Financial Policy Summary and Record – October 2023

The Financial Policy Committee (FPC) has published its most recent Financial Policy Summary and Record – October 2023 which summarizes the Committee’s current risk assessment as far as vulnerabilities are concerned that may affect the stability of the UK financial market. The key issues identified by the FPC are briefly summarized below:
(1) Overall risk assessment: According to the FPC, the global risk environment remains challenging with limited near-term growth prospects, not least caused by the significant increases in long-term interest rates. Certain aspects of the global banking and financial systems are vulnerable to stress due to rising interest rates and uncertainties in relation to economic growth, inflation, and geopolitical tensions. Furthermore, the current environment in the Chinese property market remains challenging, warranting increased monitoring as to a potential spill-over to the UK. The same holds to for the property market in Hong Kong which UK banks have significant exposures to. Coupled with a high private debt level in the country, the situation is challenging.
(2) Impact on businesses and households: In the UK, households and businesses are facing increasing living and higher borrowing costs due to rising interest rates. Although the full impact of these higher rates has not yet affected all borrowers, it’s expected to do so in the coming months as fixed-rate mortgage deals expire and new debt financing is needed. Hence, the FPC expects the average cost of mortgage payments to rise, though it is anticipated to remain below the levels seen during the 2007 global financial crisis. So far, the number of homeowners falling behind on mortgage payments has only increased slightly, but the level remains relatively low compared to historical standards. On the business side, the FPC has seen a steadily increasing number of bankruptcies, although small firms appear to be more impacted as large firms have locked in long-term low interest rates in their credit arrangements.
(3) Resilience of UK banks: The UK banking system is well-prepared to support households and businesses, even in adverse economic conditions. The banks have substantial capital reserves and resources to absorb potential losses and financial outflows. In 2022-2023, the Bank of England conducted stress tests on major UK banks, simulating a severe economic downturn, and found that the banks remained strong and capable of supporting the UK economy. Furthermore, as borrowing costs have risen, leading to decreased loan demand, banks have adjusted their lending practices in line with borrower creditworthiness. The UK countercyclical capital buffer (CCyB) rate, which provides an extra buffer for banks, has been maintained at 2% to ensure that financial institutions can handle potential losses without restricting lending to the broader economy.
(4) Market-Based Finance (MBF) vulnerabilities: The FPC notes that vulnerabilities in market-based finance have not changed significantly since July, the date of the FPC’s last assessment. These vulnerabilities could worsen though in case of sharp asset price fluctuations, impacting both households and businesses.
– Hedge fund risks: Hedge funds are still heavily leveraged in US treasuries, which can disrupt the US Treasury market as seen in March 2020. The FPC will keep a close eye on these risks.
– Resilience of investment funds: According to the FPC, the resilience framework introduced for liability-driven investment (LDI) funds in early 2023 is working as intended: these funds have upheld their overall resilience levels in line with the minimum recommendations and have started to recapitalize at more robust resilience levels compared to before. Nevertheless, there’s room for improvement. Efforts are currently underway to establish monitoring and enforcement frameworks for pooled funds.
– Resilience of money market funds (MMFs): UK authorities are currently working on a new regulatory framework to strengthen the resilience of money market funds. A corresponding draft is expected to be published „later this year“. One effective way to enhance such resilience is by increasing the amount of liquid assets held by MMFs. This would make them more resistant to various financial stresses. In fact, various analysis suggests that holding liquid assets at 50-60% of total assets would provide a high level of assurance that sterling-denominated MMFs can handle severe, but plausible challenges.
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The FPC has also published another statement in which it outlines its approach to „assessing risks in market-based finance“. In it, the Committee describes in detail its approach towards
– the identification of MBF risks;
– the assessment of the levels of MBF risks prevailing in the UK market; and
– the monitoring of prevailing risks.