The Bank of England’s Financial Policy Committee (FPC) assesses the outlook for financial stability by identifying the risks faced by the financial system and weighing them against the resilience of the system. In doing so, its aim is to ensure the financial system can continue to provide essential services to the real economy, even in adverse circumstances. In today’s release, they highlight financial stability risks, raise the counter-cyclical capital buffer in 2017 and underscore potential threats to financial stability from rapid growth in buy-to-let mortgage lending.
The FPC judges that the outlook for financial stability in the United Kingdom has deteriorated since it last met in November 2015. Some pre-existing risks have crystallised, drawing on the resilience of the system. Other risks stemming from the global environment have increased. Domestic risks have been supplemented by risks around the EU referendum. Weighed against these developments, the resilience of the core banking system has improved further since November 2015, though investor expectations of future profitability have weakened, with possible implications for banks’ ability to build resilience in the future. In some financial markets, underlying liquidity conditions have continued to deteriorate.
In December, the Committee signalled its intention to set the UK countercyclical capital buffer rate in the region of 1% in a standard risk environment. Consistent with the Committee’s assessment of the current risk environment, and its intention to move gradually, the Committee has decided to increase the UK countercyclical capital buffer rate from 0% to 0.5% of risk-weighted assets. This new setting will become binding with effect from 29 March 2017, at which time the overlapping aspects of Pillar 2 supervisory capital buffers will be lifted. This will increase transparency and sharpen the incentives of the buffer system.
The FPC also took account of the review by the PRA Board of the overlap between the risks captured by current supervisory capital buffers and a positive UK countercyclical capital buffer. Following its review, the PRA Board has concluded that existing Pillar 2 supervisory capital buffers should be reduced, where possible, by the full 0.5% UK countercyclical capital buffer. This is a one-off adjustment reflecting the transition to the new capital framework and will take place when the new setting of the UK countercyclical capital buffer rate comes into force in March 2017.
The removal of any overlap means that banks accounting for around three quarters of the outstanding stock of UK lending will not see their overall regulatory capital buffers increase as a result of the UK countercyclical capital buffer rate being increased to 0.5%. Other banks will effectively have the period over which they must meet new requirements extended. This will be documented in a forthcoming statement by the PRA Board. The FPC’s action will raise the future regulatory capital buffer of some banks, including many smaller banks that have contributed around half of the increase in net lending to the real economy over the past year. Almost all of these banks currently carry capital in excess of the 2019 Basel III requirements and the 0.5% UK countercyclical capital buffer. The FPC recognises that these banks may wish to build capital over time in order to retain some excess over regulatory capital buffers, but their current position means that any such action will be able to take place gradually.
The UK countercyclical capital buffer rate will apply to all UK banks and building societies and to investment firms that have not been exempted by the Financial Conduct Authority. Under European Systemic Risk Board rules, it will apply to branches of EU banks lending into the United Kingdom. The FPC will work with other authorities to achieve reciprocity, consistent with its own policy on reciprocity.
The Committee assesses the risks around the referendum to be the most significant near-term domestic risks to financial stability. It will continue to monitor the channels of risk closely and support mitigating actions where possible. In that regard, the FPC has considered the results of the 2014 stress test of major UK banks, which incorporated an abrupt change in capital flows, a sharp depreciation of sterling, a marked increase in unemployment and a prolonged recession. The results of that test, when combined with revised bank capital plans, suggested that the banking system was strong enough to continue to serve households and businesses during the severe shock1. Since then, UK banks’ resilience has increased further.
The FPC remains alert to potential threats to financial stability from rapid growth in buy-to-let mortgage lending. The outstanding stock of buy-to-let mortgages has risen by 11.5% in the year to 2015 Q4. The macroprudential risks centre on the possibility that buy-to-let investors could behave pro-cyclically, amplifying cycles in the housing market, as well as affecting the resilience of the banking system and its capacity to sustain lending to the wider real economy in a stress.
Overall, the Committee judges that, although measures of bank resilience have improved since November 2015, investors expect weaker future profitability.
Measures of bank resilience have continued to strengthen. Major UK banks’ aggregate common equity Tier 1 (CET1) ratio has increased further, to 12.6% at end-2015. The aggregate Tier 1 capital ratio of major UK banks reached 13.8% and the Tier 1 leverage ratio reached 4.8% – both a little higher than the FPC’s view of the steady state capital requirements for the major UK banks as currently measured3.
At the same time, investors expect future bank profitability to be weaker. UK bank share prices have fallen by around 15% since November 2015, though there are significant differences in expectations of performance across bank business models. If expectations of weaker earnings were to materialise, the future capacity of the system to withstand shocks through internal capital generation would be reduced.
