Although financial conditions have returned to normal situation following the banking crisis between March and April, credit conditions are still stringent than the pre-crisis period. However, there is widespread confidence in ability of Britain to survive financial crisis, as implied in a recent report by the Bank of England.
Parts of the global financial system remain susceptible to potential strains, which stem from several factors such as a deteriorating economic outlook, persistent high inflation, and geopolitical tensions.
During the earlier part of this year, the United States witnessed the collapse of three mid-sized banks, including Silicon Valley Bank, and Switzerland experienced the failure of a large bank, Credit Suisse. Fortunately, these global banking challenges did not have any enduring impacts on banks in the United Kingdom.
Nevertheless, in recent months, central banks worldwide have been taking action to address ongoing inflation concerns, resulting in a continued rise in interest rates. The future trajectory of interest rates remains uncertain.
Financial Crisis that Persists in England
The increase in interest rates has posed difficulties for households and businesses across many countries in managing their debt obligations. Certain sectors, such as heavily indebted businesses and global commercial property markets, face specific challenges in this regard.
UK households are encountering challenges due to rising living costs and higher interest rates. As fixed-rate mortgage agreements come to an end and households renew their mortgages, the average cost of mortgage payments will continue to rise.
While the percentage of income that UK households spend on mortgage payments is predicted to increase, it is anticipated to remain below the levels reached during the Global Financial Crisis and the early 1990s.
UK banks are well-positioned to assist customers facing payment difficulties, which should result in fewer defaults compared to previous periods when borrowers were under pressure.
In 2014, the FPC implemented regulations that have also aided in limiting the accumulation of risk in the mortgage market.
The proportion of businesses in the UK allocating a significant portion of their income to servicing their debts is also expected to rise this year, although it should still be lower than previous peaks. Overall, UK businesses are projected to remain largely resilient as the impact of higher interest rates materializes, but smaller and heavily indebted businesses may face heightened pressure.
Steps by Banks to Solve the Financial Crisis that Persists in England
The possibility of higher interest payments on loans presents a challenge as some households and businesses may struggle to meet their payment obligations, thereby increasing the potential risks for banks. However, UK banks are well-prepared and resilient enough to continue supporting households and businesses even in the face of higher interest rates. They have substantial capital buffers in place to absorb any losses.
Although some households and businesses have experienced increased pressure, there hasn’t been a significant rise in borrowers defaulting on loan payments thus far. The impact of higher interest rates on the economy is a gradual process, and its full effects are yet to be fully felt by households and businesses.
To ensure the stability of the banking system, BOE recently conducted a stress test on major UK banks using a severe scenario that was worse than the expected economic outlook. This stress test included unfavorable conditions such as an unemployment rate of 8.5%, inflation reaching 17%, and a decline of 31% in house prices. The results demonstrated that the UK banking system remains resilient and capable of supporting households and businesses, even under such extreme circumstances.
As borrowing costs have risen, there has been a decrease in the demand for loans. However, banks are not excessively reducing the availability of credit in a manner inconsistent with the creditworthiness of borrowers.
To provide additional protection, the economists regularly set the countercyclical capital buffer (CCyB) rate for UK banks. This buffer serves as a contingency reserve, enabling banks to withstand potential losses without impeding lending to the broader economy. Currently, the UK CCyB rate is maintained at 2%.
How to Make Non-Banking Institutions More Resilient?
Market-based finance plays a crucial role in providing funding for UK companies. Many businesses in the UK rely on financial markets to raise capital, and any disruption to these markets can lead to increased borrowing costs for both households and businesses. Therefore, it is vital for the stability of the UK financial system that these markets function effectively, even during challenging times. BOE is actively involved in the development of global standards aimed at minimizing vulnerabilities in the non-bank participants of these markets.
Despite progress, there are still vulnerabilities in market-based finance that may become more apparent as interest rates rise. For instance, sudden interest rate fluctuations can create liquidity difficulties for non-bank entities, as demonstrated by the disruption in the liability-driven investment sector in September 2022, which subsequently affected the UK government bond market. Such episodes can drive up borrowing costs.
There is there is widespread confidence in ability of Britain to survive financial crisis. Enhancing resilience remains a pressing need. Many firms involved in market-based finance are not subject to regulation by the Bank of England. To address this, experts are collaborating with other regulatory authorities to establish appropriate regulations and oversight.
In response to the interest rate challenges experienced by liability-driven investment (LDI) funds in late 2022, the Financial Policy Committee issued recommendations in March to bolster the resilience of these funds against interest rate shocks. Subsequently, the regulatory authorities responsible for overseeing these funds have published new guidelines in this area.
Moreover, economists have initiated a stress test that evaluates the behavior of both banks and non-banks in financially strained conditions. This recently launched exploratory scenario will provide valuable insights to help them better comprehend and address vulnerabilities in market-based finance.
Source: Bank of England Report