UK Financial Conditions: Banks Prove their Resilience

There were two developments this week that are noteworthy for UK financial markets.

One is the latest news from the Brexit talks, where the leaks suggest the UK and EU are closer on making agreements ahead of an early December deadline – before EU leaders meet in mid-December. If so, this would move the focus onto the transitional deal and trade talks.

The second was the semi-annual release from the Bank of England of their Financial Stability Report.

Let’s focus here on this Report, which gives the Bank’s insights into financial sector developments. The Report was released alongside the Bank’s latest annual stress tests of the UK banking sector.

Alongside the Monetary Policy Committee (MPC) that sets interest rates, sits the Financial Policy Committee (FPC), which oversees the stability of the financial system.

Banks must set aside more

Nowadays, banks have to hold a large amount of capital in case something goes wrong. This falls into two categories. One is the minimum requirements that now averages a high 6.7% and consists of shareholder equity and bank-specific requirements set by the regulator, the Prudential Regulation Authority (PRA).

The other category is “buffers”: systemic buffers for the big banks, capital conversion buffers and bank-specific buffers set by the PRA.

As they outlined in the summer, the FPC has raised the counter cyclical capital buffer (CCCB) for banks from 0.5% to 1%, effective November 2018. This will force banks to set aside more capital, constraining their ability to lend.

The most important aspect of this decision is that it signals that the FPC sees this as a return to more normal orderly conditions.

This rate had been cut to zero in July 2016 before rising to 0.5% this summer. While the FPC’s decision does not directly imply anything in terms of the MPC’s view on interest rates, the fact that financial conditions are now being seen as returning to normal suggests the pendulum at the Bank continues to swing – albeit slowly – towards monetary policy returning to normal, too, raising interest rates further.

Of course, the big issue re capital buffers is whether the banks are being forced to hold too much capital at the expense of lending to the real economy; based on their data the Bank would say no.

UK banks not feeling stressed

No UK bank failed the stress tests. This was taken as a further sign that the banking sector is now in resilient shape, nine years after the 2008 global financial crisis.

The economic scenario for the stress test was severe, and worse than the global financial crisis according to the Bank, although they assumed the UK would contract less and they assumed, unrealistically perhaps, that interest rates would rise sharply. But the key message was that it was a severe stress test.

The “economic loss” to the banks from the scenario in the stress tests was 3.5% to capital. As the capital conversion buffer, when phased in by 2019, will be 2.5% of risk-weighted assets –so a CCCB of 1% makes sense.

As in summer, the FPC highlighted their concerns about the consumer sector. The UK has twin deficits of budget and current account but it is usually the rise in private sector liabilities – as consumer borrowing rises – that catches the economy out.

Defaults on consumer credit – as the FPC pointed out – tend to rise substantially during recessions: they assume three-year impairment rates of 26% on credit cards, 14% on personal loans and 17% on other unsecured lending. Of course, we are nowhere near this situation yet.

In addition to such policy issues it was very interesting to read that that the FPC says market-based finance now accounts for “almost 50% of the UK financial system”. They also have an analysis of the impact of FinTech which they believe could, “cause greater and faster disruption to banks’ business models than banks project”. So the financial system may be returning to normal but it still faces big structural change.

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