Banks to face new stress tests as Bank of England remains on the prowl for financial stability risks
Regulators at the Bank of England are looking to make certain that the UK financial sector remains resilient to shocks that may arise from the rapid rise in interest rates.
The Bank’s Financial Policy Committee (FPC) warned that “the overall risk environment continues to be challenging”, according to the latest record of the FPC’s meeting.
Although it confirmed that the UK banking sector was “well capitalised, supported by strong recent profitability, and has high levels of liquidity,” UK banks will face a new kind of stress test next year to assess how they respond to multiple different scenarios.
Normally banks are given a scenario which they then use to test their own balance sheet, before submitting it to the Bank of England.
Under the new tests, known as ‘desk-based tests’, banks will submit their balance sheet on which regulators will then conduct tests themselves.
This will enable them to test a wider range of scenarios, including rates staying higher for longer and a rapid fall in rates.
“A key benefit of a desk-based exercise will be to allow for that resilience to be tested to more than one adverse macroeconomic scenario,” it said.
Regulators intend to revert back to the standard stress tests from 2025.
The change comes as rising interest rates put increasing pressure on borrowers, with the levels of arrears and delinquencies starting to pick up — albeit from historically low levels.
The FPC pointed out that the full impact of rising interest rates was yet to be felt, meaning credit losses would rise. The share of households with high debt servicing ratios is rising and will continue to rise next year.
However, stress tests earlier this year indicate that banks would withstand a “severe macroeconomic downturn”.
The FPC also voiced worries over vulnerabilities in the market-based finance sector, often known as shadow banking. Market-based finance includes a wide range of different financial institutions including insurance firms, pension funds, hedge funds and money market funds (MMFs).
Regulators around the world have been scrambling to develop new tools to monitor this burgeoning sector, which has grown dramatically since the financial crisis in 2008 and now makes up around half of global assets.
The FPC confirmed that “there is an urgent need to address these vulnerabilities”.
Today, the FPC recommended that MMFs, a critical part of the financial plumbing, maintain a higher proportion of liquid assets. MMFs play a critical role in providing short term financing to the financial sector.
The FPC warned that “significantly more liquid assets than currently required is likely to be the most effective way to increase MMF resilience and so reduce risks to financial stability”.
It suggested that MMFs maintain a weekly liquid asset levels of around 50 to 60 per cent. Regulators in the EU and US have suggested MMFs hold similar levels of liquid assets.
This level would give “a high level of assurance” that sterling denominated MMFs would be resilient to a severe stress.
The Bank will publish further details on a consultation for MMFs later this year.
Already the Bank has announced it is developing a new lending tool that will allow it channel liquidity directly into key parts of market-based finance sector.