Resilience on the rise
20 March 2018
Last week was an active one for financial regulators. The Financial Policy Committee (FPC) published its statement from its meeting on 12 March, while also announcing the key elements of this year’s stress tests for the major banks. According to the FPC, domestic risks to financial stability are standard, but global vulnerabilities are material. On the domestic front, the FPC noted that aggregate private non-financial sector leverage was rising at only a modest pace, debt servicing costs are low, while the level of debt relative to incomes remains lower than before the financial crisis (see Chart 4). There are some signs of rising domestic risk appetite – notably rising issuance of leveraged loans and high-yield bonds, a pick-up in the proportion of new owner-occupied mortgages with high loan-to-income ratios, stretched valuations in parts of the commercial real estate sector and the high current account deficit that has become more reliant on capital inflows. But none of these trends were of too much concern to the FPC and so it decided to leave the countercyclical capital buffer unchanged at 1%.
The FPC’s broadly positive assessment of financial stability risks is being buttressed by the healthy capital position of the domestic banking sector. The results of the 2017 stress tests, which were published in November, showed that the banking system would be resilient to a deep domestic and global recession accompanied by large falls in asset prices. In contrast to the pre-crisis period, when a similar sized shock would have “wiped out the common equity capital base”, the current aggregate common equity Tier 1 (CET1) ratio of 13.4% of the banking system should enable a severe stress episode to be absorbed without widespread insolvencies. Indeed, for the first time since 2014, all seven of the participating banks were able to pass the stress tests (see Chart 5). That doesn’t mean that the banks are in identical health. For example, in the severe stress scenario, the CET1 ratios of Barclays, Lloyds and RBS exceeded their hurdle rates by less than HSBC, Nationwide, Santander and Standard Chartered. However, both Barclays and RBS significantly improved their capital positions through 2017, an effort that was acknowledged by the Bank of England. The 2018 stress tests will use the same economic and financial scenarios as in 2017. But the hurdles rates will change, with the more systemic banks held to higher standards and banks required to hold capital buffers for global systemic importance rather than just their domestic importance.
One risk the FPC is a little more concerned about is Brexit. While the stress tests examined banks’ ability to absorb a severe recession and a disorderly Brexit, they did not test the impact of those shocks if they occurred simultaneously. Though the FPC considered such a scenario remote, it implied that parts of the banking system might not have enough capital in such circumstances. Moreover, it is also possible for Brexit to directly disrupt the provision of important financial services. Though the FPC welcomed the progress that had been made to mitigate some of those risks over recent months, it observed that “material risks remain, particularly in areas where actions would be needed by both the UK and EU authorities”. This should be seen a warning to both sides not to let political considerations interfere with financial stability.