corporate earnings (see Section 3 for more details on methodology).

The share of vulnerable PE-backed companies (as a proportion of all PE-backed firms) is similar to that of leveraged loan issuers, but higher than that of high-yield bond issuers (Chart 6.2). Some of these businesses may need to reduce their indebtedness, potentially through new equity, in response to the higher interest rate environment.

While the share of PE-backed firms’ debt maturing in the next five years is just under 10% of all MBF debt, it accounts for around a 25% share of all the debt maturing in risky credit markets (Chart 6.3). This means that PE-backed firms may be disproportionately exposed to refinancing risk in these riskier markets over the coming years. That could create risks through the borrower resilience channel, for example, if those corporates have to cut back sharply on investment or employment.

The extent of transparency around asset valuations, overall levels of leverage, and the complexity and interconnectedness of the sector makes assessing the financial stability risks challenging.

It is therefore important for those in the PE sector and their counterparties to manage their risks carefully. Improved transparency over valuation practices and overall levels of leverage would help reduce the vulnerabilities in the sector.

As the sector grows and adapts to the challenges it faces, it is important that vulnerabilities are mitigated to ensure the sector can continue to provide finance to UK businesses sustainably, even in substantially worse economic and financial conditions.

On 23 March 2023, the FPC made the Recommendation (23/Q1/1) that:

• The severe but plausible stresses to which liability-driven investment (LDI) funds should be resilient should account for historic volatility in gilt yields, and the potential for 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 cause financial instability, tightening credit conditions for UK households and businesses. The FPC judged that these factors meant that the size of the yield shock to which LDI funds should be resilient should be, at a minimum, around 250 basis points.
• Liquid assets held to ensure resilience in the event of such a shock should be unencumbered and immediately available. Fund managers should have scope to consider additional assets, which investors had authorised them to use to meet collateral demands. Managers should apply appropriate prudence in doing this, for example by applying suitable haircuts.
• This minimum level of resilience should be maintained in normal times but could be drawn down on in stress. Minimum resilience around this level would ensure that funds could absorb a severe but plausible historical stress and still have a remaining level of headroom necessary to operate during a period of recapitalisation. This approach was consistent with the regulatory approaches in place for some systemically important financial institutions, where their standards were designed to allow institutions to continue operating after withstanding a severe stress.
• Funds should take into account the nature of their exposures, including duration, leverage, and concentration of holdings, and the liquidity, duration, and convexity of collateral, in modelling their resilience to yield moves.
• Pension schemes using leveraged LDI should be expected to be able to deliver collateral to their LDI vehicles within five days. Funds and schemes unable to implement these operational standards should be required to be resilient to a larger shock, calibrated to their own operational timelines.
• LDI funds should maintain additional resilience over and above the minimum to manage day-to-day volatility in yields and account for other risks they might face, including operational risks, in order to be able to maintain the minimum level of resilience in normal times. The amount of additional liquidity held should be calibrated by funds according to their own assessments of their exposures and operational capabilities and other regulatory requirements, as well as interest rate trends and levels of market volatility. While this additional liquidity was expected to vary between funds, when combined with the minimum resilience to yield shocks, overall resilience levels should be broadly consistent with those currently prevailing in current market conditions (ie 300–400 basis points). Liquid asset holdings might be safely reduced over time if fund managers were able to demonstrate increased resilience through operational improvements.

On 23 March 2023, the FPC made the Recommendation (23/Q1/2) that:

• The Pensions Regulator (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. To ensure that they were able in practice to do this, it was important that trustees had a simple mechanism for monitoring, and LDI funds disclosing, levels of resilience in dynamic markets.
• TPR should have the ability to employ effective monitoring tools, and to enforce as appropriate in cases of non-compliance with this resilience level. The FPC asked TPR to report back on how it intended to implement the Recommendation.

On 28 November 2022, the FPC recommended (22/Q4/1) that regulatory action be taken by TPR, in co-ordination with the Financial Conduct Authority (FCA) and overseas regulators, to ensure LDI funds remain resilient to the higher level of interest rates that they can now withstand and defined benefit pension scheme trustees and advisers ensure these levels were met in their LDI arrangements.

Outstanding FPC Recommendations and Directions (as at the date of the FPC’s meeting on 11 June 2024)

On 23 March 2023, the FPC made the recommendation (23/Q1/2) 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.

Other FPC policy decisions which remain in place

The following text sets out previous FPC decisions, which remain in force, on the setting of its policy tools. The calibration of these tools is kept under review.

Countercyclical capital buffer rate