No less an economic luminary than Howard Archer, chief economic advisor to the EY ITEM Club, has expressed concern over the Bank of England’s decision to bring forwards its consumer credit stress tests by a couple of months, noting that:
"...The risk to financial stability coming from the recent rapid growth in consumer credit would undoubtedly be magnified if there is a near-term interest rate hike. While any interest rate hike would be small with further increases some way off, even small increases could cause problems for some consumers given their high borrowing levels...
...It is notable that the BoE is bringing forward its testing of banks’ ability to cope with major losses on consumer loans to September from November. Additionally, regulators will in July publish their expectations for lenders in the consumer credit market."
A brief history lesson
On August 4, 2016, the BoE reduced UK interest rates, cutting the base rate from 0.50% to 0.25%. This was a record low and the first cut since 2009. The decision to cut interest rates to 0.25% was approved unanimously by all nine members of the Monetary Policy Committee.
It was a measure taken following the UK’s decision to leave the European Union in June 2016 and was justified by governor Mark Carney who said the decision to leave the EU marked a regime change in which the UK would:
"...redefine its openness to the movements of goods, services, people and capital...".
"We took these steps because the economic outlook has changed markedly, with the largest revision to our GDP forecast since the MPC was formed almost two decades ago [...] by acting early and comprehensively, the MPC can reduce uncertainty, bolster confidence, blunt the slowdown, and support the necessary adjustments in the UK economy.”
The governor said that banks have "no excuse” not to pass on the lower borrowing costs to customers and will be charged a penalty if they fail to do so.
Source: Office for National Statistics and BOE
The four-panel chart above illustrates with the red rectangles the period from 2008 to 2010 when the economy saw growth, inflation, and consumer credit collapse. These metrics only responded positively after the base rate was aggressively lowered. One can see the ensuing response to the heavy pace of rate reduction and monetary accommodation.
What is notable is that GDP growth has stalled and has run at just approximately 0.75% on average since 2011 whereas consumer credit and inflation have accelerated.
Bank raises capital requirements
The BoE announced yesterday that it had increased the capital buffer on UK lenders amid concerns about the rapid growth of consumer credit, which I alluded to in the chart above.
The capital provision or counter-cyclical capital buffer sets a limit on the amount of debt that private sector banks can use to fund their balance sheets in addition to their normal regulatory buffers.
In the aftermath of the UK referendum last year it was reduced to zero to encourage continued lending so as to stimulate consumer and commercial activities aimed at supporting the wider economy.
Now, it appears the acceleration of debt levels has led the Bank's Financial Policy Committee to approve a move to increase the CCB from 0.00% to 0.50% and signal that it expects to increase it again to 1.00% in November.
This move will have to followed by lenders within an 18-month window and it effectively increases the aggregate capital requirement of UK banks by £11.4 billion. The decision is a signal that the BoE feels the risks of a credit crunch have now receded and regulators are more concerned about an excess of lending in the economy.
There is, however, an additional step to be taken. The BoE said that it would publish tighter rules on consumer lending next month as it brings forward its assessment of lenders' potential losses on consumer credit.
Leverage levels leaping ahead
Consumer credit in the UK grew at an annualised rate of 10.30% in April, which the Bank noted was faster than household incomes. It increased by £1.5bn to £198.4bn in April 2017 following a £1.6bn rise in March; in line with market expectations.
Splitting this into subsets, credit-card debt, personal loans, and car finance were all sharply higher and in this area debt write-offs in consumer credit are 10 times higher than for mortgage lending.
This is a worry as except for car or furniture loans, this credit is unsecured.
Credit card lending went up by 9.70% year-on-year to £68.1bn (from 8.9% in March) and other loans and advances grew by 10.70% to £130.3bn (from 10.9%). That must be taken in context as the growth in growth in credit card borrowing fell from 6.40% to 5.50% in May, which the British Bankers Association attributed to weaker retail sales volumes.
The profile of this credit has a relatively short maturity and the implication is that the credit quality of the stock of lending can rapidly deteriorate. The BoE said in addition that going forward lenders would need to fund themselves with a minimum level of shareholder equity equal to 3.25% of exposures, up from 3.00% although this is subject to a consultation.
Unsecured lending continues to deliver strong returns for lenders. Indeed, bad or non-performing debt in 2016 fell to pre-crisis levels and credit spreads are improving. Retail banks have used the period of ultra-low rates to prioritise unsecured lending given the margins available and the relentless pressure on other product lines.
The worry is that the credit rating one requires to receive credit from mainstream as well as fringe lenders is steadily falling. This is a folly that in retrospect will prove disastrous. The solution to a debt problem is not more debt.
"The economy is marching forward..." Photo: Shutterstock
Debt advice charity “StepChange” has cited the increase in part-time, temporary, and zero hours contracts as a reason for more reliance on credit, and said that the rise in consumer credit:
"...is an area of growing concern which risks increasing the vulnerability of households who are already struggling to make ends meet."
The BoE is right to act as it if not healthy for the UK economy to risk an increasing number of households walking a financial tightrope every month as they juggle repayments and basic living costs. It leads to elevated stress and in deteriorating health. If not tackled now, it will lead to another financial crisis.
— Edited by Michael McKenna