UK Central Bank Warns Lenders of ‘Prolonged’ Period of Stress

The Bank of England said financial institutions should expect more scrutiny of their credit portfolios.

“The operating environment for firms remains challenging,” the central bank wrote in a letter to deposit takers Tuesday (Jan. 10). “The impact of increasing interest rates, inflation and high cost of living, geo-political uncertainty, and supply chain disruptions is expected to pose challenges to firms’ credit portfolios. Firms need to be ready for a prolonged period of stress.”

The letter noted that banks have strengthened their underwriting standards and forbearance tools and gotten more prepared to make collections in recent years.

“However, these enhancements are untested under the current combination of risk factors,” wrote Bank of England (BOE) officials David Bailey and Charles Woods. “Therefore, it is important that firms ensure their credit risk management practices are robust, portfolios are closely monitored, customer support and collections arrangements are appropriately scaled, and expected credit loss provisions are recognized in a timely manner.”

The BOE said in the letter its examination of firms’ credit risk management will include traditionally higher risk areas, such as retail credit card portfolios, unsecured personal loans, leveraged lending, commercial real estate, and small business lending.

The bank’s warning came weeks after it reported that the cost of borrowing for small- to medium-sized businesses (SMBs) has nearly doubled from the 2.5% rate at the end of 2021.

A report last month by the BOE said total outstanding SMB debt has also risen by around 20% in the past three years, while the proportion of SMB debt in arrears has gone from 2% to 2.4% during the preceding year.

The increased cost of borrowing is to be expected, as the BOE has implemented a series of rate hikes this year.

But while the rising cost of new SMB bank debt follows a broader pattern affecting all borrowers, smaller businesses are particularly vulnerable to macroeconomic headwinds, given their typically lower liquidity and already steeper cost of borrowing.

For example, the British Business Bank — a government-backed development bank created in 2014 to help boost the supply of credit to small businesses — warned in its annual report that “serious headwinds” pose a material risk to SMBs for whom “the coming years are likely to be challenging.”

The BOE said last year it would begin stress testing nonbank financial institutions for the first time. One of the biggest worries for the central banks are liability-driven investment (LDI) funds, to which many U.K. citizens’ pension plans are exposed.

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