Policy paper

Meeting minutes

Published 15 October 2020

This was published under the 2019 to 2022 Johnson Conservative government

Record of the meeting between the Governor of the Bank of England and the Chancellor of the Exchequer to discuss the Financial Stability Report published on 6 August 2020

1) On 15 September 2020, the Governor and Chancellor discussed the issues set out in the August Financial Stability Report. At the time of the meeting, the Covid-19 pandemic continued to have a severely disruptive economic impact, with repercussions for UK households and businesses. In particular they noted the results of the reverse stress test which show there is capacity in the banking sector to continue to support the real economy.

2) The Chancellor thanked the Governor for the analysis that went into the Report, along with the continued work of the Bank of England to monitor and mitigate risks to financial stability at this vital time. The Chancellor welcomed the continued judgement of the Financial Policy Committee (FPC) that the unprecedented policy interventions announced by the government are playing a vital role in supporting the real economy through this period of disruption. The Chancellor further noted the results of the reverse stress test, and the FPC’s judgement that it would take an economic scenario much more severe than the central outlook to compromise bank’s ability and willingness to continue lending, reflecting the actions taken by authorities to increase the financial stability of the UK since the Global Financial Crisis.

The key themes and messages from the FSR are summarised below

The performance of the UK financial system in supporting the economy during the pandemic

Businesses

3) Companies continued to face a severe cash flow shock, and many would require further finance to bridge through this disruption and minimise the impact on employment and productive capacity. The FPC estimated that UK companies could face a cash-flow deficit of up to around £200 billion in the current financial year, based on the central projection set out in the Monetary Policy Report published on the same day, and taking into account the material support provided by the government’s fiscal measures.

4) The UK financial system had met most of the initial surge in demand for credit, supported by the extraordinary policy responses of the government and the Bank of England. Net finance raised by UK companies from banks, primarily through the government-backed loan guarantee schemes, exceeded £70 billion since the start of the Covid-19 pandemic.

5) While the number of corporate insolvencies had remained low, it was the FPC’s assessment that this was likely to increase. Some companies could struggle because they were highly leveraged or unprofitable at the outset of the Covid-19 shock, and others could face pressures because of structural changes in the economy.

Households

6) UK households entered the Covid-19 shock in a stronger financial position than before the global financial crisis. Payment holidays and government schemes were continuing to support household finances, but the sharp fall in economic activity had put pressure on many households’ incomes. The FPC has said it would be important for lenders to work flexibly with borrowers as they resumed repayments.

The outlook for financial stability as the Covid-19 shock evolves

Banks

7) The FPC’s assessment was that banks’ capital buffers were more than sufficient to absorb the losses that could arise under the central projection for the economy, set out by the Bank’s Monetary Policy Committee (MPC).

8) The FPC has carried out a “reverse stress test” to analyse how much worse than the central projection the economic outcome would need to be to jeopardise banks’ resilience and challenge their ability to lend to the wider economy. To deplete banks’ regulatory buffers of capital as much as in the 2019 stress test that was used to set their requirements, banks would need to incur £120 billion of credit losses. To generate that, the cumulative loss of economic output from the disruption associated with the Covid-19 outbreak would need to be around twice as big as in the MPC’s central projection, and be accompanied by a significant rise in unemployment to around 15%. Even then, banks would have space to absorb a further £80 billion of losses in their capital buffers, as they hold larger capital buffers than required by regulation.

9) Based on this exercise, the FPC judged banks to be resilient to a very wide range of possible outcomes. Banks had the capacity, and it was in their collective interest, to continue lending to businesses and households including to refinance existing debt, even in a severe economic downturn. This would help avoid forcing viable companies into insolvency, which would result in higher losses to lenders and a more persistent downturn.

The non-bank sector and financial markets

10) The Report also set out the need for further work to review the resilience of market‐based finance and the appropriate balance between private sector resilience and reliance on central bank liquidity support in a financial market liquidity stress, in light of the dysfunction in key markets experienced in March.

11) The financial system is reliant on government bond and repo markets remaining liquid in stress. In March, these markets were threatened by a “dash for cash”, which highlighted a number of vulnerabilities in market‐based finance the FPC has previously identified. Central bank interventions were necessary and effective in avoiding wider economic damage, but such interventions can pose risks to public funds and can encourage excessive risk taking by investors.

12) The FPC welcomed the work by the Financial Stability Board (FSB) to undertake a comprehensive review of the provision of market-based finance in light of the Covid-19 shock, given the need for this work to be internationally co-ordinated.

Productive finance and equity finance for companies

13) The Report included the FPC’s work on how the UK financial system could better support the supply of finance for productive investment, which HM Treasury had asked the FPC to consider as part of its remit.

14) The Report set out the need for greater access to equity finance for UK companies after the Covid-19 shock: as a source of finance for companies that were highly leveraged, as a means for companies to repair their balance sheets and as a source of growth to support the entry of new companies and growth of incumbents.

15) The Report had also set out areas where the FPC intended to focus its efforts. The FPC will examine possible distortions to the supply of illiquid long-term and equity-like investments. It will examine why pension funds allocate only a small proportion of assets to illiquid investments and, through the government’s review of Solvency II, consider whether any disincentives to insurance companies investing in longer-term assets can be removed without reducing insurers’ safety and soundness or policyholder protection. The FPC will also seek, through the joint Bank of England and Financial Conduct Authority review of open-ended funds, to address distortions that discourage the use of funds with longer redemption notice periods or closed-ended funds. These may be a more appropriate vehicle for investing in certain illiquid assets.

Maintaining the resilience of the financial system

16) As was set out in the Report, the FPC judged that most risks to UK financial stability that could arise from disruption to cross-border financial services between the UK and the EU had been mitigated, even if the current transition period ended without the UK and EU agreeing specific arrangements for financial services. This reflected extensive preparations made by authorities and the private sector. Thus far, the Covid-19 pandemic had not materially delayed preparations in the financial sector overall.

17) The Report highlighted the need to ensure that new ways of making payments that became critical to the functioning of the economy would need to be regulated to clear standards. To that purpose, the FPC had expressed support for the work of the UK authorities to consider reforms to payments regulation and welcomed the launch of the Call for Evidence by HM Treasury as part of its Payments Landscape Review. Consistent with its statutory responsibilities, it will where necessary, make Recommendations to HM Treasury regarding gaps in the regulatory perimeter which might represent risks to financial stability.

18) The FPC continued to make the case in the August Report for an end to the reliance on Libor benchmarks before end-2021, when they could cease to be available at short notice.