Ensuring Financial Stability: The Role of the Financial Policy Committee

The Financial Policy Committee (FPC) is dedicated to ensuring that the UK financial system remains resilient and prepared to confront a variety of risks. The goal is to create a financial environment capable of absorbing shocks rather than amplifying them, thereby serving the needs of UK households and businesses. This approach ultimately supports stability and growth within the UK economy.

Current Risk Landscape

Despite global efforts towards stabilization, risks and uncertainties remain high due to various factors including geopolitical tensions, the fragmentation of global trade and financial markets, and ongoing pressures on sovereign debt markets. Some of these geopolitical threats have materialized, contributing to persistent material uncertainty in the global macroeconomic outlook. These risks pose significant concerns for the stability of the UK financial system, given the UK's status as an open economy with a prominent financial sector.

Market Volatility and Trade Tariffs

Global fiscal pressures have catalyzed significant movements in financial markets, largely influenced by trade tariff announcements. The announcement from the US regarding intentions to implement significantly higher tariffs on April 2 resulted in a notable increase in market uncertainty and a sharp decline in the value of risky assets. Subsequently, government bond prices also fell, with rising yields in US Treasury bonds affecting government bond yields in the UK, Japan, and other advanced economies. Most pronounced was the increase in yields for longer-dated bonds, partly due to an increase in term premia, which remained elevated compared to levels observed during the November Financial Stability Report (FSR), although they have declined somewhat since April.

Currency Dynamics During Stress

The US dollar experienced a weakening trend during this period of market stress, which is contrary to historical patterns where US Treasury yields typically decline and the dollar gains strength. Since the upheaval on April 2, the US dollar has continued to depreciate, raising concerns about the implications for external trade and capital flows.

UK Growth and Debt Servicing Resilience

The growth outlook for the UK over the coming year appears relatively weaker and more uncertain compared to projections made in the November FSR. Nevertheless, the resilience of UK households and corporations appears to be robust overall. Significant macroeconomic shocks would be required for deterioration in aggregate debt servicing measures to occur. While the proportion of high loan-to-income (LTI) and loan-to-value mortgage lending has been on the rise in recent quarters, the anticipated increase in the aggregate household debt servicing ratio (DSR) is expected to be modest, and the percentage of borrowers with high DSRs is likely to remain low.

Corporate Risk Exposure

Corporate borrowers, particularly those heavily reliant on market-based finance, face heightened exposure to global shocks. However, the volume of corporate debt requiring refinancing over the upcoming year has remained relatively low since the November FSR, standing at about 10%. There exists less clarity concerning the refinancing needs of corporations borrowing in private markets, which represents a potential area of concern.

Lending Limits and Regulation

The FPC has engaged in discussions regarding its current LTI flow limit, building upon deliberations from the first quarter of the year. This included evaluating potential obstacles to the more extensive use of LTI flow limits by lenders in a manner consistent with their own risk parameters and business models. The Committee has recommended that both the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) revise the implementation of the LTI flow limit. This change would enable individual lenders to potentially increase their share of lending at higher LTIs while maintaining an aggregate lending flow consistent with a limit of 15%. By the first quarter of 2025, the share of lending at an LTI ratio of 4.5 or higher had climbed to 9.7%. This is projected to rise further throughout the year, partly due to the increased use of lower stress rates in borrower affordability assessments.

Countercyclical Capital Buffer Assessment

Maintaining stability in the financial sector, the FPC has decided to keep the UK countercyclical capital buffer (CCyB) rate at a neutral level of 2%. This decision is based on an assessment of the evolution of domestic economic conditions and any underlying vulnerabilities. Key indicators that pertain directly to risk exposure regarding banks’ UK assets, such as domestic credit growth and debt vulnerability measures, have not shown significant deviation from long-term averages. While some credit conditions, notably in mortgages, have eased, the Committee has judged that these changes have not meaningfully increased vulnerabilities that could exacerbate shocks. Ongoing close monitoring of financial conditions will ensure that the UK CCyB rate remains appropriate going forward.

Market Functionality Amidst Volatility

The UK markets navigated the heightened volatility period in April relatively well, largely due to the transient nature of the disruption. However, vulnerabilities persist, particularly related to excessive leverage, which could compromise market functionality under prolonged stress and contribute to broader financial instability.

Developments in the Stablecoin Industry

Since the release of the November FSR, the stablecoin industry has witnessed significant global developments. In the second quarter, the FPC examined feedback from the FCA and Bank of England’s discussion paper on stablecoins. Establishing a regulatory framework that is appropriate to the risks associated with stablecoins is deemed essential for financial stability. The FPC supports exploring options that could permit some return on backing assets for stablecoins frequently utilized in transactions, while ensuring that these stablecoins remain exchangeable into other forms of money at a 1:1 value at all times. Given the global nature of these markets, it remains critical for the international regulatory community to address financial stability risks associated with global stablecoins effectively.