United Kingdom: Financial Sector Assessment Program-Financial System Stability Assessment
Author:
International Monetary Fund. Monetary and Capital Markets Department
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Publication Date:
23 Feb 2022
eISBN:
9798400203268
Language:
English
Keywords:
U.K. asset management industry; U.K. government; U.K. banking sector; U.K. banking system; U.K. economy; Financial sector stability; Global; Nonbank financial institutions
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The U.K. financial sector is globally systemic, open, and complex. It has weathered the COVID-19 pandemic fittingly, thanks to the post-GFC reforms, a proactive macroprudential stance, and an effective multipronged response to maintain financial stability. Brexit uncertainties are being handled appropriately as the U.K. and EU authorities and the financial industry collaborate to prevent undesirable financial stability outcomes. The endpoint of the pandemic remains unclear, as does the actual impact on the financial system once support measures wane. At this juncture, therefore, financial stability conditions in the United Kingdom are being shaped by three key considerations: (i) the evolving U.K.-EU relationship on financial services; (ii) securing a sustainable and robust post-pandemic economic recovery; and (iii) successfully managing ongoing structural transitions.

Abstract

The U.K. financial sector is globally systemic, open, and complex. It has weathered the COVID-19 pandemic fittingly, thanks to the post-GFC reforms, a proactive macroprudential stance, and an effective multipronged response to maintain financial stability. Brexit uncertainties are being handled appropriately as the U.K. and EU authorities and the financial industry collaborate to prevent undesirable financial stability outcomes. The endpoint of the pandemic remains unclear, as does the actual impact on the financial system once support measures wane. At this juncture, therefore, financial stability conditions in the United Kingdom are being shaped by three key considerations: (i) the evolving U.K.-EU relationship on financial services; (ii) securing a sustainable and robust post-pandemic economic recovery; and (iii) successfully managing ongoing structural transitions.

Executive Summary

The U.K. financial system enjoys a strong reputation for the quality of oversight and the design of the financial stability framework set up after the 2007–09 Global Financial Crisis (GFC). The multipronged response to manage the exit from the EU, and the pandemic was effective (Section II-A). Financial market infrastructures stood resilient. The U.K. authorities demonstrated leadership in the global LIBOR transition, and with the latest reactivation of the countercyclical capital buffer policy as a preemptive macroprudential measure. These, along with other initiatives and a spate of public consultations on proposed reforms, seek to maintain the high level of resilience tested throughout Brexit and the pandemic.

Overall, the financial stability framework is well positioned to step up to the macrofinancial and related vulnerabilities identified by the FSAP. An effective prudential and supervisory structure is helping support the safety and soundness of the United Kingdom’s banking and insurance system. The strong foundations, built over time, are helping support the U.K. economy and bettering the functioning of global finance. Reforms in the post-Brexit and post-pandemic period must only help strengthen the foundations and ensure that the institutional oversight and regulatory setup remains strong, independent, and efficient. This is a prerequisite for effectively managing three key ongoing financial stability challenges:

  • The United Kingdom has addressed risks relating to the exit from the EU dexterously, but some key details regarding the EU-U.K. financial services remain open and are work-in-progress (Section III-A);

  • Economic recovery has resumed, but the macrofinancial outlook is confronting uncertainty, including the resurgence of COVID-19, supply-side disruptions, demographic shifts, inflationary pressures, and tightening of global financial conditions; and

  • Ongoing structural shifts and transitional issues including: (i) the rising intermediation by nonbank financial institutions (NBFIs);1 (ii) the permeation of financial technology and product innovation; (iii) the full passthrough of the 2019 separation between retail and investment banking; (iv) the complete switching out of Sterling LIBOR; (v) the mitigation of climate-related financial risks; and (vi) the handling of the ubiquitous threats from economic and financial crimes, and cyber-attacks.

While the three challenges intersect and interact, contagion risks across the sovereign-nonfinancial-financial channel remain muted for the present. However, given the nature of the U.K. financial system, financial stability remains sensitive to exogenous factors and cross-border channels.

The FSAP has identified the following risk factors that would benefit from continuing vigilance:

  • Pandemic obfuscated financial risks. Under FSAP stress scenarios, corporate and household vulnerabilities could materialize. (Section III-B). Banks’ capital ratios could decline by up to 4.9 percentage points under the most severe scenario (Section III-C), and the solvency ratios of a few insurers could fall below the 100-percent threshold (Section III-D). These potential losses are prima facie absorbable in the near term with their current capitalization levels.

  • Surge in house prices. Imbalances in the housing market are not apparent yet, but prices have continued to rise. Under some FSAP stress scenarios, mortgage arrears could rise sharply and peak at 2.8 percent in 2022, higher than the GFC levels (Sections III-B and III-I).

  • Deepening interconnectedness. NBFIs are now sizeable credit providers to the real economy, including in riskier market niches less served by banks. They are already interconnected among themselves and with banks, including cross-border firms and asset managers (Sections III-E and III-G). Active use of financial technology is deepening these linkages, and data gaps preclude identification and a more definitive assessment of such risks.

  • Liquidity in core markets. The risk to core financial markets remains primarily via liquidity mismatches in the internationally active NBFIs. It is desirable to actively consider strengthening backstops and allowing access to some central bank facilities to appropriately regulated, and systemically interconnected NBFIs (Section III-H).

  • Regulatory predictability. Market fragmentation risks remain amplified in the areas of derivatives clearing, and international banks and insurers’ choices of post-Brexit operating models. Both could impact systemic liquidity pools and heighten volatility. Uncertainties surrounding the long-term access of EU clearing members to the U.K. CCPs remain a source of market unease, albeit not viewed as a financial stability risk in the short term for the United Kingdom. (Section III-F).

On the institutional side, the Financial Policy Committee (FPC) is a world-class macroprudential authority. The FPC runs robust interagency processes to monitor financial stability conditions (Section IV-A). The quality of interagency coordination on prudential and related financial policies is thorough. There is seamless data-sharing within and between the BOE/PRA and the FCA. The United Kingdom also has a transparent approach to macro- and micro prudential, and conduct regulation.

The government’s ongoing Financial Services Future Regulatory Review (FRF review) seeks to redesign the post-Brexit framework for rules, regulations, and regulatory setup. The expectation is that the United Kingdom’s financial stability foundations will be strengthened further, but tension with policies to enhance “the competitiveness” of the U.K. financial system has surfaced. The FSAP has urged the authorities to remain mindful of the ultimate limits of explicit or implicit fiscal support for the financial sector, and to persevere with their demonstrated commitment, in support of highest standards of prudence and good governance of domestic and international finance. Similarly, while maintaining a competitive financial sector is an important policy goal, financial stability should not be compromised for the objectives of competitiveness.

To continue to effectively traverse multiple challenges to financial stability and make the United Kingdom’s systemic risk oversight and financial stability framework fitter for the future, the FSAP identified four areas where enhancements could be beneficial:

  • Expand the scope of systemic risk surveillance by the FPC on a continuing basis to assess risks from market-based finance, private markets, and cross-border channels (Section IV-A). It will be paramount to close the data gaps that limit mapping, identifying, and analyzing such risks (Sections IV-A and VI-B).

  • More “on the ground” supervision would provide better assurance that risks arising from digital money, green finance, technology-based intermediation and investment services, and cross-border risks are known early (Section IV-B), including risks from financial crimes (Section V-D).

  • Preserve the primacy of PRA and FCA’s objectives of safety and soundness and market integrity, and the FPC’s financial stability objective—in principle and practice—and ensure that the final set of accountability mechanisms adopted under the FRF review poses no constraints for independent and effective oversight of entities and financial markets.

  • To sustain the intensity and alacrity of oversight, maintain, always, the necessary level of skills and resources for systemic risk monitoring, oversight, and supervision of all systemically important financial firms and the core markets.

The FSAP thus recommends targeted measures outlined in in Table 1. The FSAP recognizes that, apart from its endeavor, the United Kingdom will have to rely upon active regional and international cooperation to manage cross-border and NBFI-related vulnerabilities, as well as risks from the emerging areas that are critical not only for the United Kingdom but for the safety of the international financial system.

Table 1.

United Kingdom: Key Recommendations

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I = Immediate (within one year); NT = Near Term (within 1 to 3 years); MT=Medium Term (within 3 to 5 years).

Financial Stability Context

A. Pandemic Shock and Macrofinancial Conditions

1. The United Kingdom is recovering from an unprecedented pandemic-related contraction. With comprehensive policy support, vaccinations, and removal of mobility restrictions, the economy is recovering fast and expected to grow by about 7¼ percent in 2021, returning to its pre-pandemic level by end-2021 (Table 2). Inflation has been rising markedly recently, spurred by supply bottlenecks and a recovery in demand, and could peak at about 7 percent in early 2022.

Table 2.

United Kingdom: Selected Economic Indicators, 2018–25

(Percentage change, unless otherwise indicated)

article image
Sources: Office for National Statistics; and IMF staff estimates. 1/ Contribution to the growth of GDP. 2/ In percent of GDP. 3/ In percent of potential GDP. 4/ In percent of labor force., period average; based on the Labor Force Survey. 5/ Whole economy, per worker. 6/ In percent of total household available resources.

2. The authorities swiftly launched a multipronged response to support financial stability. Direct and indirect budget support measures helped safeguard households’ and corporates’ balance sheets. Exceptional prudential measures were adopted to ensure continued lending to households and corporates via banks and securities markets and to prevent amplification of the crisis by mitigating procyclicality of regulations. The BOE, in concert with other central banks, deployed a range of tools to restore market liquidity. The FCA set new reporting thresholds on the shorting of securities.

uA001fig01

G7: Real GDP Growth in 2020 and 2021

(Percent)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF 2022 January WEO.

3. With swift and strong policy support, financial conditions progressively reversed the initial sudden tightening following the outbreak (Figure 1). Supported by central bank asset purchases and liquidity measures, asset prices recovered, the yield curve flattened, and credit spreads fell from the peaks seen during the March 2020 “dash-for-cash.” The credit-to-GDP gap declined to about zero for the first time in a decade. Bank lending rates remained low, and corporate credit growth was strong—partly on the back of publicly guaranteed loans. Residential real estate prices rose sharply since mid-2020, although the share of new mortgages issued at high loan-to-value (LTV) ratios remains low relative to the pre-pandemic period (Section III-H).

Figure 1.
Figure 1.

United Kingdom: Macrofinancial Indicators

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

4. A materialization of risks could reverberate through sovereign-financial-corporate linkages, particularly with increased contingent liabilities to the sovereign (Figure 2). Banks and insurance companies started the pandemic well capitalized and with sufficient liquidity buffers (Table 3). The limited impact of the pandemic so far on the aggregate balance sheets of nonfinancial corporates (NFCs), thanks to the extraordinary support measures, may bely the real strength of the corporate sector and pockets of household vulnerabilities. Materialization of macrofinancial risks could weaken the NFC sector and transmit via the financial sector (largely banks) to the sovereign, notably via state guaranteed loan schemes. Conversely, higher Gilt yields due to fiscal concerns would result in higher funding costs economy-wide and slow down the recovery.2 Both scenarios would exacerbate risks to financial stability

Table 3.

United Kingdom: Financial Soundness Indicators, 2015–2020

(in percent)

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Source: IMF, Financial Soundness Indicators; and IMF staff estimates.
Figure 2.
Figure 2.

United Kingdom: Macrofinancial Linkages

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: ONS, BOE, HMT, OBR, and IMF staff calculations.

B. United Kingdom in Global Finance

5. The United Kingdom remains a vital global financial hub. At end-2020, the United Kingdom was by far the largest trading marketplace for credit, foreign exchange, and interest rate derivatives. U.K.-based entities are involved in 30 to 40 percent of the world’s cross-border credit, currency, and interest rate derivatives contracts (Table 4). EU-U.K. financial linkages are strong (Figure 3, Box 1). The EU13 provides approximately between 20 and 60 percent of cross-border funding obtained by the United Kingdom, depending on the type of instrument.3 For instance, for derivatives, the outstanding volume of cross-border contracts involving an EU-based and a U.K.-based counterpart ranged between 19 percent (for currency derivatives) to 26 percent (for interest rate derivatives) of the United Kingdom’s total cross-border outstanding amounts.

Table 4.

United Kingdom: Core Global Financial Network and Degree of Interconnectedness

(In percent of each instruments’ total cross-border amounts within the network)

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Sources: IMF Coordinated Portfolio Investment Survey. BIS Banking Location a I Statistics, ESMA Annual Derivative Statistics Note: The latest date available for data on derivative: is December 2019, Degree is the average of a jurisdiction’s in-and out-degree, In-degree measures all cross-border claims on a jurisdiction in percent of the total cress-border claims of all jurisdictions. Out-degree measures all cross-border claims from a jurisdiction in percent of the total cross-border claims of all jurisdictions.
Figure 3.
Figure 3.

United Kingdom: United Kingdom and the Core Global Financial System

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF CPIS, BIS BLS, and ESMA Annual Statistics, and IMF staff calculations.Notes: EU13 comprises Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Spain, and Sweden. Figures show outstanding amount of each financial instrument in percent of recipient’s total cross-border liabilities in that specific instrument at end-2020. E.g., Claims in the form of equity from entities located in the EU on entities located in the U.K. amounted to US$621 billion, equivalent to 32 percent of the total cross-border equity claims on entities located in the U.K. Conversely, equity claims by U.K. residents on EU residents amounted to US$843 billion, or 8 percent of the total cross-border claims on EU residents. Equities include shares, stocks, and other ownership participations (e.g., American Depositary Receipts); short-term debt includes treasury bills, negotiable certificates of deposit, commercial paper, and bankers’ acceptances; long-term debt includes bonds, debentures, and long-term notes; interbank claims include non-negotiable loans and deposits (including the cash leg of repo agreements), working capital and inter-office business.

United Kingdom: Structural Features of the Financial System

Since the last FSAP, the U.K. financial system has grown in complexity, sophistication, and in the effective management of financial stability. It is a system of roughly equal asset size split into banks and NBFIs. Although banks continue to play a central intermediation role—including through market-making, brokerage, and wholesale funding—NBFIs are also important providers of retail and corporate credit and are a core part of the United Kingdom’s onshore and offshore financial system. 1 Banks and NBFIs are interlinked through both activities and ownership structures.

uA001fig02

United Kingdom Financial System Assets [in trillion £s)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: Bank of England.
uA001fig03

Other Financial Intermediaries (Percent of assets in 2019)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: Bank of England.
uA001fig04

Interconnectedness

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: Bank of England: and IMF staff calculations.Notes: Size of circles reflects size of entities: Size of arrows in percent of the respective NBFI assets: includes only entities domiciled in the U. K
uA001fig05

Offshore assets

(Q1 2020, percent of total assets in each group)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: Bank of England; ONS; and IMF staff calculations.

The United Kingdom financial system is central to global finance. About half of the banking sector’s assets and one third of NBFIs’ assets are offshore. The United Kingdom is the largest host jurisdiction to foreign financial firms as subsidiaries or branches.2 These features facilitate cross-border intermediation, product innovation, and an array of cross-border and cross-firm intragroup transactions. One-third, and sometimes even one-half, of the world’s currencies and derivatives are traded and cleared in London, and most of the global broker dealers are concentrated in the United Kingdom. The United Kingdom also hosts two global systemically important CCPs (LCH, ICE Clear), and LME Clear.

uA001fig06

U.K. Export of Financial/Insurance Services

(Billions of GBP, 2018)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: ONS U.K.; and IMF Staff calculations.
uA001fig07

Global CCP market

(Percent of total IM, 2019)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: CCP12; IOSCOPQD.
uA001fig08

Global Currency Market

(Average daily volume, in trillion USD)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: BIS.
uA001fig09

Global Market for IR Derivatives

(Average daily volume, in trillion USD)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: BIS.
1 NBFIs hold one third of corporate bonds, half of corporate loans, and one-half of unsecured consumer loans. 2 Branches of international banks in the United Kingdom has £8.4 trillion in assets, which puts the United Kingdom in a category by itself as a large host of international activity.

Issues in Systemic Risk and Resilience

A. Brexit and Financial Stability

6. The Brexit transition period ended without a materialization of risks for financial stability. The United Kingdom closely monitored risks, engaged with the industry, and provided necessary regulatory certainty in a timely manner (see Table 5 for measures taken by the U.K. and EU authorities). The United Kingdom has replicated most of the equivalence determinations in respect of overseas jurisdictions made by the European Commission pre-Brexit. In November 2020, the United Kingdom also granted a package of equivalence decisions in respect of the EEA states. As of November 2021, 32 jurisdictions plus the EEA benefit from equivalence decisions under the United Kingdom’s framework.4

Table 5.

United Kingdom: High-Priority Exit Risks and Other Selected Exit Risks

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Sources: HMT, BOE, and IMF staff.

7. At the time of the FSAP the impact of the exit from the EU on the U.K. financial system is not creating financial instability, but the risk of market fragmentation, and uncertainty remain. In anticipation of the loss of EU passports, some U.K. firms set up EU establishments or restructured existing ones to access EU clients. Relocation of assets and jobs is below initial estimates. Some market fragmentation has already occurred. For instance, following EU and U.K. rules requiring trading of certain shares and derivatives on domestic venues or equivalent third-country venues, EU share trading in the United Kingdom. largely migrated to the EU, and some OTC derivatives trading (notably EUR interest rate swaps) shifted to EU and U.S. venues). Temporary U.K. relief mitigated the impact of fragmentation on U.K. firms. The industry sees Brexit’s current impact as leading to increased costs (e.g., reallocation of internal capital and cost of new authorizations). It expects further optimization of their EU footprints informed inter alia by future U.K. and EU regulatory developments and supervisory expectations.

8. The United Kingdom’s structured regulatory cooperation with the EU is of mutual and global interest, and the institutional framework continues to evolve. Each party maintains its regulatory autonomy, including equivalence decisions to grant unilateral cross-border market access and mitigate regulatory overlaps and duplications. The United Kingdom issued a package of equivalence decisions for the EU. A Memorandum of Understanding (MOU) providing a cooperation framework was agreed at the technical level but is not signed yet.

9. The long-term ability of U.K. CCPs to operate in the EU remains an open issue. Currently three U.K. CCPs, two of which are globally systemic, serve EU clearing members based on a Commission equivalence decision and ESMA recognition decisions expiring on June 30, 2022. The Commission recently signaled that it would avoid cliff-edge risks by March 2022 through an extension of its equivalence decision; also, a recent ESMA review of the “substantial systemic importance” of two U.K. CCPs refrained from a recommendation to derecognize while adopting mitigating measures for risks relating to these CCPs serving EU market participants. Yet, while the EC intends a 3-year extension to June 2025, there is no clarity yet on the details of the extension of equivalence and mitigation measures. However, the status of U.K. CCPs in the long run remains uncertain, mainly in relation to some EUR products. In any event, no financial stability risks appear evident over the short term, and the United Kingdom is expected to remain a primary clearing center for derivatives given that non-EU clearing members—accounting for over 70 percent of activity—will stay in the United Kingdom at least until 2025. That said, a broader concern is that increased costs to clear derivatives in case of market fragmentation—due to loss of multi-currency netting benefits, higher margin requirements, and concentrations in fragmented local markets—may create pressures globally to relax the clearing mandate, a key post-GFC reform that is important for financial stability.

10. Cooperation on the prudential supervision and resolution of banks works well. While U.K.-EU cooperation on supervision and resolution matters is no longer a mutual obligation legally, the U.K. authorities’ cross-border cooperation mandate with the EU remains strong, supported by obligations in U.K. primary legislation, and parties have agreed an extensive network of cooperation arrangements. However, the effectiveness of crisis management arrangements will be tested in times of stress.

B. Macrofinancial Linkages

11. Despite having endured the crisis well, economic agents continue to face interlinked risks ranging from the effects of a prolonged pandemic to rising global inflation and post-Brexit uncertainties. Thus, to assess the resilience of the U.K. financial system, the FSAP considered a baseline scenario aligned to the October 2021 WEO, and two adverse (tail) scenarios covering a five-year span (2021–25) upon which stress tests were built for corporates, households, banks, and insurers (Appendices I, II and Figure 4). The results from the corporates and household stress-tests fed into those for banks and insurers to account for second-round effects.

  • The first adverse scenario entails a recession with lasting economic scars from a protracted pandemic.

  • The second scenario considers a surge in global inflation and consequent tightening of global financial conditions.

Figure 4.
Figure 4.

United Kingdom: Systemic Stress Scenarios

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF Calculations.

12. Recent developments suggest that both macrofinancial risk scenarios considered in the FSAP remain very present. Omicron is impacting global growth and derailing some aspects of the budding recovery. Global trade could be further undermined as the pandemic continues to dislocate international supply chains. Supply-demand mismatches combined with a rise in energy and commodity prices could generate further inflationary pressures and lead to a tightening of global financial conditions which could weaken the corporate, and household balance sheets, and in turn impact financial firms. The BOE increased its policy rate in December 2021 and has announced its Quantitative Tightening strategy, and expectations for policy tightening in the U.S. have increased. Since current account deficits were largely financed by portfolio investment, the volatility of capital flows is a potential source of vulnerability (Appendix III).5

Nonfinancial Corporate Vulnerabilities

13. NFC vulnerabilities are concentrated in SMEs and sectors hardest hit by the pandemic (Figure 5).6 In the baseline scenario, the FSAP team estimates that SMEs would face a liquidity shortfall of 2 percent of turnover and an equity gap of 1.5 percent of turnover in 2022–23.7 The liquidity and equity gap would reach 4 percent and 3 percent in the accommodation sector.

Figure 5.
Figure 5.

United Kingdom: Nonfinancial Corporates

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

14. NFC vulnerabilities could amplify financial stability risks through macrofinancial linkages.8 Under the two adverse scenarios described above, firms’ financial positions would be weakened through lower revenues due to lower GDP growth and rising financing costs. Also:

  • (a) Under the recession with scarring scenario, the share of firms experiencing financial stress would almost double (Figure 6). The public balance sheet would accumulate losses if guaranteed loan defaults increased, and public debt would rise further, increasing the government’s need to secure financing. This would further tighten financial conditions, slow down NFCs’ recovery, and weigh on growth.

  • (b) Under the inflationary and tightening of financial conditions scenario, the impact on NFCs is more concentrated in leveraged firms, where higher interest rates and risk premia outweigh stronger near-term growth. Fiscal financing needs would still rise (even without assuming government guarantees being called) given elevated interest rates. Private credit would be constrained on the back of more Gilt purchases and rising NPLs.

Figure 6.
Figure 6.

United Kingdom: Nonfinancial Corporates Under Stress Scenarios

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Household Vulnerabilities

15. Household indebtedness could become a source of financial vulnerability (Figure 7). Although households’ net financial wealth is high, many of their assets are illiquid and sensitive to valuation changes. Households’ indebtedness largely stems from mortgages. The FSAP estimates that the average mortgage arrears would increase moderately in 2021 and 2022 under the baseline scenario (thanks to the policy support), remaining comparable with historical averages. The bottom quintile income group has the highest average probability of mortgage arrears. The risk of household mortgage arrears would increase sizably under the inflationary and tightening of financial conditions scenario. With 80 percent of mortgages lent by banks, household mortgage vulnerabilities are relevant mostly for banks.

Figure 7.
Figure 7.

United Kingdom: Household Balance Sheets

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

C. Banking Sector Solvency and Liquidity

16. The results from solvency stress tests of the eight largest U.K.-based banks suggest the banking system is resilient to some severely adverse scenarios (Appendix I, Figures 8–11). At the individual level, all banks would remain above their hurdle rates under Adverse Scenario 1; under Adverse Scenario 2, two banks would fall below their hurdle rates but with very small capital CET1 shortfalls amounting to 0.08 percent of GDP at the peak (or 0.035 after additional tier 1 (AT1) conversion).9 Factoring in feedback effects, the initial macroeconomic shocks could be amplified through weaker credit growth. This would translate into higher probabilities of default (PDs) and lower capital ratios (by about 57 basis points throughout the scenarios’ horizon).

Figure 8.
Figure 8.

United Kingdom: Bank Stress Tests At-A-Glance: Scenarios and Results

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: IMF staff calculations.
Figure 9.
Figure 9.

United Kingdom: Bank Solvency Stress Test Results

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: BOE, FINREP, COREP, and IMF staff calculations.
Figure 10.
Figure 10.
Figure 10.

United Kingdom: Solvency Stress Test Results

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: BOE, FINREP, COREP, and IMF staff calculations.
Figure 11.
Figure 11.

United Kingdom: Macrofinancial Feedback Effects

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: BOE, FINREP, COREP, and IMF staff calculations.

17. After having consolidated its approach to” bottom-up” stress testing, the BOE could invest in strengthening its “top-down” stress testing capacity. The BOE has been running its program of annual cyclical scenarios (ACS) and biennial exploratory scenarios (BES) since 2016. The framework is well-consolidated, and it has produced interesting results through the years. The exercises are run in bottom-up modality, with the BOE employing some internal tools to validate the banks’ own results. Its internal toolkit is wide, but it does not cover the whole spectrum of portfolios and P&L components that would be needed to run a full-fledged top-down stress test. The BOE could invest in completing and consolidating its in-home analytics to be able to independently run stress tests at a higher frequency, when needed, and progressively cover all systemically relevant components and their mutual interactions

18. The results of LCR-based stress tests show that the U.K. banking system is overall liquid and resilient to sizable withdrawals of funding and haircuts to liquid assets. Liquidity Coverage Ratios (LCRs) are currently well above the regulatory minimum of 100 percent for all banks surveyed. The FSAP team conducted a stressed LCR simulation, based on the combination of “haircut” and “outflows” scenarios. It showed that banks generally maintain high “total currencies” liquidity ratios under all scenarios. The analysis by single currency revealed potential FX liquidity shortfalls but would require more granular information to quantify them accurately. The addition of further details to the PRA own reporting scheme on liquidity (PRA 110) would help provide a better sense of the potential liquidity gaps in foreign currency.

D. Insurance Sector Solvency and Liquidity

19. During the pandemic, insurers’ balance sheets proved stable, with solvency ratios declining only temporarily when markets became more volatile in February/March 2020 (Figure 12). Earnings of life insurers declined due to lower sales amid lockdown restrictions. General insurers were moderately affected, mainly through business interruption claims.

Figure 12.
Figure 12.

United Kingdom: Insurance Sector—Solvency and Profitability

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.Notes: Insurers may apply a matching adjustment (MA) to the risk-free interest rate when valuing their life insurance obligations if they hold bonds or other assets with similar cash-flow characteristics, immunizing them against spread risk on those assets. The MA is calculated by each insurer based on the spreads between the interest rate that could be earned from the undertaking’s assets and the risk-free interest rate. Until 2031, insurers may apply the transitional measure on technical provisions (TMTP), a deduction to insurance obligations concluded before the start of Solvency II, based on the difference between technical provisions under Solvency I and technical provisions under Solvency II. Over a period of 16 years the transitional deduction is reduced to zero.

20. A top-down stress test of 14 larger U.K. insurers showed vulnerabilities from lower interest rates and equity price declines, particularly for life insurers. The analysis applied two severe scenarios to insurers’ balance sheets at end-2020, covering about 70 percent of the market. The instantaneous top-down modeling does not recognize hedging instruments and management actions—companies would normally have different options to de-risk their balance sheet and improve solvency positions.

21. In the “scarring” scenario, which involves a downward interest rate shift, life insurers are considerably more affected than general insurers (Figure 12). Solvency ratios of two firms would drop below the 100 percent threshold with an aggregated capital shortfall of almost £9 billion, highlighting the need for recovery plans. Among general insurers, the balance sheet impact is much smaller. The increase in corporate bond spreads contributes most to the reduction in available capital.

22. With tightening financial conditions, the aggregate impact on both sectors is milder and even positive for life insurers (Figure 13). Lower life insurance liabilities compensate for investment losses, while for general insurers the results are diverse, as interest rate exposures differ across companies—further stress (not modeled) could stem from higher claims inflation

Figure 13.
Figure 13.

United Kingdom: Insurance Solvency Stress Test

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF staff calculations based on PRA supervisory reporting data.

23. Life insurers are largely resilient to variation margin calls in their interest rate swap portfolio, but cash buffers differ markedly across firms. An analysis of five large life insurers shows that even sizable upward shifts in interest rates would not cause systemic liquidity stress (Figure 14).

Figure 14.
Figure 14.

United Kingdom: Insurance Liquidity Risk Analysis

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF staff calculations based on PRA supervisory reporting data.

24. For a comprehensive analysis of liquidity risks, the PRA should enhance its supervisory reporting and monitor cash pooling arrangements within insurance groups. Liquidity risks could stem, besides margin calls, from higher outflows following policy surrenders or catastrophe events, or from lower premiums. To analyze combined liquidity drains, more granular data and a monitoring framework is needed.

E. Market-Based Finance

25. NBFIs play an important role across several lending segments, including in the riskier market niches less served by banks. NBFI lending has expanded domestically and cross-border, especially in the CRE and SME sectors, and in specific mortgage products and unsecured consumer credit. Some nonbank lending, such as buy-now-pay-later schemes and corporate loans, remain outside the regulatory perimeter and lack granular data for an in-depth risk analysis, including interconnectedness through key market segments. Some nonbank lenders rely heavily on bank funding and on securitizations, creating interlinkages with the rest of the financial system, including banks, that could amplify contagion. For instance, nearly half of funding of U.K. finance companies comes from banks. Balance sheet linkages exist with overseas banks and asset managers as well.

26. The lending cycles of nonbanks and banks are synchronized to a large degree, but lack of data could mask important variation within the NBFI segment. The analysis of aggregate lending shows a high degree of co-movement (71 percent) between bank and nonbank credit. Nonbank lending under stress is assessed using the estimated determinants of nonbank lending applied to the two stress scenarios considered for the bank stress tests. Under the recessionary scenario with “scarring” effects, nonbank credit contracts less and resumes growth faster than bank credit. In the scenario of tightening global financial conditions, nonbank lending overall also contracts less and is less procyclical than bank lending (Figure 15). This analysis could be even more informative if data were available at the level of individual firms, as aggregated data masks variability across the heterogenous NBFIs. Each type of NBFI is subject to different prudential requirements and thus may show different procyclicality, hence disaggregated analysis could bear important macroprudential implications.

Figure 15.
Figure 15.

United Kingdom: Credit Cycles

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

F. Central Counterparties

27. U.K.-based CCPs are among the largest in the world. LCH Ltd., ICE Clear Europe Ltd., and LME Clear Ltd. are CCPs domiciled in London with clearing members in 23 jurisdictions. The aggregate initial margin (IM) they collect is close to around 33 percent of total IM collected by CCPs worldwide. U.K. regulators have significant experience supervising them and participate actively in international regulatory bodies.

28. U.K.-based CCPs proved resilient during March 2020, but spikes in margins exposed differing abilities by clearing members and clients to cope with higher liquidity needs. Increased volatility saw the IM and variation margin (VM) surge, resulting in margin calls for which clearing members’ and clients’ preparedness was mixed (Figure 16). Nevertheless, the ability to deal with higher margin calls varied among clearing members and clients.

Figure 16.
Figure 16.

United Kingdom: IM and VM Margin Calls

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: LCH Ltd., ICEU PQDs, and IMF staff calculations.Note: Max VM, Max IM right axis; IM house, IM client left axis, all values in billions. The figure only captures IM and VM. Clearing members may have faced additional requirements due to their contributions to various buffers meant to guarantee CCP resilience.

29. The BOE’s proposed supervisory CCP stress testing framework could be augmented. This could be done by increasing transparency under stress conditions, and reporting stressed margin demands on clearing members and especially clients. Lack of information on potential liquidity needs could be at the heart of members’ and clients’ different abilities to plan. CCPs provide limited information regarding potential IM increases in advance of a stress, particularly towards clients. Increasing transparency on liquidity demands, for example by providing estimates of increases in IM under stressed conditions, would help balance the need for resilience of CCPs and the potential effects on clearing members, clients, and markets.

G. Asset Managers

30. The U.K. asset management industry is the second largest in the world. Its assets under management of £11 trillion consist of savings, pensions, and investments of millions of clients across the world. The industry supports 114,000 people, including 42,200 directly employed, and contributes about 1 percent to the United Kingdom’s GDP. The U.K. government announced a review in early 2021 to make the United Kingdom more attractive to set up, manage, and administer funds.10 The United Kingdom is also leading the transition to green the financial system as part of its net-zero commitment.

31. The global nature and complex structures complicate monitoring by the U.K. supervisors alone. Many funds used by U.K. investors and/or investing in U.K. assets are domiciled outside the United Kingdom. U.K. regulators rely partly on fund surveys and on commercial databases for simulations to assess the market impact of the actions of non-U.K. domiciled funds that may be relevant to U.K. markets. In relation to U.K. domiciled funds, the U.K. authorities can and do collect information through both regular regulatory reporting requirements and ad hoc data requests. The U.K. authorities have several MOUs on cooperation in place and are exploring data sharing agreements with regulators in funds’ domiciles. A complete assessment of market liquidity will require collecting more information on Sterling holdings. An international consensus on regulation and U.K.’s engaging in data sharing agreements with regulators of funds operating in the United Kingdom will need to continue to better monitor and address liquidity vulnerabilities.

32. Assessing liquidity risks posed by asset managers ought to be based on fund specific risks–redemptions, increased margins, funding risks, and de-levering:

  • Money Market Funds (MMFs)—especially non-government MMFs—faced large withdrawals in March 2020. Decoupling regulatory thresholds from fees and gates during stress periods while permitting them at critically low liquidity buffer levels would help MMFs to use cash buffers instead of liquidating assets. Access to BOE liquidity support could also help encourage MMFs to use buffers.

  • Available data for sterling MMFs and open-ended funds (OEFs) used to calculate liquidation demands under the March 2020-size shock indicate that risks are limited (Figure 17 and 18, Tables 6 and 7). Using the data in AIF Managers Directive (AIFMD), Figure 19 shows that aggregate expected losses for AIFs, expressed as a percentage of assets under management, in a March 2020-sized shock are limited. Nevertheless, large variations may exist for individual funds. Hedge funds are leveraged, although the overall exposure is small. OEFs may have significant liquidity mismatch. Liquidity demands would be best assessed under a scenario of simultaneously increasing redemptions, declining leverage, and rising IMs and funding costs, e.g., using historical information or by considering specific stress scenarios.

United Kingdom: Proportional Liquidation Asset Profile for MMFs Under a Weekly Redemption Shock

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Sources: Crane data and IMF staff calculations. Notes: MMF portfolio reference date April 9, 2021, values in £ billions.
Table 7.

United Kingdom: Proportional Liquidation Maturity Profile for MMFs Under a Weekly Redemption Shock

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Sources: Crane data and IMF staff calculations. Notes: MMF portfolio reference date April 9, 2021, values in £ billions.
Figure 17.
Figure 17.

United Kingdom: Money Market Funds

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: Crane.Note: While Crane is the best source available it does not cover 100 percent of the market.
Figure 18.
Figure 18.

United Kingdom: Fixed Income and Equity Open-Ended Funds

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: Morningstar.Note: While Morningstar is the best data source available, it does not cover 100 percent of the market.
Figure 19.
Figure 19.

United Kingdom: Alternative Investment Funds

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: AIFMD.Note. Stressed P/L is calculated by applying a shock similar to March 2020 to reported sensitivities. Credit Risk and Interest rate leverage are defined as the ratio of the sum of the absolute value of DV01 (CS01) for short and long positions over the absolute value of the net DV01 (CS01). Liquidity mismatch is the share of assets of a fund whose liquidation would have a market impact if all investors, at a certain time horizon, redeemed their investments in the fund. Financial leverage is the amount borrowed by a fund relative to a fund’s AUM.

33. The authorities should continue to push for a more consistent use of liquidity management tools, calibrated to the liquidity of underlying assets. In response to the findings of inconsistent application of swing pricing—which could exacerbate systemic risks—in July 2021, the BOE and FCA proposed a framework that includes enhanced swing pricing, which would aim to reduce the potential financial stability risks associated with first-mover advantage. The new framework would also introduce a more consistent liquidity classification of funds’ assets. The FPC should ensure for the open-ended fund sector that both sensible swing pricing and redemption notice periods are calibrated to the liquidity of underlying assets. This is in line with its 2019 principles on liquidity mismatch.

H. Systemic Liquidity and Core Markets

34. The pandemic shock roiled core U.K. markets, and the BOE, with other central banks, effectively responded to restore liquidity. Gilt market liquidity was pressured, reflecting a significant imbalance of supply and demand for Gilts that market makers could not effectively balance, while the FX and cross-currency swaps markets reflected a global desire for U.S. dollars. While global drivers such as deleveraging among NBFIs and liquidity demands from official sectors investors pressured U.K. markets, a particularly important issue in the United Kingdom was liquidity mismatches among liability driven NBFIs who were poorly prepared for the shock. The BOE (with peer central banks) quickly augmented its regular repo operations and front-loaded bond purchases to support market liquidity (Figure 20). Non-financial firms’ liquidity was backstopped via the Covid Corporate Financing Facility (CCFF) and Term Funding Scheme with SME incentives (TFSME; Figure 20).

Figure 20.
Figure 20.

United Kingdom: Systemic Liquidity Stresses and the BOE’s Response

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

35. The BOE’s toolkit would be reinforced by including some key classes of appropriately regulated NBFIs. While ultimately effective, the BOE’s toolkit was not ideally positioned to meet NBFI liquidity needs as most cannot directly access BOE liquidity. The BOE’s main option is to use asset purchases to provide liquidity to the entire market, which, while effective, results in a significant long-term expansion of the BOE’s balance sheet, even if liquidity stresses are transitory and concentrated. Incorporating NBFIs into the BOE’s operational framework would improve the BOE’s options in future stress situations if the first best approach of mitigating the impact of NBFI stress on markets—beefing up regulation and supervision—falls short. Allowing appropriately regulated and systemically interconnected NBFIs—which could include firms such as MMFs, insurance companies, asset managers, and pension funds—access to at least some of the BOE’s facilities would widen the range of options available to counteract future market-wide stresses. Not all NBFIs would be eligible for access to BOE liquidity as the focus should be on those that are large and have the most significant holdings of sterling securities in core markets and the greatest degree of interconnectedness with the wider financial system. Support should be focused on instruments traded in the United Kingdom’s most interconnected markets (Gilts and Gilt repos especially). Strengthening the BOE’s liquidity support toolkit could be valuable if the BOE’s move to tighten policy (via interest rate increases and Quantitative Tightening) increases risks of bumps in the level and distribution of liquidity around the financial system. Any backstop will need to balance the risks posed to the BOE’s balance sheet against limitations on the scope of the facility.

36. The design of facilities accessible to NBFIs should reflect their diverse nature and adequately address moral hazard risks. Both asset purchase operations and lending facilities are needed as some NBFIs are unable to use repo facilities.11 Backstops should only be provided to NBFIs that are adequately supervised and subject to more prescriptive liquidity requirements to manage risks that BOE backstops give rise to increased NBFI liquidity mismatches. This will involve close coordination with the PRA and FCA as NBFI supervision is shared among agencies. Backstops should be priced to encourage a stronger link between ex-post support and ex-ante risk taking, encourage users to use market funding but not discourage use in stressed conditions to avoid asset fire sales. Clearly defined exit criteria should be developed and communicated ex ante to better align market expectations of support with the BOE’s short-term backstop role. Since foreign NBFIs play an important role in core Sterling markets, they could be factored into the BOE’s operational framework, supported either by arrangements with foreign supervisors or through direct information sharing requirements to ensure that any foreign counterparts provided access to BOE liquidity meet standards equivalent to U.K. based counterparties.Table 6.

I. Real Estate Markets

37. The continued surge in house prices warrants closer monitoring (Figure 21). House prices have posted the strongest gains since November 2004 and the house price-to-earnings ratio, at 5.6, surpassed historical highs from 2007. The house price increase is more pronounced outside London. The share of new mortgage lending at high-LTI ratios also continues to rise. Booming transactions reflect support measures (Stamp Duty Land Tax (SDLT), Mortgage Guarantee Scheme (MGS)) and other factors—larger household savings, demand for additional space, lower construction activity, and advantageous financing conditions. Nonetheless, the share of new mortgages issued at high-LTV ratios remains low relative to the pre-pandemic period. In December 2021, the FPC judged that the LTI flow limit—which restricts the number of mortgages that lenders can extend at LTI ratios of 4.5 or higher to 15 percent of their new mortgage lending—plays a strong role in guarding against unsustainable household indebtedness through the housing market cycle. In the first half of 2022, the FPC will therefore consult on withdrawing its affordability test, noting that the FCA’s Mortgage Conduct of Business Framework still plays an important role.12 This would not constitute a significant change in the macroprudential stance through the housing cycle, as the FCA’s Mortgage Conduct of Business Framework still requires that in many cases mortgage providers stress interest rates over a minimum five-year horizon. Any removal of the FPC’s affordability test, at this juncture, will require careful consideration, as housing prices have been rising markedly and inflation risks loom.

38. The Commercial Real Estate (CRE) market continues to cool down. The CRE market slowed sharply following Brexit. The BOE recognized a potential fall in CRE prices as a domestic financial stability vulnerability in December 2019. The slowdown in the CRE market has accelerated during the pandemic. The BOE considered the risk of a potential third decline in CRE prices in its 2021 stress test. The FPC concluded that the banking sector is resilient to the overall stress scenario, including the sharp decline in CRE prices. Against this background, the FSAP sees the potential systemic impact of CRE risks as contained.

J. Climate-Related Vulnerabilities

39. Climate-related balance sheet risks for financial institutions were assessed through a separate scenario-based analysis for transition risk, and sensitivity analyses for physical risks. This covered the eight largest banks, eight largest life insurers, seven large general insurers, and a sample of investment and pensions funds.

  • Transition risk. The transition risk of financial institutions is measured as the potential materialization of credit and market losses in a “climate Minsky moment,” through the impact on their exposures to corporate counterparts (Figure 23). The source of shock is a policy change, i.e., a switch in the economic agents’ expectation from a low and relatively flat carbon price path to a high and steep one, in the United Kingdom and globally.

  • Physical risk. For “chronic” physical risk (reduction in GDP levels and growth because of global warming), a sensitivity analysis was done on banks’ sovereign bond portfolios. For acute physical risk (intensification of natural disasters because of climate change) a sensitivity analysis was conducted on general insurers’ technical reserves (see Figure 22).

Figure 21.
Figure 21.

United Kingdom: Housing Price Developments and Household Debt Indicators

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Figure 22.
Figure 22.

United Kingdom: Methodological Approaches for Climate Risk Analysis

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

T = Analysis of transition riskP = Analysis of physical riskNGFS = Network for Greening the Financial SectorNGFS ‘Phase I’: ‘National Determined Contributions’ and ‘1.5°C with Carbon Dioxide Removal’ scenarios, published in June 2020NGFS ‘Phase II’: ‘National Determined Contributions’ (NDC) and ‘Net Zero 2050’ (NZ2050) scenarios, published in June 2021GTAP = Global Trade Analysis Project model, used by IMF staff to simulate sectoral Gross Value Added under different NGFS scenarios up to 2050CCA = Oliver Wyman + Standard & Poor’s Climate Credit Analytics platform, used to simulate companies’ financials up to 2050 under different NGFS scenarios[a] = impact on companies’ financials simulated in CCA under the NGFS scenarios up to 2050, conditional on GTAP’s simulated GVA paths; impact on probabilities of default, ratings, and credit spreads based on S&P Global Market Intelligence PD Model Fundamentals and IMF staff calculations[b] = impact on U.K. mortgage loss-given default (LGD) by U.K. region based on carbon price paths under NGFS Phase II scenarios (NDCs, NZ2050, and Divergent Net Zero) and buildings’ Energy Performance Certificates (EPCs)[c] = impact on sovereign bonds based on expected sovereign rating migration under RCP8.5 scenario (from Klusak et al., 2021) and IMF staff calculations[d] = impact on loss distribution based on assumed increase in frequency and severity of U.K. floods, U.S. hurricanes and European windstormsSources: IMF staff calculations.
Figure 23.
Figure 23.

United Kingdom: The Logic of the ‘Climate Minsky Moment’

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

∆MVE: change in market value of equity∆MVA: change in (unobserved) market value of assets∆DtD: change in Distance to Default∆PD: change in probability of defaultSources: Carney (2016) “Resolving the climate paradox,” and IMF staff calculations.

40. For transition risk, the evolution of the relevant risk factors was simulated up to 2050. The estimation of the impacts is based on a revision of asset valuations and risk repricing, which is assumed to occur within a five-year horizon (Figure 23). Sectoral Gross Value Added (GVA) and companies’ cash flows have been simulated via a sectoral model (GTAP-E) and a financial model suite for climate risks (CCA), respectively, under the NGFS scenario “National Determined Contributions” (representing the “status quo”) and two alternative scenarios representing a new status, with the expectation of more ambitious decarbonization policies and a steeper carbon price path: “1.5°C with Carbon Dioxide Removal” and “Net Zero 2050”. The difference in valuations between the status quo and alternative scenarios represents the potential asset price correction affecting all marketable assets and the probabilities of default of companies.

41. The FSAP analysis shows that, under a switch to orderly transition scenarios, financial institutions would be affected significantly but with modest financial stability effects. Under a switch from “National Determined Contributions” to “1.5°C with Carbon Dioxide Removal”, banks would suffer credit losses on their corporate loans higher, on average, than 1 percent, and market losses of 3.5 and 1.6 percent, on average, on their equity and corporate bond holdings, respectively. For insurers, the loss on investments would range between 1 and 3 percent of total investments. Losses would be modest for U.K.-domiciled investments funds and defined benefit pension schemes. Under a switch to an orderly scenario with an even higher carbon price path and more dispersion across industries (Net Zero 2050), the impact could be significantly larger: for banks, credit losses would more than triple and market losses would almost double. It is to be expected that losses would be even higher under a switch to a disorderly transition scenario.

42. The impact of chronic physical risk on banks’ sovereign bond portfolios is strongly dependent on assumptions about the future variability of global surface temperature. The change in credit spreads could determine an overall drop of 0.6 percent in the aggregate value of banks’ sovereign bond portfolios. However, if the increase in mean temperature is accompanied by an increase in its variability, the average impact could rise to 3 percent.

43. Physical risks in the general insurance sector are driven by disaster risks. U.K. insurers are materially exposed to U.S. hurricanes, European windstorms, and domestic floods; but reinsurers—mostly located outside the United Kingdom—provide effective risk mitigation. Expected annual losses from natural disasters would increase by up to 50 percent (before reinsurance) if frequency and severity were to increase by 30 percent each (Figure 24).

Figure 24.
Figure 24.

United Kingdom: Insurance Climate Risk Analysis

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Sources: IMF staff calculations based on PRA supervisory reporting data.

44. To retain its leadership on climate-related risk analyses, the BOE should accelerate the development of its own analytical toolkit. In the past years the BOE has led the global effort to fully incorporate the consideration of climate change in the financial industry and in the day-to-day activity of central banks and financial regulators. To remain at the frontier of the increasingly intense international dialogue on climate-related risks in the financial system, the United Kingdom must seek to complement its current framework with a larger suite of internal analytical tools: in particular, it could equip itself with a full-fledged suite of in-home models (at macro, sectoral, and micro levels) to run independent (top-down) scenario-based analyses of the impact of climate-related risks on financial institutions—as a few other central banks have recently done—and, in perspective, their propagation across the whole financial system. It will also be important to deepen the understanding of how financial firms’ climate-related risks will be influenced by public policies, particularly around transitions risks (e.g., use of revenues from carbon taxes, energy efficiency measures, other decarbonization policies), but also for physical risks (e.g., future role of Flood Re and general disaster prevention policies).

Issues in Systemic Risk Mitigation, Oversight, and Supervision

A. Macroprudential Framework

45. Financial stability considerations are at the center of the institutional framework in the United Kingdom. This has helped make the U.K. banking and insurance system more resilient post-GFC. There is effective collaboration and almost seamless data-sharing among departments within the BOE and across regulators, supporting macro- and microprudential objectives. The BOE’s policy committees meet regularly and have overlapping membership to enhance coordination. The FPC relies on information-sharing and substantive analytical contributions from the PRA and the FCA, each of which runs its own regular “horizon scanning” exercise (Table 8). Joint meetings with the MPC or PRC are conducted where needed and became more frequent, for example, during the pandemic crisis.

Table 8.

United Kingdom: FPC’s Annual Assessment of Risks Banking and Selected Inputs

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Notes: FSSR=BOE Financial Stability Strategy and Risk Directorate PPD=PRA’s Prudential Policy Directorate SRPC=PRA’s Supervision, Risk, and Policy Committee SRS=PRA Supervisory Risk Supervisors IBD=PRA’s International Banks Directorate FMID=BOE’s Financial Market Infrastructure Directorate BPI=BOE’s Banking. Payments, and Innovation Directorate Sources: U.K. authorities, IMF staff.

46. The FPC runs interagency processes to monitor financial stability conditions on a regular basis. The FPC’s annual interagency Risks Beyond Banking (RBB) exercise assesses risks of roughly 40 nonbank activities. Since the last FSAP, the FPC has conducted several thematic deep-dives and continues to conduct its regular in-depth reviews of its rules for the housing market, including on the rules’ calibration. The FPC also reviews the appropriateness of the regulatory perimeter in its RBB exercise.13 However, consideration of insurance matters, cross-border NBFIs, interconnectedness and contagion occur relatively less frequently at the FPC. The next natural step is to expand the scope of systemic risk surveillance by the FPC on a continuing basis.

47. FPC’s primary objective in setting the Countercyclical Capital Buffer (CCyB) is to ensure that the U.K. banking system can withstand stress without restricting essential services. The FPC record from November 2015 states that the CCyB should be 1 percent after a period of recovery, but before risks are elevated. The judgment to set the CCyB’s neutral or standard risk rate in the region of 1 percent was based in part on an analysis in Brook et al. (2015)14 and later confirmed by the conclusion of the 2016 stress test. The FPC announced an increase in the CCyB to 0.5 percent in March 2016, in line with this policy. Three months later, before the increase had taken effect, it lowered the CCyB to 0 percent to prevent risks from materializing following the U.K. referendum to leave the EU.

48. The FPC announced in December 2019 that the new neutral, standard risk rate of the CCyB would be two percent, to take effect 12 months hence. The main objective of the increase in the standard risk environment CCyB was to improve the responsiveness of capital requirements to economic conditions, so that banks would be better able to absorb losses and maintain lending through the cycle. The FPC also expected to lower the economic cost of the buffer build-up by moving early before risks were elevated. It expected banks’ overall loss-absorbing capacity to stay broadly unchanged, as the PRA reduced Pillar II capital requirements accordingly.15 However, the combination of a higher CCyB and lower Pillar II requirement raised the overall quality of capital by replacing Pillar II capital with the Tier 1 capital that the CCyB requires. Once the pandemic hit, however, the FPC lowered the CCyB to 0 percent. In December 2021, the FPC raised the CCyB to 1 percent, effective December 2022, as it judged that domestic risks to U.K. financial stability had returned to around their pre-COVID levels. This is in line with the FPC policy of raising the CCyB in measured steps to the 2 percent standard risk environment levels.

49. Evaluating systemic NBFI and cross-border risks remain a challenge. Data gaps continue to impair the U.K.’s ability to monitor, identify, and analyze NBFI risks (Box 2). While the FPC has acknowledged these risks in its systemic risk work for many years, progress is still to be made on the material data gaps mentioned in the 2016 FSAP.16 The BOE has expanded its use of external data providers and market intelligence to mitigate data deficiencies while regulators have cooperated on ad hoc information requests and surveys.

United Kingdom: Select Financial Stability Data Gaps

A list of key aspects concerning data gaps:

  • 1. Overall, data collection of NBFI lending activities and cross border operations should be enhanced. International cooperation is also key to share data from trade repositories across jurisdictions.

  • 2. Flow of funds data for domestic and foreign NBFIs must be completed.

  • 3. Data on holdings of Sterling-denominated instruments should be collected by each type of investor.

  • 4. Regular use can be made of the data available at the FCA on trading of sterling Gilts and corporate bonds to assess liquidity conditions.

  • 5. On insurers, derivatives data enhancements and quality-check are essential for assessment of financial stability risks.

  • 6. Data on cross-border business and intermediation channels is limited. This complicates an assessment of the systemic relevance of large international active insurers in third-country markets.

  • 7. Data on funds is insufficient (low frequency, non-verifiability, and limited coverage) to assess potential liquidity demands in stress events. International cooperation is key to share data across jurisdictions.

Sources: IMF Staff.

50. Since the GFC, U.K. authorities have often taken the lead in international efforts to improve data and surveillance of market-based finance and will need to redouble those efforts following the pandemic. The FPC has special powers to call for new data collections but has not yet used them. That is partly because the international nature of market-based finance would limit the value of domestic-only collections. The BOE and FCA have been proactive in elevating market-based finance issues at the FSB and IOSCO.

51. Regulatory practice, data, and supervisory requirements, as well as cross-border data sharing vary across funds (U.K. authorized, U.K. unauthorized, U.K. managed). The response to the pandemic sparked ad hoc international information-sharing initiatives. For example, Luxembourg authorities shared information with the BOE about registered money market funds active in the United Kingdom. The BOE is seeking to formalize such agreements for normal times.17 Going forward, stronger, and ongoing international coordination appears essential to enable the U.K. and other authorities to monitor the spectrum of cross-border nonbank financial firms, as illustrated by recent failures of international firms not regulated in the United Kingdom.

B. Microprudential Framework

52. The United Kingdom operates a sound and transparent regulatory and supervisory framework for banks and insurers. The PRA uses an array of tools and techniques to implement its risk-based approach. It has taken steps to address key concerns raised during the 2016 FSAP and increased the intensity of supervision on non-systemic smaller banks. The regulatory framework for insurance supervision is sophisticated and the United Kingdom. are leaders in supervisory techniques. Regulators have also implemented reforms to enhance firms’ operational resilience. The joint PRA-FCA Senior Manager and Certification Regime (SMCR) rolled out from 2016 designed to increase individual accountability of senior managers is producing positive results, but the PRA has not yet used the full range of powers provided for by the framework.

53. However, a stronger on-the-ground’ focus on individual banks, insurers and other systemically important financial firms and their activities is highly desirable—a point also made in earlier FSAPs. The current supervisory approach is a blend of a cross-firm supervision and firm-level oversight. The PRA has significant engagement with the largest and most significant firms, meeting senior management and key function holders very regularly. The PRA should use the full range of existing tools on a more frequent basis while conducting in-depth investigations and providing timely and substantive feedback to firms. This would provide better assurance that risks arising from the most complex activities and those that could materialize later in the context of COVID-19 are adequately measured and mitigated by firms. The potential that firms’ risk management becomes hubristic should not be underestimated in the current environment. In banking supervision, the Section 166 Skilled Persons Review authority should also be used in a more proactive supplemental manner while the PRA increasingly develops more competencies internally. Indeed, the S-166 Review should not be a long-term solution to inadequate resourcing within the professional staff involved in banking and insurance supervision.

54. Cloud outsourcing heightens the need for more direct supervisory attention and understanding of the underlying structures and practices. The PRA and FCA lack express statutory authority to directly review and examine any critical services from cloud and other third-party providers to regulated entities. Firms’ increasing use of the cloud to perform core services raises operational (and potentially systemic) risks given the relatively small number of providers involved. The authorities should seek legislation granting direct supervisory access to third-party providers.

55. The PRA and FCA are proactively addressing the financial risks associated with climate change into their regulatory programs. The PRA set a deadline of end-2021 for firms to have fully embedded supervisory expectations for the management of climate-related financial risks. In June 2021, it launched a Climate Biennial Exploratory Scenario exercise to explore the resilience of major U.K. banks, insurers, and the financial system to these risks. The Climate Change Adaptation Reports published by the U.K. financial regulators conclude that financial institutions have made tangible progress against supervisory expectations on climate. However, more remains to be done, especially with respect to firms’ risk management and scenario analysis capabilities. Banks’ climate disclosures remain incomplete despite tangible progress, but further initiatives have been launched.18 As they advance their proposals, it will be very important for the U.K. authorities to specify regulatory standards and guidance with sufficiently detailed requirements and expectations, building on existing work and in accordance with international standards that are currently being developed.

Banking-Specific Issues

56. International banking activities are a major regulatory and supervisory responsibility of the United Kingdom. International banks, including G-SIBs undertaking corporate and investment banking (CIB) activities, can operate in the United Kingdom as either subsidiaries or branches. The United Kingdom’s entity-neutral approach is largely unique among jurisdictions hosting large financial centers. This has implications for supervision as it presents certain limitations and may raise practical challenges in the case of branches. The U.K. authorities have recognized their global responsibility to maintain top-notch prudential standards and that openness must be accompanied by financial and operational resilience. It will be important, however, for the PRA to further enhance cooperation with relevant third-country home authorities to maximize information sharing and supervisory collaboration and review regularly whether the approach to supervising international banking firms delivers the expected supervisory outcome and preserves financial stability.

57. The post-Brexit challenge will include streamlining the prudential framework while continuing to meet internationally agreed standards. The process of preserving the EU legislation has been completed, but at the end of the Brexit transition period, the United Kingdom is left with a relatively complex regulatory structure that integrates core aspects of the EU regulatory framework into a multilayered mix of primary legislation, on shored regulations and other statutory instruments, as well as technical standards, and PRA and FCA rules and guidance. The post-Brexit challenge will include streamlining the prudential framework and introducing appropriate levels of proportionality without weakening internationally agreed requirements and creating opportunities for regulatory arbitrage. The PRA intends to introduce proportionality measures into the prudential framework for banks that are neither systemically important nor internationally active. The diversity of deposit-taking institutions that comprise the U.K. banking sector is conducive to a proportional approach to regulation, but non-internationally active banks must remain subjected to rigorous prudential standards, broadly consistent with the Basel framework.

Insurance Issues

58. The United Kingdom has a highly developed framework for insurance supervision, implemented by highly sophisticated regulators. This is borne out in a very good assessment outcome of the FSAP ‘Detailed Assessment of the IAIS Insurance Core Principles (ICPs) where 17 ICPs were found to be observed, six largely observed, and only one partly observed. The Solvency II framework inherited from the United Kingdom’s former membership of the EU is a rigorous prudential framework, and the conduct requirements are similarly robust and both regulators are advanced practitioners of supervision. Post-Brexit, the United Kingdom should take care not to reduce these high standards while tailoring the adopted European requirements to the domestic and international aspects of its insurance market.

59. The Society of Lloyds and the broader London Market for specialist insurance is important for the United Kingdom and for many insurance markets in advanced economies and emerging markets. While the Society plays a useful economic and market role, the PRA should consider setting up a platform for supervisory cooperation for Lloyds to allow interactions with supervisors where Lloyds operates both regulated operations and operates in markets without physical operations. This will allow for better understanding of the role played by Lloyds in insurance markets around the world and can build on existing systemic risk analysis performed in relation to Lloyds. It would also foster understanding among other cross border supervisors of the supervisory activity performed by the PRA with respect to Lloyds.

60. The institutional framework is strong and the independence of the PRA and FCA should continue to be preserved. The risks can clearly be seen in the Solvency II review with HMT running the consultation process with the PRA in a central but essentially supportive role. One way forward to address this issue would be to ensure that requests for advice from the PRA are made transparently by HMT and that the PRA can provide that advice in an independent and transparent way. Any variation in final policy compared to PRA advice would then be clear.

61. The mission encourages HMT and the BOE/PRA to proceed with the development of a resolution regime for insurers, as such regime does not yet exist in the United Kingdom. Practically, insurers can be resolved through market transfers of portfolios of insurance liabilities, sale of companies, or winding-up of companies. There is a vibrant market for portfolios of insurance liabilities in the United Kingdom with some significant companies specializing in the market. The risk of a failure of a large insurer not being easily resolvable through market mechanisms or run-off is currently not addressed, although work to address this issue is in train. Currently, the United Kingdom is assessed as partly observed for ICP 12 (exit from the market).

Crosscutting Challenges to Financial Stability

A. LIBOR Transition

62. Most LIBOR settings ceased in December 2021 and all will end by June 2023, creating urgency to rebase all contracts to more robust risk-free rates (RFRs). A voluminous stock of legacy contracts (amounting to around U.S.$14 trillion) needs to be transitioned, mainly in U.S. dollars. Many Sterling-denominated LIBOR-based assets mature after the end of Sterling LIBOR (Figure 25).

Figure 25.
Figure 25.

United Kingdom: Indicators of the Importance of LIBOR and Transition Progress

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

63. The United Kingdom as the regulator of LIBOR’s administrator, has shown leadership in the LIBOR transition effort, which is well advanced domestically. Transition is well advanced in Sterling markets, importantly supported by the strong adherence to new protocols that will govern how derivatives contracts operate post-LIBOR (Figure 25). The United Kingdom, as host and regulator of LIBOR, has also effectively sponsored the global transition. Progress is less advanced in the key U.S. dollar markets that trade in the United Kingdom risking fragmentation in some key FX markets traded in the United Kingdom to the detriment of third-country users who might not have backup funding and hedging options available.

64. Mitigating LIBOR-related financial stability risks requires ending production of new LIBOR exposures, active conversion of legacy instruments, and a forward-looking oversight regime to prevent re-emergence of LIBOR-like risks. As the Sterling markets have moved off LIBOR, the focus is on converting legacy instruments to RFRs, supported using synthetic LIBOR in a limited number of cases. In FX-denominated instruments, the U.K. authorities have an important advocacy and support role to play, as foreign regulators complete their transitions while also managing risks to U.K. entities and supporting emerging market users. Looking forward, a more permanent preemptive oversight and risk management infrastructure needs development to help minimize the costs of future problems with emerging financial benchmarks.

B. Open Banking and Crypto Assets

65. The United Kingdom’s Open Banking (O.B.) initiative was launched in 2018 to increase competition.19 The direct impact on banks’ profitability from increased competition is contained by the relatively small size of U.K. banks’ income from payment services (about 0.8 percentage points of return on equity) and the slow uptake of O.B. The entry of sizeable platform-based technology companies in future versions of O.B. could bring opportunities and risks. A gradual process should help contain risks, as the system adjusts to increased competition. However possible challenges to liquidity and income will bear minding within the current monitoring frameworks. Operational risks are mitigated by licensing and supervision of O.B. providers and safeguards for the Application Programming Interface (API) infrastructure underpinning O.B.

66. The acceleration of technological changes suggests a need to review policy coordination and develop more innovative and effective ways for the oversight of the digital finance markets. The ongoing structural transformation could increase competition in both domestic and cross border financial services and compound the existing sources of financial stability risks. Combined with a rapid entry of BigTech into financial services, the sector could face a considerable transformation. Building on the innovative Digital Regulation Cooperation Forum launched in 2020, formal mechanisms could be considered to ensure that the views from regulators are taken into consideration in deliberations on competition policy interventions as the needs for coordination across public policy interests in competition and stability continue to grow.

67. The United Kingdom has a proactive approach towards developing a policy framework and tracking risks posed by crypto asset innovation. The United Kingdom has issued regulations for crypto assets to ensure consumer protection, and regulations for stable coins are being developed following international guidance. As host of the most prominent global financial center, the authorities’ commitment to innovation and robust regulatory standards will require a continued and special focus in containing emerging and possibly systemic financial stability risks arising from crypto’s high-paced growth and increasing links to the financial system. Innovation will continue to challenge the status quo. While a steady state is presently hard to envision, policy and regulatory frameworks will need to remain nimble, and resources allocated appropriately and timely, allowing the oversight agencies to react quickly and prevent any rapid buildup of risks to financial stability.

C. Cybersecurity Threats

68. Safeguards against growing cyber threats are a top concern for U.K. authorities. Growing reliance on critical third parties to provide vital services is increasing risks, especially in the absence of greater direct regulatory oversight. In June 2017, the FPC set out a strategy to withstand and recover from cyber incidents. The authorities oversee cyber resilience by regulating and supervising the sector (macroprudential) and single firms (microprudential). The CBEST program, aimed at assessing the effectiveness of cyber defenses with simulated attacks, is the cornerstone of the testing strategy. The regulatory framework builds on good international practices and cross-sectoral cybersecurity standards.

69. The cyber risk management framework must continue to be built to contain three financial stability concerns: (i) complexity of operational risks; (ii) unregulated third-party services; and (iii) span of entities covered. The United Kingdom must complement existing supervisory practices with onsite activities to verify the operational effectiveness of cybersecurity controls and to capture cyber incident underreporting. Statutory powers will allow a direct assessment of the resilience of any critical services provided by certain systemically important third parties (including cloud outsourcing). The FPC along with FCA and BOE/PRA should consider specific resilience standards for these providers and their inclusion in resilience testing.

D. Combating Financial Crimes and Safeguarding Financial Integrity

70. The United Kingdom continues to combat financial crimes across a wide range of activities (Figure 26). Its AML/CFT regime is one of the most effective worldwide (Figure 27). The FCA is strengthening proactive and reactive supervisory activities using modular/thematic approaches and data analysis. The People with Significant Control (PSC) Register allows public access to beneficial ownership information of legal entities and requires entities with AML/CFT obligations to report discrepancies. The authorities can share financial intelligence with foreign peers, and the Global Anti-Corruption Sanctions Regulations require the freezing of U.K. assets of designated persons involved in foreign corruption.

Figure 26.
Figure 26.

United Kingdom: Supervisory Population of Entities with AML/CFT Obligations

(as of end-December 2020)

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: U.K. authorities and IMF staff calculations.
Figure 27.
Figure 27.

United Kingdom: AML/CFT: Comparison of Mutual Evaluation Report Ratings

Citation: IMF Staff Country Reports 2022, 057; 10.5089/9798400203268.002.A001

Source: Financial Action Task Force.

71. Several additional measures could boost the authorities’ AML/CFT objectives. 20 To enhance the FCA’s risk-based supervision, technology tools (e.g., machine learning) should be leveraged. Properly supervised “skilled persons” could supplement FCA’s AML/CFT oversight functions for low-risk entities. Having OPBAS conduct direct AML/CFT supervision for low-capacity or high-risk PBS can maximize efficiencies and harmonize approaches. The proposed legislation to improve verification of information in the PSC register and for a beneficial ownership register for foreign entities owning U.K. properties should also advance, in addition to augmenting support to CDs and BOTs for adopting effective beneficial ownership registers. Unexplained wealth orders should continue to be utilized to confiscate illicit assets and generate financial intelligence for cross-border investigations.

Preparing for Future Crises

A. Resolution Framework

72. Many of the 2016 FSAP recommendations on the financial safety net and crisis management have been followed by the United Kingdom. The United Kingdom is working towards the 2022 deadline to make all eight systemic U.K. banks resolvable. A comprehensive Resolvability Assessment Framework (RAF) supports the authorities and the firms in meeting this commitment. Material foreign subsidiaries and some mid-tier banks too are subject to the RAF, except for the reporting and disclosure requirements.

73. The authorities are strengthening their crisis readiness. The BOE has revamped its crisis readiness governance, including a Heightened Contingency Framework Project; HMT has furthered its Professionalizing Crisis Management Project. Similar developments are ongoing at the FCA and the FSCS. The authorities test and update their crisis readiness individually and collectively, including with U.S. and EU counterparts. The authorities should continue preparing for diverse failure scenarios, including fast-fail resolutions and concurrent failures of multiple systemic and mid-tier banks.

74. The special resolution regime (SRR) for banks appears robust but assigns HMT a critical role in firm-specific resolution decisions. The SRR includes modified insolvency regimes for banks, building societies, and investment firms. The BOE plays a crucial role in the court-based insolvency proceedings. Under certain conditions, HMT can also play a critical role in elements of firm-specific decisions although this remains untested, including in cross-border cases. Moreover, certain parts of the United Kingdom resolution regime that were introduced or maintained to comply with EU rules may constrain resolution funding. The authorities should eliminate these constraints from their rulebook, and review and explain to moderate HMT’s involvement in firm-specific resolution decisions to focus on cases where public funds are at risk.

75. The authorities are considering enhancing the resolution regimes for CCPs and insurers. With modifications for CCP characteristics, the SRR applies to the three recognized U.K. CCPs, aiming to achieve the same objectives as the banks’ SRR, under similar conditions and with similar powers. However, this regime predates pertinent international guidance issued since 2012; nor was the EU CCP RRP regime on shored prior to Brexit given it had not been yet implemented in the EU at that stage. HMT is considering statutory changes for an expanded CCP resolution regime with more powers for BOE. HMT, alongside the BOE, is also considering an SRR for insurers, and the PRA, together with the BOE, is developing an RRP approach for insurers. These legislative and policy efforts should be accelerated and complemented with a RAF-like regime.

B. Internationally Active Mixed Financial Groups

76. Internationally active financial groups are actively seeking arbitrage advantage through several demand-side and technology-based shifts. These entities seek to divert risk to areas where data, reporting, and oversight seem looser and avoid stronger regulation through regulatory arbitrage across jurisdictions. These entities (hybrid structures, finance companies, family offices, and other non-traditional forms) are also often CIB banks’ counterparties (some of them are supervised in the United Kingdom). 21

77. Recent cases that have garnered public attention involved excessive leverage in unregulated or lightly regulated entities, as well as limited disclosure requirements. While different, these cases illustrate the challenges of identifying vulnerabilities in dynamic cross-border NBFI activities. While the global supervisors later described the incidents as ‘nonsystemic’, the events point to neglected risks in cross-border activities that could have become systemic under different circumstances. The incidents have revealed that several banks and CIB branches did not have appropriate governance and risk management arrangements and were unable to monitor and mitigate risks arising from these activities. Moreover, supervisors did not systematically monitor these types of positions on a real-time basis and were not aware of the common exposures across banks globally. Elements in domestic regulatory regimes, such as the U.K.’s approach to “appointed representatives,” also helped keep the risks off supervisors’ radar. 22 Furthermore, these entities are not subject to detailed regulatory public disclosure requirements. Such or similar businesses, enhanced by ongoing technology transformation could amplify channels for arbitrage and bypassing of financial stability oversight.

78. The United Kingdom and peer foreign authorities should address data gaps and improve cross-border supervisory cooperation. The United Kingdom is already considering measures to address the data gaps, but any such effective reform will require international cooperation given the cross-border nature of these activities. The BOE could also expand its biannual survey of prime brokers to include in a more granular manner cross-border, cross-market, and cross-product exposures. The United Kingdom should consider whether its oversight over internationally active NBFIs operating in the United Kingdom should be expanded to include additional monitoring criteria. That would include the need to take a closer look at the unregulated entities of mixed cross-border groups to evaluate their impact on the regulated entities and any potential systemic implications. It also should review whether the existing supervisory cooperation arrangements provide sufficient information-sharing for effective monitoring of systemic risks. The authorities should also consider fundamental changes in the appointed representative regime.

C. Agency Independence and Resources

79. The U.K. financial regulators have separate mandates, with a clear focus on financial stability, safety and soundness, and market integrity. They also have, respectively, secondary objectives to facilitate effective competition and to support the economic policy of the government. Unlike the former Financial Services Authority, the PRA and the FCA do not have an express competitiveness mandate. However, this approach is being questioned increasingly. “Competitiveness” has been listed in Remit Letters issued by the Chancellor since 2015 as an aspect of government economic policy to which the FPC and PRA should have regard. The Financial Services Act of 2021 introduced additional considerations that the PRA must have regard to when making rules implementing Basel III standards, including the international competitiveness of the U.K. financial sector.

80. Moreover, HMT’s Financial Services Future Regulatory Review (FRF review) has sought comments on redesigning the regulatory framework for financial services regulators.23 Under the proposal, regulators would be empowered to set out the regulatory and supervisory requirements that apply to firms while being subject to enhanced accountability and other arrangements. The proposal also introduces a statutory secondary objective for the FCA and PRA to “facilitate the long-term growth and international competitiveness of the U.K. economy.”

81. Certain measures could constrain U.K. regulators’ ability to discharge their new rulemaking responsibilities. Taken in totality, measures simplifying the rulebook, delegating rulemaking, and expanding the regulatory remit to new activities are beneficial. The process of repealing relevant retained EU law and replacing it with regulators’ new rules will maintain continuity of regulatory requirements. Other proposals will need to be designed carefully, to ensure the FCA and PRA maintain their focus on their primary prudential objectives and can retain their operational independence.

82. Going forward, preserving the primacy of the U.K. regulators’ general objectives in principle and practice will be paramount. Delegating responsibility to the regulators for setting requirements that are often technical and complex is beneficial, but the United Kingdom must avoid a proliferation of wider financial services policy priorities that could divert focus from financial stability. Enhanced accountability and transparency mechanisms should also operate in a way that preserves the independence of regulators and should not reduce operational and regulatory effectiveness. Concerning resolution, strengthening the operational autonomy of the BOE where public funds are not at risk and the FSCS regarding funding, and ensuring that the BOE undertakes the resolvability assessments of the banks with a high degree of autonomy will be critical. Maintaining robust and high-quality regulatory standards that naturally encourage investment and growth is the best way to preserve the United Kingdom’s role as a major financial center.

83. Always maintaining adequate skills and resources for systemic risk oversight, and supervision of systemically important financial firms and financial markets is crucial. The current level of resources is fully deployed given the range and nature of the tasks outlined in the FSAP report. Going forward, new post-Brexit prudential rulemaking responsibilities, an increased number of firms to be supervised after Brexit, the need for more intrusive supervisory practices, new climate change responsibilities, rapid technological change, the need to deliver on major U.K. financial sector projects, and participating in international standard setting body activities will require the BOE/PRA and FCA to carefully evaluate and maintain the level of resources required to deliver on their objectives for regulated firms. The authorities should also continue to pursue staffing resources for resolution and crisis management that are commensurate in quantity and quality with increasing demands due to market developments and policy ambitions. Leveraging technologies (big data and machine learning) and exploring further data and platform synergies between the BOE/PRA and the FCA can support timely identification of risks, maximize oversight efficiencies, and move the financial stability framework to the next level. Finally, and related to agency independence and resources, the FSAP welcomes the progress made by the United Kingdom in taking forward the recommendations of the 2016 FSAP and urges the authorities to assign resources to complete the implementation of those FSAP recommendations where action has been initiated but work is underway (Appendix IV).

Authorities’ Views

84. The authorities welcomed the FSAP, offering their appreciation of the IMF’s work, and remain highly supportive of FSAPs as financial stability tools. Overall, they agreed with much of the assessment and found the conclusions broadly reasonable. They welcomed the assessment’s positive endorsement of the United Kingdom’s effective financial stability framework, its prudential policies, and the overall stability of the United Kingdom as a global financial center which acts as a global “public good.” They especially welcomed the strong emphasis placed by the FSAP on ensuring financial stability remained the primary objective of financial sector oversight. The authorities stressed their commitment to developing and adhering to the highest standards and practices for financial regulation and supervision. They welcomed the FSAP’s recognition of the United Kingdom’s unrelenting commitment to international cooperation and collaboration. The authorities indicated their intent to assess and follow up on the FSAP recommendations and agreed to publish the FSSA and FSAP Technical Notes and the Detailed Assessment Report (DAR).

85. The FSAP reviewed several high-profile challenges for global financial stability and the authorities welcomed the IMF’s efforts both to share lessons learned with the international community and to help drive the necessary global response. The authorities welcomed the IMF’s positive feedback on the authorities’ mitigation of financial stability risks that could otherwise have resulted from the end of the Brexit transition period and on the United Kingdom’s response to the pandemic, agreeing on the need to continue enhanced monitoring of risks to financial stability stemming from the protracted pandemic. Noting the IMF’s detailed review of insurance and banking supervision, the authorities concurred with the FSAP’s very positive assessment of their approach and the increased resilience of U.K. banks and insurers. The authorities appreciated the IMF’s observation of the leading role they have played in the global transition away from LIBOR and welcomed the opportunity to share their leading approach to mitigating climate risks. On NBFIs, the authorities emphasized that while responsibility for addressing many of the key risks identified rests at a global level, the United Kingdom. intends to be at the forefront of this work. More broadly, the authorities acknowledged that the complexities of modern-day finance, with a more digital, cross-border business model, require stronger global cooperation to maintain effective systemic risk monitoring and mitigation. Finally, the authorities noted their confidence in current decision-making processes to deal with emerging risks but recognize that new technologies and emerging issues require continued analysis, consistent communication, and appropriate collaboration with all relevant domestic and international stakeholders.

Appendix I. Banking Sector Stress Test Matrix

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Refers to the 2021 Solvency Stress Test exercise rather than Annual Cyclical Scenario (ACS). Key differences with respect to the ACS are that the latter includes baseline projections and the approach to traded risk is different.

de-Ramon, S., Francis, W., Milonas, K. (2017) An overview of the U.K. banking sector since the Basel accord: Insights from a Regulatory Database. Bank of England Staff Working Paper SWP 652, March 2017.

Appendix II. Insurance Stress Testing Matrix

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Appendix III. FSAP Risk Assessment Matrix

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Appendix IV. Implementation Status of 2016 Key Recommendations

Key Recommendations in Table 1 Financial Sector Stability Assessment (FSSA) Report

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Interim Status was reported in the 2018 Article IV Consultation – IMF Country Report No. 18/316. This Appendix reports developments as of end June 2021.
1

NBFI refers to all types of investment funds, finance companies, broker-dealers, structured finance vehicles, central counterparties, money lenders, captive funds, and bank holding companies. NBFI credit providers comprise investment funds, insurers, pension funds, money lenders, and finance companies.

2

The public Debt Sustainability Analysis (DSA) in the Staff Report for the 2021 Article IV Consultation highlights that higher government financing needs would call for higher demands on NBFIs’ and banks’ gilt holdings, with implications for crowding out private credits, raising interest rates, and tightening sovereign-financial links.

3

The EU13 are the 13 members of the EU for which data across the three databases used here (IMF CPIS, ESMA Annual Statistics, and BIS BLS) could be obtained.

4

Note that the EEA Agreement extends the EU single market for financial services to EEA countries (Iceland, Liechtenstein, and Norway). However, as EU institutions are the relevant authorities shaping together with the United Kingdom, the development of cross-border financial services between the United Kingdom and the EU/EEA, this FSSA refers to the EU.

5

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. The conjunctural shocks and scenario highlight risks that may materialize over a shorter horizon (between 12 to 18 months) given the current baseline. Structural risks are those that are likely to remain salient over a longer horizon.

6

BOE’s analysis indicated that the increase in SME indebtedness substantially outpaced large businesses during the pandemic. Total debt increase in large firms from Dec 2019 to Mar 2021 is about 2 percent, compared with a 25 percent increase in SMEs. Therefore, the FSAP’s analysis focuses on SMEs’ financial vulnerabilities. Firm and household-level financial indicators were estimated using structural models using individual-level data and macrofinancial indicators. For further details of NFC and household analyses, please see the Technical Note on the balance sheet resilience and financial stability.

7

Firms’ financial positions were projected up to 2025 in both baseline and two stress scenarios.

8

Due to data limitations, the FSAP team can only map firm-level financial vulnerabilities to major banks. Therefore, the analysis cannot quantify NBFIs’ exposures to NFCs’ financial vulnerabilities.

9

Credit risk is one of the most important risk factors for the U.K. banking system, as the loan portfolio accounts for about 56 percent of total assets. By type, mortgage loans account for about 54.9 percent of the total exposures at default (EAD). Corporate loans correspond to 32.5 percent of credit exposures and retail to 12.6 percent. Under the first adverse scenario, domestic mortgage PDs increase by 4pp at the start of 2022. Under the second adverse scenario they initially fall and then peak at 7.7 percent by the end of 2023. This is consistent with the scenario paths for house prices and unemployment. Similarly, foreign mortgage PDs peak at 8.1 in 2022 under the adverse scenario 1 and reach 9.9 percent in 2023 under scenario 2.

11

Other central banks have used both lending facilities (for example, the Primary Dealer Credit Facility in the United States) and asset purchase facilities (the U.S. Secondary Market Corporate Credit facility) to good effect.

12

The analysis substantiating this decision by the FPC was based on the FCA maintaining its affordability stress testing rules, which call for a stress on interest rates based on expected interest rate paths for the next five years or 100bps, whichever is higher.

13

To date, it has not found it necessary to recommend expansions to the ‘regulatory’ perimeter, although it said in the December 2019 FSR that it was considering its first recommendation, to regulate new payment services. Parliament and HMT ultimately determine which activities and entities are subject to regulation.

14

Financial Policy Committee. “The Financial Policy Committee’s approach to setting the countercyclical capital buffer.” London: Bank of England (2016).

16

Enhanced financial accounts (flow-of-funds) activities of NBFIs and buy-to-let mortgage market.

17

For example, the FPC noted in its July 2021 FSR that international regulators need to develop a way to aggregate and share trade repository data to better analyze cross-border exposures in derivatives markets.

18

Building on previous initiatives, the U.K. government published in October 2021 its Roadmap to Sustainable Investing, setting out details on new Sustainability Disclosure Requirements (SDR) and on the U.K. Green Taxonomy. An indicative path towards “integrated economy-wide disclosure” under the SDR framework has been proposed.

19

O.B. allows consumers and SMEs to have more choices for certain financial services by securely sharing bank account information with regulated O.B. providers.

20

2019–22 Economic Crime Plan.

21

As part of its international finance activities, private capital markets are also becoming a major force out of the United Kingdom for corporate and SME financing. This is routed mainly through “alternative asset managers”, who offer private equity, venture capital and private credit funding options. Data on this practice is scant, and this trend needs to be fully explored with international cooperation.

22

Under U.K. laws, an appointed representative can carry out specific regulated activities without direct government oversight if a regulated firm, known as the appointed representative’s “principal,” has agreed to take responsibility for them.

23

After a first consultation in October 2020, HMT has published for consultation in November 2021 a second package of detailed proposed measures.

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Cover IMF Staff Country Reports
United Kingdom: Financial Sector Assessment Program-Financial System Stability Assessment
Author:
International Monetary Fund. Monetary and Capital Markets Department
Volume/Issue:
Volume 2022: Issue 057
Publisher:
International Monetary Fund
ISBN:
9798400203268
ISSN:
1934-7685
Pages:
94
DOI:
https://doi.org/10.5089/9798400203268.002

G7: Real GDP Growth in 2020 and 2021

(Percent)
Figure 1.

United Kingdom: Macrofinancial Indicators
Figure 2.

United Kingdom: Macrofinancial Linkages
Figure 3.

United Kingdom: United Kingdom and the Core Global Financial System

United Kingdom Financial System Assets [in trillion £s)

Other Financial Intermediaries (Percent of assets in 2019)

Interconnectedness

Offshore assets

(Q1 2020, percent of total assets in each group)

U.K. Export of Financial/Insurance Services

(Billions of GBP, 2018)

Global CCP market

(Percent of total IM, 2019)

Global Currency Market

(Average daily volume, in trillion USD)

Global Market for IR Derivatives

(Average daily volume, in trillion USD)
Figure 4.

United Kingdom: Systemic Stress Scenarios
Figure 5.

United Kingdom: Nonfinancial Corporates
Figure 6.

United Kingdom: Nonfinancial Corporates Under Stress Scenarios
Figure 7.

United Kingdom: Household Balance Sheets
Figure 8.

United Kingdom: Bank Stress Tests At-A-Glance: Scenarios and Results
Figure 9.

United Kingdom: Bank Solvency Stress Test Results
Figure 10.

United Kingdom: Solvency Stress Test Results
Figure 10.

United Kingdom: Solvency Stress Test Results
Figure 11.

United Kingdom: Macrofinancial Feedback Effects
Figure 12.

United Kingdom: Insurance Sector—Solvency and Profitability
Figure 13.

United Kingdom: Insurance Solvency Stress Test
Figure 14.

United Kingdom: Insurance Liquidity Risk Analysis
Figure 15.

United Kingdom: Credit Cycles
Figure 16.

United Kingdom: IM and VM Margin Calls
Figure 17.

United Kingdom: Money Market Funds
Figure 18.

United Kingdom: Fixed Income and Equity Open-Ended Funds
Figure 19.

United Kingdom: Alternative Investment Funds
Figure 20.

United Kingdom: Systemic Liquidity Stresses and the BOE’s Response
Figure 21.

United Kingdom: Housing Price Developments and Household Debt Indicators
Figure 22.

United Kingdom: Methodological Approaches for Climate Risk Analysis
Figure 23.

United Kingdom: The Logic of the ‘Climate Minsky Moment’
Figure 24.

United Kingdom: Insurance Climate Risk Analysis
Figure 25.

United Kingdom: Indicators of the Importance of LIBOR and Transition Progress
Figure 26.

United Kingdom: Supervisory Population of Entities with AML/CFT Obligations

(as of end-December 2020)
Figure 27.

United Kingdom: AML/CFT: Comparison of Mutual Evaluation Report Ratings