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Financial Stability Report – December 2023

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Financial Policy Summary

The Financial Policy Committee (FPC) seeks to ensure the UK financial system is prepared for, and resilient to, the wide range of risks it could face – so that the system is able to absorb rather than amplify shocks, and serve UK households and businesses.

The overall risk environment

The overall risk environment remains challenging, reflecting subdued economic activity, further risks to the outlook for global growth and inflation, and increased geopolitical tensions. Long-term interest rates in the UK and US are now around their pre-2008 levels. The full effect of higher interest rates has yet to come through, posing ongoing challenges to households, businesses and governments, which could be amplified by vulnerabilities in the system of market-based finance. So far, and while the FPC continues to monitor developments, UK borrowers and the financial system have been broadly resilient to the impact of higher and more volatile interest rates.

Financial market developments

Current market pricing suggests that policy rates in the US, UK and euro area are at or near their peaks, and central banks have emphasised that they expect rates will need to remain at these levels for an extended period, in order to continue to address inflationary pressures. Returning inflation to target sustainably supports the FPC’s objective of protecting and enhancing UK financial stability.

Long-term interest rates are high and remain volatile in major advanced economies. Despite falling back somewhat since Q3, US long-dated government bond yields have risen since the July Financial Stability Report (FSR), with UK, euro area and Japanese long-term government bond yields following a similar pattern. Most of the recent upward move in US long-dated yields can be attributed to estimated term premia – the additional compensation that investors require to hold longer term rather than short-term bonds – which have increased from previously low levels. A number of factors could explain the rise in term premia across major advanced economies, including increased uncertainty around the longer-term economic outlook and interest rates, as well as evolving investor expectations of future supply and demand in government bond markets.

The full impact of higher interest rates will take time to come through. Given the impact of higher and more volatile rates, and uncertainties associated with inflation and growth, some risky asset valuations continue to appear stretched. Credit spreads are broadly unchanged since Q3, with the exception of leveraged loan spreads which have widened a little. Some measures of equity risk premia remain compressed, particularly in the US.

Global vulnerabilities

The adjustment to higher interest rates continues to make it more challenging for households and businesses in advanced economies to service their debts. Riskier corporate borrowing in financial markets, such as private credit and leveraged lending, appears particularly vulnerable. Although there are few signs of stress in these markets so far, a worsening macroeconomic outlook, for example, could cause sharp revaluations of credit risk. Higher defaults could also reduce investor risk appetite in financial markets and reduce access to financing, including for UK businesses.

Some banks in a number of jurisdictions have been impacted by higher interest rates. They also remain exposed to property markets, including commercial real estate where prices in some countries have fallen significantly.

High public debt levels in major economies could have consequences for UK financial stability, especially if market perceptions for the path of public sector debt worsen. The FPC will take into account the potential for these to crystallise other financial vulnerabilities and amplify shocks when making its assessment of the overall risk environment.

Vulnerabilities in the mainland China property market have continued to crystallise, and significant downside risks remain. This could lead to broader stresses in other sectors of the mainland Chinese economy, and materially affect Hong Kong. The results of the 2022/23 annual cyclical scenario indicated that major UK banks would be resilient to a severe global recession that included very significant falls in real estate prices in mainland China and Hong Kong.

Geopolitical risks have increased following the events in the Middle East, increasing uncertainty around the economic outlook, particularly with respect to energy prices. If these risks crystallised, resulting in significant shocks to energy prices, for example, this could impact on the macroeconomic outlook in the UK and globally, as well as increasing financial market volatility.

UK household and corporate debt vulnerabilities

Since the July FSR, household income growth has been greater than expected. This has reduced the share of households with high cost of living adjusted debt-servicing ratios, and a lower expected path for Bank Rate has reduced the extent to which that share is projected to rise. Nevertheless, household finances remain stretched by increased living costs and higher interest rates, some of which has yet to be reflected in higher mortgage repayments. Arrears for secured and unsecured credit remain low but are rising as the impact of higher repayments is felt by borrowers.

In aggregate, UK corporates’ ability to service their debts has improved due to strong earnings growth and the sector is expected to remain broadly resilient to higher interest rates and weak growth. But the full impact of higher financing costs has not yet passed through to all corporate borrowers, and will be felt unevenly, with some smaller or highly leveraged UK firms likely to remain under pressure. Corporate insolvency rates have risen further but remain low.

UK banking sector resilience

The UK banking system is well capitalised and has high levels of liquidity. It has the capacity to support households and businesses even if economic and financial conditions were to be substantially worse than expected. The overall risk environment remains challenging, however, and asset performance deteriorated among some loan portfolios in Q3. Some forms of lending, such as to finance commercial real estate investments, buy-to-let, and highly leveraged lending to corporates – as well as lenders that are more concentrated in those assets – are more exposed to credit losses as borrowing costs rise.

Aggregate net lending remains subdued, driven by reduced demand for credit and a tightening in banks’ risk appetites. The tightening in credit conditions over the past two years appears to have reflected the impact of changes to the macroeconomic outlook, rather than defensive actions by banks to protect their capital positions.

There is some evidence that net interest margins (NIMs) have peaked. The aggregate profitability of the major UK banks is nevertheless expected to remain robust, with NIMs expected to remain higher than in recent years when Bank Rate had been close to the effective lower bound, and similar to levels seen before the global financial crisis when Bank Rate was comparable to its current level.

Alongside the higher risk-free interest rate environment, a number of system-wide factors are likely to affect funding and liquidity conditions in the UK banking sector over the coming years, including as central banks normalise their balance sheets. Those factors will affect sources of bank funding and could affect their cost – for example through continued competition for deposits and greater use of some forms of wholesale funding. Banks will need to factor these system-wide trends into their liquidity management and planning over the coming years.

The impact on individual banks will depend, amongst other things, on their funding structure and business model. Banks have a range of ways in which they can adjust to changing trends in funding and liquidity, including through their mix of funding and liquid assets, and through the nature, quantity, and pricing of lending they undertake.

The FPC will monitor the implications of these trends for financial stability.

The UK countercyclical capital buffer rate decision

The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at its neutral setting of 2%. The FPC will continue to monitor developments closely and stands ready to vary the UK CCyB rate, in either direction, in line with the evolution of economic and financial conditions, underlying vulnerabilities, and the overall risk environment.

The resilience of market-based finance

Vulnerabilities in certain parts of market-based finance remain significant, and in some sectors have increased since the July FSR. Funds investing in riskier corporate credit have seen outflows. Hedge fund net short positioning and asset managers’ leveraged net long positions in US Treasury futures have also increased further, which could contribute to market volatility if hedge funds needed to unwind their positions rapidly. While the financial system has so far been broadly resilient to the higher interest rate environment, vulnerabilities in market-based finance could crystallise in the context of higher and more volatile interest rates or sharp movements in asset prices, leading to dysfunction in core markets and amplifying any tightening in credit conditions.

Alongside international policy work led by the Financial Stability Board, the UK authorities are also working to reduce vulnerabilities domestically where this is effective and practical. The FPC welcomes proposals by UK authorities to increase the resilience of UK-based money market funds, which have been published today.

In November, the Bank released the hypothetical scenario for its system-wide exploratory scenario (SWES) exercise. The SWES will assess the behaviours of banks and non-bank financial institutions during stressed financial market conditions, and how they might interact to amplify shocks to markets core to UK financial stability. Under the stress scenario, participating firms will model the impact of a shock that is faster, wider ranging and more persistent than those observed in recent events in financial markets.

1: Developments in financial markets

Current market pricing suggests that policy rates in the US, UK and euro area are now at or near their peaks, and central banks have emphasised that they expect them to remain elevated for an extended period.

In the UK, Bank Rate is currently 5.25%. While at the time of the July FSR the expectation was for Bank Rate to peak at 6.2%, current market pricing now implies that market participants are not expecting further rises. This reduction in short-term expectations for peak policy rates has been reflected in a slight decline in yields on UK government bonds of maturities out to 10 years. In the US and the euro area, market pricing similarly implies that market participants expect that policy rates have broadly peaked.

Central banks have emphasised that they expect rates to remain at these levels for an extended period, in order to continue to address inflationary pressures. Returning inflation to target sustainably supports the FPC’s objective of protecting and enhancing UK financial stability. Globally, potential sources of further inflationary pressures remain. In particular, recent events in the Middle East have increased uncertainty around future oil prices (see Section 2). In addition, US growth projections have been revised up since July, with the economy expected to expand by around 2¼% in 2023, although the outlook for global growth generally remains subdued.

Some longer-term interest rates have continued to rise since the July FSR…

Yields on 30-year government bonds are now close to 4.6% in both the UK and the US, which is around their levels prior to the global financial crisis (GFC) (Chart 1.1, left panel). Since July, the upward shift has been most pronounced in the US, with the UK and other advanced economies following a broadly similar pattern (Chart 1.1, right panel).

Chart 1.1: In advanced economies long-term bond yields have risen significantly

Yields on UK, US and German 30-year government bonds

Line chart showing changes in 30 year government bond yields for the UK, US and Germany, since 2003. The chart highlights the recent changes, with all three lines rising across 2023, meaning that they reach levels previously seen prior to the global financial crisis.
  • Source: Bloomberg Finance L.P.

Long-term interest rates in part reflect market expectations of future policy rates. For example, current market pricing implies that Bank Rate in ten years’ time is expected to be around 4%, up from around 3.5% at the end of Q2. This means that financing costs for households, businesses and governments could remain higher further into the future than had been previously anticipated (see Section 3). It is possible that market perceptions of the equilibrium real interest rate have risen.

…in part reflecting an increase in term premia.

Interest rates on long-term government bonds can also be affected by the amount of additional compensation that investors require to hold these instruments rather than rolling over short-term assets. This compensation, referred to as ‘term premia’, cannot be observed directly and estimates are sensitive to the model used. Model estimates indicate that the roughly 60 basis point increase since the July FSR in the 10-year US Treasury bond yield – a globally important benchmark – is attributable to an increase in the term premium (Chart 1.2). Although the term premium has increased, it remains low relative to its long-run average level. The term premium is also estimated to have risen on 10-year UK gilts since July. A number of factors could explain the rise in term premia, including increased uncertainty around the longer-term economic outlook and interest rates, and evolving investor expectations of future supply and demand in government bond markets (because, other things equal, increased net supply of government debt can increase term premia).

Chart 1.2: Term premia have pushed up interest rates on some long-term government bonds

Decomposition of changes in the 10-year US Treasury bond yield into expected rates and term premium

Line chart showing the term premia and expected rates components of changes in nominal 10-year US Treasury bond yields since 30 June 2023. Term premia are the dominant factor in the upward shift across the period.
  • Sources: Federal Reserve Bank of New York and Bank calculations.

Volatility in core rates markets remains elevated, but they are functioning normally.

Volatility in rates markets has been elevated by historical standards during 2023. For example, the MOVE index of implied volatility in US Treasury markets is in the top quartile of its historical range. Market volatility, if severe enough, can cause a deterioration in market functioning and interact with vulnerabilities in market-based finance to create risks to financial stability. But market contacts and liquidity metrics, such as bid-offer spreads (Chart 1.3), suggest that liquidity in core markets is within a normal range. Nonetheless, liquidity conditions could deteriorate quickly, especially if market volatility were to increase further, or if vulnerabilities in MBF were to crystalise.

Chart 1.3: Core market liquidity is within its normal historical range

Bid-offer spread versus realised volatility for the 10-year benchmark gilt, since 2019 (a)

Scatter plot showing realised 10-day volatility against 10-day bid-off spread, since 2019. The latest data point is highlighted. It sits in the lower half of the distribution for both measures.

Despite rising interest rates, corporate credit spreads are broadly unchanged since July…

Rising yields on government debt have fed through into higher yields on riskier lending to corporates. Higher yields push up refinancing costs, increasing pressure on corporates. However, the additional yield – the ‘spread’ that investors demand in return for credit risk – has been broadly unchanged for investment grade and high-yield bonds since the July FSR (Chart 1.4). These spreads are slightly wider than their long-run average levels in the UK, and slightly tighter in the US.

Chart 1.4: Credit spreads are broadly unchanged since July

Investment grade and high-yield bond spreads over risk-free rates

Line chart showing credit spreads for investment grade and high yield bonds, for both US dollar and pound sterling denominated debt, since January 2020. The chart shows that levels have recently been broadly flat.
  • Sources: ICE BofA USD High Yield Index (Ticker: H0A0), USD Investment Grade Index (Ticker: C0A0), GBP High Yield Index (Ticker: HL00), GBP Investment Grade (Ticker: UR00).

For leveraged lending, spreads have widened a little over recent months. In the UK, they are around 550 basis points, broadly in line with their 10-year historical average. See Box B for further discussion of leveraged lending.

Market intelligence suggests that market participants are in general relatively sanguine about credit risk, in part because the perceived likelihood of recession has reduced since the start of the tightening cycle, and because of a perception that corporates have generally been proactive with their refinancing needs. And while default rates on riskier credit have recently increased, in particular for leveraged loans, they remain well below their GFC peaks. Nonetheless, the relative stability in credit valuations has taken place against a backdrop of elevated and more volatile interest rates and uncertainty over their impact on borrowers and on the macroeconomy.

…and US equity valuations appear stretched…

The FPC judges that given the impact of higher interest rates, and uncertainties associated with inflation and growth, the valuations of some risky assets continue to appear stretched, particularly in the US. Since the July FSR, the US, UK and European stock markets have been broadly flat. However, in the context of rising long-term interest rates, the excess cyclically adjusted price-to-earnings (CAPE) yield – a measure of the excess return that investors expect from equities relative to government bond yields – on US equities has continued to fall, and is approaching its lowest level since around the time of the dotcom crash in the early 2000s (Chart 1.5). This could imply that US equity valuations have become more stretched.

Chart 1.5: US equity valuations are high relative to risk-free alternatives

Excess cyclically adjusted price-to-earnings yield (excess CAPE) for the S&P 500

Line chart showing the Excess CAPE yield for the S&P 500 since 1994. The current level is below the series average, and approaches levels seen prior to the dotcom crash in the early 2000s.
  • Sources: Bloomberg Finance L.P., Federal Reserve Bank of St Louis and Bank calculations.

.…increasing the risk of sharp reductions in asset prices, and an associated tightening of financial conditions for households and businesses.

Should growth weaken or other risks crystallise, a reduction in investor risk appetite could trigger a revaluation of assets, particularly since a deterioration in demand or corporate earnings would negatively impact debt servicing capacity. Sharp decreases in asset prices could further tighten financial conditions, especially for riskier borrowers when they refinance their debts and if signs of a slowdown in private markets (such as private credit and private equity) persist (see Box B). This could impair businesses’ ability to raise finance, by increasing the cost of bond and equity issuance.

A sharp reduction in asset values could also directly affect the financial system – for example through direct losses on asset holdings, by reducing the value of collateral securing existing loans, or by creating sharp increases in the demand for liquidity. Any such moves could be amplified by vulnerabilities in MBF, potentially tightening financial conditions for UK households and businesses (Section 5).

Box A: Developments in cryptoasset markets

The FPC conducts regular horizon scanning to identify emerging risks to the financial system. As part of this, the Committee has been monitoring risks from cryptoassets and associated activities. Cryptoassets are a digital representation of value or contractual rights that can be transferred, stored or traded electronically, and which typically use cryptography, distributed ledger technology or similar technology.

In March 2022, the FPC judged that direct risks to the stability of the UK financial system from cryptoassets and associated markets and activities, including decentralised finance (DeFi) were limited, but that risks would emerge if cryptoasset activity and its interconnectedness with the wider financial system developed.

That assessment reflected their small size and limited interconnectedness with the wider financial system. The FPC stated that it was monitoring risks to financial stability that could arise through four risk channels: risks to systemic institutions; risks to core financial markets; risks to the ability to make payments; and the impact on real economy balance sheets.

The FPC also judged that enhanced regulatory frameworks, both domestically and at a global level, were needed to address developments related to cryptoassets.

In accordance with the principle of ‘same risk, same regulatory outcome’, the FPC judged that where cryptoasset technology is performing an equivalent economic function to one performed in the traditional financial sector, this should take place within existing regulatory frameworks, and that the regulatory perimeter should be adapted as necessary to ensure an equivalent regulatory outcome. Innovation from cryptoassets and DeFi can only be sustainable if undertaken safely and accompanied by effective regulation that mitigate risks.

The FPC stated that it would pay close attention to developments in cryptoasset markets to ensure the UK financial system was resilient to systemic risks that might arise. The rest of this box outlines the developments in cryptoassets and associated markets and activities since the March 2022 Financial Stability in Focus, including an update on financial stability risks, and on the development of regulatory frameworks to address these.

The systemic risks that the FPC previously said could arise in future from cryptoasset activities have not materialised thus far.

The market capitalisation of the cryptoasset ecosystem declined by more than 70% from a peak of around US$3 trillion in November 2021 to US$800 billion in November 2022, before increasing to around US$1.4 trillion in November 2023 – (Chart A). This remains very small in the context of global capital markets: by way of comparison, the market capitalisation of the global equity market is estimated to be just above US$100 trillion, and outstanding global fixed-income securities around US$130 trillion in 2023.

Associated cryptoasset markets and activities have also declined over the same period: the total monetary value locked in the smart contracts of DeFi protocols has declined by 74% from its peak in November 2021 to US$47 billion; the average (mean) daily trading volume of bitcoin on exchanges in October 2023 was 44% of the daily average in November 2021; and the market capitalisation of stablecoins has declined from a peak of around US$180 billion in April 2022 to US$125 billion at present (Chart A).

Chart A: The size of the cryptoasset ecosystem has declined since March 2022

Market capitalisation of: all cryptoassets (a) and stablecoins (b)

The chart shows two time series plots: the market capitalisation of stablecoins; and the market capitalisation of all cryptoassets between 2013 and the present date. The total market capitalisation of cryptoassets peaks at around 3 trillion dollars in late 2021, before falling by more than two-thirds, and then recovering to roughly half of its original peak by late 2023. The market capitalisation of stablecoins rose quickly between early 2020 and early 2022, but has declined steadily thereafter to roughly two-thirds of its peak.

Events since November 2021 have also illustrated the need to bring cryptoassets and their associated activities within the regulatory perimeter.

The bankruptcies of the cryptoasset exchange FTX and cryptoasset lending firms such as Celsius, BlockFi and Voyager Digital have demonstrated that cryptoasset institutions are prone to a number of vulnerabilities that regulation in the conventional financial system is designed to avoid. For example, a number of centralised crypto trading platforms operate as conglomerates, bundling products and functions within one firm, whereas in conventional finance these functions are either separated into different entities or managed with tight controls and ring-fences and independent governance. The collapse of the algorithmic stablecoin TerraUSD, and the temporary depegging of the largest fiat-backed stablecoins USD Coin and Tether, have demonstrated risks in existing stablecoin arrangements. And to date, no so-called stablecoin has been able to maintain parity with its peg at all times.[1]

Systemic financial institutions’ involvement in cryptoassets remains very limited, but may grow in future.

A survey of wholesale banks conducted by the FCA in February 2023 found that around three quarters of survey respondents did not conduct any activities in relation to cryptoassets at that time, nor did they intend to conduct any activities in the future. Among those firms that indicated some involvement in cryptoasset markets, dealing – particularly as an agent – was by far the most common activity. A small number of firms not currently offering cryptoasset services plan on acting as dealers, offering custodial services, or issuing a stablecoin in future. The PRA reminded firms of their obligations with respect to cryptoasset exposures in March 2022, and clarified its expectations of deposit takers with respect to new forms of digital money in November 2023 in ‘Dear CEO’ letters.

Banks are more positive about the use of cryptoasset technologies (eg programmable ledgers and smart contracts) for the tokenisation of money and assets. Current applications are very limited in scope, and a significant share of projects are taking place on permissioned ledgers that do not involve the use of cryptoassets. However, some projects are also taking place on public blockchains. The growth of asset tokenisation on public blockchains could contribute to greater systemic risks from stablecoins and unbacked cryptoassets: it could increase the size of the cryptoasset ecosystem (eg by increasing the demand for cryptoassets to pay blockchain transaction fees, or stablecoins to act as a settlement asset); increase the interconnectedness of markets for cryptoassets and traditional financial assets (since they are represented on the same ledger); and create direct exposures for systemic institutions.

Risks to core financial markets from cryptoassets and associated market activities remain limited by the degree of institutional cryptoasset adoption. But this adoption could accelerate as regulatory frameworks and market infrastructures develop.

Institutional adoption of cryptoassets and associated derivatives remains small. In the market for Chicago Mercantile Exchange (CME) bitcoin futures (an institutional market owing to its relatively large contract size and regulated nature) the number of contracts held by market participants reached an all-time high in November 2023. However, the notional value at US$3.8 billion remains very low. By comparison, CME E-MINI S&P 500 futures contracts have an outstanding notional value of around US$490 billion.

According to market intelligence, the largest barriers to investment in cryptoassets for institutional investors include: price volatility; lack of fundamentals for valuation; regulatory challenges; challenges around security (eg adequate custody solutions); and market manipulation. However, developments in regulation and market infrastructure may catalyse greater institutional investment in cryptoassets in future.

Use of cryptoassets for payments in the UK remains very small, but this could change if a sterling-denominated stablecoin used for retail payments emerges.

There is currently no widely used sterling denominated stablecoin used for payments or in the cryptoasset ecosystem, and the use of cryptoassets for payments is extremely low. However, payment companies with large established networks have the potential to accelerate the adoption of stablecoins for payments quickly. Some payment service providers (eg PayPal) have recently launched services supporting stablecoins. The Bank will continue to monitor payment activities in relation to cryptoassets and stablecoins.

UK households’ cryptoasset holdings remain limited but are increasing.

An FCA consumer survey conducted in August 2022 found that 9% of UK adults owned cryptoassets at that time, up from 4.4% in 2021. While the mean holding was around £1,600, 40% of owners held less than £100 of cryptoassets.

Against this backdrop, the UK authorities have taken important steps towards putting in place a regulatory regime for the sector.[2]

The FCA has introduced money laundering and counter-terrorism financing rules for cryptoassets businesses in the UK (January 2020 and September 2023). In October 2023, the FCA put into place a regime for the marketing of crypto to UK consumers, ensuring that any marketing to retail consumers is clear, fair, not misleading and subject to approval by a regulated firm. The rules for marketing cryptoassets are aligned with existing rules for other high-risk investments. The FPC has urged investors to take a cautious approach to cryptoassets.[3]

In November 2023, the Bank and the FCA published discussion papers on their proposed approach to regulating stablecoins, which will support safe innovation in retail payments. HM Treasury (HMT) now intends to bring forward secondary legislation to bring stablecoins into the regulatory perimeter by early 2024.

HMT has also set out its approach to regulating broader cryptoasset activities and the FCA will develop the regulatory regime.

Beyond the proposals to regulate stablecoins, HMT recently finalised its proposals to regulate a number of trading and investment activities related to cryptoassets, which were set out in a February 2023 consultation paper. Secondary legislation and FCA rules will be required to implement the regime. The FPC noted that while this regime would not achieve the outcome of market integrity to the same degree as in traditional securities markets, it considered the consultation to be an important step in developing a regulatory regime, with further work anticipated as cryptoasset markets evolved and international standards were developed.

The high degree of interconnectedness and cross-border activity associated with cryptoassets mean that global risks are most effectively addressed through internationally co-ordinated reforms.

Many cryptoasset service providers, such as wallets and exchanges, as well as some issuers, operate from offshore jurisdictions while providing services globally.[4] International co-ordination can reduce the risks of cross-border spillovers, regulatory arbitrage, and market fragmentation.

Internationally, standard setters have made good progress in developing a global baseline for regulating cryptoassets.

This has been in line with the principle of ‘same risk, same regulatory outcome’. In July 2023, the Financial Stability Board (FSB) finalised its global regulatory framework for cryptoassets and stablecoins, focused on addressing risks to financial stability. Alongside this overarching framework, standard setters are establishing sectoral standards on market integrity and investor protection, on systemically important stablecoin arrangements, and on the treatment of banks’ exposures to cryptoassets.

Ensuring a wide and timely implementation of the international regulatory baseline will be key to mitigating the financial stability risks from cryptoassets.

The FSB will conduct a review of the implementation of its recommendations by end-2025. Given the cross-border nature of these markets, it will be important to ensure that both the FSB recommendations and sectoral international standards are implemented by the widest possible set of jurisdictions particularly those markets with the largest cryptoasset activity. Given the risks of regulatory arbitrage, this should include jurisdictions with currently limited regulation and jurisdictions with large crypto activity.

The FPC welcomes these developments and will seek to ensure that the UK financial system is resilient to systemic risks that may arise from cryptoassets and associated activities.

2: Global vulnerabilities

  • The outlook for global growth remains subdued and long-term interest rates have risen further. Geopolitical risks have increased following events in the Middle East.
  • Higher interest rates in advanced economies continue to pose challenges to UK financial stability through their impact on households, businesses, sovereigns and financial institutions.
  • Riskier corporate borrowing, such as private credit and leverage lending appears particularly vulnerable.
  • Some overseas banks could also be vulnerable to higher interest rates, including through their exposures to property markets, including commercial real estate, where prices in some countries have fallen significantly.
  • Vulnerabilities in the mainland China property market have continued to crystallise since the July 2023 FSR.
  • Major UK banks could experience spillovers from a materialisation of global risks, including in China. The results of the 2022/23 ACS indicated that major UK banks can continue to serve the UK economy in a severe global stress with elevated interest rates and very significant falls in real estate prices in mainland China and Hong Kong.

2.1: The global economic outlook

The outlook for global growth remains subdued, partly reflecting higher interest rates.

Projections in the November Monetary Policy Report (MPR) indicate that global growth over the next year is expected to remain below its 2010–19 average, reflecting tighter monetary and financial conditions. However, US growth projections have been revised upwards since July, with the economy expected to expand by around 2¼% in 2023.

Headline inflation remains elevated in advanced economies, but is declining. This largely reflects lower energy price inflation, although food and goods price inflation have also declined, particularly in the US. Global services inflation, however, remains elevated.

The paths for policy rates implied by current financial market pricing suggest rates are now expected to be at or near their peaks in the UK, US and euro area. Central banks have emphasised that they will need to remain high for an extended period in order to continue to address inflationary pressures. Long-term interest rates in advanced economies have increased since the July FSR, particularly in the US, where yields on 30-year government bonds are now around pre-GFC levels (see Section 1).

Geopolitical developments continue to add uncertainty to the economic outlook, and can pose risks to UK financial stability through a number of channels.

Geopolitical risks have increased following events in the Middle East. These events led to a relatively limited rise in energy prices, which has since retraced. However, uncertainty around future oil prices has increased. Further escalation of geopolitical tensions in the region could cause disruption to oil and gas markets and trade flows. A larger shock to energy prices would lead to higher inflation and increased cost of living pressures on households and businesses.

Other geopolitical risks remain. For example, in 2022, following Russia’s invasion of Ukraine, there was significant volatility in commodity markets, as well as increased volatility and risk aversion in financial markets more generally. And tensions between the US and China could disrupt global trade. Further escalation of geopolitical risks would increase the likelihood of vulnerabilities crystallising, which could impact the macroeconomic outlook in the UK and globally through trade and other channels, increase financial market volatility, and could particularly affect the UK’s internationally focused banks. Geopolitical developments are consistently cited by market participants as one of the biggest sources of risk to the UK financial system in the Bank’s Systemic Risk Survey.

2.2: The impact of higher interest rates on the global financial system

The adjustment to higher interest rates in advanced economies continues to pose challenges to UK financial stability.

As set out in Financial Stability in Focus: Interest rate risk in the economy and financial system, and in Figure 2.1, higher interest rates (and associated weaker global growth) could impact UK financial stability in a number of ways.

  • Banks could incur losses in the event of an increase in global risk aversion and falls in asset prices (including property prices), and UK financial conditions could tighten in response. The US banking stress earlier in the year illustrated how contagion could spread across borders even where there are no direct connections between institutions.
  • Increases in debt-servicing costs for foreign borrowers could increase defaults. UK banks could therefore also incur losses on their lending to non-UK borrowers.
  • A reversal in risk appetite among global investors can increase the cost or reduce the availability of market-based finance for UK institutions (see Section 1).
  • More broadly, global vulnerabilities can also amplify economic shocks in foreign economies and lead to spillovers to the UK, for example through lower demand for UK exports.

If rates remain higher for longer, it will pose particular refinancing challenges for highly leveraged corporates (see Box B).

Figure 2.1: Global shocks can affect UK financial stability in a number of ways

2.2.1: The impact of higher rates on the global banking system

Some banks in a number of jurisdictions have been impacted by higher interest rates.

The overseas banking sector stress earlier this year demonstrated how contagion could spread within jurisdictions and across borders via financial market pricing, affecting banks’ funding costs and share prices. US bank equity prices recovered slightly over the summer, but have since weakened as long-term interest rates have risen, particularly for regional banks (Chart 2.1).

Following the stress, a number of mid-sized US banks have been downgraded by credit rating agencies. Recent rises in long-term US bond yields could pose increased challenges for some US banks, which are likely to continue to struggle with large unrealised losses on portfolios of fixed-rate assets that have fallen in value as a result of higher market interest rates. Banks with significant CRE exposures may also be vulnerable given recent rises in long-term interest rates and falls in CRE prices (see Section 2.2.3). However, immediate risks in the US banking sector appear to have stabilised: deposits held in smaller US banks have continued to recover, and though there have been marginal increases in usage of the Federal Reserve’s Bank Term Funding Program in recent weeks, overall usage has remained largely stable since the July 2023 FSR.

Since the July FSR, the US authorities have proposed measures that are designed to increase the resilience of US banks with over US$100 billion in assets (capturing most of the largest regional banks), as part of their implementation of Basel III. In addition, in August, US authorities outlined proposals to strengthen the resolution framework.

Euro-area banks have so far appeared largely resilient to the higher interest rate environment. Indeed, these banks have generally benefitted from rising net interest margins in the first half of 2023. However, as in the US, there are vulnerabilities in a number of banks related to higher interest rates and asset quality – including with respect to real estate exposures (see ECB Financial Stability Review). Generally, US and euro-area bank profitability has been supported by rising interest rates. But for some banks in both regions, a combination of low-yielding assets and rising funding costs pose longer-term challenges to profitability.

Chart 2.1: US bank equity prices recovered slightly over the summer, but have weakened since, particularly for regional banks

Global bank equity prices (a)

UK and European bank indices fell by around 17% in March during the global banking stress. UK and European indices have largely failed to recover since. US bank equities saw larger falls in March and have also failed to recover – equity prices for US regional banks, where investor concerns were concentrated have fallen by over 40% since March, while a broader sample of US banks is around 15% below March levels.

2.2.2: The impact of higher rates on the global real economy

Higher interest rates continue to make it more challenging for households and businesses in advanced economies to service and refinance their debts.

Higher rates continue to put pressure on households globally. Interest rates on new lending to households have increased sharply since the beginning of 2022 and have increased further since the July 2023 FSR. While some borrowers in the euro area will be shielded from the impact of higher rates on mortgages repayments due to long-term fixed deals, other borrowers will be exposed to the impact of rising rates in the near term. In the US, most existing mortgage borrowers – unless they move home – are likely to be shielded from higher interest rates as most mortgage debt is fixed rate, typically with long terms. Higher interest rates have therefore led to a significant fall in existing home sales in the US. A slowdown in the US housing market could have knock-on effects to the wider financial system (see below).

Credit conditions in the US and euro area have continued to tighten since the July FSR. The ECB’s October 2023 euro-area bank lending survey and the Federal Reserve’s October 2023 Senior Loan Officer Opinion Survey both reported tightening lending standards for both households and businesses. In both jurisdictions, a significant share of banks also reported that demand for new lending had weakened further since Q2.

Highly leveraged corporates – particularly in the US – could be vulnerable to higher interest rates as it becomes more expensive to service their debt. The default rate on leveraged loans has increased further since the July FSR, from 5.0% to 5.4%, and up from 1.8% a year ago. Although there are few signs of stress in these markets so far, a worsening in the macroeconomic outlook could cause sharp revaluations of credit risk. Higher defaults could also reduce investor risk appetite in financial markets and could reduce access to financing, including for UK businesses (see Box B).

Global commercial and residential real estate valuations have faced significant downward pressure.

Global CRE prices have fallen further since data available at the time of the July 2023 FSR, with aggregate prices down 10% on a year earlier in both the euro area and the US (Chart 2.2). This partly reflects long-term structural challenges in the sector, including the post-pandemic shift to more remote working. Residential real estate price growth has also fallen since 2022, with annual growth turning slightly negative in the euro area (Chart 2.3).

Higher interest rates are a key factor weighing on prices, reducing affordability for residential homebuyers. Absent rent increases, higher interest rates also reduce the profitability of real estate investments relative to other assets such as bonds, and increase the cost of servicing related debt. Investors – many of whom are leveraged – may face losses as result of a decline in the value of their assets. This could result in fire-sales, exacerbating any downturn, and heightening risks to the core financial system. Price falls can also present risks to lenders by reducing the value of the collateral held against their loans.

The results of the 2022/23 ACS, which included very sharp falls in global property prices well beyond those seen to date, suggest that major UK banks are resilient to their global real estate exposures. However, as noted above, some banks in the US and euro area may be more exposed to the sector, which could create spillovers to the UK via banking and financial market channels.

Chart 2.2: CRE prices are falling sharply across regions

Nominal CRE price growth

US, and euro area CRE prices were growing by around 5% a year between 2016 and 2020, while UK CRE price growth oscillated between growth of 5% and -5%. US and UK prices then increased sharply to highs of around 20% at the end of 2021 and early 2022. Price growth in all three regions have since fallen sharply to around -10% in the US and euro area (as of August and June 2023, respectively) and around -15% in the UK (as of October 2023).
  • Sources: European Central Bank, Federal Reserve Board, MSCI and Bank calculations.

Chart 2.3: Global residential real estate price growth has slowed markedly

Nominal residential property price growth

Year on year property price growth in the UK, US and euro area was around 5% between 2016 and 2020, though dipped to a little above zero in the UK in 2019. In 2021, growth then increased to around 20% in the US and just under [10%] in the UK and euro area. In 2023, growth fell once again to around zero in all three regions.
  • Sources: European Central Bank, LSEG Eikon, ONS and Bank calculations.

Vulnerabilities associated with high public debt levels could pose challenges in an environment of tightening financial conditions.

The FPC has previously highlighted vulnerabilities created by high public debt levels in major economies, including through interlinkages between banks and sovereigns. These vulnerabilities, the extent of which are in part related to the level of interest rates, could have several consequences for UK financial stability.

  • Higher servicing costs on public sector debt could reduce governments’ capacity to respond to future shocks, which could make global GDP more volatile.
  • There may be more pronounced volatility in government bond prices if market perceptions for the path of public sector debt deteriorate. This could interact with vulnerabilities in market-based finance, resulting in a tightening in credit conditions for households and businesses.
  • Concerns about the sustainability of government debt in some countries could prompt capital outflows. This could lead to increased market volatility and losses for financial market participants, including banks.

The FPC will continue to monitor these risks and take into account the potential for them to crystalise other financial vulnerabilities and amplify shocks when making its assessment of the overall risk environment.

2.2.3: The impact of higher rates on other parts of the global financial system

Markets reacted in an orderly manner to announcements by the Bank of Japan that it would conduct its yield curve control policy with greater flexibility.

In July, the Bank of Japan made a surprise adjustment to its yield curve control policy. Then, in October, the Bank of Japan introduced further flexibility into the 1% ceiling on 10-year yields. Yields on 10-year Japanese government bonds are now 0.8%, up from under 0.5% at the time of the July 2023 FSR.

So far, markets have reacted in an orderly manner to these announcements. But there remains a risk that further policy changes could trigger larger or more volatile price adjustments in Japan, which could lead to losses on domestic government bond holdings for some Japanese banks. Major UK banks’ holdings of Japanese government bonds are limited, accounting for only 5% of major UK banks’ overall holdings of debt securities. However, asset price moves in Japan could spill over to other countries, for example if they lead to substantial reallocations of bond holdings across jurisdictions, which could affect financial conditions in the UK.

Financial conditions in emerging markets could also come under pressure.

Financial conditions have tightened in most major non-China emerging market economies (NCEMEs) since the July 2023 FSR. But most major NCEMEs have been resilient to the higher interest rate environment so far. Reflecting this, the spread between dollar-denominated NCEME government bond yields and US Treasury yields – a key indicator of stress – has been relatively flat.

NCEMEs could still be vulnerable, however, to a sharp repricing of NCEME assets and sudden capital outflows in response to a deterioration of risk sentiment, for example as a result of a further escalation of geopolitical risks. Spillovers to the UK from NCEME distress are likely to be limited, however, they could affect exposures of some major UK banks, and have a wider impact on UK economic activity via lower demand for UK exports.

2.3: Risks from developments in China

Property market vulnerabilities in mainland China have continued to crystallise since the July 2023 FSR.

Activity in the mainland Chinese property sector has been contracting since mid-2021 (Chart 2.4) and property prices have been falling since late 2021 for both new and existing property.

Chinese developers have continued to default in the face of falls in sales and tighter financial conditions. Since the July 2023 FSR, Country Garden – China’s largest property developer by sales in 2021 – officially entered default on some of its offshore bond repayments. And significant concerns remain around the ability of Evergrande – the world’s most indebted property developer – to successfully restructure and meet its debt obligations.

In light of these developments, the Chinese authorities have put in place measures to provide some support, aimed at limiting spillovers from losses being borne by creditors, against the backdrop of a longer-term strategy to reduce speculation in the sector.

The outlook for the mainland Chinese economy more broadly remains subdued. Further deterioration in property activity and prices could pose additional risks to the mainland Chinese economy and its financial sector, making the policy response more challenging. This could impact the UK via trade or financial spillovers, including through disorderly asset price adjustments that could be amplified by vulnerabilities in market-based finance.

Chart 2.4: Real estate activity in mainland China has continued to weaken

Twelve-month rolling sum of floor space sold in mainland China

The twelve-month rolling sum of floor space sold in China increased from 1.3 million metres squared at the start of 2013 to 2.1 million metres squared mid-2021. It has since fallen to 1.4 million metres squared in August 2023.
  • Sources: CEIC and Bank calculations.

Hong Kong could be materially affected by the crystallisation of risks in mainland China. But UK banks remain resilient to a severe downturn in the region.

In common with mainland China, Hong Kong also has high private sector debt levels and elevated property prices. UK banks’ exposures to Hong Kong are larger than those to mainland China. And while direct trade links with the UK are relatively modest, a materialisation of risks could propagate through financial market channels.

Despite differences between the risk profiles of the two property sectors, should current challenges in mainland China’s property sector lead to a significant downturn in the broader Chinese economy, spillovers to Hong Kong’s property market could be material.

Some UK banks have material direct exposures to property markets in mainland China and Hong Kong, though the greater security and seniority on Hong Kong exposures relative to Chinese exposures helps to mitigate the impact of any potential losses on UK banks. The 2022/23 ACS indicated that major UK banks would be resilient to a severe global recession that included severe real estate price falls in mainland China and Hong Kong. The FPC will continue to monitor closely developments in China, and the potential for spillovers to UK financial stability.

Box B: Highly leveraged corporates

Highly leveraged corporates are particularly vulnerable to the global tightening of financing conditions. This could present risks to UK financial stability through a number of channels (Figure A).

Higher interest rates continue to weigh on the ability of businesses in advanced economies to service and refinance their debts (see Section 2). Businesses that have borrowed in risker credit markets, including through leveraged loans and private credit, are particularly vulnerable to higher interest rates because their debt tends to be floating rate and because they tend to be highly leveraged. As interest coverage ratios (ICRs) (a business’ earnings relative to its interest payments) are a key variable in determining their creditworthiness to lenders, a decrease in ICRs as interest rates rise may make it harder for some businesses to refinance their debt, or mean they face less favourable terms when they do. In addition, some of these businesses will have experienced weaker earnings because of subdued economic growth.

As a result of these pressures, affected businesses may reduce investment and employment and, in some circumstances, may default on their debt, creating direct losses to lenders and other financial market participants. If these losses are significant, this could cause an excessive tightening in risk appetite, disrupting the functioning of some markets and tightening credit conditions in the real economy. This box assesses these risks to UK financial stability.

Figure A: A crystallisation of risks in highly leveraged corporates can impact UK financial stability through a number of channels

Many of these more vulnerable businesses are reliant on funding from the private credit, leveraged loan and high-yield bond markets.

Leveraged loans and high-yield bonds are typically used by firms who are highly indebted, have a sub-investment grade rating or are owned by a private equity (PE) sponsor. In recent years, private credit (lending bilaterally negotiated between borrowers and lenders and typically arranged by non-bank financial institutions (NBFIs)) has been growing as an alternative source of finance for highly leveraged firms. The different features of these forms of lending are set out in Table 1.

Table 1: Features of different forms of leveraged finance

Leveraged loans

Private credit

High-yield bonds

Type of issuer

Highly leveraged and typically sub-investment grade

Highly leveraged and unrated

Sub-investment grade

Typical maturity at origination

4–7 years

5–7 years

5–10 years

Rate type

Floating

Floating

Mostly fixed

Primarily arranged by

Global banks and, to a lesser extent, NBFIs

NBFIs

Global banks

Syndication structure

Syndicated

Generally not syndicated

Exposures placed by arranging banks among bondholders

Mostly held by

Global banks and institutional investors including insurers, hedge funds, pension funds and other investment funds (including via CLOs)

Insurers, pension funds and other institutional investors (Chart E)

Institutional investors (including insurers, hedge funds, asset managers and pension funds) and, to a lesser extent, global banks

Data availability

Good

Poor

Good

Size

US$4.6 trillion

US$1.8 trillion

US$3.4 trillion

Growth since 2015

1.9x

c.3–4x

1.3x

These markets have grown rapidly in recent years.

The leveraged lending, high-yield bond and private credit markets account for around a quarter of all market-based debt globally (Chart A). Combined, private credit and leveraged lending have roughly doubled in size over the past decade. Within that, although it remains relatively small, estimates suggest that private credit has grown much faster, picking up volumes from PE sponsors and lower-rated companies looking to access financing more quickly.

Chart A: Private credit and leveraged loans have grown rapidly in recent years

Estimated breakdown of total outstanding market-based corporate debt globally (in US dollars) (a)