By Adrian Bishop
Some risks remain over disruption to UK financial services from Brexit, the Bank of England (BoE) has warned.
Global vulnerabilities rising
In addition, risks from global vulnerabilities have increased, the Financial Policy
More work needs to be done
The UK has made progress to avoid disruption to financial services during Brexit, but more needs to be done, according to the BoE’s Financial Stability Report for June 2018.
£26 trillion of derivatives contracts at risk
For instance, action is needed from both the UK and European Union authorities to ensure the continuity of existing derivative contracts.
This involves the validity of contracts used to insure businesses making currency trades, for example, involving institutions in Britain and the EU. If no action is taken, it is believed £29 trillion worth of contracts could become "unserviceable" after March 2019.
GBP falls against major currencies
Following the publication of the report, GBP fell marginally from a 12-hour mid-market high of around 1.135 to a low of 1.133. Against the US Dollar it fell from a high of 1.322 to 1.315. Against the Canadian Dollar, it dropped slightly more, from 1.761 to 1.747 and the same was true against the Australian Dollar, as it fell: 1.794 to 1.779.
More movement in store for the Pound?
Ricky Nelson, Head of Corporate Dealing at Halo Financial, says, “The report reinforces the market’s fears over Brexit uncertainty and the Pound suffered a little against that background.
“With the vital EU Summit, there could easily be more movement in the Pound before the weekend.”
Domestic risk appetite still strong
Excluding Brexit, domestic risks are standard, the six-monthly report states. Although they have reduced a little in recent months, domestic risk appetite remains strong.
Cyber attacks pose real danger
UK firms also need to show they can restore services quickly after cyber-attacks and should steer away from using Libor contracts, says the report.
Many risks from ‘beyond our shores’
BoE Governor, Mark Carney, says, “Events of the past few months are a reminder that many of the most important risks to financial stability in the United Kingdom originate beyond our shores.
“The recent tightening in global financial conditions could be a precursor to a much more substantial snapback in world interest rates and more challenging bank, corporate and sovereign funding conditions.
Rising protectionist sentiment
“Rising protectionist sentiment could sap some of the current strength of the global economy and reduce the size of sustainable external imbalances.
“While UK authorities are putting in place measures to address financial stability risks that can be dealt with unilaterally, the complete set of mitigants to the risks of a cliff-edge Brexit also rely on the efforts of EU authorities; and cyber risks to UK financial services could originate from anywhere on the planet.”
The role of The Financial Policy Committee
The Financial Policy Committee aims to ensure the UK financial system is resilient, prepared for a wide range of risks and can serve UK households and businesses in bad times as well as good.
Bank system can support disorderly Brexit
It judges that the UK banking system could continue to support the real economy during a disorderly Brexit.
Following this week’s passing of the EU Withdrawal Bill, plans for temporary permissions so EU‑based companies can continue to provide financial services to UK customers after the UK has left the EU, would ease the risks of disruption, says the report.
UK and EU need work on derivative contracts
“The biggest remaining risks of disruption are where action is needed by both UK and EU authorities, such as ensuring the continuity of existing derivative contracts. As yet the EU has not indicated a solution analogous to a temporary permissions regime.”
However, the FPC has welcomed the establishment in April of a technical working group, chaired by the European Central Bank and Bank of England, on risk management of financial services around 30 March 2019.
Over The Counter contract permissions
Regarding uncleared over-the-counter (OTC) derivative contracts, the report warns that UK and EEA parties may no longer have the necessary permissions to service the contracts with parties in the other jurisdiction.
“Effective mitigation of the risk, other than through a bilateral agreement, would require legislation in both the UK and EEA to protect the servicing of existing contracts. The UK Government has committed to legislate, if necessary, to allow EEA counterparties to continue servicing contracts with UK entities (through a temporary permissions regime and additional legislation if required). EU authorities have not announced an intention to enable UK counterparties to continue servicing contracts with counterparties in the EEA.”
EU red warnings
The EU is facing three ‘red warnings’ over contracts and clearing.
Both the UK and EU face amber warnings over the ability of banks and asset managers to continue providing other services across borders, as well as on the lack of agreement on the cross-border flow of personal data between Britain and the EU.
UK debt and credit
Levels of household and corporate debt in the UK relative to incomes remain materially below their 2008 levels. Overall, credit growth remains broadly in line with the growth in nominal GDP and debt‑servicing burdens are low, says the report. But in recent months, corporate bond spreads have increased and mortgage loan spreads have widened a little.
Growth in non-bank lending to riskier companies
Non‑bank lending to riskier companies has been expanding rapidly, but lending by banks has been muted, limiting the increase in overall corporate leverage and the effect on banks’ resilience.
Consumer credit expanding rapidly
Consumer credit continues to expand rapidly. Although banks’ risk appetite in mortgage lending has increased over the past few years, weak demand has kept mortgage credit growth modest.
Italian government bond yield increases
Global threats include increases in Italian government bond yields, which suggest rising risks in the euro area and underline the vulnerabilities created by high public debt levels and interlinkages between banks and sovereigns in a currency union.
Tightening in US Dollar funding markets
Tightening conditions in US Dollar funding markets are also increasing risks in some emerging markets.
Trade tensions increasing
In addition, trade tensions have intensified. Debt levels in China remain highly elevated and corporate leverage in the US has continued to increase.
Stress test holds firm
However, the 2017 stress test showed that the UK banking system is resilient to severe domestic, global and market shocks. The FPC is maintaining the UK countercyclical capital buffer (CCyB) rate at 1%. This is intended to protect the banking sector against losses from cyclical systemic risks.
Vulnerable to drop in foreign investment
But the report points out that the UK is more vulnerable to a reduction in foreign investor appetite for UK assets, as the share of capital inflows vulnerable to refinancing risk has risen and material global risks could spill over to the UK.
2018 stress test
The FPC will conduct as normal a comprehensive assessment of the resilience of the UK banking system in the 2018 stress test and review the adequacy of the 1% CCyB rate, the report says.
Robust prudential standards
Irrespective of the particular form of the UK’s future relationship with the EU, and consistent with its statutory responsibility, the FPC will remain committed to the implementation of robust prudential standards in the UK.
“This will require maintaining a level of resilience that is at least as great as that currently planned, which itself exceeds that required by international baseline standards.”
Cyber-attack stress test
The FPC is setting standards for how quickly critical financial companies must be able to restore vital services following a cyber-attack. It plans to test them against these in cyber stress tests. Working with the National Cyber Security Centre and others, the bank will test that firms would be able to meet the FPC’s standards for recovering services.
Continued reliance of financial markets on Libor poses a risk to financial stability that can be reduced only through a transition to alternative rates, the Financial Stability Report states. The FPC will monitor progress and report regularly.