Financial Stability Report and Stress Test results - November 2018

• 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

• 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

• 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.

• 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

• 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.

• 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.

• 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.

• 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)

• 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 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 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.