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Banking Essentials Newsletter: 8th March Edition

Bank of England fears rise in loans to heavily indebted firms risks stability

A rapid growth in lending to already highly indebted U.K. companies is worrying the Bank of England which said Oct. 9 it will review the increasing role of non-banks in this market to assess risks to financial stability.

The Bank's Financial Policy Committee said in its October report that the global leveraged loan market is larger and growing as quickly as the U.S. subprime mortgage market was in 2006 before the crash.

It also said lending terms for leveraged loans had loosened, too, with the proportion of U.K. leveraged loans with maintenance covenants — loan terms agreed between lenders and borrowers which are regularly tested — falling from nearly 100% in 2010 to just 20% today.

The committee said there had been a rapid growth in leveraged loans issued by nonfinancial companies and this had reached a record £38 billion in 2017 while a further £30 billion had been issued already this year. The committee said that taking high-yield bonds and leveraged loans together the estimated stock of debt outstanding in Britain's non-investment grade firms is now estimated to account for about 20% of total U.K. corporate debt.

Though leveraged loans are usually sold to non-bank investors, banks still retain exposure, said the committee, since they make other loans to the same highly indebted companies. The committee is looking at the implications of the rapid growth in this market for both banks and non-banks. In the meantime, the committee said it would maintain the U.K.'s countercyclical capital buffer rate at 1% and will review this at its meeting in November.

Overall, however, the committee said both corporate and household debt in the U.K. remained well below 2008. Borrowing by U.K. companies from U.K. banks was subdued, rising by just 2.7% in the past year.

Cliff-edge Brexit

The U.K.'s banking system would cope even with a disorderly, cliff-edge Brexit but the European Union itself needs to act fast if it is to be ready for such an event, the committee said.

While there had been considerable progress in the U.K. to address the risks of the country quitting the EU next March without any form of implementation period or withdrawal agreement there had been only limited progress in the EU. It said EU households and businesses currently rely on U.K. banks for around half their wholesale services.

The consequences of the EU authorities failing to act could be striking, said the committee, since in the absence of an agreement, £69 trillion of contracts EU members currently have with U.K. central counterparties will need to be transferred or closed out by March 2019 when the U.K. is due to quit the EU. This, the committee noted, will be "disruptive and costly."

It emphasized that there is only a limited amount companies could do on their own to mitigate the risks of disruption to cross-border services and it said the British government is introducing legislation to allow U.K. households and businesses to continue to access financial services provided by EU countries.

The British government has said it will authorize European clearing houses and give temporary permissions for three years from 2019 to allow financial companies to continue with their existing regulatory arrangements. Clearing houses stand between parties in a deal to absorb the risk if one party default and London is the center for the bulk of EU clearing requirements.

Rising costs for banks

The EU, however, has not put forward similar arrangements and without access to clearing houses, banks and other market participants face a rise in costs.

"Timely action by EU authorities is needed to mitigate the risks to financial stability, particularly those associated with derivative contracts and the transfer of personal data," said the committee.

The U.K. has said it will allow the free flow of personal data from the U.K. to the EU after Brexit which would help U.K. consumers and business maintain continuing contact with EU financial service providers. But without reciprocal action from the EU, the bloc's consumers and businesses would struggle to access U.K. financial service providers.

In its overview of the risks to the U.K. from global developments, the Bank said the U.S. trade dispute with China, whereby each country has imposed tariffs does not pose a material risk to Britain's financial stability, though deepening tensions could encourage China to ease domestic financial conditions which could encourage a further build up of risks.

Debt is high in emerging economies, the Financial Policy Committee noted, singling out Turkey and Argentina which also have large current account deficits. The recent increases in Italian government bond yields also underline the vulnerabilities created by high public debt and the links between banks and sovereign debt in the euro area. There are risks, too, from the U.S. corporate sector as leverage has continued to increase and underwriting standards have loosened.