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U.K. Banks Face The Weakening Macroeconomy From A Resilient Balance Sheet Position

Risks in the economy are intensifying, but U.K. banks are prepared. The strong starting position of their asset quality, cautious approach to new lending, and conservative provision stocks support their resilience and provide a sound platform from which to face an increasingly challenging economic outlook. These supportive features were central to the major U.K. banks' strong first-half-year 2022 results (see "Higher Rates Spur U.K. Banks' Strong First-Half Earnings Amid A Weakening Economic Outlook," published on Aug. 10, 2022).

Early warning credit quality indicators show limited signs of borrower stress, but economic growth is slowing and risks are stacked to the downside. Our base case remains a modest economic slowdown. In our view, banks are well placed to navigate this, aided by significant fiscal support to mitigate households' and businesses' increased energy costs. Nevertheless, a longer and deeper recession would challenge borrowers, push insolvencies higher, weaken collateral values, and provide a greater test to bank creditworthiness.

In this commentary, we take stock of U.K. banks' current exposures and examine their resilience to a more severe downturn. To do this, we draw on the banks' downside modeling and projections. While these modeled downside scenarios reflect varying levels of stress, they suggest a capacity to absorb the effects of a significantly harsher economic environment within earnings. In addition to the likelihood of a stronger fiscal response, this is in part thanks to higher policy rates in those scenarios that would provide a boost to net interest income, cushioning the effect on earnings from higher credit impairments and easing the risk of capital depletion.

Asset Quality Is Strong As U.K. Banks Brace For Domestic Turbulence

U.K. banks' loan books are weighted toward mortgages but have differing levels of corporate or consumer unsecured exposures (see chart 1). As a result, the effect of broad economic stress is unlikely to be uniform across U.K. banks. History suggests that consumer credit and small business lending incur the highest loss rates during stressful economic periods, while prime mortgages fare best, reflecting good collateral cover and households' incentive to prioritize mortgage payments above other obligations.

Chart 1


Nevertheless, U.K. banks enter a period of weakening conditions with strong asset quality indicators across asset classes. Stage 3 impaired loans at end-June 2022 were about 1.5% on a simple average for major banks (see chart 2), below the pre-pandemic level of 1.7% in 2019. At the half year, stage-2 loans on average represented close to 9.5% of gross loan books. This is above both the 8.0% seen in 2019 and 9.0% at the beginning of 2022, but partly reflects banks' conservatism in assessing prospective economic conditions since the beginning of the year, and a proactive migration of performing loans to stage 2 in anticipation of additional stress among borrower cohorts. The vast majority of stage 2 loans are fully performing.

Chart 2


U.K. banks appear appropriately provisioned across asset classes. We view the banks' stronger coverage of stage 3 and stage 2 consumer credit (charts 3 and 4) as prudent given their higher risk characteristics. While the provision intensity on mortgages lags other asset classes, this signals the low expected loss-given default on the asset class. This reflects both strong post-crisis collateral requirements on new lending, with less than 5% of new lending extended at loan-to-value (LTV) ratios above 90% over the best part of the past 10 years, alongside property price growth during that period.

Coverage Is High On Stage 3 And Unsecured Loans

Chart 3


Chart 4


Mortgage arrears are at multi-year lows, with less than 1.0% of borrowers behind on their repayments (chart 5). Banks should be able to manage a modest rise from this level. Amid rising borrowing costs and falling real wages, lenders have lowered their appetite for high LTV loans. In particular, banks have further reduced their already small share of new lending above 95% LTV (chart 6). The share of new lending above 90% LTV in 2022 has risen as the economy recovered from the pandemic but remains below 2019 levels.

Chart 5


Chart 6


Midway through 2022, early warning indicators of rising credit risk in consumer credit books, typically an early indicator of household stress, remained benign. Barclays' first-half 2022 results showed a U.K. cards 30-day arrears rate of 1.0%, comparing well with 1.7% at the end of 2019. In addition, at roughly 0.75%, the share of Lloyds' credit card balances entering arrears remains stable and below the pre-pandemic level.

The strong performance of U.K. household credit is unsurprising as unemployment remains low, but job creation is likely to falter somewhat as the full effects of inflation play out. The current squeeze on household budgets from energy and other costs pressures affordability and could push up arrears despite unemployment remaining relatively low. However, outstanding mortgage and consumer credit debt is heavily skewed toward the highest earning population segments, where people have scope to lower savings ratios and discretionary spending to offset increased essential expenditure and debt repayments (see charts 7 and 8).

Chart 7


Chart 8


In the corporate sector, supply chain disruptions, higher wage and energy costs, staff shortages, and constrained discretionary expenditure and investment have dealt a blow to debt servicing capacity. However, sector-wide debt leverage multiples look manageable and nearly all new lending during the pandemic by U.K. banks to businesses has been extended under government guarantee schemes, limiting banks' exposure to losses. In addition, we believe that U.K. banks have manageable exposures to sectors such as retail and leisure, which are still recovering from the pandemic and now face further earnings shocks. Nevertheless, marginal borrowers across all sectors will likely encounter difficulty.

Extraordinary fiscal support and monetary easing were crucial for banks to avoid a significant rise in realized losses during the COVID-19 pandemic. With borrowing costs now increasing, fiscal policy will be particularly important to ease risks during this downturn. Consequently, we view the U.K. government's recent announcement on energy support as a bolster for the banking sector. The typical household's energy cost in the coming two years will be capped at about double the winter 2021/2022 rate but well below the price it would otherwise have reached. Companies will receive a six-month cut in energy expenses, with more targeted support planned thereafter. These fiscal initiatives are likely to ease stress on borrowers and lower the default rate.

Banks Have Headroom To Absorb Downside Scenarios

Since the start of 2022, the largest U.K. banks have revised their International Financial Reporting Standard (IFRS) 9 base-case scenarios to reflect projections for weaker economic output and rising inflationary pressures. Downside scenarios have become harsher, with more severe stagflationary scenarios now weighted into bank provisioning.

U.K. banks generally use two adverse scenarios in their provision modeling, a moderate (or 'downside 1') and a severe ('downside 2') scenario. Moderate downside scenarios reflect a more tempered deterioration in base-case economic conditions and generally suggest limited additional provisioning needs if it were to materialize.

In contrast, banks' severe scenarios envisage deep shocks to key macroeconomic variables. If the base case began to resemble these shocks, banks would expect far greater stress across their loan books and higher credit losses. In our analysis of U.K. banks' downside resilience, we focus on their severe modeled scenarios, given the limited additional modeled provision requirements implied by moderate scenarios. In first-half 2022 disclosures, these reflected a deep recession in 2023 with widespread unemployment, severe cumulative asset price correction, and an aggressive path for policy rates to contain rampant inflation (chart 9).

Chart 9


Banks' disclosures detail the potential impact on modeled provisions of a 100% weight to various scenarios, including a severe downturn. To assess the sensitivity of the largest U.K. banks' earnings to a downside shock, we assumed that the increase in modeled provisions signaled by the 100% severe downside scenario is charged through our base cases for major bank earnings as an increase in impairments.

Outcomes vary by bank, but under these simplified assumptions, the effect of a sharp and immediate increase in provisions in a downside scenario should be manageable. For HSBC, NatWest, Barclays, and Lloyds, a 100% weight on severe downside scenarios implies average additional impairment charges of close to 50 basis points (bps) of gross loans (table 1). Under our individual bank base cases, we expect that the banks can absorb these incremental charges within their projected annual earnings.

Table 1

Modeled Provision Requirements
June 30, 2022 HSBC NatWest Barclays Lloyds
Provision stock (mil. £) 8,619 3,515 6,023 4,120
Modeled weighted ECL 4,320 1,530 4,182 2,408
PMAs 960 841 1,581 801
Other (outside modeled ECL) 3,339 1,144 260 911
Modeled scenarios (mil. £)
100% base case 3,520 1,411 4,085 3,744
Downside 1 (moderate) 5,040 1,664 4,729 4,423
Downside 2 (severe) 8,800 2,499 5,802 6,450
Increase in modeled provisions (mil. £)
Downside 1 720 134 547 2,015
Downside 2 4,480 969 1,620 4,042
Increase in modeled provisions (% gross loans)
Downside 1 0.09 0.04 0.14 0.44
Downside 2 0.54 0.27 0.42 0.88
ECL--Expected credit loss. PMA--Post-model adjustment. Source: S&P Global Ratings, bank disclosures. HSBC figures are converted to U.K. pound sterling.

The implied losses from banks' modelling reflect a combination of rising probability of default and weakening loss-given default. These stresses combine to push more exposures toward stage 2, requiring lifetime provisioning, from stage 1, demanding only 12-month expected losses. Provision coverage levels within stages would also rise.

For the banks we analysed, modeled provision needs for groupwide wholesale exposures rise immediately by a combined £5.6 billion, or on average 25 bps of total gross loans (see chart 10). This would reflect a combined impairment rate of close to 70 basis points on gross wholesale lending. HSBC contributes most of the increase, with the bank's wholesale exposures demanding the largest top-up in provisioning of more than £3 billion at the current exchange rate, or 40 bps of total gross loans on top of the existing modeled provisions of 25 bps.

Incremental provision requirements on retail exposures remain comparatively contained in these scenarios, with a combined modeled top-up of £3.8 billion, or an average of 20 bps of total gross loans (see chart 11). Lloyds is the exception among its peers, requiring a materially larger top-up in retail than wholesale provisions during severe stress. This reflects the bank's focus on retail lending and its assumption of aggressive house price decline: more than 25% from peak to trough.

Chart 10


Chart 11


Despite this deep level of potential stress, U.K. banks' solid earnings capacity underpins our expectation that they could absorb these losses within our forecast pre-tax earnings. Holding other variables constant, a total rise in provisions of close to £10 billion would significantly dent, but not totally consume, our base-case forecast for the full-year aggregate pretax earnings of these banks, which remains above £25 billion.

The banks' profitability in modeled IFRS9 downside scenarios contrasts with the outcomes of the Bank of England's much more severe stress test, the most recent of which resulted in a 5.5 percentage point hypothetical hit to their aggregate Common Equity Tier 1 ratios (see "U.K. Banks Show Balance Sheet Resilience In Latest Stress Test," published on Dec. 14, 2021). This supposed, among other assumptions, a 37% cumulative GDP decline across over three years, a 33% peak-to-trough fall in domestic property prices, and unemployment peaking close to 12%.

In contrast, as shown in chart 9, severe modeled scenarios entail on average only a cumulative GDP decline across 2023-2024 of close to 5%, an unemployment peak of close to 8%, and an average peak-to-trough decline in residential property prices of about 24%. IFRS9 downside scenarios are less severe because they are weighted by their likelihood into the banks' models for determining provisioning stocks, and are not scenarios used to assess resilience.

Management Overlays Provide An Additional Buffer

Major U.K. banks hold almost £5 billion of post model adjustments across their global loan books at half-year 2022 (see chart 12). These provisions, which in aggregate are more than 20 bps of the banks' gross loans, are in place to provide for difficult-to-model economic impacts. At the half year, more than half of the largest U.K. banks' post-model adjustments (PMAs) are for the effects that inflationary pressures have on customer affordability, as well as supply chain disruption hitting corporate clients' debt servicing capacity. This is a material repurposing from the beginning of the year, when most PMAs reflected more general economic uncertainty, and is evidence of the banks' flexibility in ascribing provisions to new risks as they emerge.

Chart 12


If a rapid deterioration in the economic environment stressed provision requirements, the banks would likely run down part of these PMAs by repurposing them into expected credit loss provisions (ECLs). This would mitigate an otherwise larger potential hit to earnings and could contain modeled sector impairment charges at close to 30-40 basis points, slightly above the long-term average.

Losses Could Exceed Those Implied By Banks' Modelling

Downside risk to bank provisioning remains, however. If the severe downside scenario became the base case, actual ECL provisions could exceed those modeled under the severe scenarios. The true scale of modeled provisions would also depend on the newer, still more severe downside scenarios and the weights applied to them.

In addition, the banks' scenario analysis does not fully capture potential increases in stage 3 exposures, which the banks assume will remain largely unchanged in downside scenarios. This is partly because some transition criteria rely only on observable evidence of default. While stage 3 exposures are similar to stage 2--in that they require lifetime provisioning--their loss-given default and so provision requirements can be higher. As such, our assumed impact of a harsher economic scenario on bank earnings does not include this important consideration for bank loan loss provisioning.

Furthermore, bank disclosures of modeled ECL sensitivity do not capture non-modeled exposures. These are typically large or unusual corporate exposures that require transaction-specific analysis underwriting and credit risk management. These are small for most U.K. banks; HSBC is the notable exception in that the group assesses all wholesale stage 3 exposures individually, that is, outside modeled provisions. This means that half the bank's provision stock is evaluated outside of modeled ECLs--a greater share than domestic peers. Consequently, relative to the other U.K. banks, HSBC's impairments could rise more materially above modeled assumptions in a significant stress scenario if individually assessed exposures deteriorate.

Supportive Interest Rates Likely To Soften Effects Of Severe Economic Shock

Major U.K. banks are united in their view that risks to the U.K. economy center around weak growth, rising unemployment, and spiraling inflation. While this scenario is set to raise credit losses, higher policy rates provide banks with income upside. Lloyds recently implemented a discretionary adjustment to its base provisioning model, which previously associated weaker economic growth with lower inflation, higher unemployment, and lower interest rates. Instead, its adjusted scenario now reflects the current risk of a deep output shock coinciding with sharply higher inflation and interest rates.

The assumptions in the banks' severe downside scenarios include U.K. policy rates through 2024 that are 1.0%-2.0% higher than the market-implied bank rate through this horizon, which is also higher than the current rate of 175 bps (see chart 13). Consequently, banks should experience a material net interest income boost in a severe downside shock, which would at least partially offset rising credit losses.

Chart 13


Interest rate sensitivity analysis in the banks' first-half disclosures for 2022 used inconsistent assumptions but generally implied a 5% increase in net interest income for a 25 bp parallel shift in benchmark rates (see chart 14). Across the banks, this 5% income boost equates to close to 10 bps of gross loan books. Our previous analysis also suggested that the U.K. banking system stands to gain the most out of 11 surveyed developed market European banking systems, with a 25% boost to net interest income on the back of a 200 bps parallel rate shock (see "When Rates Rise: Not All European Banks Are Equal," published on June 8, 2022).

Chart 14


Nevertheless, while rates would propel earnings, tighter financial conditions in a severe downside scenario would likely entail higher wholesale funding costs for the banks, which would curtail some net interest income upside. Banks are also likely to pass on a higher proportion of future interest rates to depositors. In addition, more entrenched inflation may pressure operating costs, and trading losses might hit earnings. Consequently, higher interest rates are unlikely to completely neutralize the effect of higher impairments on bank earnings.

Nevertheless, we see the prospect of a boost from higher interest rates to be key for sector earnings resilience and stability, which should help the banks ride out the challenges presented by a shaky economic outlook.

Rating Stability Reflects Resilience, But Risks Are To The Downside

Strong earnings momentum heading into more difficult conditions, net interest margin resilience, good asset quality today , and a proactive stance to provisioning and new lending suggest that the U.K. banking system can navigate the weakening domestic and global economic environments. These factors underpin the current stable outlooks on most of our U.K. bank ratings. A sustained period of marked economic deterioration, as captured in banks' severe IFRS9 downside scenarios, remains some distance outside our base case but would test the sector's earnings resilience and could pressure outlooks and ratings.

This report does not constitute a rating action.

Primary Credit Analyst:Riley Michel, CFA, London +44 7816 123244;
Secondary Contacts:Richard Barnes, London + 44 20 7176 7227;
William Edwards, London + 44 20 7176 3359;

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