Is the UK Labour Market Easing at the Margin?
The Bank of England (“BoE”) has released two reports this week we think are particularly worth a read. The first one is the UK Banking Sector Stress Test where the BoE takes the eight largest banks in their jurisdiction and puts them through what observers might consider a heart-stopping stress scenario simulation. The idea is to assess the extent of the damage in this tail risk situation to individual banks, to the sector as a whole and to try to predict what the impact might be for consumers and firms trying to access credit. The second one is the Credit Conditions Survey where the BoE asks major banks’ management teams questions about the availability of credit, demand trends and pricing in corporate, unsecured consumer and mortgage books. There are a few points we think are worth mentioning, which we have summarised below.
Starting with the stress tests, the first paragraph of the report delivers an unbeatable summary: “The results of the 2022/23 annual cyclical scenario (ACS) stress test indicate that the major UK banks would be resilient to a severe stress scenario that incorporated persistently higher advanced-economy inflation, increasing global interest rates, deep and simultaneous recessions in the UK and global economies with materially higher unemployment, and sharp falls in asset prices”. It is worth touching on what exactly the scenario entails. Many of the assumptions are more severe than experienced during the GFC. Inflation in particular peaks at 17% and averages 11% in the first three years of the simulation, monetary policy rates peak at 6%, 4.7% and 6.5% for the UK, Eurozone and US respectively, unemployment doubles, equity indices fall 45%, global growth falls 2.5% - which is worse than the 1.9% during the GFC - and residential property prices fall a massive 31%.
In this horror movie scenario the report concludes that the banking sector is actually expected to perform remarkably well, all things considered. The CET1 ratio of the system falls from 14.6% in Q1 2023 to a low point of 10.8%. While non-Performing Loans and Impairments increase markedly and are the largest contributor to the decline in the CET1 ratios; interestingly, residential mortgages and CRE have a relatively small contribution to impairments, with the bulk explained by consumer credit and corporate lending. Property prices in the UK have increased dramatically in the last few years, which along with tighter lending criteria means that indexed LTVs are relatively low and CRE lending has declined as a percentage of the overall books. Therefore the severe stress in this sector does not translate in oversized losses on banks’ balance sheets. Regarding subordinated debt , despite the severity of the stresses, there would be no write down or conversion of AT1 bonds for any of the banks involved.
Moving on to the Credit Conditions Survey, we were actually more concerned about what this report might show than we were about the stress test report, given the well-known strength of the banking sector in the UK. However, trends in credit supply were unchanged from the previous quarter, in unsecured credit to households and in corporate credit, although there was less availability of secured credit to households. The main reasons cited by banks for the latter were a “changing economic outlook” and “tighter wholesale funding conditions”. The survey covers changes in the period from March to May compared to the period from December to February, therefore it was to be expected that the Credit Suisse and US regional banking issues would have impacted bank’s responses, with the period from June to today being a lot more benign. But we will have to wait and see if there is a reversal in this sector in the next report. Demand for credit was reported to have increased in secured and unsecured lending to households as well as in corporate lending. Going forward banks expect demand to cool off next quarter in secured credit while it’s forecasted to remain unchanged for the rest.
In summary, we have once again received an endorsement of the strength of the UK banking sector. These reports are definitely welcome news and they come at a time when there is nervousness and frequent headlines about potential problems in the mortgage and CRE markets in the UK. After over a decade of additional regulation and disclosure the banking sector is projected to be able to withstand storms of the size of GFC or Covid with relative ease. Considering spreads in financials still score very wide to their own history, and to other asset classes, we believe that the opportunity in bank debt continues to look very attractive. While we acknowledge that sentiment is still fragile, some AT1 bonds are still trading in the 65-70 cents range, we believe their recovery post CS and US regional banks still has some way to go yet.