The Financial Policy Committee’s medium-term priorities (2023–2026)

1: Further improve risk identification in, and the functioning and resilience of, market-based finance

Context

Market-based finance is the system of markets, non-bank financial institutions (NBFIs) and infrastructure that, alongside banks, provide financial services to support the wider economy. Since the global financial crisis, NBFIs have grown to account for around half of UK financial sector assets, while nearly all of the net increase in UK corporate debt since then has come from market-based finance. This has diversified the supply of finance for UK businesses, but also makes it vital that market-based finance is resilient enough to absorb, and not amplify, economic shocks – and thus continues to support the provision of financial services to UK households and businesses.

The FPC has previously identified a number of vulnerabilities in the non-bank financial sector. These vulnerabilities have crystallised during market volatility episodes over the past three years. For example, in March 2020, they amplified the initial market reaction to the pandemic to create a severe liquidity shock (the ‘dash for cash’). This disrupted market functioning and threatened to harm the wider economy, and significant policy action from central banks was needed in response. In March 2021, high levels of hidden leverage through equity derivatives were a key factor in the default of Archegos, leading to sizeable losses for banks. The stable functioning of some commodity markets was tested by extreme price volatility following Russia’s invasion of Ukraine in February 2022, highlighting vulnerabilities in these markets. In late September 2022, the repricing of long-dated UK government bonds exposed vulnerabilities associated with leveraged liability-driven investment (LDI) funds. It is important that vulnerabilities in the non-bank financial sector are addressed – both globally, reflecting the international nature of these markets and their interconnectedness, and in the UK – to reduce the risk of such events occurring again.

The FPC’s past actions

The FPC has in the past assessed the resilience of market-based finance, with the aim of identifying vulnerabilities that could pose risks to UK financial stability, and taken action to build resilience. In particular:

• As part of its regular review of risks originating outside the core UK banking sector, it has undertaken in-depth assessments of investment funds, market liquidity, the investment behaviour of insurance companies, derivatives networks and the role of leverage in the non-bank sector. These assessments resulted in a number of policy conclusions and further work, as summarised in Annex 1 of the 2021 Bank of England report ‘Assessing the resilience of market-based finance’.
• In June 2021, the FPC fully endorsed the conclusions of the Bank and Financial Conduct Authority (FCA)’s joint review of open-ended funds. This included a possible framework for how an effective liquidity classification for open-ended funds could be designed, as well as for the calculation and use of swing pricing. Taken together, these measures could reduce the liquidity mismatch in certain funds.
• In the July 2021 Financial Stability Report, following its assessment of the ‘dash for cash’, the FPC set out international policy work required to address vulnerabilities in market-based finance including: the need to examine and address the mismatch between the liquidity of assets held in open-ended funds – including money market funds (MMFs) – and the redemption terms they offer; assessing the role of leveraged non-bank investors in the functioning of core markets under stress; assessing the liquidity demands from margin calls in stress; enhancing the capacity of markets to intermediate in a stress without compromising on the resilience of dealers through the use of banks’ capital and liquidity buffers; identifying potential new central bank liquidity tools that can address dysfunction in core markets; and enhancing data on the non-bank financial sector.
• In July 2022, the FPC welcomed the joint Bank and FCA Discussion Paper exploring the UK authorities’ initial assessment of the options for enhancing the resilience of money market funds. This followed agreement by the Financial Stability Board (FSB) members to assess and address the vulnerabilities that MMFs posed in their jurisdictions.
• In September 2022, the FPC assessed the risk to UK financial stability from dysfunction in the gilt market and recommended that action be taken to address it. The Bank undertook temporary and targeted purchases in the gilt market on financial stability grounds at an urgent pace, and the FPC welcomed this intervention. The intervention gave LDI funds time to build their resilience to future volatility in the gilt market and mitigated the risk to UK financial stability. The Bank completed the sale of its portfolio of temporary gilt holdings in January 2023.In March 2023, the FPC recommended that the severe but plausible stresses to which LDI funds should be resilient should account for historic volatility in gilt yields, and the potential for forced sales to amplify market stress and, disrupt gilt market functioning. The FPC also recommended that TPR takes action as soon as possible to mitigate financial stability risks by specifying the appropriate minimum levels of resilience for the LDI funds and LDI mandates in which trustees may invest.

The FPC’s future priorities

Given its increasing importance to the UK economy, it is vital that the vulnerabilities in market-based finance are addressed. To that end, the FPC will:

• Continue to assess and develop policy responses to address underlying vulnerabilities in market-based finance, and continue to contribute to and progress the international work agenda on this issue, led and coordinated by the FSB. The FPC supports the development of international standards through the FSB work and, consistent with its statutory responsibilities, remains committed to the implementation of robust standards.
• Alongside the international work, continue to assess and respond to vulnerabilities domestically where it is effective and practical, and complements international efforts, for example as it has done in the context of LDI funds.
• Support the Bank’s work to develop its stress testing approaches to understand better the resilience of NBFIs to shocks and their interconnections with banks and core markets. The Bank will also run, for the first time, an exploratory exercise to (i) to enhance understanding of the risks to and from NBFIs, and the behaviour of NBFIs and banks in stress, including what drives that behaviour; and (ii) to investigate how these behaviours and market dynamics can amplify shocks in markets and potentially bring about risks to UK financial stability. The exercise will provide useful information on how firms manage risks across the system – information useful to both the participating firms and their regulators, as well as the Bank.
• Seek to improve the quality and coverage of data on the non-bank financial sector, in order to develop a more comprehensive understanding of the risks to and resilience of the sector. In doing so, the Bank will continue to invest in its capabilities with respect to existing data, and work closely with other organisations to help remediate data gaps. Global co-operation and data sharing will also be required to remediate the data gaps effectively, given the global nature of markets and the many cross-border activities of NBFIs.
• Set out the FPC’s approach to assessing risks in market based finance in 2023. As part of this, the FPC will continue to assess the suitability of the regulatory perimeter, in line with its remit. This work will be underpinned by research into the relationship between financial stability, sources of financing for households and corporates, and economic growth.

2: Continue to identify, assess and respond to structural changes and new risks in the financial system and the economy

Context

The financial system is constantly evolving. Innovation brings new ways of providing UK households and businesses with financial services, and existing activities adapt to changes in the economic and geopolitical environment.

Innovation can bring benefits to the households and businesses that rely on the financial system to support their economic activities. It can lower the costs of financial services and promote the resilience of households and businesses to economic shocks. But innovation can also present new risks to the stability of the financial system and its contribution to growth. Changes in the economic and geopolitical environment can further expose new vulnerabilities that reduce the resilience of the financial system.

The FPC’s past actions

The FPC seeks to identify, assesses and respond to structural changes and new risks in the financial system and the economy. In recent years, actions include:

• In December 2019, the FPC set out its expectations for stablecoins used as money-like instruments in systemic payment chains. This outlined the standards stablecoins would need to meet to become successful as a safe and trusted means of payment. In July 2021, the FPC welcomed the publication of the Bank’s Discussion Paper on new forms of digital money.
• In March 2022, the FPC outlined in depth its assessment on the emerging risk to financial stability: growth in cryptoassets and decentralised finance. The FPC judged that direct risks to the stability of the UK financial system from cryptoassets and DeFi were limited, reflecting their limited size and interconnectedness with the wider financial system. However, if the pace of growth seen in recent years continued, and as these assets become more interconnected with the wider financial system, cryptoassets and DeFi would present financial stability risks. In March 2023, as a first step, the FPC welcomed HMT’s consultation and call for evidence for a financial services regulatory regime for cryptoassets, and its aim to achieve the same regulatory outcome for equivalent risks consistent with the FSB’s proposed recommendations.^{footnote [2]}
• In March 2023, the FPC welcomed the joint consultation by HMT and the Bank, “The digital pound: a new form of money for households and businesses?” on the potential case for a UK retail central bank digital currency (“digital pound”). In that paper, the Bank and HMT judged it likely that a digital pound would be needed in the future and, while it was too early to decide whether to build the infrastructure for one, the next stage of preparatory work was justified. The FPC welcomed the consultation paper’s consideration of potential financial stability risks, and the proposal to place limits on holdings of digital pounds, at least during an introductory period, in order to manage those risks.
• In October 2021, the FPC outlined in depth its assessment of the emerging risk to financial stability: increasing debt vulnerabilities in the UK corporate sector following the Covid-19 pandemic. The FPC judged that the UK corporate sector posed limited risk overall to UK financial stability, although there was a sizeable tail of highly leveraged companies and potential fragilities in financial markets which could affect the provision of finance to companies. In May 2022, the FPC published the results of its latest Biennial Exploratory Scenario. This explored the financial risks posed by climate change for the UK’s largest banks and insurers through three, 30-year, climate scenarios. The results suggested that climate risks were likely to create a drag on the profitability of UK banks and insurers, but the overall costs would be lowest with early, well-managed action to reduce greenhouse gas emissions and so limit climate change.
• In July 2022, the FPC set out its assessment of the disruption in commodity markets in light of the Russian invasion of Ukraine. The FPC noted that the disruption had highlighted a number of vulnerabilities within commodity markets – including the presence of highly leveraged participants, and the liquidity mismatch at the centre of some participants’ business models. Alongside the interconnections with the broader financial system, there were large interconnections within commodity markets. Given the vital role of commodities in the economy, the FPC judged that these vulnerabilities could pose risks to the UK financial system, particularly via the impact of commodity market disruption on the broader economy and commodity markets’ potential to amplify macroeconomic shocks.

The FPC’s future priorities

Looking forward, the FPC’s priorities are to:

• Identify and assess new risks in the financial system and economy and progress work on new risks already identified, including:
  • Risks from higher levels of corporate debt, against a backdrop of pressures from: the material deterioration in the economic outlook, higher interest rates, weaker earnings, and supply chain disruption.
  • Developments and innovations in the mortgage market, including monitoring the provision of mortgage lending and borrower resilience, the role of non-banks and any emerging risks.
• Seek to ensure that innovation in crypto assets and markets is sustainable, and that financial stability risks arising from new forms of digital money are managed. This includes:
  • Monitoring the development of the regulatory regime for systemic stablecoin arrangements^{footnote [3]} with regard to the FPC’s expectations that (i) payment chains that use stablecoins should be regulated to standards equivalent to those applied to traditional payment chains, and (ii) where stablecoins are used in systemic payment chains as money-like instruments they should meet standards equivalent to those expected of commercial bank money in relation to stability of value, robustness of legal claim and the ability to redeem at par in fiat.
  • Supporting international and domestic regulatory initiatives to enhance regulatory and law enforcement frameworks for cryptoassets. This includes supporting work by the FSB, CPMI-IOSCO and the BCBS, to identify and address gaps in the international regulatory framework for the regulation and supervision of crypto assets. And supporting the HMT-FCA-Bank-PSR Cryptoassets Taskforce on assessing the UK regulatory approach to cryptoassets and associated markets.
• Undertake work, including through international fora, to develop a toolkit that can monitor the financial risks of climate change. Building on the Climate Biennial Exploratory Scenario and its focus on the largest UK banks and insurers, explore ways to extend the analysis to include non-bank financial institutions and the role of climate-related structural change. Identify emerging new risks to financial stability from the transition to net zero, including through assessing ways in which the financial system can support it.
• Undertake further research on structural change in the financial system and economy and the impact on: the provision of financial services; interactions between the financial system and growth; and risks to financial stability. Assess the efficacy of existing regulatory measures for mitigating risks to financial stability and consider whether further action is required.
• Work with the FSB to assess and address vulnerabilities within commodity markets, given the global nature of commodity markets and their interconnectedness with the global financial system.

3: Respond to lessons learned for macroprudential policy from the FPC’s experience in periods of stress

Context

The financial system is central to a market economy. It provides the financial services households and businesses need to undertake economic activities that contribute to growth. As such, it can either amplify or dampen periods of economic stress.

Economic stress can directly harm the financial system, through the system’s exposure to both households and businesses. A negative outlook for economic growth can also increase the financial system’s aversion to risk. This can amplify a period of stress. Conversely, when a financial system is resilient, it can absorb rather than amplify shocks – thereby facilitating the supply of vital financial services. This can further be supported through actions by the authorities.

In the wake of the global financial crisis, an enhanced framework was put in place both domestically and globally to build the resilience of the financial system. This framework has been tested by a series of large shocks, including the sharp increase in economic uncertainty associated with the result of the referendum to exit the European Union; the Covid-19 pandemic; the impact of the Russian invasion of Ukraine on energy prices and financial conditions; and stresses in LDI funds and the global banking sector. Throughout, the UK financial system has remained resilient but the FPC has also learned lessons for macro-prudential policy. These lessons relate to both the financial system and actions taken by the macro-prudential authorities during periods of stress. Responding to these lessons is important to ensuring the macro-prudential framework is fit for the future.

The FPC’s past actions

The FPC seeks to enhance the ability of the financial system and the economy to withstand periods of stress, and takes action when stresses occur:

• The FPC sets the UK countercyclical capital buffer (CCyB) rate on a quarterly basis. This is a buffer that increases capital for banks over and above regulatory minima. The FPC has established a steady state level for the CCyB in the region of 2%. In setting the CCyB, the FPC aims to build a buffer that can be released during stress, thereby increasing UK banks’ capacity to lend. The FPC has released the CCyB on two separate occasions: in July 2016, following the sharp increase in economic uncertainty associated with the result of the referendum to exit the European Union; and in March 2020 at the onset of the Covid-19 pandemic. And the FPC has increased the CCyB rate to build resilience when vulnerabilities were judged to have increased - most recently in June 2022 to its neutral rate of 2% (with binding effect from 5 July 2023).
• The FPC has conducted annual stress tests of the UK banking sector. Banks are assessed on the adequacy of their capital positions to not only withstand a severe economic and market shock but also continue to lend to households and businesses. The FPC further adapted its approach to stress testing in 2020 given that UK banks were already facing a severe economic and market shock. In place of the annual cyclical scenario stress test, the FPC conducted a desk-based stress test in May 2020 and a reverse stress test in August 2020. Based on these tests, the FPC judged that UK banks had the resilience to keep lending even under more severe paths for the economy.
• The FPC regularly reviews the measures it put in place in 2014 in the mortgage market. These measures were designed to guard against a loosening in underwriting standards and a material increase in household indebtedness, which could amplify an economic downturn and increase financial stability risks. Since these interventions were introduced, household indebtedness has remained stable even while house prices have continued to increase. In its latest review, the FPC judged that, on current evidence, the LTI flow limit, without the FPC’s affordability test Recommendation, but alongside the wider assessment of affordability required by the Financial Conduct Authority’s (FCA’s) Mortgage Conduct of Business (MCOB) responsible lending rules ought to deliver the appropriate level of resilience to the UK financial system, but in a simpler, more predictable and more proportionate way. Following consultation, the FPC therefore decided to withdraw the affordability test Recommendation with effect from 1 August 2022.

The FPC’s future priorities

In responding to lessons learned for macro-prudential policy, the FPC’s priorities are to:

• Broaden and deepen the Bank’s approach to stress testing. This will include updating the Bank’s approach to stress testing the banking system. It will also include developing the Bank’s overall approach to stress testing the financial system, taking account of how the existing sector-level exercises fit together and including new approaches to assess system-wide risks. As noted above, the Bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches.
• Enhance the ability of the banking sector to support businesses and households in stress. This includes consideration of how the usability of UK banks’ capital buffers beyond the CCyB could be improved. Recent evidence, including the lessons learnt from the Covid-19 pandemic, suggests that banks could be reluctant to use buffers in practice to support lending.
• Review and prepare the crisis toolkit. This includes working with the Bank to ensure it has the tools to address dysfunction in market-based finance, where such tools should act as a backstop, be designed in a way to minimise any increase in moral hazard, and come with a significant increase in private sector liquidity self-insurance.
• Draw lessons from the recent stresses in the global banking sector, including the failure of SVB and resolution of SVBUK, to support the pursuit of its objectives to protect and enhance the resilience of the UK financial system. That will include assessing banks’ resilience with a greater focus both on their assets and their liabilities.

4: Continue to improve macroprudential oversight of operational resilience, in light of its growing importance to financial stability

Context

Operational resilience is increasingly important for maintaining UK financial stability. As firms have become more digitised and interconnected at an operational level, the associated risks have become threats to the wider financial system. The FPC focuses on risks that could lead to systemic operational disruption.

Cyber-attacks, where an individual or group seeks to exploit vulnerabilities in IT systems, are one example of operational incidents that could have a significant impact on firms’ ability to provide vital services. The FPC considers these risks because a successful attack on a systemic institution or vital infrastructure could cascade throughout the financial system. Cyber risk has been increasingly cited by respondents to the Bank’s Systemic Risk Survey as a key source of risk to UK financial stability over the past decade, reaching 79% of respondents in 2022 H1 – the most cited of any risk. It was also judged to be the most challenging risk for firms to manage.

Firms are also increasing their use of critical third parties (CTPs) – including cloud service providers, who offer services such as shared virtual data storage and processing capabilities. There are potential benefits for firms of using cloud services, for example through better operational resilience than their on-site information communications technology infrastructure. However, the increasing criticality of the services that CTPs provide to UK financial firms, and the fact that the provision of these services is often concentrated in a small number of third parties, poses a threat to UK financial stability in the absence of greater direct regulatory oversight of the services they provide.

The FPC’s past actions

The FPC has been monitoring the potential systemic risks from cyber-attacks and the financial system’s increasing reliance on CTPs for several years:

• In June 2018, the FPC agreed that it would build upon its previous work to establish a cyber-vulnerability testing framework (CBEST) by setting ‘impact tolerances’ for how quickly critical financial companies must be able to restore vital financial services following a severe but plausible cyber incident. The Bank uses regular cyber stress tests to test firms’ ability to meet these impact tolerances in severe but plausible scenarios.
• In March 2022, the FPC agreed that the exploratory cyber stress test in 2022 would be used to explore firms’ capabilities and the potential financial stability impact of a hypothetical scenario involving data integrity disruption to retail payments. The FPC reviewed the findings from the first phase of the stress test in December 2022. And in March 2023, the FPC updated its impact tolerance for critical payments, based in part on the findings of the 2022 cyber stress test.
• In October 2021, the FPC set out what additional policy measures, some requiring legislative change, were likely to be needed to mitigate the financial stability risks stemming from concentration in the provision of some third party services to UK firms. In response, the Government included legislative proposals in the Financial Services and Markets Bill, currently before Parliament, to grant the supervisory authorities’ powers to directly oversee the resilience of services that CTPs provide to the UK financial sector.
• In March 2022, the FPC supported the intention of the Bank, PRA and FCA to publish a joint Discussion Paper in order to facilitate effective engagement with industry on measures to manage systemic risks posed by CTPs.

The FPC’s future priorities

In this field, the FPC will:

• Advance and develop its understanding of how financial stability risks can arise from operational resilience weaknesses and how these can be reduced. In doing so, it will seek to ensure work on cyber stress testing, and use of cloud services and other critical third parties, delivers system-wide resilience. This will include:
  • Ensuring the findings of the 2022 exploratory cyber stress test and future stress tests will be used by supervisors and firms to understand and enhance firms’ response and recovery capabilities; and
  • Continuing to support the development of the Bank’s, PRA’s and FCA’s policy framework to manage the systemic risks posed by CTPs, that will incorporate feedback from the 2022 Discussion Paper.
• Continue to identify and monitor the channels through which operational risks could affect financial stability. This includes those arising through technological developments such as Artificial Intelligence (AI) and the use of blockchain.