Tag: Bank of England

UK Regulators Worry About 17% Housing Investment Loans

The latest Financial Stability report released by the Bank of England provides insights into the UK mortgage market, and some of the concerns the regulators are addressing. Of note is the information on “Buy-to-Let” loans, or Investment Mortgage Loans. Most striking is the strong concerns expressed about the rise to 17% of all loans being for this purpose. In Australia, by comparison, 35% of housing loans are for investment purposes. We also look at household debt ratios and countercyclical buffers.

Buy-to-let mortgage lending has driven mortgage lending growth in recent years.  Seventeen per cent of the stock of total secured lending is now accounted for by buy-to-let mortgages, and the gross flow of buy-to-let lending in 2015 was close to its pre-crisis peak.

The PRA conducted a review of underwriting standards in the buy-to-let mortgage market between November 2015 and March 2016. It reviewed the lending plans of the top 31 lenders in the industry, who account for over 90% of total buy-to-let lending. A number of lenders planned to increase their gross buy-to-let lending significantly, with overall planned lending in the region of £50 billion.

UK-BuytoLetGiven competition in the sector, this strong growth profile raises the risk that firms could relax their underwriting standards in order to achieve their plans. The review further highlighted that some lenders were already applying underwriting standards that were somewhat weaker than those prevailing in the market as a whole.

The draft Supervisory Statement aims: to ensure that buy-to-let lenders adhere to a set of minimum expectations around underwriting standards; and, to prevent a marked loosening in underwriting standards. It also clarifies the regulatory capital treatment of certain buy-to-let exposures.

At its March meeting, the FPC welcomed and supported the draft Supervisory Statement. The Supervisory Statement reflects microprudential objectives, aiming to reduce the risk that buy-to-let lenders make losses that can threaten their safety and soundness. From a macroprudential perspective, policies that prevent a slippage in buy-to-let underwriting standards should also reduce the threat of buy-to-let lending amplifying wider housing market risks. The FPC discussed that, although the 200 basis points increase in buy-to-let mortgage rates was lower than the interest rate stress applied to owner-occupied lending under the FPC’s June 2014 Recommendation, lenders tended to assess affordability for buy-to-let mortgages using interest cover ratios of at least 125%. In addition, loan-to-value ratios at origination in excess of 75% were less common in buy-to-let mortgages than in owner-occupied mortgages. Buy-to-let loans therefore typically started with a larger equity cushion for lenders, which reduced the associated credit risk in the first few years of the loan given that these loans were typically non-amortising. The FPC considered that no action beyond this was warranted for macroprudential purposes at that time. It will continue to monitor developments and potential threats to financial stability from the buy-to-let mortgage market closely, and stands ready to take action.

Another piece of data in the report is the household indebtedness. Worth comparing this with the RBA chart we highlighted yesterday, where the ratio in Australia is north of 175%.

UK-DebtMore broadly, The Stability Report highlighted the risks to the UK economy, especially around Brexit. The webcast is worth listening to.

Of note is that fact that the regulators reduced the UK countercyclical capital buffer rate from 0.5% to 0% of banks’ UK exposures
with immediate effect, reflecting heightened risk and the wish to encourage banks to lend.  Australia already has a zero percent buffer.

The FPC is reducing the UK countercyclical capital buffer rate from 0.5% to 0% of banks’ UK exposures with immediate effect. Absent any material change in the outlook, and given the need to give banks the clarity necessary to facilitate their capital planning, the FPC expects to maintain a 0% UK countercyclical capital buffer rate until at least June 2017. This action reinforces the FPC’s view that all elements of the substantial capital and liquidity buffers that have been built up by banks are able to be drawn on, as necessary, to allow them to cushion shocks and maintain the provision of financial services to the real economy, including the supply of credit and support for market functioning.

It will reduce regulatory capital buffers by £5.7 billion. For a banking sector that, in aggregate, targets a leverage ratio of 4%, this raises their capacity for lending to UK households and businesses by up to £150 billion.

In March, the FPC had begun to supplement regulatory capital buffers with the UK countercyclical capital buffer. This reflected its assessment that the risks the system could face were growing and additional capital was needed that could be released quickly in the event of an adverse shock.

At that time, the FPC judged that risks associated with domestic credit were no longer subdued, as they had been in the period following the financial crisis, and global risks were heightened. The Committee raised the UK countercyclical capital buffer rate to 0.5% and signalled its expectation that it would increase it further, to 1%, if the risk level remained unchanged. As set out in this Report, a number of economic and financial risks are materialising. The FPC strongly expects that banks will continue to support the real economy, by drawing on buffers as necessary.

Consistent with the FPC’s leverage ratio framework, the countercyclical leverage ratio buffer rate will also fall.

The Committee’s decision in March to raise the UK countercyclical capital buffer rate to 0.5% was due to take effect formally from 29 March 2017. However, as the Committee explained in March, there is an overlap between the risks captured by existing PRA supervisory capital buffers and a positive UK countercyclical capital buffer rate of 0.5%. The PRA Board concluded in March 2016 that, to ensure there is no duplication in capital required to cover the same risks, existing PRA supervisory buffers of PRA-regulated firms should be reduced, as far as possible, to reflect a UK countercyclical capital buffer rate of 0.5%, when such a rate came into effect.

The FPC has therefore accompanied its decision to reduce the UK countercyclical capital buffer rate with a Recommendation to the PRA that it bring forward this planned reduction in PRA supervisory capital buffers.

Recommendation: The FPC recommends to the PRA that, where existing PRA supervisory buffers of PRA-regulated firms reflect risks that would be captured by a UK countercyclical capital buffer rate, it reduce those buffers, as far as possible and as soon as practicable, by an amount of capital which is equivalent to the effect of a UK countercyclical capital buffer rate of 0.5%.

The PRA Board has agreed to implement this Recommendation. This means that three quarters of banks, accounting for 90% of the stock of UK economy lending, will, with immediate effect, have greater flexibility to maintain their supply of credit to the real economy. Other banks will no longer see their regulatory capital buffers increase over the next nine months, increasing their capacity to lend to UK households and businesses too.

Consistent with this, the FPC supports the expectation of the PRA Board that firms do not increase dividends and other distributions as a result of this action.

UK Banking Risks Escalate

The Bank of England has released the latest edition of The Systemic Risk Survey, which is conducted by the Bank of England on a biannual basis, to quantify and track market participants’ views of risks to, and their confidence in, the stability of the UK financial system. This report presents the results of the 2016 H1 survey which was conducted between 11 April and 29 April.

UK-RisksProbability of a high-impact event and confidence in the UK financial system

  • The perceived probability of a high-impact event in the UK financial system over the short term has risen considerably. The
    perceived probability of such an event over the medium term has increased slightly. 56% (+46 percentage points since the
    2015 H2 survey) of respondents now consider the probability of a high-impact event as high or very high over the next year;
    37% (+6 percentage points) between one and three years ahead.
  • Confidence in the stability of the UK financial system has fallen since the 2015 H2 survey. Respondents are less likely to judge themselves as very or completely confident (14%, -15 percentage points since the 2015 H2 survey) and more likely as not very confident (10%, +4 percentage points).

Sources of risk to the UK financial system

  • The two risks to the UK financial system most cited by respondents were those of an economic downturn (mentioned by 73% of respondents, +1 percentage point since 2015 H2) and UK political risk, which increased significantly (+46 percentage points to 72%). UK political risk was also identified as the number one source of risk (+61 percentage points to 65%). In the history of this survey only one other risk has ever been identified by a larger proportion of respondents as their number one source of risk.
  • Around half of respondents citing an economic downturn specifically referenced a slowdown in global economic growth,
    rather than a UK-specific slowdown.
  • Almost all respondents that mentioned UK political risk explicitly referenced the possibility of the United Kingdom leaving the European Union.
  • The perceived risk of a cyber attack increased, albeit marginally, for the third consecutive survey to a new survey high
    (+2 percentage points to 48%). The proportion of respondents citing risk of financial market disruption/dislocation fell
    slightly (-7 percentage points to 37%). Perceived risks surrounding the low interest rate environment rose (+13 percentage
    points to 34%). Respondents perceived geopolitical risks to have fallen noticeably (-14 percentage points to 32%). The risks
    around regulation and taxes have increased (+9 percentage points to 28%), driven by concerns over regulation rather than
    taxation.

Risks most challenging to manage as a firm

  • UK political risk was most commonly cited as the risk most challenging to manage. The percentage of respondents
    mentioning this risk increased by 39 percentage points (14% to 53%). Only sovereign risk, in the period between 2011 and
    2013, has ever been perceived as a more challenging risk to manage since this survey began in July 2008.

There Are Limits To Monetary Policy – Carney

In a speech entitled “Uncertainty, the economy and policy“, given by Mark Carney, Governor of the Bank of England, he highlights that waves of uncertainty are washing over the UK economy, and these waves are getting larger. The result of the referendum is clear. Its full implications for the economy are not. But the question is not whether the UK will adjust but rather how quickly and how well. As risks have risen, further monetary policy interventions are likely, but he says there are limits to how much can be achieved with these levers.

CArney-Uncertainty… The decision to leave the European Union marks a major regime shift. In the coming years, the UK will redefine its openness to the movement of goods, services, people and capital. In tandem, a potentially broad range of regulations might change.

Uncertainty over the pace, breadth and scale of these changes could weigh on our economic prospects for some time. While some of the necessary adjustments may prove difficult and many will take time, the transition from the initial shock to the restructuring and then building of the UK economy will be much easier because of our solid policy frameworks.

At times of great uncertainty, households, businesses and investors ask basic economic questions. Will inflation remain under control? Will the financial system do its job?

In recent years, economic uncertainty has been elevated because of fragilities in the financial system and overhangs of public and private debt.

These challenges have been compounded by deeper forces that have radically altered the balance of saving and investment in the global economy. In the process, these have moved equilibrium interest rates into regions that monetary policy finds difficult to reach. Whether called ‘secular stagnation’ or a ‘global liquidity trap’, the drag on jobs, wages and growth is real.

All this uncertainty has contributed to a form of economic post-traumatic stress disorder amongst households and businesses, as well as in financial markets – that is, a heightened sensitivity to downside tail risks, a growing caution about the future, and an aversion to assets or irreversible decisions that may be exposed to future ‘disaster risk’.

Even before 23rd June, we observed the growing influence of uncertainty on major economic decisions. Commercial real estate transactions had been cut in half since their peak last year. Residential real estate activity had slowed sharply. Car purchases had gone into reverse. And business investment had fallen for the past two quarters measured. Given otherwise accommodative financial conditions and a solid domestic outlook, it appeared likely that uncertainty related to the referendum played an important role in this deceleration.

It now seems plausible that uncertainty could remain elevated for some time, with a more persistent drag on activity than we had previously projected. Moreover, its effects will be reinforced by tighter financial conditions and possible negative spill-overs to growth in the UK’s major trading partners.

As the MPC said prior to the referendum, the combination of these influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than set out in the May Inflation Report. In such circumstances, the MPC will face a trade-off between stabilising inflation on the one hand and avoiding undue volatility in output and employment on the other. The implications for monetary policy will depend on the relative magnitudes of these effects.

Today, while the economy is more complex and our models less reliable, the Bank has identified the clouds on the horizon and can see that the wind has now changed direction.

Over the past few months, working closely with the Chancellor and with HM Treasury, we put in place contingency plans for the initial market shocks. They are working well.

Over the coming weeks, the Bank will consider a host of other measures and policies to promote monetary and financial stability.

In short, the Bank of England has a plan to achieve our objectives, and by doing so support growth, jobs and wages during a time of considerable uncertainty.

Part of that plan is ruthless truth telling. And one uncomfortable truth is that there are limits to what the Bank of England can do.

In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock. The future potential of this economy and its implications for jobs, real wages and wealth are not the gifts of monetary policymakers.

These will be driven by much bigger decisions; by bigger plans that are being formulated by others. However, we will relentlessly pursue monetary and financial stability. And by doing so we will facilitate the adjustments needed to realise this economy’s full potential.

 

Statement from the Governor of the Bank of England following the EU referendum result

Statement from the Mark Carney, Governor of the Bank of England

The people of the United Kingdom have voted to leave the European Union. Inevitably, there will be a period of uncertainty and adjustment following this result. There will be no initial change in the way our people can travel, in the way our goods can move or the way our services can be sold. And it will take some time for the United Kingdom to establish new relationships with Europe and the rest of the world.

Some market and economic volatility can be expected as this process unfolds.  But we are well prepared for this.  The Treasury and the Bank of England have engaged in extensive contingency planning and the Chancellor and I have been in close contact, including through the night and this morning. The Bank will not hesitate to take additional measures as required as those markets adjust and the UK economy moves forward. These adjustments will be supported by a resilient UK financial system – one that the Bank of England has consistently strengthened over the last seven years.

The capital requirements of our largest banks are now ten times higher than before the crisis. The Bank of England has stress tested them against scenarios more severe than the country currently faces. As a result of these actions, UK banks have raised over £130bn of capital, and now have more than £600bn of high quality liquid assets. Why does this matter? This substantial capital and huge liquidity gives banks the flexibility they need to continue to lend to UK businesses and households, even during challenging times. Moreover, as a backstop, and to support the functioning of markets, the Bank of England stands ready to provide more than £250bn of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required. We expect institutions to draw on this funding if and when appropriate, just as we expect them to draw on their own resources as needed in order to provide credit, to support markets and to supply other financial services to the real economy. In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses.

Conclusion. A few months ago, the Bank judged that the risks around the referendum were the most significant, near-term domestic risks to financial stability. To mitigate them, the Bank of England has put in place extensive contingency plans. These begin with ensuring that the core of our financial system is well-capitalised, liquid and strong. This resilience is backed up by the Bank of England’s liquidity facilities in sterling and foreign currencies. All these resources will support orderly market functioning in the face of any short-term volatility. The Bank will continue to consult and cooperate with all relevant domestic and international authorities to ensure that the UK financial system can absorb any stresses and can concentrate on serving the real economy. That economy will adjust to new trading relationships that will be put in place over time. It is these public and private decisions that will determine the UK’s long-term economic prospects. The best contribution of the Bank of England to this process is to continue to pursue relentlessly our responsibilities for monetary and financial stability. These are unchanged. We have taken all the necessary steps to prepare for today’s events. In the future we will not hesitate to take any additional measures required to meet our responsibilities as the United Kingdom moves forward.

FinTech – Revolution or Evolution?

FinTech could mean a more open, more transparent, and more democratic global financial system according to Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board,  in a speech “Enabling the FinTech transformation – revolution, restoration, or reformation?”. He also announced the Bank is launching a FinTech Accelerator to work in partnership with FinTech to help harness FinTech innovations for central banking. He concludes that FinTech should neither be the Wild West nor strangled at birth.

The Potential impact of FinTech on financial and monetary stability

FinTech has the potential to affect monetary policy transmission, the safety and soundness of the firms we supervise, the resilience of the financial system, and the nature of shocks that it might face.

It could also have profound implications for the Bank’s secondary objective, as supervisors, to facilitate effective competition between the firms we regulate.

The impact on firms’ safety and soundness depends on several factors. By making wholesale and retail settlement faster and capital allocation more efficient, FinTech could boost banks’ returns and therefore viability.

Already, FinTech is spurring new entrants including payments providers, peer-to-peer lenders, robo advisors, innovative trading platforms, and foreign exchange agents. This could, with time, unbundle traditional banking models and deny banks their traditional economies of scale and scope.

The systemic consequences of FinTech are even more complex. More diverse business models and alternative providers are positives for financial stability. By allowing better credit screening and less adverse selection, FinTech could improve risk assessment, credit allocation, and capital efficiency. But if it encourages herding on common information, trading positions could become more correlated. And if switching costs in funding markets fall, liquidity risk could rise and systemic risks grow.

Indeed, sometimes when I hear of democratising finance, spreading risk in capital-light originate-to-distribute models, I think I haven’t been this excited since the advent of sub-prime.

FinTech could also affect the conduct of monetary policy. Unbundled banking would change the roles of bank capital and funding costs in the credit channel of monetary policy. If FinTech enhances participation in financial markets, the wealth channel of monetary policy could strengthen.

More broadly, Big Data techniques could tell us about the state of the economy more accurately and promptly. Forecast performance could improve, akin to the forecast improvements that better measurement of atmospheric conditions has, over time, delivered for meteorologists.

My own forecast is that FinTech’s consequences for the Bank’s objectives will not become fully apparent for some time. Many of the technologies needed to deliver such transformations are nascent – their scalability and compatibility untested beyond Proofs of Concept. Moreover, the bar for displacing incumbent technologies is very high. Nor will the Bank of England take risks with the resilience of the core of the system. Disruption won’t come either easy or cheap.

Enabling the FinTech Transformation

We are actively exploring how new financial technologies could support our policy objectives. There are five ways the Bank is enabling the FinTech transformation.

The first is widening access to central bank money to non-bank Payments Service Providers, known as PSPs.

As the internet revolutionised commerce, making trade faster and markets more competitive, payments technology lagged in many countries, although it is worth remembering that the UK has been a global leader on real-time retail payments. Faster Payments (FPS) was one of the earliest real-time retail systems introduced, in 2008. Now, new entrants and established players are seeking to provide payment services that are instantaneous, secure, reliable and accessible anytime from anywhere.

Retail consumers and firms are increasingly demanding payments completed in seconds, not hours or days.

They expect payments to be seamless, reliable and cheap whether to recipients overseas or just up the street.

And they expect to make payments without visits to a bank branch or even logging onto a desktop computer.

Similarly, companies, financial intermediaries and governments want to process ever larger and more complex bulk payments covering multiple systems, countries and currencies.

Central banks lie at the hearts of payment systems, giving households and firms the assurance that transactions have settled in the most secure form of payment: central bank money. To fulfil that role, our payments infrastructure needs to remain fit for purpose: reliable, resilient and robust. But we must also be responsive to changing payments demands. So earlier this year the Bank announced we would be drawing up a blueprint to replace our current real-time gross settlement (RTGS) system, now twenty years old.

48 institutions currently have settlement accounts in RTGS. All other users of the systems that settle across RTGS access settlement via one of four agent banks. These users include over 1000 non-bank PSPs serving customers’ increasingly demanding standards, and many rely on major UK payment schemes, particularly Faster Payments (FPS).

As they grow, some PSPs want to reduce their reliance on the systems, service levels, risk appetite and goodwill of the very banks with whom they are competing. Re-selling services ultimately provided by banks limits these firms’ growth, potential to innovate, and competitive impact.

That is why I am announcing this evening that the Bank intends to extend direct access to RTGS beyond the current set of firms, allowing a range of non-bank PSPs to compete on a level playing field with banks.

By increasing the proportion of settlement in central bank money, diversifying the number of settlement firms, and driving greater innovation in risk-reducing payments technologies, expanding access should bring financial stability benefits. It should also enable more efficient, effective and inclusive payments, including in ways that we cannot fully anticipate.

It is not a one-way street, however.

As we extend access, we will safeguard resilience in three ways: by holding settlement account holders to the appropriate standards; by removing legislative barriers to non-bank access; and by designing the right account arrangements for new entrants.

I am pleased that both the FCA and HMRC, who together supervise these institutions, are committed to developing a strengthened supervisory regime for those who apply for an RTGS settlement account, to give assurance that non-bank PSPs can safely take their place at the heart of the payment system.

And I welcome the Chancellor’s commitment tonight to make the necessary legislative changes to ensure that these new entrants can access RTGS safely and efficiently.

By extending RTGS access, our objective is to increase competition and innovation in the market for payment services. To ensure that PSPs are not disadvantaged relative to banks offering equivalent payment services, the Bank intends to give appropriate remuneration for balances that PSPs will be required to hold overnight to support their payments activities.

The second way the Bank is enabling the FinTech transformation is by being open to providing access to central bank money for new forms of wholesale securities settlement.

Securities settlement is the lifeblood of modern wholesale financial markets – the associated payments account for fully half of RTGS’s daily settlement flows.

However, as with retail payments, securities settlement is now ripe for innovation. A typical settlement chain can involve many different intermediaries, meaning securities settlement is comparatively slow. Transactions that take nanoseconds to execute settle in days. This also means large costs and operational risk. And, like in payment systems, economies of scale introduce concentration and create single points of failure. All of that ties up potentially tens of billions of pounds worth of capital. With the economics of wholesale banking under pressure, cutting inefficiencies is a high priority for industry.

That is why it is welcome that FinTech innovators are exploring the potential of distributed ledger technology to simplify the settlement chain, reduce its cost, and raise its speed while increasing resilience. The instruments involved range from equities to bank loans. However, the challenges facing such projects are legion, including reliability, resilience, security and scale. And fundamentally, how to prove technologies that are still nascent?

One challenge an otherwise robust system of sufficient scale would not face is access to central bank money from the Bank of England. The Bank has for many years sought to ensure that, wherever possible, wholesale securities settlement occurs in central bank money.

We are already clear that we stand ready to act as settlement agent both for regulated systemically important schemes supervised by the Bank, and, on a case-by-case basis, for other new systems.9 The Bank will use this to enable innovation and competition, without compromising stability.

The third way the Bank is enabling the FinTech transformation is by exploring the use of Distributed Ledger (DL) technology in our core activities, including the operation of RTGS.

If distributed ledger technology could provide a more efficient way for private sector firms to deliver payments and settle securities, why not apply it to the core of the payments system itself?

The great promise of distributed ledgers for central banks is their potential to enhance resilience. Distributing the ledger means multiple copies of the system. It can continue to operate if parts get knocked out. That removes the single point of failure risk inherent in a centralised system.

But if we are to entrust the heart of our financial system to such technology, it must be robust and reliable. The payments system we oversee processes £½ trillion of bank transactions, equivalent to around 1/3 of annual GDP, each day. Disruptions are potentially costly. That is why, in payments and settlement, the Bank has an extremely low tolerance for any threat to the integrity of the economy’s ‘plumbing’. We won’t beta test RTGS.

To help distinguish DL’s potential from its hype, the Bank has set up our own as a Proof of Concept. We have learned a great deal – about the opportunities and the challenges that need to be met before DL could be used in central banking.

Some of those challenges are familiar to any payments system.10 Others are more specific to DL. For example, we would need assurance that DL systems can be scaled, retain data integrity, and operate at the speeds and volumes required by central bank infrastructure – day in, day out.

And we need to be certain that the privacy of the data in those distributed copies cannot be compromised by cyber attack, not just today but in the future. One way this might be achieved is to limit the distribution of the ledger to existing trusted parties, such as other public sector entities.

To move forward we are working with other central banks. Beyond this we are open to working with others to explore further possibilities, including alternative applications of the technology.

In the extreme, a DL for everyone could open the possibility of creating a central bank digital currency. On some levels this is appealing. For example it would mean people have direct access to the ultimate risk-free asset. In its extreme form, it could fundamentally and perhaps abruptly re-shape banking.

However, were it to co-exist with the current banking model, it could exacerbate liquidity risk by lowering the frictions involved in running to central bank money.11 These questions and others are why these topics are being examined as part of the Bank’s research agenda, with the prospect of a central bank digital currency for the UK, in my view, still some way off. We will work to make payments easier, and though cash may no longer be king it once was, its reign will endure for some time.

The fourth way the Bank is enabling the FinTech transformation is by partnering with FinTech companies on projects of direct relevance to the Bank’s mission.

I am announcing tonight that the Bank is launching a FinTech Accelerator to work in partnership with FinTech firms on challenges that we, as a central bank, uniquely face. The Accelerator will work with new technology firms to help us harness FinTech innovations for central banking. In return, it will offer firms the chance to demonstrate their solutions for real issues facing us as policymakers, together with the valuable ‘first client’ reference that comes with it. With time, the Accelerator will build a network of firms working in this space for the benefit of us and them alike.

How will this help us?

Consider that the Bank monitors risks that threaten the operational resilience of the UK financial system.

At the Financial Policy Committee’s instigation, we have been working with other authorities to encourage firms to improve their cyber defences.

Over the past two years, twenty-three firms have undergone CBEST penetration tests, with all core banks expected to have completed tests by the end of this year.

To complement these efforts, the Bank has begun examining how public data could be used to assess firms’ cyber resilience, including looking for malware on a firm’s systems, software vulnerabilities, or weak encryption that could be exploited by hackers.12

As a proof of concept and good cyber hygiene, we are using data publically available on the web to assess our own resilience. Early results indicate these techniques could complement existing tests in our regular assessments of firms’ operational resilience.

We are also exploring how we – and others – could use the data the Bank collects more effectively. Big Data has the potential to help the Bank’s policy committees identify trends in systemic risk and the economy. Much of the data we collect is rightly subject to strict limits on confidentiality and sharing. For example, our regulatory mortgage contract data comes under strict control to guarantee personal data protection. We can’t just share the private data to which we have access with external researchers, foreign authorities or even across the Bank.

But this means that, simply put, the people of the United Kingdom are not getting the most out of the data the Bank collects.

That’s why we are investigating ways of anonymising and de-sensitising data – fully respecting privacy laws without losing analytical content – to allow wider sharing.

Progress has been encouraging creating the prospect of better informed policy making.13

These are just two examples of a bigger programme of collaboration between the Bank and technology innovators. We are open to further collaboration and tomorrow will provide details of the next steps.

Finally, the Bank is calibrating its regulatory approach to FinTech developments.

FinTech should neither be the Wild West nor strangled at birth. The Bank is devoting considerable resources to ensure whatever develops is sustainable, not ephemeral.

If FinTech enables a great unbundling of financial services, risks will change in tandem.

Our interest is in ensuring the safety and soundness of banks, the protection of insurance policy holders and the resilience of financial ecosystem as a whole to these changing risks. It is about activities not labels.

That is why the Bank has been engaging with FinTech firms to understand better the financial stability risks that could emerge as banking is re-shaped. We will monitor those that arise along the transition path and those that could endure.

Where firms or activities become systemic and risks to the real economy grow, they will come within the purview of the Bank’s responsibilities for the stability of the system as a whole. The Financial Policy Committee will continue to monitor the scope of the regulatory perimeter. Adjustments will follow if necessary.

When FinTech companies fall within our remits, we will monitor them in the same proportionate way that we approach other firms – backed by analytics and judgement, taking action where appropriate.

We are building a system that allows for orderly failures. Not just to end the blatant unfairness of Too Big to Fail, but also to foster industry dynamism and better outcomes for consumers. After all, ease of exit promotes ease of entry. We won’t discourage avatars by preserving dinosaurs.

UK Regulators Finalise SRB Regulations; Shows Low Australian Bank Capital Ratios

The UK’s Financial Policy Committee (FPC) has released the final version of its Systemic Risk Buffer (SRB) framework for banks relating to Domestically  Significantly Important Banks) (D-SIB). It also shows Australian Banks relatively weaker capital position.

The framework highlights again that further risk capital will need to be held so that financial firms will be able to absorb losses while continuing to provide critical financial services. In the UK, depending on the size of the institutions, the buffer will be set between 0 and 3%. The SRB increases the capacity of UK systemic banks to absorb stress, thereby increasing their resilience relative to the system as a whole. The FPC judges that the appropriate Tier 1 capital requirement for the banking system is around 13.5% of Risk Weighted Assets.

Note, separately, an additional capital weight, per the Basel framework will apply for global systemically important banks (G‐SIBs).

Of special interest to Australian Banks is this table which shows that on a comparable basis, local banks here currently are required to hold less capital than peers in many other countries. Is the D-SIB here at 1% correctly calibrated? – especially, given 63% of all bank lending is residential property related?

UK-DSIB

The UK document just released, sets out the framework for the SRB that will be applied by the PRA to ring‐fenced banks, and large building societies that hold more than £25 billion in deposits and shares (excluding deferred shares), jointly, ‘SRB institutions’. The aim of the SRB is to raise the capacity of ring‐fenced banks and large building societies to withstand stress, thereby increasing their resilience. This reflects the additional damage that these firms could cause to the economy if they were close to failure. The FPC intends that the size of a firm’s buffer should reflect the relative costs to the economy if the firm were to fall into distress. The PRA will apply the framework from 1 January 2019 and later this year will consult on elements relating to the implementation of the SRB.

Overall, based on an analysis of the economic costs and benefits of going concern bank equity, the FPC judged the appropriate non‐time‐varying Tier 1 capital requirement for the banking system, in aggregate, should be 11% of RWAs, assuming those RWAs are properly measured. As up to 1.5 percentage points of this can be met with additional Tier 1 contingent capital instruments, the appropriate level of common equity Tier 1 capital is around 9.5% of RWAs. This judgement was made on the expectation that some of the deficiencies in the measurement of risk weights would be corrected over time. Until remedies are put into place to address this, the appropriate level of capital is correspondingly higher. On current measures of risk weighting, the FPC judges that the appropriate Tier 1 capital requirement for the banking system is around 13.5% of RWAs. This assessment refers to the structural equity requirements applied to the aggregate system that do not vary through time. In addition to baseline capital requirements, the FPC intends to make active use of the countercyclical capital buffer that will apply to banks’ UK exposures.

Under the SRB Regulations, the FPC is required to produce a framework for the SRB at rates between 0 and 3% of risk‐weighted assets (RWAs) and to review that framework at least every two years. The legislation implements the recommendation made in 2011 that ring‐fenced banks and large building societies should hold additional capital due to their relative importance to the UK economy. The FPC has considered its equality duty, and has set out its assessment of the costs and benefits of the framework.

Systemic importance is measured and scored using the total assets of ring‐fenced bank sub‐groups and building societies in scope of the SRB, with higher SRB rates applicable as total assets increase through defined buckets.

SRB-UKThose with total assets of less than £175bn are subject to a 0% SRB. The FPC expects the largest SRB institutions, based on current plans, to have a 2.5% SRB initially. Thresholds for the amounts of total assets corresponding to different SRB rates could be adjusted in the future (for example, in line with nominal GDP or inflation) as part of the FPC’s mandated two‐year reviews of the framework.

In July 2015, the FPC issued a Direction and a Recommendation to the PRA to implement the leverage ratio framework for UK G‐SIBs and other major UK banks and building societies on a consolidated basis. The FPC anticipates that the leverage ratio framework will be applied to UK G‐SIBs and other major UK banks and building societies at the level of the ring‐fenced bank sub‐group from 2019 (where applicable), as well as on a consolidated basis.

 

Global Low Rates For Longer

What is driving long-term interest rates lower around the world lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years. The ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

BoE-RatesIn a speech to the London Business School, external Bank of England MPC member Gertjan Vlieghe, explores the reasons for low long-term interest rates. “Long-term interest rates play an important role in monetary policy.

They are a key part of the transmission mechanism, via which monetary policy affects the wider economy.

And they contain useful information about expected future policy rates and expected future inflation.”

Jan also reflects on the current UK outlook. He says that the EU referendum has caused increased uncertainty and poses challenges for the MPC in assessing how much of the continued slowdown in GDP growth “is due to the referendum, an effect which should be short-lived, and how much of it reflects a more fundamental loss of underlying momentum, which might be more persistent”. Given this, following the referendum he “would like to see convincing evidence of an improvement in the economic outlook, in line with the forecasts in the May Inflation Report. If such improvement is not apparent soon, this will reduce my confidence that inflation is likely to return to the target within an acceptable time horizon without additional monetary stimulus.”

In the UK, long-term interest rates have been coming down gradually since the early 1980s and the current 10 year bond yield is now about 1.5%.

Jan decomposes long-term interest rates into real and nominal components as well as expectations and risk premia components. He finds that “the most important factor behind the fall in long-term interest rates since the financial crisis has been a downward revision in the expected path of policy rates, with inflation expectations relatively stable, thus reflecting lower expected future real rates”.

This analysis suggests that “the reason expected future real rates are low is that monetary policy has responded, and is expected to continue to respond, appropriately to persistent forces weighing on demand and inflation”.

The analysis also suggests asset purchases have not “distorted” government bond yields. Instead, the main effect of asset purchases on long-term interest rates appears to have been due to the signal sent by purchases about the Bank’s reaction function and thereby led to a downward revision of the expected future path of interest rates. This finding also “sheds light on the likely impact of unwinding asset purchases”.

Finally, Jan applies the same decomposition to a range of countries with varying monetary policies all of which show “a substantial fall in the expected path of future interest rates” with the path of future policy rates “revised down by several percentage points on average.” This suggests that “what is driving long-term interest rates lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years”.

This supports Jan’s argument in his speech in January that ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

Bank of England Warns On Brexit

The latest statement of monetary policy from the Bank of England kept the base rate at 0.5% and to maintained the asset purchases at £375 billion. They said inflation was o.5%, well below the 2% target and growth has slowed in Q1 and is expected to slow further.  They say the most significant risks to the MPC’s forecast concern the referendum.  A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy.

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target and in a way that helps to sustain growth and employment.  At its meeting ending on 11 May 2016 the MPC voted unanimously to maintain Bank Rate at 0.5%.  The Committee also voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at 

Twelve-month CPI inflation increased to 0.5% in March but remains well below the 2% inflation target.  This shortfall is due predominantly to unusually large drags from energy and food prices, which are expected to fade over the next year.  Core inflation also remains subdued, largely as a result of weak global price pressures, the past appreciation of sterling and restrained domestic cost growth.

Globally, sentiment in financial markets has improved.  There has been a broad-based recovery in risky asset prices, a resumption of capital flows to emerging market economies, and a sharp rise in the price of oil. Near-term prospects for China and other emerging market economies have improved a little, although medium-term downside risks remain.  In the advanced economies, growth has picked up in the euro area in Q1 but slowed in the United States.  A modest pace of growth in the United Kingdom’s main trading partners is likely over the forecast period, broadly similar to that in the February Inflation Report projections.

In the United Kingdom, activity growth slowed in Q1 and a further deceleration is expected in Q2.  There are increasing signs that uncertainty associated with the EU referendum has begun to weigh on activity.  This is making the relationship between macroeconomic and financial indicators and underlying economic momentum harder to interpret at present.  In the Committee’s latest projections, activity growth recovers later in the year, but to rates that are a little below their historical average.  Growth over the forecast horizon is expected to be slightly weaker than in the February projection.  The May projection is conditioned on a path for Bank Rate implied by market rates and on continued UK membership of the European Union, including an assumption for the exchange rate consistent with that.

As the dampening influence of past falls in energy and food prices unwinds over the next year, inflation should rise mechanically.  Under the same forecast conditioning assumptions described above, spare capacity is projected to be eliminated by early next year, increasing domestic cost pressures and supporting a return of inflation to the 2% target by mid-2018.  Thereafter, as in the February Inflation Report, inflation is forecast to rise slightly above the target, conditioned on the path for Bank Rate implied by market rates.

Given the outlook described in the May Inflation Report projections, returning inflation to the 2% target requires achieving a balance between the drag on inflation from external factors and the support from gradual increases in domestic cost growth.  Fully offsetting the drag from external factors over the short run would, in the MPC’s judgement, involve too rapid an acceleration in domestic costs, one that would risk being excessive and lead to undesirable volatility in output and employment.  Given these considerations, the MPC intends to set monetary policy to ensure that growth is sufficient to return inflation to the target in around two years and keep it there in the absence of further shocks.

Consistent with the projections and conditioning assumptions set out in the May Inflation Report, the MPC judges that it is more likely than not that Bank Rate will need to be higher by the end of the forecast period than at present to ensure inflation returns to the target in a sustainable manner.  All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.  This guidance is an expectation, not a promise.  The actual path Bank Rate will follow over the next few years will depend on economic circumstances.  With macroeconomic and financial indicators likely to be less informative than usual in light of the referendum, the Committee is currently reacting more cautiously to data releases than would normally be the case.

The most significant risks to the MPC’s forecast concern the referendum.  A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy.  Households could defer consumption and firms delay investment, lowering labour demand and causing unemployment to rise.  At the same time, supply growth is likely to be lower over the forecast period, reflecting slower capital accumulation and the need to reallocate resources.  Sterling is also likely to depreciate further, perhaps sharply.  This combination of influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than in the central projections set out in the May Inflation Report.  In such circumstances, the MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other.  The implications for the direction of monetary policy will depend on the relative magnitudes of the demand, supply and exchange rate effects.  Whatever the outcome of the referendum and its consequences, the MPC will take whatever action is needed to ensure that inflation expectations remain well anchored and inflation returns to the target over the appropriate horizon.

Against that backdrop, at its meeting on 11 May, the MPC voted unanimously to maintain Bank Rate at 0.5% and to maintain the stock of purchased assets, financed by the issuance of central bank reserves, at £375 billion.

The impact of P2P lending on conventional banks

A working paper from staff at the Bank of England  “Peer-to-peer lending and financial innovation in the United Kingdom” looks at the P2P lending market in the UK. As well as looking at the geographic dispersion of lenders and borrowers, they also make some observations about the future impact of P2P on traditional banks. First, they expect to see a fall in the interest rate charged on unsecured personal loans, which will put pressure on bank profitability in this product line, and second, P2P platforms offer a model for banks as they shift their distribution channels from bricks-and-mortar branches to internet and mobile services.

Although there is P2P lending to fund businesses and real estate, we think consumer credit is the area where banks will face most competition from online platforms. In part, this is because it is the asset class in which P2P emerged and is most mature. For example, one striking fact to emerge from Nesta’s survey of the industry is the difference in the credit profile of individual and business borrowers on P2P platforms.

In the P2P market for personal loans, 59% of respondents sought funding from banks at the same time they applied for a P2P loan, and 54% were granted it but chose to fund themselves via the platforms. By contrast, in the market for P2P business loans, 79% sought funding from banks but only 22% were granted it. One interpretation of these results is that, while banks and P2P platforms are operating with different credit risk and lending models when it comes to business loans, P2P platforms are actually competing away some customers from banks in the unsecured personal loans market.

Looking ahead, unsecured personal loans are the market where P2P platforms are likely to continue to make inroads against banks. In contrast to the retail mortgage and deposit market, no British bank has a dominant position in consumer credit. In addition, British banks’ unsecured lending is typically a small component of their overall balance sheet.

The results of this competition could be good for consumers, increasing the availability of unsecured personal credit while lowering its price. This would amplify recent trends. Last year, UK banks increased their issuance of unsecured personal loans, and quoted interest rates on these fell sharply. However, we caution that P2P platforms still trail banks by some distance in terms of their share of the unsecured personal loans market. For example, in Q4 2014, the net lending flow to individuals through P2P platforms was just over £70 million, while those from UK banks and building societies topped £2 billion.

A second, longer term, less direct but still important impact we expect P2P lenders will have on banks is in how they interact with consumers. Over the last two decades, banks have taken steps to move their customers online to reduce costs from operating physical branches. By some estimates, 30 to 40 percent of retail banks costs in the UK come from running physical branches, even though footfall in them has been falling at 10 percent per annum in recent years, possibly because younger generations are more comfortable doing business just online. This means banks are likely to accelerate the transition of their customers from brick and mortar branches to Internet browsers. As this happens, we anticipate banks will look to P2P platforms for inspiration in how to redesign their websites, as these are often noted for being slick and speedy because, for example, they incorporate videos, pictures and communication channels for investors to interact with borrowers.

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee or Prudential Regulation Authority Board.

 

A 21st century approach to dealing with failed banks

In a speech Sir Jon Cunliffe Deputy Governor for Financial Stability, Bank of England, urges regulators and banks to press ahead with implementing rules designed to enable banks to fail without the need for government bailouts.  Jon says that a vast amount of work has been done to come up with better ways to deal with a failed bank and a better answer than ‘the taxpayer’ to the question of ‘who pays?

“I think it is possible to have a world in which large banks can fail in an orderly way – without the contagion and damage to the economy that in the past has forced the taxpayer to come in and absorb losses. But there is no single, silver bullet to achieve that; rather it requires the application of a comprehensive set of policy and powers.”

Jon declares that the UK is now in a much stronger position to deal with bank failures than it was in 2008, thanks to substantial progress on five key planks of reform: improved bank resilience; ensuring that authorities have the necessary powers and machinery to manage the failure of a bank; structuring banks so that they are resolvable; ensuring that banks are financed in a way that supports resolution, and international cooperation.

However, moving to an effective resolution regime will require a major transition, Jon warns: “Many larger banks will need to make changes to their structure and financing.  There will inevitably be higher costs as the implicit public subsidy is removed. There is no free lunch.”

Jon observes there is evidence that the multipronged approach to addressing Too Big To Fail is already having an effect:  ratings agencies have started to reduce their “government support” uplifts for big banks, while spreads between senior and structurally subordinated debt of UK Global Systemically Important Banks (G-SIBs) suggests that resolution regimes are gaining credibility. 

“In part, this is a result of the entry into force of the BRRD, and in the UK the Bank’s consultation paper on the setting of the Minimum Requirement for own funds and Eligible Liabilities (MREL). But it has almost certainly been reinforced by other events that have brought the issue into sharper relief,” Jon notes, adding that one of the key benefits of ensuring that certain creditors can be bailed in is that those creditors have a much stronger incentive to monitor and, if necessary, constrain the risks banks are taking.

Nonetheless, the transition to an effective resolution regime needs to be carefully managed, which is why the Bank of England is pursuing an approach to resolution in the UK that is proportionate, gradualist and provides clarity to banks and their creditors.

“The resolution requirements for a bank should be what is necessary to deliver the resolution strategy for that bank – no more and no less,” according to Jon.

The Bank’s proposed approach to setting MREL is based on the judgement that large banks cannot be allowed to cease operating abruptly; they have to be stabilised and resolved over time. As a result, the bank needs to have enough debt that can be bailed in to restore its capital so it can continue to operate as an authorised firm while it is being resolved. Smaller banks that can more easily be separated need to hold resources to recapitalise only the parts of their business that provide critical economic services and that can be sold, while the remainder can go into insolvency. The very smallest institutions do not need to be kept in operation as an abrupt stop in activity should not generate contagion or damage the economy. Insolvency rather than resolution is the proportionate strategy and so they do not need bail in debt.

In keeping with the second key principle, gradualism, the Bank is proposing to allow the full four year transition period for banks to meet their MREL requirements.  This will allow the market for MREL – eligible debt to develop and allow banks to smooth out their debt issuance, minimising issuance and interest costs.

Finally, banks and their creditors need to have clarity – both in relation to the requirements of the new regime and clarity as to their liability if things go wrong.

“This is not just a case of making sure that those that buy bank debt that can be bailed in realise the risks of the instruments they have purchased.  It also means making sure that creditors understand the resolution strategy of the institution to which they have lent money.  Unprotected depositors in institutions that have no bail in debt should be clear that in the event of trouble, they stand next in line after shareholders when it comes to absorbing losses.”

Jon concludes that while regulators cannot expect to insulate fully all institutions from all external shocks, the legal, financial and practical arrangements are in place to resolve banks of all sizes.

“But this will only be true if we implement the new regime on resolution fully.  Both regulators and industry have an incentive to do so.  If, next time there is a crisis, authorities face the same unenviable choice as in the crisis, if taxpayer bailouts cannot be avoided, then the case for breaking up banks and making them much, much simpler will be very hard to resist.”

“The powers, international standards and institutions are all in place. The authorities and the banking system have strong and common incentives to complete the implementation. It is in all our interests that we do so.”