BoE published the financial stability report, which sets out views of the Financial Policy Committee (FPC) on stability of the financial system in UK. The report highlights that the UK banking system has so far been able to meet most of the initial surge in demand for credit due to COVID-19 pandemic, primarily through government-backed schemes. This reflects the resilience that has been built up since the global financial crisis as well as the extraordinary policy responses of the government and BoE. Critical financial infrastructure, on which the economy relies, has also been resilient. However, underlying vulnerabilities remain and disruption could resurface in the face of certain triggers. There could also be an amplified tightening of credit conditions in the event of a large wave of downgrades of corporate bonds or leveraged loans. Banks will incur losses if businesses struggle to weather disruptions related to the outbreak of COVID-19.
Overall, the financial stability report identifies key risks to the financial stability in UK and describes actions being taken to mitigate the identified risks. The report also presents the activities of FPC over the reporting period and the extent to which the previous policy actions of FPC have succeeded in meeting the objectives. In the financial stability report, FPC highlights that banks have buffers of capital more than sufficient to absorb the losses that are likely to arise under the central projection of the Monetary Policy Committee. Also taking into account the lending guarantee schemes of the government, banks have the capacity to continue providing credit to support the UK economy. FPC also highlights that the banking system cannot be resilient to all possible outcomes―there are inevitably very severe economic outcomes that would challenge the ability of banks to lend. However, FPC recognizes that, having entered a period of stress, there are costs to banks taking defensive actions, such as cutting lending to seek to boost their resilience. By restricting lending, those actions could make the central outlook materially worse.
FPC, therefore, takes an explicitly countercyclical approach to stress testing banks, building up their resilience outside stress periods so that their buffers of capital can then be used in a stress to continue to lend. Based on its "reverse stress test" exercise, FPC judges banks to be resilient to a very wide range of possible outcomes. It would, therefore, be costly for them and for the wider economy to take defensive actions. It remains the judgement of FPC that banks have the capacity, and that it is in the collective interest of the banking system, to continue to support businesses and households through this period. FPC will continue to monitor the risks to the economic outlook against the results of the "reverse stress test" and keep its judgement under review. FPC welcomes the work by FSB to undertake a comprehensive review of the provision of market-based finance in light of the COVID-19 shock.
The report further highlights that most risks to the UK financial stability that could arise from disruption to cross-border financial services have been mitigated, even if the current transition period ends without the UK and EU agreeing specific arrangements for financial services. Thus far, the COVID-19 pandemic has not materially delayed preparations in the financial sector overall. Further action is needed to minimize risks of disruption to the derivatives markets. Disruption to cleared derivatives markets can be avoided by ensuring clarity on the recognition of UK central counterparties by the end of September. The report also states that it is essential to end reliance on LIBOR benchmarks before the end of 2021. After that point, LIBOR benchmarks could cease to be available at short notice. Authorities and industry working groups have revised plans that seek to ensure that the transition from LIBOR is delivered by then. FPC welcomes the forthcoming publication of a protocol for legacy LIBOR-linked derivatives contracts by ISDA. Firms should seek to incorporate appropriate fallback language into their legacy derivatives contracts. The report also mentions that new ways of making payments that become critical to the functioning of the economy will need to be regulated to clear standards.
The financial stability report also includes a technical annex that describes the data and assumptions used to produce the analysis in the report of how the COVID-19 shock might affect UK corporate finances this year. Along with the report, BoE has published a summary and record of the FPC meetings held on July 29, 2020 and August 03, 2020. The next policy meeting of FPC will be on September 30, 2020 and a record of that meeting will be published on October 08, 2020.
Keywords: Europe, UK, Banking, Insurance, Securities, COVID-19, Financial Stability Report, Stress Testing, Guarantee Scheme, Credit Risk, Brexit, Transition Period, LIBOR, FPC, BoE
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