UK banks remain well protected amid a “challenging” global risk environment, according to the Bank of England’s latest Financial Stability Report published today (12 July). However, it warned that non-bank financial institutions “continue to need more resilience” and that the Bank is “working internationally to achieve this”.
Banks are facing various headwinds this year, with rising interest rates increasing the risk of borrowers defaulting on their debts. As inflation remains stubborn, more and more fixed-rate mortgage deals will expire while rates are higher than they have been in recent years, meaning mortgage payments will continue to increase.
“Although the proportion of income that UK households overall spend on mortgage payments is expected to rise, it should remain below the peaks experienced in the global financial crisis and in the early 1990s,” the BoE said.
“UK banks are in a strong position to support customers who are facing payment difficulties. This should mean lower defaults than in previous periods in which borrowers have been under pressure.”
It said there are several factors limiting the impact of higher rates on mortgage defaults, including “robust capital and profitability” from banks, “stricter regulatory conduct standards” and new support measures agreed by the Financial Conduct Authority, the Chancellor of the Exchequer and principal mortgage lenders at the end of last month.
See also: “Chancellor Hunt addresses inflation, regulatory shifts and reform in Mansion House speech“
On the corporate side, the BoE added that more businesses will spend a higher proportion of their income on servicing their debt this year, but that this “should also remain below previous peaks”.
“While corporate insolvency rates have risen above pre-Covid rates, they remain low relative to longer-term average levels,” it reasoned. “The large majority of the increase in insolvencies has been among very small firms that hold little debt, and a high proportion of the debt they do hold is fixed at low rates and government guaranteed.
“More broadly, the corporate sector has been repaying debt and its near-term refinancing needs appear limited.”
The BoE used a “severe stress scenario” – which it believes to be much worse than its projected economic outlook – in order to test UK banks. This scenario included the unemployment rate increasing to 8.5%, inflation rising to 17% and house prices falling by 31%.
“The results of this stress test showed that the UK banking system would continue to be resilient, and be able to support households and businesses, even if economic conditions turned out to be much worse than we expect,” the BoE said.
“As borrowing costs have increased, the demand for loans has reduced. Banks do not appear to be cutting the availability of credit in a way that is out of line with changes in borrower creditworthiness.”
It added that it has maintained its countercyclical capital buffer – a ‘rainy day’ buffer which can be used to help banks can withstand potential losses without restricting lending – at a rate of 2%.
‘Vulnerabilities in market-based finance’
However, the BoE warned there are “vulnerabilities” in market-based finance, which it said “could become more apparent as interest rates increase”.
“Rapid changes in interest rates can lead to liquidity challenges for non-banks, as we saw in September 2022, when the impact of a shock in the liability-driven investment (LDI) sector led to further market dysfunction in UK government bonds,” it pointed out. “Episodes like this can make push up the cost of borrowing.”
Following the weaknesses exposed in LDI funds last year, the Financial Policy Committee published recommendations to protect such vehicles against interest rate spikes. There has also been “new guidance in this area” published since, according to the Bank.
“Many UK firms rely on financial markets to raise funding, and disruption to these markets can increase the cost of borrowing for households and businesses more generally,” it warned.
“Many firms involved in market-based finance are not regulated by the Bank of England, so we are working with other regulatory authorities to achieve this. It added: “It is important for UK financial stability that these markets function well, even under stress. We are continuing to help develop global standards to limit vulnerabilities in the non-bank participants in these markets.”
