Stress tests reveal lenders are understanding exposure to bad debt in face of an economic downturn.
The Bank of England has issued its strongest warning yet about the UK’s ballooning consumer debt, saying Britain’s banks could incur £30bn of losses on their lending on credit cards, personal loans and for car finance if interest rates and unemployment rise sharply.
After assessing the fast growth in the consumer credit market, The Edneedle Street is requiring the banking system to hold an extra £10bn of capital as protection against any future losses after finding that lenders are underestimating their exposure to bad debts in an economic downturn.
publishing its latest assessment of risks to the financial system, the Bank also spelt out specific concerns about the impact of Brexit on £20tn of derivatives contract used by companies and financial firms to manage their risks.
The UK’s withdrawal from the EU also raises questions about whether banks will be able to hold consumer data in Britain and the ability of insurance companies to make payments to consumers across the union.
The Bank’s financial policy committee – set up to look for risks to the financial system in the wake of the 2008 crisis – is concerned there is a “pocket of risk in the rapid growth of consumer credit”.
This is not perceived to be a risk to economic growth as consumer lending is only 11% of household debt. But it is a risk to lenders’ ability to withstand losses in a downturn as these loans are the ones that are less likely to be repaid when consumers lose their jobs or face higher interest rates.
As a result, the Bank has brought forward stress tests of the UK’s banks based on hypothetical scenarios of interest rates rising to 4% and unemployment reaching 9.5%. This found they would incur £30bn of losses – about 20% of their consumer lending and a similar level to the crisis but £10bn more than might have been expected.
Each lender will be told how much they are impacted at the time of the annual stress tests in November while the smaller lenders which do not participate in the tests will also be assessed.
The FPC said it had concluded that lenders “have been attributing too much of the improvement in consumer credit performance in recent years to underlying performance in credit quality and too little to the macro economic environment”.
“As a result they have been underestimating the losses they could incur in a downturn,” the FPC said, after lenders’ losses fell to 2% from 5% between 2001 and 2016.
The move follows a warning in July by Alex Brazier, the Bank’s executive director of financial stability, of a “spiral of complacency” about a consumer credit market that was growing at 10% a year when household income had grown only 1.5%.
The Bank had already told lenders to start amassing £11.4bn of extra capital in the next 18 months.
The focus on consumer credit has led to Labour’s proposal to put a cap on credit card rates, meaning people would not have to pay back more than twice the amount of their credit card borrowings, to try to help customers in specific debt.
The Bank’s announcement on Monday did not contain such detailed proposals but the warning that lenders’ will need to hold more capital could lead to banks gradually pushing up interest rates to cover their additional costs. The FPC said it “expects banks will begin to factor these market-wide levels of stressed losses on consumer credit into their overall lending and capital plans”.
Its announcement also considers the impact of a hard Brexit – one with no deal when the UK leaves the EU in March 2019 – on the way that derivatives contracts are handled by the City and concludes tens of thousands of deals could be affected. This is a quarter of all contracts, for instance to protect to against interest rates or oil prices increasing, that are not passed through clearing houses.
For large dealers involving the big US banks, between 2,000 and 4,000 of their counterparties would need to be contacted to change the terms of contracts.
The Bank warned “there are no precedents” for these types of changes to take place within the 18 months left before Brexit.
Legislation could be needed to allow existing contracts to remain as they are – a process known as “grandfathering” – and only new ones impacted by the changes that are taking place.
The Bank – which has seen each firms’ Brexit plans – said they also lack “robust contingency plans” to tackle changes to the way that they will be able to store consumer data in the UK after March 2019. “Many firms currently rely on data centres located in the United Kingdom to provide financial services across Europe,” the Bank said.