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Report of the Financial Policy Committee June-November 2017

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The Financial Policy Committee (FPC) was established in 1998 and amended in 2012. The main objective of the committee is to ensure the financial stability of the United Kingdom, which is one of the fundamental pillars of the Bank of England. In addition to supervising the health of the financial system, it must also aim at the good development of the economy by supporting other committees and the objectives of the Crown that are based on growth and employment. The responsibilities of the committee are mainly to identify, monitor and take necessary actions to remove or reduce the systematic risks of the financial system of the United Kingdom.

The Financial Policy Committee (FPC) has the objective of ensuring that the financial system of the United Kingdom is resistant to the various risks and situations that they may face over time. The FPC evaluates internal and international risks and is always monitoring variables such as credits, mortgages and others so that they are within an acceptable range for the committee.

In recent years in the UK, consumer credit has grown rapidly. The conditions for access to a mortgage have become more accessible so it is easy to think that there are negative incentives for bankers who often prioritise their economic benefits and profits of the banks before the security of the financial system.

Another concern of the committee is Brexit. This event has generated much uncertainty in international markets and is still unclear on what will be the conditions of the departure of the United Kingdom from the European Union. This is a concern because it is clear that the financial system will be affected when Brexit is completed.

On the other hand, in the June report, the Committee observed that many of the global risks had not materialised which was a relief to the financial system and the economy of the UK, but they continued to observe vulnerabilities in the Chinese financial system, so they were still analysing the situation in China. For the FPC, market volatility measures and the valuation of some assets such as corporate bonds and UK real estate did not seem to show signs that investors had these global negative projections within their valuation models, in addition to very low interest rates which affected long-term assets.

To maintain the soundness of the financial system and avoid possible future risks, the bank decided to increase the UK countercyclical capital buffer (CCyB) rate to 0.5% from 0% Also, the FPC expected to increase the rate to 1% at its November meeting. The countercyclical capital buffer (CCyB) is a tool that enables the FPC to adjust the resilience of the banking system. The FPC increases the CCyB when they consider that risks are building up. The bank forces commercial banks to have more capital reserves to face possible economic or financial shocks, absorbing the losses which makes a stronger financial system and prevents bank failures.

The bank performs multiple stress tests of the economy, taking different scenarios to analyse what the response of banks and the financial system would be in general, to study what possible measures can be taken to reduce the risks to which the system is exposed. The bank’s annual stress test assesses the banks’ resistance to consumer credit risks. Due to the rapid growth of consumer credit in the last year, the FPC began to perform stress tests analysing what the possible losses of the banks could be if a problem was found in the local economy.

Credit card debt and personal loans were the main variables that increased rapidly. But the committee noted that the losses in consumer loans were low and the loan environment was good so there was a large number of loan offerings. The downside is that the maturity of the loans was very short, so the quality of the loans could go down drastically and very quickly.

The Brexit negotiations had already begun before the June meeting and the bank had very broad expectations about the possible paths that the negotiation could take, so there was no clarity about the possible steps to follow. To be prepared, the FPC had a contingency plan to reduce the financial risks derived from Brexit as much as possible.

Spreads on sovereign bonds in the Eurozone had declined due to the resolution of some political uncertainties. In China, the outflow of capital had stabilised but the economic growth of the country was still based on a very rapid expansion of credits, which made it a risky scenario due to possible problems in the financial system. In the UK, yields on 10-year government bonds were close to -2% and in general, in the G7, long-term interest rates were low, which was evidence of negative growth expectations in addition to the uncertainty of the investors. The above can be seen in the following graph.

 

Graph 48. International ten-year real government bond yields. Retrieved 27th January 2018, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

It is evident in the FPC reports that the main local concern is Brexit. This is because there are many companies and banks that could leave and stop operating in the UK because if the regulation changes after the negotiations, there could be changes in the rules which would affect the margins of the companies, make contracts again or relocate resources which could be costly. The withdrawal of the United Kingdom from the European Union has the potential to affect the economy through the supply, demand and exchange rate channels.

In global financial markets, the uncertainty measures implicit in the prices of the options were low. In June, the VIX measure of implied capital volatility derived from the prices of the S&P 500 stock index options had reached its lowest level since 1993. The Committee noted that, often in periods of low volatility, the risk increases, and then they become evident.

As previously mentioned, long-term risk-free interest rates in advanced economies remained low, which is consistent with pessimistic growth scenarios and a great uncertainty of the global situation is perceived. As for short-term expectations, they improved in the last period despite the fact that world average growth was lower compared to the pre-crisis period.

The committee argued that the prices of global assets were vulnerable due to possible increases in long-term interest rates or adjustments in growth expectations. Regarding the exposure of the UK banks to the real estate market, positive signs were found because the exposure to this market was reduced to half of the figures seen before 2008, making the financial system more robust, at least in this aspect.

The UK banking system continued to strengthen its capital positions due to the valuation of different metrics in addition to the results of the stress tests, so the committee concluded that the system was well capitalised, with good liquidity and good financing coverage.

The June report concluded that the recovery capacity of the UK financial system had strengthened significantly since the crisis and is capable of absorbing shocks to the real economy. The future of the economy was expected to be full of risks due to events such as, risks in China, negative expectations and mainly due to uncertainty about the completion of the Brexit talks, but the FPC promised to carry out all the possible studies to have greater clarity about what awaited the UK after leaving the European Union, and taking the necessary measures to maintain a robust financial system and good growth rates.

The following graph shows the comparison of the main debt metrics, market conditions and the balance sheet of the bank. As it is observed, the values up to the June meeting did not show high risks being within the values seen historically.

Graph 49. Core indicator set for the countercyclical capital buffer. Retrieved 27th January 2018, from https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

At the November meeting, the FPC raised the UK countercyclical capital buffer rate from 0.5% to 1%. This measure was taken by the bank due to the results obtained in the stress test where some risks were observed, so it was decided to raise the rate as a precaution.

In November, the FPC continued to observe Brexit as a major risk, some risks in the domestic economy and global risks were due to some erroneous asset valuations. But despite these risks, after the stress test of the financial system, the FPC concluded that the system was robust and could support the economy in case of a disorderly Brexit that would lead some variables to show negative trends such as employment, the real estate market and even an aversion to UK assets. If the worst case scenario were to occur for the British economy, the financial system would have the strength not to collapse and support the economic recovery.

The conjuncture that could generate a crisis in the banking system would be a messy Brexit and a severe global recession. In this scenario, it would be possible to generate a credit restriction for new loans because the capital of the banks would be threatened, so the financial system would not be able to support the economy.

Regarding local conditions, it was observed that the main variables were within normal parameters without any excessive risk, although the committee must continue to monitor the system, especially due to the high level of indebtedness in the economy. The credit growth rate was above the nominal GDP growth, but there was no evidence of excessive risk at the moment. The following graph shows that consumer credit was not at alarming levels.

 

Graph 50. Outstanding consumer credit to income. Retrieved 27th January 2017, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/november-2017.pdf?la=en&hash=8CB2A5526478872DE14D531254B948BB6FD47793#page=9

As already mentioned, if after Brexit, investors stop acquiring British assets, this could affect the financial system which would reduce the number of loans granted to people, which would have an impact on the economy and could affect the economic growth of the country in the short term.

Regarding external factors, the committee explained that the current account of the UK has been in deficit persistently since 1999 and has increased since 2012 reaching 4.6% of GDP in the second quarter of 2017. It has been increased mainly by lower profits from the foreign direct investment.

Long-term global interest rates have remained near historically lower levels. This has been evidence of structural factors such as demographic changes and expectations of low inflation despite solid but moderate growth. As in June, the committee observed worldwide investors have placed an excessive weight and optimism in current economic conditions, and have not correctly assessed the medium-term risks which have created a risk in the global financial markets, which in future may come to affect the British financial system.

In the corporate bond market, spreads were at levels seen before the financial crisis with a more compressed high yield, compared to historical levels. This has come along with greater leverage of companies in the United States. In the UK, there is a high risk that economic growth will be weak, so the UK’s risk-free rates have been falling since mid-2016 compared to other economies.

Short-term expectations have improved in terms of global economic growth with better prospects for the IMF by the end of 2017. The better prospects were given by better behaviour in the Eurozone, Japan, China, Russia and emerging Europe. Despite these better prospects, the FPC observed some vulnerabilities in some financial systems and markets due to a significant increase in the debt of non-financial sector companies as part of the GDP at previous levels of the 2008 crisis, especially in China where the debt has grown about 60% in the last 5 years. Finally, on the international scene, the government confirmed its intentions that by the 29th of March 2019 the United Kingdom must have completed its negotiations to leave the European Union and establish trade negotiations after it no longer belongs to the economic union.

In conclusion, the Financial Policy Committee is very explicit about which risks will be faced by the financial system and how the committee is prepared to face them by taking the respective measures. In the last two reports, the committee focused on the same risks at the local and international level, taking the Brexit negotiations as the main risk for the United Kingdom, which could lead the financial system to limit its offer, which could affect British growth. They also emphasise that the interest rates of developed countries have remained low due to not so optimistic expectations of the countries, in addition to the fact that inflation has remained low. This is a recurring theme in the reports of the central banks of the United States and England because they have not seen a totally positive behaviour in inflation and in growth, so when they have been making monetary policy decisions they have been very cautious.

Based on the FPC report it is also evident that there is an optimism among investors worldwide that has prioritised current conditions but has not valued the global economic risks such as excessive Chinese companies’ debt and some geopolitical conflicts, whereby markets and financial systems are exposed to a risk given the overvaluation. This represents a threat to global economic growth and especially to the United States where the large rise in stock market shares has generated households with greater wealth. This has encouraged consumption and in turn, this has boosted economic growth, but the overvaluation of assets could affect the economic growth since it affects the main engine of the economy.

China also represents a global risk because it is the second largest economy, so if a crisis occurs in the financial system, domestic consumption would decrease drastically and exports around the world would be affected. It is perhaps the most latent risk internationally for developed countries that could trigger other risks such as falls in stock market indices and contagion in global financial systems.

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