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Optimism from the FPC

6 August 2020 by Gary Kirk

As expected the Monetary Policy Committee (MPC) kept UK base rates at 0.1% and maintained their current level STG IG corporate bond on the BoE balance sheet at £745bn, with no immediate expectations of a need for further stimulus.

More interesting for us was the release of the Financial Stability Report (FSR) – a detailed analysis of the transmission mechanism and UK banking sector. The first thing to note is the Financial Policy Committee (FPC) revised down their expected credit losses for the banking sector to “somewhat less than £80bn”. They state that in their assessment “banks have buffers of capital more than sufficient to absorb the losses that are likely to arise under the MPC’s central projection”. Interestingly they publish results from a “reverse stress test model” which suggests UK Bank CET1 ratios would be reduced by approximately 5.2% from the 2019 y/e levels (i.e. from 14.8% to 9.6%). To put this in perspective it would still leave around 40% of existing capital buffers (not including the increases seen so far ytd). The 60% capital depletion is effectively due to the impairments we have witnesses so far (c.£120bn), with many banks acting prudently by front loading the potential headwinds.

The FPC go on to say that for real stress in the sector the economic output would need to be twice as bad as the MPC’s projection, with unemployment rising to above 15% (currently they expect 7.5%) and the current accumulation of CET1 to come to a shuddering halt.

Of course there can still be unforeseen events that change the optimistic outlook, however, the FPC judge that banks have the capacity to continue to support businesses and households through this period of uncertainty. It effectively echoes Mark Carney’s words that banks are part of the solution rather than the problem. It also supports our view that bank balance sheets are extremely robust, with more than sufficient buffer capital to see them through this downturn and give comfort to subordinated bond holders.

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