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Financial Stability Report and Stress Test Results (UK) - November 2018

Regulators	1960 VIEWS
Regulators
1960 VIEWS

Thursday, November 29, 2018 06.01AM / By Bank of England

The UK financial system is resilient to the wide range of risks it could face, including Brexit.

Highlights

1. Stress testing: Our stress test shows that UK banks could continue to lend in a scenario more severe than the financial crisis.

2. Bank resilience: UK banks are prepared and strong enough to continue to serve UK households and businesses even through a disorderly Brexit.

3. Brexit checklist: The UK government is making sure the financial services UK households and businesses get from EU providers won’t be disrupted.

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

Stress Testing

The 2018 stress test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis and that are combined with large falls in asset prices and a separate stress of misconduct costs.

In the 2018 stress-test scenario, UK GDP falls by 4.7%, the UK unemployment rate rises to 9.5%, UK residential property prices fall by 33% and UK commercial real estate prices fall by 40%. The scenario also includes 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%.

Our stress test is more severe than the shocks experienced during the financial crisis

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Major UK banks have continued to strengthen their capital positions. They started the 2018 stress test with an aggregate common equity Tier 1 (CET1) capital ratio nearly three and a half times higher than before the global financial crisis.

Despite facing loss rates consistent with the global financial crisis, the major UK banks’ aggregate CET1 capital ratio after the stress would still be twice its level before the crisis.

Banks are much stronger than before the financial crisis

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All participating banks remain above their risk-weighted capital and leverage hurdle rates and would be able to continue to meet credit demand from the real economy, even in this very severe stress.

The 2018 stress test is the first to be conducted under a new accounting standard, International Financial Reporting Standard 9 (IFRS 9). The test results take account of internationally agreed transitional arrangements. The Bank will use these results to assess how best to avoid the interaction of IFRS 9 and the stress test leading to an unwarranted de facto increase in capital requirements, as these transitional arrangements are phased out.

Brexit

Since the EU referendum in 2016, the FPC and other authorities have identified risks of disruption to the financial system that could arise from Brexit and worked to ensure they are addressed. Stress tests and supervisory actions have ensured major UK banks have levels of capital and liquidity to withstand even a severe economic shock that could be associated with a disorderly Brexit. The Government is taking forward the legislation necessary to avoid disruption to financial services provided by EU firms to UK households and businesses. The Bank, other UK authorities and financial companies have engaged in extensive contingency planning.

The FPC has reviewed a disorderly Brexit scenario, with no deal and no transition period, that leads to a severe economic shock. Based on a comparison of this scenario with the stress test, the FPC judges that the UK banking system is strong enough to continue to serve UK households and businesses even in the event of a disorderly Brexit.

The UK economic scenario in the 2018 stress test of major UK banks was sufficiently severe to encompass the outcomes based on ‘worst case’ assumptions about the challenges the UK economy could face in the event of a cliff-edge Brexit.

These worst case assumptions include: the sudden imposition of trade barriers with the EU; loss of existing trade agreements with other countries; severe customs disruption; a sharp increase in the risk premium on UK assets; and negative spillovers to wider UK financial markets.

Because major UK banks would be resilient to the tougher annual stress test, they would also be resilient to, rather than amplify, this disorderly Brexit scenario.

UK banks have enough capital to withstand a disorderly Brexit

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Major UK banks have sufficient liquidity to withstand a major market disruption.

Major UK banks have sufficient liquidity to withstand a major market disruption. Since the financial crisis, major UK banks have substantially reduced their reliance on wholesale funding. At group level, they hold more than £1 trillion of high-quality liquid assets. They are able to withstand more than three months of stress in wholesale funding markets.

As a result of supervisory actions and their own prudent risk management, major banks have aligned the currency of their liquid assets to that of their maturing wholesale funding. They can now withstand many months without access to foreign exchange markets.

In addition, banks have pre-positioned collateral at the Bank of England that would allow them to borrow a further £300 billion. The Bank is able to lend in all major currencies.

Brexit Checklist

Most risks of disruption to the financial services that EU firms provide to UK households and businesses have been addressed, including through legislation. Further UK legislation, currently in train, will need to be passed to ensure the legal framework for financial services is fully in place ahead of Brexit.

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The Bank, other UK authorities and financial companies have engaged in extensive contingency planning.

Legislative preparations in the UK have progressed further. In November, Parliament passed legislation to allow Temporary Permissions and Recognition Regimes. These will allow UK households and businesses to continue to access financial services provided by EU firms.

The FPC welcomes the European Commission’s recent statement that it is willing to act to ensure that EU counterparties can continue to clear derivatives at UK central counterparties (CCPs) after March 2019.

However, without greater clarity on the scope, conditions and timing of the prospective EU action, the contracts that EU members have cleared with UK CCPs would need to be closed out or transferred by March 2019 — a process that would need to begin in December 2018.

Irrespective of the particular form of the UK’s future relationship with the EU, and consistent with its statutory responsibilities, 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, as well as maintaining more generally the UK authorities’ ability to manage UK financial stability risks.

CCyB

The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 1%. It stands ready to move the UK CCyB rate in either direction as the risk environment evolves.

If an economic stress were to materialise, the FPC is prepared to cut the UK CCyB rate, as it did in July 2016. This would enable banks to use the released buffer to absorb up to £11 billion of losses, which might otherwise lead them to restrict lending. Given losses of that scale, a cut in the UK CCyB rate to zero could preserve their capacity to lend to UK households and businesses by around £250 billion. This compares to £65 billion of net lending in the past year.

The FPC judges that, apart from those related to Brexit, domestic risks remain at a standard level overall. Lender risk appetite is strong but, reflecting uncertainty, demand for credit has been muted. Were that uncertainty to fade, credit demand could rebound significantly and lead to an increase in the riskiness of banks’ exposures. Given current accommodative lending conditions, that could require a timely policy response to ensure resilience.

Leveraged lending

Leveraged lending to businesses has grown rapidly, both globally and, more recently, in the UK. Strong creditor risk appetite, including for securitisations of leveraged loans, has loosened underwriting standards materially. However, UK banks’ holdings of these securitisations are very small and their aggregate exposures to leveraged lending were covered in the Bank’s 2018 stress test.

The rapid growth in leveraged lending has been driven by increased securitisation activity through collateralised loan obligations (CLOs), as well as demand from investment funds. Given the decline in underwriting standards, investors in leveraged loans are at increasing risk of loss.

CLOs are held mainly by non-bank investors. Although international banks hold around a third of the outstanding stock of CLOs, UK banks and insurance companies only hold a very small share of the stock.

UK banks hold only a small proportion of leveraged loan securitisations (CLOs)

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Rapid growth of leveraged lending means that higher-risk borrowers account for more of the stock of total UK corporate debt. However, UK banks’ domestic corporate lending does not reflect a material shift towards higher-risk borrowers

Global debt

Risks to UK financial stability from global debt vulnerabilities are material. Reflecting that, the FPC incorporated a very severe global stress in the 2018 stress-test scenario.

Global financial conditions have continued to tighten since June. Global equity markets have fallen and credit spreads have risen.

A further deterioration in Italy’s financial outlook could result in material spillovers to the euro area and the UK.

Financial conditions in emerging market economies have shifted from accommodative to tightening. Debt levels in China remain highly elevated. A sharp slowdown in growth in China — possibly as a result of an escalation of trade tensions with the US — would make its elevated debt levels significantly less sustainable.

Non-bank leverage

The FPC has completed an in-depth assessment of the risks associated with leverage from the use of derivatives in the non-bank financial system. Risks of forced sales to meet derivative margin calls currently appear limited. However, more comprehensive and consistent monitoring by authorities is needed to keep this under review.

Non-bank leverage can support financial market functioning, but it can also expose non-banks to greater losses and sudden demands for high-quality collateral, which could result in forced sales of potentially illiquid assets.

The FPC’s assessment focused on the capacity of non-banks in the UK to cover the posting of variation margin on over-the-counter interest rate derivatives. Most non-banks appear to have sufficient liquid assets to meet such calls.

The Bank will work with other domestic supervisors to enhance the monitoring of these risks. Internationally, the International Organization of Securities Commissions (IOSCO) has issued a consultation paper on how to operationalise the Financial Stability Board’s (FSB’s) recommendation to develop consistent leverage measures for funds. For IOSCO to deliver the objective of the FSB recommendation, the FPC considers that a core set of measures will need to be consistent globally and enable effective monitoring of the potential losses and liquidity demands funds could face.

Related Link

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