Bank of England Raises Buffer Rate as Stability Risks Grow

  • FPC increases countercyclical buffer rate to 0.5% of RWAs
  • `Brexit' vote poses risk to financial stability, FPC says

U.K. Conservative Party Division Over ‘Brexit’

The Bank of England said banks should begin building up capital earmarked to support lending when the economy turns down, as the outlook for U.K. financial stability worsens.

The BOE’s Financial Policy Committee raised the countercyclical capital buffer rate for U.K. exposures to 0.5 percent of risk-weighted assets from zero, becoming binding from March 29 next year. The buffer applies to U.K. banks and building societies, as well as to branches of other European Union banks that lend into the country.

“Risks associated with domestic credit are no longer subdued,” and global risks “which can also affect U.K. exposures indirectly, are heightened,” the FPC said on Tuesday in explaining its decision. The June 23 referendum on the U.K.’s membership of the EU is the source of “the most significant near-term domestic risks to financial stability,” the regulator said in a statement.

The BOE said it intends to set the countercyclical capital buffer at about 1 percent in a “standard risk environment.” The aim of the measure is to push against banks’ tendency to boost lending in boom times only to slash it in a bust, exacerbating damage to the economy.

The central bank also wants to use the buffer to help simplify its capital requirements and make them more transparent.

‘Financial Imbalances’

Toward this end, overlapping elements of existing bank-specific capital buffers will be reduced, “where possible,” by 0.5 percent as the countercyclical buffer is increased, the FPC said. As a result, “banks accounting for around three quarters of the outstanding stock of U.K. lending will not see their overall regulatory capital buffers increase,” the regulator said. This is a “one-off adjustment reflecting the transition to the new capital framework,” it said.

A countercyclical leverage ratio buffer will be set at 35 percent of the risk-weighted buffer, applying only to big U.K. banks and building societies.

“The bank is creating room on the downside, space that can be used if there’s a Brexit, for example,” Philip Rush, U.K. economist at Nomura International Plc in London, said before Tuesday’s decision. “It’s basically a neutral reallocation of capital within the current structure. There are some large financial imbalances in the U.K. economy that could correct if there’s a Brexit.”

Sterling Spot

On risks to stability from the EU-membership referendum, the FPC said the effect so far “has been most marked in sterling spot and options markets,” and “heightened and prolonged uncertainty has the potential to increase the risk premia investors require on a wider range of U.K. assets.”

The FPC said some market developments “motivate careful review” and consideration of possible changes to international rules to promote “market effectiveness.”

“Some measures of liquidity, such as bid-ask spreads, do not suggest deteriorating conditions,” the FPC said. “However, the Committee also places weight on indications of lower market depth, smaller trade sizes on average and greater price impact of asset sales.”

Officials plan to feed the results of stress tests, which the banks undergo annually, into the calculation of buffer rates.

Post-Crisis Period

The BOE published the key elements of its 2016 stress test, which is applied to banks and building societies with total retail deposits of more than 50 billion pounds. The scenario reflects the central bank’s judgment that “domestic risks to the U.K. banking system have risen beyond their subdued levels during the immediate post-crisis period, but are not yet elevated.”
 
Under the BOE’s five-year macroeconomic stress scenario, U.K. gross domestic product falls 4.3 percent, with a 4.5 percentage point increase in unemployment. Residential property prices fall 31 percent, and commercial real estate prices plummet 42 percent.
 
Banks are expected to meet minimum risk-based capital requirements in the stress scenario, though no common hurdle for common equity Tier 1, the highest-quality capital, has been set because the BOE considers some bank-specific requirements as part of the minimum.
 
A Tier 1 leverage ratio hurdle rate of 3 percent will be applied to all banks in the test.
 
The four biggest U.K. lenders will also undergo a Europe-wide stress test this year run by the European Banking Authority.

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