In December 2023, the Bank of England unveiled its Financial Stability Report, offering a comprehensive assessment of the risk landscape facing the UK's financial system. The report delves into the impact of macroeconomic forces on households and businesses, evaluates the resilience of the UK banking system, and scrutinizes risks emanating from non-bank (market) finance.
Projections from the Bank of England's November Monetary Policy Report indicate expectations of global growth remaining below its 2010-19 average, primarily due to tighter monetary and financial conditions. While inflation remains elevated, recent data suggests a declining trend. Financial markets have factored in the likelihood that major central banking policy rates are either at or nearing their peaks, potentially alleviating pressure on credit for households and corporations in the future.
However, external events, such as the ongoing conflict in Ukraine and recent developments in the Middle East, may persistently impact energy prices, exacerbating inflationary pressures and sustaining higher interest rates for an extended period. The report singles out the volatility in oil futures as a key risk, driven by uncertainties surrounding trade flows resulting from geopolitical events.
These higher interest rates, whether sustained or not, are poised to reverberate across the global financial system. The report underscores potential ramifications, including an increase in global risk aversion leading to marked-to-market losses on banking assets, particularly in the global commercial real estate (CRE) market, which has seen a 10% year-on-year decline in aggregate prices in both Europe and the U.S. and looking at global residential prices in recent years since March 2016:
Figure A
Source: William John Analytics, Bank of England
The devaluation of real estate poses a material risk to major lenders, diminishing the value of collateral held against their loans. Moreover, foreign borrowers facing higher debt-servicing costs could experience an uptick in defaults, resulting in losses on non-UK lending. As global investors reassess risk appetite, the cost and availability of market-based finance for UK institutions may be impacted, presenting acute refinancing challenges for highly leveraged companies.
Examining the overseas banking economy in Europe and the U.S., the report points to stress earlier in the year with the collapse of Silicon Valley Bank and Credit Suisse, underscoring the potential contagion effects across jurisdictions. This stress extended to financial market pricing, influencing banks' funding costs and share prices, particularly in the United States. While US bank equity prices showed a modest recovery over the summer, recent weaknesses have emerged with the rise in long-term interest rates, particularly affecting regional banks.
Figure B
Source: William John Analytics, Bank of England, FTSE UK Banks Index, Stoxx Europe 600 Banks Index, S&P 500 Banks Index, KBW Regional Banking Index
Several mid-sized US banks have experienced downgrades by credit rating agencies. The recent increase in long-term US bond yields presents additional challenges, particularly for banks contending with substantial unrealized losses on fixed-rate asset portfolios devalued by higher market interest rates. Banks with significant exposures to commercial real estate (CRE) face heightened vulnerability due to the concurrent rise in long-term interest rates and declines in CRE prices.
Despite these challenges, immediate risks in the US banking sector appear to have stabilized. Smaller US banks have witnessed a recovery in deposits, and while there have been marginal increases in the utilization of the Federal Reserve's Bank Term Funding Program, overall usage has remained relatively stable since the July 2023 Financial Stability Report (FSR).
Since July, US authorities have proposed measures aimed at enhancing the resilience of banks with over US$100 billion in assets, covering most of the largest regional banks. These measures align with the implementation of Basel III. Additionally, in August, US authorities outlined proposals to fortify the resolution framework, demonstrating a proactive stance in addressing potential vulnerabilities.
In contrast, euro-area banks have demonstrated resilience to the higher interest rate environment, benefitting from rising net interest margins in the first half of 2023. However, vulnerabilities persist in some banks, particularly concerning higher interest rates and asset quality, including real estate exposures, as highlighted in the ECB Financial Stability Review.
Although rising interest rates have generally supported profitability for US and euro-area banks, certain institutions in both regions face longer-term challenges due to a combination of low-yielding assets and escalating funding cost – it seems it is only a matter of time before rates or assets give way.
Any opinions expressed in this document are those of William John and are provided for information only. E&OE
