We have also launched a stress test designed to consider how banks and non-banks act in stressed financial conditions. This newly launched exploratory scenario will provide useful insights to help us better understand and address vulnerabilities in market-based finance.
The Financial Policy Committee FPC seeks to ensure the UK financial system is prepared for, and resilient to, the wide range of risks it could face — so that the system is able to absorb rather than amplify shocks, and serve UK households and businesses.
Since the December Financial Stability Report, global interest rates have risen further, reflecting actual and expected increases in central bank policy rates in response to continued inflationary pressure.
The sharp transition to significantly higher interest rates and greater market volatility over the past 18 months has, however, created stress in the financial system through a number of channels. The failure of three mid-sized US banks — and the failure of a global systemically important bank G-SIB , Credit Suisse, due to long-running concerns about its risk management and profitability — caused a material rise in financial market risk premia and volatility earlier this year.
The impact on the UK banking system through lower bank equity prices and increases in funding costs was limited, and market risk sentiment has stabilised since then.
Nonetheless, elements of the global banking system and financial markets remain vulnerable to stress from increased interest rates, and remain subject to significant uncertainty, reflecting risks to the outlook for growth and inflation, and from geopolitical tensions.
In the UK, given the prevalence of variable-rate and short-term fixed-rate mortgages and other loans, the impact of higher interest rates is relatively lower in the financial system than in the real economy, compared to some other jurisdictions.
The UK economy has so far been resilient to interest rate risk, though it will take time for the full impact of higher interest rates to come through. In the financial system, interest rate risks crystallised in Autumn , with stress in liability-driven investment LDI funds requiring a temporary and targeted intervention by the Bank.
The ability of those funds to absorb shocks has since been reinforced through the setting of new standards, and the rest of the UK financial system has so far been resilient to higher interest rates.
This is partly due to the range of regulatory measures introduced after the global financial crisis to manage interest rate risk and to build resilience into the financial system more generally.
Higher interest rates increase debt-servicing costs facing household and business borrowers. This makes them more likely to cut back on spending, worsening the economic environment, and increases the risk that they will default on loans.
Both these factors increase credit risks for lenders. In the UK, more households are being affected by higher interest rates as fixed-rate mortgage deals expire. The proportion of households with high debt service ratios, after accounting for the higher cost of living, has increased and is expected to continue to do so through But it is projected to remain some way below the historic peak reached in There are several factors that should limit the impact of higher interest rates on mortgage defaults.
Given robust capital and profitability, UK banks have options to offer forbearance and limit the increase in repayments faced by borrowers, including by allowing borrowers to vary the terms of their loans.
There are now stricter regulatory conduct standards for lenders with respect to supporting households in payment difficulties. And on 23 June, the principal mortgage lenders, the Chancellor and the Financial Conduct Authority FCA agreed new support measures for mortgage holders.
This has increased borrower resilience and played a role in reducing payment difficulties for residential mortgagors. Buy-to-let mortgagors are also experiencing increases in mortgage interest payments, and other structural factors are also likely to put pressure on their incomes.
This could cause landlords to sell, putting downward pressure on house prices. Alternatively, they may seek to continue to pass on higher costs to renters. Similar to other forms of borrowing, buy-to-let mortgages are subject to affordability testing.
In , the PRA issued a supervisory statement outlining its expectations for underwriting standards in the buy-to-let market to safeguard against a deterioration in such standards. The overall number of mortgages in arrears increased slightly over the first quarter of but remained low by historical standards.
It will take time for the full impact of higher interest rates to come through. The UK corporate sector is expected to remain broadly resilient to higher interest rates and weak growth.
Nevertheless, higher financing costs are likely to put pressure on some smaller or highly leveraged firms. The debt-weighted proportion of medium and large corporates with low interest coverage ratios is projected to continue to increase throughout as debts are refinanced at higher rates, although it is expected to remain some way below previous peak levels.
While corporate insolvency rates have risen above pre-Covid rates, they remain low relative to longer-term average levels. 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 UK banking system is well capitalised and maintains large liquidity buffers. Asset quality overall remains relatively strong, with higher interest rates having had a limited impact on credit risk so far.
However, the overall risk environment is challenging. Some forms of lending, such as to finance commercial real estate investments, buy-to-let, and highly leveraged lending to corporates — as well as lenders that are more concentrated in those assets — are more exposed to credit losses as borrowing costs rise.
In aggregate, smaller lenders are also well capitalised and maintain strong liquidity positions. These lenders typically hold greater amounts of capital as a share of their risk-weighted assets, relative to regulatory requirements, than larger firms and maintain significant liquidity buffers.
The stress test scenario is not a forecast of macroeconomic and financial conditions in the UK or abroad. The rise in interest rates from a low level has increased bank net interest margins in aggregate.
UK banks manage these risks through their hedging practices within a regulatory framework that includes rules designed to ensure that UK banks have capital against interest rate risks in their banking book, the maintenance of substantial liquid asset buffers, supervision by the PRA, and regular stress testing.
The FPC continues to judge that the UK banking system is resilient, and has the capacity to support households and businesses through a period of higher interest rates, even if economic and financial conditions were to be substantially worse than expected.
The FPC judges that the tightening of lending standards seen over recent quarters does not reflect banks restricting lending primarily to protect their capital positions.
The FPC will continue to monitor UK credit conditions for signs of tightening that are not warranted by changes in the macroeconomic outlook. This will help to ensure that banks have sufficient capacity to absorb future shocks without unduly restricting lending.
The FPC stands ready to vary the UK CCyB rate, in either direction, in line with the evolution of economic and financial conditions, underlying vulnerabilities, and the overall risk environment. Higher interest rates have affected households and businesses in other advanced economies in similar ways.
Jurisdictions where long-term fixed-rate mortgages are more prevalent are likely to have financial sectors that are more naturally exposed to interest rate risk. Riskier corporate borrowing in financial markets — such as private credit and leveraged lending — appears particularly vulnerable, and global commercial real estate markets face a number of short and longer-term headwinds that are pushing down on prices and making refinancing challenging.
Nevertheless, the FPC will draw lessons from the episode. For example, the impact of the stress underscored how contagion can spread across and within jurisdictions, even where smaller institutions are involved.
It also highlighted that while an individual institution may not be considered systemic, if a risk is common — or perceived to be common — among similar institutions, the collective impact can pose a systemic risk.
The stress highlighted the need for all banks to be adequately capitalised against the risks they are exposed to, including interest rate risk. Deposit outflows at some regional US banks were large and rapid, with digital banking technology and social media playing a role in increasing the speed at which information was shared and deposits withdrawn.
The Bank will contribute to relevant international work to consider whether lessons can be learnt for the liquidity framework for banks, or components of it, in the light of the size and pace of outflows witnessed in recent events.
These events also showed the importance of being able to resolve firms effectively and of maintaining confidence in resolution frameworks.
In co-ordination with HM Treasury, the Bank is seeking to ensure that for small banks, which do not need to hold additional resources to meet the minimum requirement for own funds and eligible liabilities MREL , there are resolution options that improve continuity of access to deposits and so outcomes for depositors.
The FPC supports this work. Vulnerabilities in certain parts of market-based finance MBF remain. These could crystallise in the context of the current interest rate volatility, amplifying any tightening in financial conditions.
Although the business models of some non-bank financial institutions NBFIs , such as pension funds and insurance companies, mean that they can benefit from the impact of higher interest rates, the use of derivatives to hedge their interest rate exposures can create material liquidity risk.
Liquidity risks also arise when NBFIs use derivatives and repo to create leverage. These liquidity risks must be managed, as evidenced by the LDI stress seen in September The risks from higher interest rates can also be amplified by NBFIs deleveraging and rebalancing their portfolios.
The FPC will continue to develop its approach to monitoring such risks as the financial system adjusts to higher interest rates.
There continues to be an urgent need to increase resilience in MBF globally. Alongside international policy work led by the FSB, the UK authorities are also working to reduce vulnerabilities domestically where it is effective and practical.
For example, in March , the FPC recommended that The Pensions Regulator TPR take action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest. Since then, both the FCA and TPR have published detailed guidance on LDI resilience.
The FPC welcomes this guidance and the steps taken by TPR and the FCA to ensure the continued resilience of LDI funds.
In recent months as interest rates have risen further, funds have in general maintained levels of resilience consistent with the minimum levels recommended by the FPC in March, and have initiated recapitalisation at higher levels of resilience than previously. The Bank will continue working with the FCA, TPR and overseas regulators to monitor the resilience of LDI funds closely.
The Bank has recently launched its system-wide exploratory scenario SWES exercise, which will be the first exercise of its kind. It aims to improve understanding of the behaviours of banks and non-bank financial institutions in stressed financial market conditions.
It will explore how these behaviours might interact to amplify shocks in financial markets that are core to UK financial stability. In bringing together information from various parts of the financial system to develop system-wide and sector-specific insights, it will be able to account for interactions and amplification effects within and across the financial system that individual financial institutions working alone cannot assess.
The FPC supports the SWES and considers it an important contribution to understanding and addressing vulnerabilities in market-based finance. Since the December Financial Stability Report, global interest rates have risen further.
This reflects actual and expected increases in central bank policy rates in response to continued inflationary pressure. The outlook for global growth has improved slightly, despite stress in the global banking system and continued heightened geopolitical uncertainty.
Although UK growth prospects remain subdued, they have also improved somewhat since December, supported by lower energy prices. UK government bond yields have risen sharply in recent months, mainly reflecting increases in the expected path of Bank Rate given recent inflation outturns. US and European government bond yields have also increased, but by less than UK gilt yields.
The failure of three mid-sized US banks — and the failure of a globally systemically important bank, Credit Suisse, due to long-running concerns about its risk management and profitability — caused a material rise in financial market risk premia and volatility earlier this year.
US bank equity prices fell significantly as a result, and have not recovered. UK and European bank equity prices fell by a smaller amount, and have since partially recovered. Market risk sentiment has since stabilised. But global financial markets remain subject to significant uncertainty, reflecting underlying uncertainties about the outlook for growth, inflation and interest rates.
Volatility in some interest rate markets — such as gilts and short-dated US Treasuries — has been particularly elevated. Global risky asset valuations look broadly in line with their recent historical distributions, with the possible exception of US equities, where certain technology stocks in particular are highly valued relative to historical distributions.
However, given the current level of macroeconomic uncertainty, there is a risk that further unanticipated increases in market interest rates and interest rate volatility, or a deterioration in the economic outlook, could lead to sharp reductions in risky asset prices, further tightening financial conditions for UK households and businesses.
Global interest rates have risen further as inflationary pressure has continued, but the outlook for global growth has improved slightly. Since the December FSR, the global outlook for growth has improved slightly, despite stress in the global banking system and continued heightened geopolitical uncertainty.
But global growth is still expected to remain subdued, and risks to the outlook remain. UK growth prospects also remain subdued.
UK and European wholesale gas spot prices are around a quarter of the level seen at the time of the December FSR. However, despite lower energy prices in the UK and Europe, global inflationary pressures have continued.
Central bank policy rates in advanced economies have increased in response. The market-implied near-term path for UK Bank Rate has increased further since the December FSR, and is now expected to peak at around 6.
Yields on year UK government bonds have risen sharply since the December FSR, particularly in May. This mainly reflects increases in market expectations for the path of Bank Rate given recent inflation data.
Yields on US and European government bonds are also higher than at the time of the December FSR, but have increased by less than UK gilt yields Chart 1. Changes in year government bond yields since the beginning of At the beginning of , stronger risk appetite was evident in credit markets, but volatility in rates markets had remained elevated.
Stronger risk appetite had been evident in movements in global corporate bond and leveraged-loan spreads at the start of Liquidity in UK gilt markets had largely recovered from the disruption in Autumn Chart 1. But volatility in interest rates markets remained elevated globally Chart 1. In part, this reflected the fact that uncertainty over the path of policy rates remained high.
Five day average of Merrill Lynch Option Volatility Estimate for interest rates MOVE index a. US bank equity prices fell following the failure of three US banks, impacting wider financial markets. In the first half of this year, three US banks — Silicon Valley Bank SVB , Signature Bank, and First Republic Bank — failed, following substantial deposit outflows prompted by concerns over poor management of interest rate risk and liquidity risk.
Credit Suisse, which had previously experienced a series of risk-management, business model and profitability concerns, came under renewed pressure, and was ultimately taken over by UBS, following an intervention by the Swiss authorities see Section 4.
Aggregate US bank equity prices fell sharply following these events. Following this stress — and against a backdrop of broader market uncertainty — there was a material increase in spreads on high-yield and investment-grade corporate bonds and leveraged loans Chart 1.
Credit default swap index spreads also widened. Volatility in equities, and credit markets increased sharply, and remained somewhat elevated due the uncertainty around the raising of the US government debt ceiling, which has since been resolved.
Gilt market liquidity conditions became more challenging during this period given broader volatility in financial markets.
Global bank equity price indices a. Current levels of credit spreads as a percentile of historical values a b c. Market conditions have partly recovered from the disruption in March, but global financial markets remain subject to significant uncertainty around interest rates, related to the outlook for growth and inflation.
US bank equity prices have failed to recover from the March stress Chart 1. Meanwhile, European and UK bank equity prices have partly recovered. Spreads on corporate bonds have also partly retraced to lower levels. That said, spreads are still slightly elevated and risky debt issuance is subdued, especially in the leveraged-loan market, which may reflect a lasting increase in risk aversion among investors.
If the economic outlook were to deteriorate, then spreads could widen sharply again. Volatility in equity and credit markets has fallen back, but remains high in some rates markets — particularly for gilts and shorter-dated US treasuries — reflecting uncertainty in the expected path of global growth and inflation Chart 1.
Since March, gilt market liquidity conditions have improved overall, but bid-ask spreads for year UK gilts have remained somewhat elevated Chart 1.
Global equity market valuations look broadly in line with their recent historical distributions. So far, equity prices have been largely resilient to the recent increases in global interest rates.
The UK stock market has been broadly flat. In Europe, the equity market gains have been more broad-based, supported by recent falls in energy prices. Excess cyclically adjusted price-to-earnings CAPE yield — a measure of the excess return that investors expect from equities relative to risk-free investments — on US equities is now around the lowest it has been since before the global financial crisis, driven in large part by the recent gains among large technology companies.
However, valuations appear less stretched relative to a longer time series Chart 1. Nonetheless, if market participants were to re-evaluate materially the prospects for growth, inflation or interest rates, this could lead to sharp reductions in asset prices, further tightening financial conditions for households and businesses.
Higher interest rates combined with an uncertain outlook for growth can trigger a revaluation of asset prices. A sharp reduction in asset values could also directly affect the financial system; for example through direct losses on asset holdings; by reducing the value of collateral securing existing loans; or by creating sharp increases in the demand for liquidity.
Any such moves could be amplified by vulnerabilities in market-based finance, and would tighten financial conditions for UK households and businesses. Since the s, many countries around the world have achieved the positive effects of rapid financial industry growth owing to the progress of financial liberalization.
At the same time, however, they have also experienced periods of dramatic slowdown in economic growth, due to heavy economic expenses arising from financial instability or financial crises.
Against this backdrop, many countries have started to place great emphasis on financial stability when implementing their policies. Attention paid to financial stability is growing, as new factors with the potential to generate financial instability, including the strengthening of financial sector links among countries and the rampant development of complex financial instruments, have recently emerged.
But a new IMF working paper highlighted the potential for rising tensions to drive outflows of cross-border capital, including direct investment, from countries, with particularly high risks for developing and emerging market economies. Such7 stability risks are driven through financial channels, IMF researchers said in the paper, prepared for next week's IMF and World Bank spring meeting as part of the Global Financial Stability Report.
Financial stability is expected to be a major topic at the meetings after recent banking system turmoil, marked by the failures of Silicon Valley Bank and Signature Bank in the U. and Switzerland's forced sale of Credit Suisse to rival UBS UBSG.
S , opens new tab. The paper cited research using the U. This, in turn could lead to banks cutting lending, reducing economic growth in the real economy and feeding back into more financial instability, the fund said. To curb the risk of potentially destabilizing fallout from geopolitical events, the IMF said banking supervisors, regulators and financial institutions should use stress tests and scenario analysis to better understand how rising tensions could be transmitted to the financial system.
It said policy makers should strengthen crisis management frameworks by ensuring cooperative arrangements between national and regional authorities.
Concerns over heavy reliance on uninsured deposits, declining fair values of long-duration fixed-rate assets associated with higher interest A stable financial system is capable of efficiently allocating resources, assessing and managing financial risks, maintaining employment levels close to the Overall, estimated runnable money-like financial liabilities increased percent to $ trillion. (75 percent of nominal GDP) over the
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