The Bank of England sits in London, U.K. (Photographer: Simon Dawson/Bloomberg)

U.K. Banks Brace for $14.5 Billion Capital Demand From BOE

(Bloomberg) -- The Bank of England plans to increase capital requirements for U.K. lenders by 11.4 billion pounds ($14.5 billion) to tackle risks posed by the recent rapid growth in consumer credit and prepare for the uncertain outcome of Brexit talks.

The BOE set the countercyclical capital buffer at 0.5 percent of risk-weighted assets for U.K. loans effective in June 2018, and if nothing material changes the central bank plans to increase the level again to 1 percent in November. Additionally, next month regulators will publish new guidelines for consumer lending to ensure risks are priced and managed appropriately.

“We want to move the levels of capital back up to the level they should be -- any time you move into more benign credit conditions there have been fewer defaults,” which can lead to complacency, Governor Mark Carney said on Tuesday. Regarding Brexit, “there are risks around that process, so contingency planning needs to be not only put in place but also activated.”

Each increase of 0.5 percent will swell banks’ cushion of common equity Tier 1, the highest-quality capital, by 5.7 billion pounds, according to the BOE’s Financial Stability Report. The BOE opted for a staggered approach because it’s less likely to result in banks tightening lending in response.

“It is a sensible way for the bank to try to take some of the steam out of the consumer debt growth without immediately impacting the nominal rates paid by mortgage borrowers,” said Gregory Turnbull Schwartz, an investment manager at Baillie Gifford & Co. in Edinburgh. “It’s more targeted than a general base rate hit and more easily reversed should they see the need to do that in the near term.”

Boom Times

The countercyclical capital buffer is meant to guard against banks’ tendency to boost lending in boom times and slash it in a bust, potentially exacerbating a slowdown. The regulation is meant to ensure banks have enough capital to weather losses and continue making loans to support the economy.

In the immediate aftermath of Britain’s vote to leave the EU last June, the BOE reversed a planned increase in the buffer to help stave off the U.K. slump that was predicted by economists. Since the referendum vote, the economy has performed better than expectations, leading Governor Carney to suggest the capital buffer could be increased.

The overall risks from U.K. exposures are at “neither particularly elevated nor subdued,” according to the BOE.

U.K. Banks Brace for $14.5 Billion Capital Demand From BOE

By the time the BOE considers raising the buffer rate to 1 percent, it will be able to factor in the results of its 2017 stress test of major U.K. banks. Because of the “rapid growth” in consumer credit in the last 12 months, the BOE will bring forward an assessment of stressed losses on this lending to inform its November decision on the buffer.

‘Stable’ Economy

The BOE previously said raising the countercyclical buffer is likely to tighten credit, with bank lending spreads increasing by about 10 basis points in response to a 1 percent buffer level in a “stable” economic environment.

The BOE also proposed boosting the leverage ratio, a risk-blind measure of lenders’ capital, to 3.25 percent of exposures excluding central-bank reserves. The increase from 3 percent is intended to restore the “level of resilience” delivered before the FPC decision to exclude central-bank reserves from the measure, according to the report.

The FPC also tightened standards for mortgage lending, requiring banks to stress test borrowers’ ability to repay loans at 3 percentage points above the standard variable rate. Previously some banks were able to game the system by assuming they’d pass along less than the full 3 percent increase to borrowers, the BOE said.

The BOE also said some corporate bonds and U.K. commercial real estate appear overvalued because they “do not appear to fully reflect the downside risks that are implied by very low long-term interest rates.” Both asset classes will be a focus of the stress tests later this year.

‘Possible Outcomes’

On Brexit, the BOE said it will oversee banks’ contingency planning for a “range of possible outcomes” of the talks on the U.K. withdrawal from the European Union. The bank warned some scenarios, including the U.K. crashing out with no financial deal in place, could affect financial stability.

“Fragmentation of market-based finance could result in higher costs and greater risks for both EU and U.K. companies and households,” the BOE said. For example, a single basis-point cost increase resulting from splitting clearing of interest-rate swaps -- which is currently focused in London -- could cost EU firms 22 billion euros a year, the BOE said, citing industry estimates.

The central bank highlighted U.K.-located firms are counterparty to more than half of over-the-counter interest rate derivatives traded by EU companies and banks, while U.K. asset managers account for 37 percent of all assets managed in Europe.