Bank Of England Testing Financial Sector’s Resilience

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Frothy stock market valuations, a dash for cash and digital money – all on Bank of England’s risk radar

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Q2 2021 hedge fund letters, conferences and more

  • The economic outlook has improved, but risks to the recovery remain.
  • Banks have the capital and liquidity to be able to support the economy.
  • Risky asset prices have continued to increase, partly due to higher risk taking.
  • New monetary tools being explored to stop a ‘dash for cash’.
  • Bank of England testing financial sector’s resilience to climate change.
  • Spotlight turned on digital money.

BofE has released its financial stability report.

The Bank Of England Applauds The Banking Sector’s Resilience

"The Bank of England has rolled with the good news first by applauding the banking sector’s resilience for steering the UK economy through the pandemic and for having the liquidity to withstand further punches.

Banks have clearly played a key role in helping businesses and consumers survive the financial crisis by extending loan terms, offering payment holidays and providing a bridge over troubles waters. Government loan schemes have also been a lifeline. Since March 2020, UK businesses have raised  around £76 billion of net additional financing from UK banks and global financial markets. That has helped businesses’ cash balances increase by a quarter, around £132 billion since the end of 2019.

We are not out of the danger zone just yet, with the recovery still fragile. The economy is still going to need a helping hand to emerge with growing strength from the combined effects of the Covid shock and the withdrawal from the European Union, so keeping the tap of bank funding on will be crucial to help viable, productive businesses stay afloat. To stop a squeeze on bank lending, the UK’s countercyclical capital buffer rate of 0% will be kept until December 2021 as a precaution, with any change not coming in until the end of 2022. If the economy does take a turn for the worse, and unemployment rises, banks should brace themselves for loans turning bad on consumer credit rather than mortgages with more defaults on loans and credit cards historically linked to job losses. While the housing market has been red hot, the Bank of England doesn’t expect demand to drop like a stone after the stamp duty holiday comes to an end, given that interest rates are still attractively low. Like in other economies the race to find space and adapt to working from home long term are trends expected to continue.

What is now flashing a warning light for the Bank is the increase in risky asset prices with valuations high on an historic basis. Its concerned that the search for higher returns in a low interest rate environment is leading to higher risk taking. It’s singled out high yield corporate bonds and evidence of loose underwriting standards, as a particular cause for concern, as firms which have borrowed up to the hilt could see a dramatic reversal of fortunes which could accelerate economic downturns.

Warning For Sharp Corrections

The Bank of England is warning that sharp corrections could be on the way if worries rear up about inflation and a higher interest rate environment. It is clearly concerned that there could be a knock on effect on the finance available for households and businesses. Already we’ve seen financial markets wobble as central banks flag price rises, with growth stocks in particular taking seeing small corrections. The Bank of England is clearly fearful this could amplify as markets come off the drug of cheap money.

Like a family elder trying to make its younger relatives more responsible so it can take a step back, the Bank of England is also trying to lay the groundwork to limit central bank involvement in future market turmoil. The dash for cash as the pandemic unfolded saw  huge losses in March 2020 and the financial market volatility led to central banks stepping in to calm the storm. The Bank of England wants to see reforms to enhance the resilience of money market funds and better understand the role of leveraged investors in bond markets and the preparedness for margin calls in a high stress environment.

The Bank is also clearly worried that central banks are running out of the weapons needed to help fight future crises in financial markets system. Already the arsenal has been depleted, with ultra-low interest rates and mass bond buying programmes still in force. So it wants to find new tools to tinker with system, which crucially don’t encourage risk taking, given the concerns that loose monetary policy is seen as partly behind the current frothy valuations of some assets.

There are fresh threats looming, not least climate change and the Bank is already testing the resilience of banks and insurers for their ability to withstand and transition to new environment and low carbon targets.

The revolution in the global payments system is also on the bank’s radar given how critical its smooth running is to financial stability. It has highlighted the need for regulators to keep up with digital coin developments, and ensure the public have the confidence and trust to use digital money. It has again flagged stable coins, pegged to fiat currencies, as systemically important, indicating that these are likely to be a central feature in the monetary system going forward."

Article by Susannah Streeter, senior investment and markets analyst, Hargreaves Lansdown

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