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The Bank of England's Financial Policy Committee on Tuesday said the health of the UK economy has ‘deteriorated materially’, but lenders appear resilient.
‘Following Russia's illegal invasion of Ukraine, global inflationary pressures have intensified sharply. This largely reflects steep rises in energy and other commodity prices that have exacerbated inflationary pressures arising from the pandemic, and further disruption of supply chains,’ the central bank said.
In its biannual report, the Financial Policy Committee gives its view on the stability of the UK financial system.
In the July report, the committee noted that household real income has fallen.
Households have come under increasing pressure in recent months, as the UK's annual inflation rate hit 9.1% in May.
‘Tighter financial conditions and reduced real incomes will weigh on debt affordability for households, businesses and governments in many countries, increasing the risks from global debt vulnerabilities,’ the BoE said.
It also noted there are ‘a number of downside risks’ that could further hurt the UK's financial stability - with the war in Ukraine the ‘key factor’.
It added: ‘Given downside risks from additional supply shocks, faster-than-expected monetary policy tightening and slower-than-expected economic growth, risky asset prices remain vulnerable to further sharp adjustments.’
Despite this volatility and increased downside pressure, the BoE feels UK lenders have ‘considerable capacity’ to support lending to households and businesses ‘even with the deterioration in the economic outlook.’
‘In line with expectations, capital ratios declined in 2022 Q1 and are expected to fall back slightly over coming quarters. Nevertheless, major UK banks' capital and liquidity positions remain strong, and profitability has strengthened in aggregate,’ the report noted.
However, the committee said the banks will need to set aside more cash to absorb shocks in the financial markets from next year, despite the Bank of England saying lenders are well-placed to support households and businesses.
Officials have ordered them to set aside 2% of their capital - or around £22 billion - as part of the countercyclical capital buffer from this time next year.
The buffer introduced in the wake of the financial crisis to ensure banks have a rainy day fund was slashed to zero during the pandemic, releasing billions of pounds to help businesses and households.
The Bank of England announced last December that it would be increased to 1% as conditions normalised. It will now rise to 2% after the mandatory 12-month notice to banks.
‘Although downside risks will present headwinds, the FPC judges that UK banks have capacity to weather the impact of severe economic outcomes,’ it added.
‘In such scenarios, banks are likely to manage prudently their lending activity, commensurate with changes in credit quality in the real economy. Setting lending terms to reflect the new risk environment is appropriate. Restricting lending solely to defend capital ratios or capital buffers would be counterproductive and could prevent credit-worthy businesses and households from accessing funding. Such excessive tightening would harm the broader economy and ultimately the banks themselves.’
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