Leveraged lending

The FPC is concerned by the rapid growth of risky lending to businesses.

Global debt

Emerging market debt has risen in the past decade. This makes those economies, and the world economy, riskier.

Financial Policy Committee Statement from its policy meeting, 3 October 2018

The Financial Policy Committee (FPC) aims to ensure the UK financial system is resilient to, and prepared for, the wide range of risks it could face — so that the system can serve UK households and businesses in bad times as well as good.

At its meeting on 3 October, the FPC reviewed developments since its meeting on 19 June.

Risks to UK financial stability from Brexit

The FPC continues to judge that the UK banking system would be strong enough to serve UK households and businesses through a disorderly, cliff-edge Brexit.

• Consistent with its remit to ensure the financial system is resilient to major shocks, the FPC continues to review estimates of possible ‘worst case’ economic outcomes associated with Brexit, however unlikely they may be.
  
• The FPC continues to judge that the 2017 stress test encompassed an appropriately wide range of UK macroeconomic outcomes that could be associated with Brexit.  As it has set out previously, the FPC judges that Brexit risks, including those of a disorderly, cliff-edge Brexit in which there was no agreement or implementation period, do not warrant additional capital buffers for banks.
  
• The 2017 stress test scenario included the UK unemployment rate rising to 9.5%, UK residential property prices falling by 33% and UK commercial real estate prices falling by 40%.  It also included a sudden loss of overseas investor appetite for UK assets, a 27% fall in the sterling exchange rate index and Bank Rate rising to 4%.
  

• At 16.8%, the aggregate Tier 1 capital ratio of the major UK banks is around three times that of ten years ago.  Losses on a scale that would have wiped out the common equity capital base of the system in 2007 can now be readily absorbed by available capital.
  

An implementation period would reduce the risks of disruption to the supply of financial services to UK and EU households and businesses as the UK exits the EU.  The FPC has been monitoring risks of disruption that could arise in the absence of an implementation period or any other agreement (see the updated checklist in Table 1).  There has been considerable progress in the UK to address these risks, but only limited progress in the EU.   In the limited time remaining, it is not possible for companies on their own to mitigate fully the risks of disruption to cross-border financial services.  The need for authorities to complete mitigating actions is now pressing. 

• The UK government is taking forward legislation that will allow UK households and businesses to continue to access financial services provided by EU companies.  That legislation needs to be passed by Parliament prior to Brexit to be effective.  
  
• EU or member state rules will restrict EU households and businesses from continuing to use some financial services provided by UK firms.  In some cases, particularly in insurance, UK financial companies are restructuring so they can continue to serve their EU customers post Brexit.  However, actions by firms alone can be only partially effective.  
  
• Timely action by EU authorities is needed to mitigate risks to financial stability, particularly those associated with derivative contracts and the transfer of personal data.
  
• Absent action by EU authorities, EU rules create legal uncertainty about whether EU clearing members could continue to meet their ongoing obligations to UK CCPs and about the consequences for UK CCPs of continuing to provide services to the EU.  To ensure the safe operation of CCPs and avoid financial stability risks, particularly in a stress, the contracts EU clearing members have with UK CCPs will need to be closed out, or transferred, before March 2019.  This will be costly to EU businesses and could strain capacity in the derivatives market.
  

Irrespective of the particular form of the UK’s future relationship with the EU, and consistent with its statutory responsibility, the FPC will remain committed to the implementation of robust prudential standards in the UK.  This will require maintaining a level of resilience that is at least as great as that currently planned, which itself exceeds that required by international baseline standards.

The outlook for UK financial stability and the UK countercyclical capital buffer rate decision

The FPC continues to judge that, apart from those related to Brexit, domestic risks remain at a standard level overall.

• Levels of household and corporate debt in the UK relative to incomes remain materially below their 2008 levels but remain high by international and historical standards.  However, debt servicing burdens remain low.
  
• Over the past year, the debt of UK households and businesses has grown only a little faster than nominal GDP.  
  

The risk appetite of creditors remains strong.  But financial conditions have tightened over the course of the year and borrower demand has been restrained.  As a consequence credit growth has slowed.

• Although financing conditions have tightened, they remain accommodative for large companies.  The extra compensation investors demand for the market and credit risk in corporate bonds is compressed.
  
• The stock of bonds issued by UK companies has increased by around 3% in the past 12 months.  Borrowing by UK companies from UK banks has also been subdued, rising by just 2.7% in the past year.
  
• In the mortgage market, the additional interest rate charged on a 90% LTV mortgage compared to a 75% LTV mortgage has compressed and the proportion of new mortgage lending at LTV ratios above 90% has further increased to 17.8% in 2018 Q2.
  
• Despite these very attractive terms, household mortgage borrowing increased by only 3.1% in the year to August, broadly in line with household disposable income growth.  Soft demand may reflect affordability challenges and uncertainty.
  
• The Committee is concerned by the rapid growth of leveraged lending, including to UK businesses.  The FPC will assess any implications for banks in the 2018 stress test and also review how the increasing role of non-bank lenders and changes in the distribution of corporate debt could pose risks to financial stability.
  
• The global leveraged loan market  is larger than – and growing as quickly as – the US subprime mortgage market was in 2006.  The Committee is reviewing the implications for UK financial stability more intensively, even though it recognises that there are important differences between these two markets, for example with less reliance now on short-term wholesale funding.
  
• In common with the US and Europe, high investor demand has driven strong growth in UK leveraged loans.  Lending terms have loosened with the proportion of UK leveraged loans with maintenance covenants falling from close to 100% in 2010 to around 20% currently.  Gross issuance of leveraged loans by UK non-financial companies reached a record level of £38 billion in 2017 and a further £30 billion has already been issued in 2018.  Taking high-yield bonds and leveraged loans together, the estimated stock of debt outstanding in UK non-investment grade firms is now estimated to account for about 20% of total UK corporate sector debt.  
  
• Leveraged loans are typically sold to non-bank investors (including to collateralised loan obligation funds), whose ability to sustain losses without materially impacting financing conditions is uncertain.  However, banks retain some exposure and make other loans to the same highly indebted companies. The FPC is therefore assessing the implications of rapid growth of leveraged lending for both non-banks and banks. 
  

Given the current balance of risks, the FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 1%.  The FPC will conduct, as normal, a comprehensive assessment of the resilience of the UK banking system in the 2018 stress test and review the adequacy of the 1% CCyB rate at its meeting on 28 November.

Risks to the UK from global vulnerabilities remain material.  Accordingly, the 2018 stress scenario incorporates a synchronised global downturn in output growth.

• The tightening of US monetary policy that began in December 2015 has begun to contribute to a tightening in global financial conditions, particularly over the past six months in emerging market economies.
  
• The most acute market pressures to date have focused on Turkey and Argentina, which have large current account deficits and high levels of debt.  But a more widespread change in risk appetite could expose broader vulnerabilities, including for other emerging market economies with high debt levels and large current account deficits.
  
• The imposition of trade barriers by the US and China, although detrimental to the outlook for global growth, does not itself pose a material risk to UK financial stability.  But deepening tensions could trigger a further and more severe tightening of global financial conditions.  They could also encourage China to ease domestic financial conditions and, in doing so, encourage a further build-up of risks.
  
• Recent further increases in Italian government bond yields underline the vulnerabilities created by high public debt levels and interlinkages between banks and sovereigns in the euro area.
  
• Risks from the US corporate sector remain material, as leverage has continued to increase and underwriting standards have loosened further. 
  

The 2019 biennial exploratory scenario

Recognising the deployment of resources both within the Bank and at private institutions to prepare for Brexit, the FPC and PRC have decided to delay the Bank’s launch of the next biennial exploratory scenario to September 2019.   The Bank expects to publish the results of this exercise alongside the Financial Stability Report in June 2020.

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