Bank of England – Page 19 – Digital Finance Analytics (DFA) Blog

UK Macroprudential Update

The Bank of England just released their latest Financial Stability report. Within the document there is a section on the implementation of macroprudential measures relating to mortgage lending. This makes an interesting contrast with the Australian Regulatory framework.

Mortgage affordability test – Implemented: When assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, Bank Rate were to be 3 percentage
points higher than the prevailing rate at origination.

Loan to income limit – Implemented: The PRA and the FCA should ensure that mortgage lenders do not extend more than 15% of their total number of new residential mortgages at loan to income ratios at or greater than 4.5. This Recommendation applies to all lenders which
extend residential mortgage lending in excess of £100 million per annum.

Powers of Direction over leverage ratio – Action under way: The FPC recommends that HM Treasury exercise its statutory power to enable the FPC to direct, if necessary to protect and enhance financial stability, the PRA to set leverage ratio requirements and buffers for PRA-regulated banks, building societies and investment firms, including:

a minimum leverage ratio requirement to remove or reduce systemic risks attributable to unsustainable leverage in the financial system;
a supplementary leverage ratio buffer that will apply to G-SIBs and other major domestic UK banks and building societies, including ring-fenced banks to remove or reduce systemic risks attributable to the distribution of risk within the financial sector;
a countercyclical leverage ratio buffer to remove or reduce systemic risks attributable to credit booms — periods of unsustainable credit growth in the economy.

The Government intends to lay the final legislation before Parliament in early 2015, alongside publishing a consultation response document and impact assessment. As with the housing instruments, the FPC intends to issue a draft Policy Statement in early 2015 to inform the Parliamentary debate.

HM Treasury intends to consult separately on LTV/interest coverage ratio powers for the buy-to-let sector in 2015, with a view to building further evidence on how the UK buy-to-let housing market may pose risks to financial stability.

Results of UK Bank’s Stress Tests

The Bank of England announced the results of the first concurrent stress testing exercise of the UK banking system. Alongside the stress test publication, the Bank of England also published its Financial Stability Report, which sets out the Financial Policy Committee’s (FPC) assessment of the outlook for the stability and resilience of the financial sector, and the Systemic Risk Survey, which quantifies and tracks market participants’ perceptions of systemic risks.

Following on from the EU-wide stress test, the 2014 UK stress test of the eight major UK banks and building societies was designed specifically to assess their resilience to a very severe housing market shock and to a sharp rise or snap back in interest rates. This was not a forecast or expectation by the Bank of England regarding the likelihood of a set of events materialising, but a coherent, severe ‘tail risk’ scenario.

The eight banks and building societies tested as part of this exercise were Barclays Bank, Co-operative Bank, HSBC Bank, Lloyds Banking Group, Nationwide Building Society, Royal Bank of Scotland, Santander UK and Standard Chartered.

There was substantial variation across the banks and building societies in terms of the impact of the stress scenario. From an individual-institution perspective, the Prudential Regulation Authority (PRA) Board judged that this stress test did not reveal capital inadequacies for five out of the eight participating banks, given their balance sheets at end-2013 (Barclays, HSBC, Nationwide, Santander UK and Standard Chartered). The PRA Board did not require these banks to submit revised capital plans.

Following the stress testing exercise, the PRA Board judged that, as at end-2013, three of the eight participating banks (Co-operative Bank, Lloyds Banking Group and Royal Bank of Scotland) needed to strengthen their capital position further. But, given continuing improvements to banks’ resilience over the course of 2014 and concrete plans to build capital further going forward, only one of these banks (Co-operative Bank) was required to submit a revised capital plan.

The FPC considered the information provided by the stress-test results from the perspective of the resilience of the UK banking system as a whole. The FPC noted that only one bank fell below the 4.5% threshold at the trough of the stress scenario, that the capitalisation of the system had improved further over the course of 2014 and that the PRA Board had agreed plans with banks to build capital further. Overall, the FPC judged that the resilience of the system had improved significantly since the capital shortfall exercise in 2013. Moreover, the stress-test results and banks’ capital plans, taken together, indicated that the banking system would have the capacity to maintain its core functions in a stress scenario. Therefore, the FPC judged that no system-wide, macroprudential actions were needed in response to the stress test.

Projected CET1 capital ratios in the stress scenario

	Actual (end 2013)	Minimum Stressed ratio (before the impact of ‘strategic’ management actions)	Minimum Stressed ratio (after the impact of ‘strategic’ management actions)	Actual (latest, Q2 or Q3 2014)
Barclays	9.1%	7.0%	7.5%	10.0%
Co-operative Bank Plc	7.2%	-2.6%	-2.6%	11.5%
HSBC Bank Plc	10.8%	8.7%	8.7%	11.2%
Lloyds Banking Group	10.1%	5.0%	5.3%	12.0%
Nationwide Building Society	14.3%	6.1%	6.7%	17.6%
Royal Bank of Scotland	8.6%	4.6%	5.2%	10.8%
Santander UK	11.6%	7.6%	7.9%	11.8%
Standard Chartered Plc	10.5%	7.1%	8.1%	10.5%

Central Bank Psychology

Andrew Haldane, Chief Economist of the Bank of England, will be speaking at the Royal College of Medicine conference on Leadership: stress and hubris. He will discuss how psychological biases can affect policy making, and how the institutional design of policy making committees at the Bank of England have been designed to counteract those effects.

In the speech, Andrew highlights four “cognitive ticks that can affect human decision making” that may be relevant for public policy making:

Preference biases – where the decision maker might put “personal objectives over societal ones, such as personal power or wealth”

Myopia biases – “people differ materially in their capacity to defer gratification” and studies suggest that people who show greater patience “outperform their impatient counterparts in everything from school examinations, to salaries, to reported life satisfaction”.

Hubris biases – over-confident individuals are “more likely to be promoted to positions of influence” but tend to pursue “over ambitious targets” like “undertaking over-complex company takeovers. That way nemesis lies”

Groupthink biases – people tend to adapt their view to confirm to those around them and also have a “tendency to search and synthesize information in ways which confirm their prior beliefs”.

Andrew then shows how policy making at the Bank of England has been organised to try to protect from these biases.

To tackle preference bias, the Bank’s does not set its own objectives. It has three policy making committees – for monetary policy (MPC), financial policy (FPC) and prudential regulation (PRA Board). In addition, “to ensure the actions of the Bank’s policy committees are well-aligned with society’s wishes” their targets are “set ex-ante in legislation by Parliament acting on behalf of society”.

To prevent myopia, the Bank of England has been made independent from government when choosing how to set monetary and financial policy to achieve their respective objectives. These decisions have been given to an institution “whose time horizon stretches beyond the political cycle”. Andrew suggests that central bank independence has been successful at taming “the inflation tiger” but he warns that “as some countries are finding today, the tiger is capable of biting back” in the form of low and falling inflation expectations. Andrew notes that while inflation expectations in the UK have held up pretty well, this is something he is “watching like a dove.”

To guard against Hubris at the Bank, “all policy decisions … are made by Committee rather than an individual” which “provides some natural safeguard against over-confidence bias”. Andrew notes that external MPC members have contributed importantly to the diversity of opinion on the committee “on average they have been around twice as likely as internals to dissent from monetary policy decisions”.

Finally to ward off groupthink, each member of the policy committees is individually accountable for their vote or view, and this should encourage “a variety of analytical perspectives”. That said Andrew notes that analysis of MPC minutes suggests that they did not devote enough time to discussing banking issues in the run up to the financial crisis, something that in hindsight, “looks like a collective analytical blind-spot”. He argues that despite all the changes to the Bank’s policy responsibilities since the crisis, “it is too soon to tell whether any remaining blind-spots remain”. Also, in his view “improvements to the Bank’s forecasting process have some considerable distance still to travel”.

Andrew concludes by highlighting a key new development at the Bank – a “cultural revolution” for bank research work. Rather than being used solely to “nourish and support the Bank’s policy thinking”, as has typically been the case in the past, future Bank research will instead be published that challenges the policy orthodoxy as often as supports it . “This research will hopefully act as spur and springboard for new policy thinking”. “It will act as another hopefully powerful, bulwark against over-confidence biases and groupthink.

Managing Global Finance As A System

Andrew Haldane, Chief Economist of the Bank of England, gave the annual Maxwell Fry lecture on Global Finance at Birmingham University. There are some powerful observations here, relevant to the Australian context, as well as the potential to amplify risks associated with a more interconnected world. He also takes macroprudential discussions further.

Andrew’s main theme was the growing size and complexity of global capital flows between countries. He noted that ‘cross-border stocks of capital are almost certainly larger than at any time in human history’. And the apparent independence of domestic investment from domestic saving suggests that ‘measured levels of global capital market integration … remain at higher levels than at any point in history’. He discussed how this can be ‘double-edged’ from a financial stability perspective: it both shares risk (which can be stabilising) but also spreads and amplifies risk (which can be destabilising) – potentially generating ‘more frequent and/or larger dislocations’.

He argued that many lessons have been learned from the financial crisis, not least the need to ‘safeguard against systemic risk’. Yet when it comes to the fortunes of the international monetary system ‘it is far from clear that these lessons have been learned, much less that the international rules of the road have been reformed’. ‘Arguably, the rules of the road for this system have failed to keep pace with the growing scale and complexity of global financial flows’.

One of the consequences of the growth in cross border capital flows is ‘the steady rise in the degree of co-movement in asset prices over time’. Cross-border spillovers are becoming more important and global common factors more potent. A particular example is the behaviour of yield curves across countries. ‘To a first approximation, global yield curves appear these days to be dancing to a common tune’.

Andrew identified four areas where the global financial system could be strengthened:

a) Improve global financial surveillance, by tilting IMF surveillance away from monitoring individual country risk and towards multilateral surveillance and having more real-time tracking of the global flow of funds.

b) Improve country debt structures, for example by encouraging countries to issue GDP linked bonds, or Contingent Convertible (CoCo) bonds.

c) Enhance macro-prudential and capital flow management policies. For example, he suggests that ‘total credit follows a global cycle that has strengthened over time’ in which case ‘there may in future be a case for national macro-prudential policies leaning explicitly against these global factors’ taking international macro-prudential policy co-ordination ‘to the next level’. This next phase of macro-prudential policy may see measures ‘targeted at particular markets, as well as particular countries’.

d) Improve international liquidity assistance, for example by increasing the resources available to the IMF.

UK Bank Write-Downs Normalising

The Bank of England just released their latest datapacks. One interesting view is the loss trends reported by Banks and Building Societies.

The chart (shown by value) highlights the significant issues in credit cards amongst the UK banks in 2010/2011, and by contrast shows the value of write-offs from dwellings has been lower and more stable.

Losses are more normalised now, showing the UK economy is beginning to heal. But a case study in what happens in a significant financial crisis to household write-offs, and the relative risks of secured and unsecured lending.

The UK’s “Twin Peaks”

Speaking at the Kenilworth Chamber of Trade business breakfast event Andrew Haldane, the Chief Economist of the Bank of England, discussed developments in the labour market, and the implications for monetary policy in the United Kingdom. His perspective is important and relevant in the Australian context.

The main messages of Andrew’s speech are:

In June, as he made clear in a speech, he put even weight on moving interest rates sooner (which he termed being ‘on the front foot’) and moving interest rates later (being on the back foot). Three months on, the statistics now appear to favour the back foot.
Recent evidence, in the UK and globally, has shifted Andrew’s views about the likelihood of weaker outcomes. That reflects markdowns in global growth prospects and weak pipeline inflationary pressures, both from wages and prices internally, and energy and commodity prices externally. He is gloomier about demand and sees inflationary forces weakening in the near term. This implies that interest rates could remain lower for longer than he had expected three months ago, without endangering the inflation target.
Turning to the performance of the UK economy, Andrew notes various reasons to be cheerful: ‘growth at the top of the G7 league table’ and ‘well balanced between consumption and investment’; ‘borrowing costs at exceptionally low levels’; ‘employment up 1.8 million since its trough’ and unemployment falling from 8.4% to 6%, and expected to fall further. The combination of GDP growth, inflation and unemployment suggests that the economy is in ‘fine fettle’ and has only been bettered in 5 of the last 44 years.
But looking at a different set of indicators suggests ‘reasons to be fearful’. ‘Growth in real wages has been negative for all bar three of the last 74 months’. ‘The level of productivity is no higher than it was six years ago’. And real interest rates are around zero. This combination of poor economic outcomes is ‘virtually unprecedented going back to the late 1800s, with the exception of the aftermath of the world wars and the early 1970s.’
Andrew concludes that the economy appears to be ‘writhing in both agony and ecstasy. It is twin peaked’.
Looking forward he suggests that the key issue is which of these twin forces will win out. The Monetary Policy Committee’s forecast suggests that by 2017, ‘productivity growth and real wage growth are back to around 2% and real household deposit rates are in positive territory’ or in other words ‘the sun will come out tomorrow’. But Andrew notes that such forecast have been confounded in the past, and he also notes that the low level of expected real interest rates implied in the UK’s yield curve may reflect pessimistic assumptions about future growth prospects.
Turning to the labour market he finds more evidence of polarising patterns: ‘the upper peak of the labour market is clearly thriving in both employment and wage terms. The mid-tier is languishing in both employment and real wage terms. And for the lower skilled, employment is up at the cost of lower real wages for the group as a whole’.
Turning to the implications for interest rates, he suggests that financial market participants must weigh up the likelihood of the UK taking a strong path or a weak path – the twin peaks he has been discussing. ‘Over the past few months, the implied path for interest rates has shifted down’. ‘One interpretation of that move is the market now assigning a somewhat higher probability to the lower peak’. That is also his own assessment of how the balance of risks has shifted.

Macroprudential Bites in the UK – Bank of England

The Bank of England (BoE) recently published their Q3 Credit Conditions Survey. This is the first edition since the recent Mortgage Market reforms were introduced, and the macroprudential controls were tabled. Looking specifically at secured lending to households they report that demand for credit has eased, and the proportion of higher loan to value loans has reduced. In other words macroprudential is biting!

After eight consecutive quarters of expansion, lenders reported that the availability of secured credit to households fell significantly in the three months to early-September.

The contraction in overall availability was reported to be driven by a changing appetite for risk and lenders’ expectations about house prices. Many lenders noted that operational issues associated with the implementation of the Mortgage Market Review had pushed down on credit availability over the summer. And some lenders commented that they had tightened availability a little in response to the recommendations made by the Financial Policy Committee to mitigate risks stemming from the housing market.

Credit availability was reported to have fallen in Q3 both for borrowers with loan to value (LTV) ratios below 75% and for borrowers with LTV ratios above 75%. Lenders also reported that they had become less willing to lend at LTV ratios above 90% for the first time since the question was introduced in 2013, and some noted that they had introduced policies which restrict lending at high loan to income (LTI) ratios.

Consistent with a tightening in credit availability, credit scoring criteria for granting household loan applications were reported to have tightened in Q3 and the proportion of household loan applications being approved fell.