Bank of England Financial Stability Report, June 2017

The Bank of England’s new report by the Financial Stability Committee contains a number of startling observations and conclusions. This report is a twice yearly publication that has financial stability as its focus and financial risk as its flip side. Look at it here.

Credit

The credit train just keeps on picking up steam: “Consumer credit grew by 10.3% in the twelve months to April 2017 markedly faster than nominal household income growth. Credit card debt, personal loans and motor finance all grew rapidly”. It bemoans the fact that “lenders have less capacity to absorb losses, either with income or capital buffers”. They won’t stop lending just because of a pesky lack of buffer though, after all sales commissions don’t grow on trees. There could be more restrictions on the obviously deceptive enticements companies offer to consumers to get them to sign on the dotted line. But the real villains are those greedy mortgage borrowers who have the temerity to save money (instead of spending it on consumer junk) when times get hard “Historically, the build-up of mortgage debt has been a significant risk to financial and economic stability. Because highly indebted borrowers need to cut spending sharply in a downturn, recessions become deeper. And looser underwriting standards expose banks to bigger losses”. Expect a harsher attitude from banks towards defaults in the future near, putting more pressure on homelessness and social housing.

Brexit

The distaste of the BOE for brexit is hilariously clear. It seems to have Mark Carney spitting feathers “A very large part of the United Kingdom’s legal and regulatory framework for financial services is directly or indirectly derived from EU law. UK-located banks underwrite around half of the debt and equity issued by EU companies…. and are counterparty to over half of the over-the-counter interest rate derivatives traded by EU companies and banks” in other words “we have too much to lose! Please don’t do this!!!”. Another bone of contention is the oh-so-cozy relationship of derivative trading with central clearing “if EU firms are unable to move their existing derivatives contracts to EU authorised or recognised central counterparties, they would face capital charges that are up to ten times higher……. Separation of derivatives clearing would reduce the benefits of central clearing. It would impair the ability to diversify risks across borders and, by increasing costs, reduce incentives for firms to hedge risks”. Those poor darling derivatives will have their costs increased so they might sulk and refuse to hedge risks (to themselves, I might add). But the real endgame was almost inevitable “Together, these effects could increase the reliance of both the UK and EU economies on their banking systems and reduce the diversification and resilience of finance”. Yes, don’t worry, we’ll save you…. Another effect coming our way according to the BOE is a drop in overseas investment “The United Kingdom’s withdrawal from the European Union has the potential to affect the economy through supply, demand and exchange rate channels… A material reduction in the appetite of foreign investors to provide finance to the United Kingdom would tighten financing conditions for UK borrowers and reduce asset prices and investment…The effect could be most pronounced in markets that have recently had greater reliance on access to overseas capital, such as commercial real estate (CRE)”. I don’t know this for a fact but I’m guessing the majority of overseas investment is targeted at London which has a considerable buffer ahead of any other rival in the UK and must be the lead city of Europe itself. Indeed the loss of London to Europe will be more painful to the EU than the rest of the UK put together. I expect investment in London as a safe haven to rise particularly as the rest of the world begins to fall apart “Around half of the investment in UK CRE since 2015 has been financed by overseas investors”.

Other Macroeconomic Shocks Incoming

China Risks: “In China, capital outflows have stabilised, but economic growth continues to be accompanied by rapid credit expansion”. Credit expansion + capital outflows = collapse.

Uk Assets: “Some asset valuations, particularly for some corporate bonds and UK commercial real estate assets, appear to factor in a low level of long-term market interest rates but do not appear to be consistent with the pessimistic and uncertain outlook embodied in those rates… These asset prices are therefore vulnerable to a repricing, whether through an increase in long-term interest rates or an adjustment of growth expectations, or both. The impact of this could be amplified given reduced liquidity in some markets”. So, companies are cherry picking data to make their assets look good, knowing that a downturn in the economy would turn their racehorses into donkeys.

Cyber Security: “banks representing more than 80% of the outstanding stock of PRA-regulated banks’ lending to the UK real economy, so far having completed penetration testing and having action plans in place, the FPC is satisfied that its 2015 Recommendation has been met…. (The BOE) will now consider its (presumably the economy) tolerance for the disruption to important economic functions of the financial system in the event of cyber attack”. Presumably yet another Government organisation will be shuffled into existence to administer such measures and tolerance testing. Hopefully the results will be made public. No chance of that in reality.

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