All major UK banks passed the Bank of England’s stress test for 2017 without the need to increase their capital position, despite scenarios that were significantly more severe than during the 2008 financial crisis.
This is the first time all banks have passed since stress testing was introduced in 2014. The overall loss to the UK banking system after two years of a stress scenario is estimated to be £50bn. This would have ‘wiped out the common equity capital base of the UK banking system ten years ago’, according to the BoE’s November financial stability report. The capital buffers built up since then mean banks would be able to absorb such potential losses.
The bad news is that various risks highlighted in the report seem increasingly likely to materialise. Investors are placing ‘excessive weight’ on the recent benign market environment, in which growth has been moderate, inflation subdued, asset prices high and volatility muted. Markets expect long-term interest rates to remain low, and investors are inadequately compensated for risks they are taking on.
Yet a range of shocks, including a ‘disorderly Brexit’, a global recession, or heightened sensitivity to global debt levels, could lead to an increase in long-term interest rates, a downgrading of growth expectations, or both. That would result in higher funding costs for borrowers, falling asset prices and a further depreciation of sterling, providing an ‘indirect’ risk to the resilience of the financial system. Even if UK banks were able to continue supplying credit throughout such a shock, the effect on the economy would be grave.
The UK runs a current account deficit of 4.6%. This is financed by capital inflows from abroad, reflected in the UK’s gross external liabilities of 420% of GDP. Lower growth prospects, such as those forecast by the Office for Budget Responsibility ahead of the Budget presented on 22 November, could significantly reduce the attractiveness of UK assets to foreign investors. Another fall in sterling, perhaps resulting from uncertainty over Brexit, would exacerbate this risk.
Over the past year net demand for UK assets has remained stable, but significant vulnerabilities exist. The UK commercial real estate sector is especially exposed. Current prices are at the upper end of the range of estimated sustainable valuation levels used by the BoE, boosted by rental yields that are significantly above their 15-year average. A return of rental yields to their historical average, spurred by a rise in long-term interest rates or an adjustment of risk premia, both of which the BoE deem feasible, would portend a price correction. Because 75% of small and medium-sized companies that borrow from banks use commercial real estate as collateral for their loans, a fall in prices would have significant consequences for the supply of credit to the domestic economy.
For every 10% fall in UK commercial property prices, the BoE estimates a 1% decline in UK economy-wide investment, due to reduced access to bank loans for companies seeking to make new investments. The stress test allows for a 40% fall in commercial real estate prices in its scenarios. Yet at a time of heightened sensitivity to the effect of low investment on productivity, much smaller declines could cause substantial economic damage.
The UK real estate sector has a particular importance for global public investment institutions, especially pension funds and sovereign funds. These have significantly boosted their exposure to real estate over the last few years in their search for yield and greater diversification. London is a key destination for these investments, with overseas investors accounting for 80% of total investment in the city’s corporate real estate market in 2017. A correction in real estate prices, particularly those of central London offices, which the bank expects to fall by 5% on average by 2019, would hit returns, at a time when income on traditional assets is already strained.
The UK’s status as an investment hub has underpinned its economic performance over the last few decades, boosting asset prices and economic growth and helping to fund the current account deficit. Since the fall in sterling following June 2016’s EU membership referendum, the UK’s substantial net foreign assets have resulted in it becoming a net creditor for the first time since 2008. This has boosted the UK’s primary income balance, thereby reducing the size of the overall current account deficit as well.
Yet continued uncertainty about Britain’s post-Brexit relationship with the EU, as well as global financial vulnerabilities that the UK’s highly interconnected financial sector is exposed to, could reverse this trend. Reduced confidence in UK assets and heightened outflows on the capital account would be severely disruptive. While the banks may have passed the latest stress test, the risks to the UK economy appear greater than ever before.
Ben Robinson is Senior Economist at OMFIF.