How resilient are UK corporate bond issuers to refinancing risks?

Laura Achiro and Neha Bora

Central banks in most advanced economies have tightened monetary policy by raising interest rates. Tighter financing conditions may make it harder for some businesses to refinance their debt or could mean they face less favourable terms when they do. This blog explores the extent to which bond maturities could crystallise these refinancing risks. Overall, UK corporate bond issuers appear broadly resilient to higher financing costs, but risks are higher for riskier borrowers particularly if the macroeconomic outlook and funding conditions were to deteriorate.

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Stressed or in distress? How best to measure corporate vulnerability

Alice Crundwell, William Bennett and Will Banks

Accurate measures of the number of firms at risk of failure are becoming increasingly important for policymakers, as corporate insolvencies are continuing to rise and interest rates are expected to remain higher than over much of the past decade. The share of vulnerable firms is often assessed by looking at debt-servicing ability via the interest coverage ratio (ICR) – companies’ earnings before tax and interest divided by their interest expense. But several other factors are also associated with a higher probability of firm failure. This post will explore the merits of looking at a combination of financial indicators of corporate distress to better measure the share of firms at risk of failure and the associated level of debt at risk.

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Mortgage affordability for borrowers who re-fixed in 2023

Daniel Norris, Elio Cucullo and Vasilis Jacovides

When borrowers enter a fixed-rate mortgage, lenders test whether they could continue to afford their mortgage if interest rates were to increase by the time it comes to re-fix. This ‘stressing’ is designed to create additional resilience for borrowers and the financial system. Over the last two years, mortgage rates have increased by over four percentage points, raising the cost of repayments for those re-fixing. We look at UK mortgage data and compare the stress rates applied at origination to rates available to borrowers when re-fixing. We find that the vast majority of borrowers who came to the end of their fixed terms in 2023 faced new mortgage rates which were lower than those they had been ‘stressed’ at.

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How auction design can make a difference: the case of the Bank’s Indexed Long-Term Repo Facility

Julia Giese and Charlotte Grace

In response to the global financial crisis, the Bank of England (BoE) began using Product-Mix Auctions (PMA) to provide liquidity insurance to financial institutions. The PMA, designed by Paul Klemperer, allows the quantity of funds lent against different types of collateral to react flexibly to the economic environment and market stress. It maximises overall surplus, or ‘welfare’, assuming bidders bid their true values for loans. Mervyn King, the then BoE Governor, described the BoE’s use of PMAs as ‘a marvellous application of theoretical economics to a practical problem of vital importance‘. In this post, we describe a staff working paper that shows that the PMA generates welfare gains relative to simpler alternative auction designs, which cannot achieve such fine-tuned responses.

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Why lower house prices could lead to higher mortgage rates

Fergus Cumming and Danny Walker

Bank Rate has risen by more than 5 percentage points in the UK over the past couple of years. This has led to much higher mortgage rates for many people. In this post we analyse another potential source of pressure on mortgagors: the potential for falls in house prices to push borrowers into higher – and therefore more expensive – loan to value (LTV) bands. In a scenario where house prices fall by 10% and high LTV spreads rise by 100 basis points, we estimate that an additional 350,000 mortgagors could be pushed above an LTV of 75%, which could increase their annual repayments by an extra £2,000 on average. This could have a material impact on the economy.

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Bias, fairness, and other ethical dimensions in artificial intelligence

Kathleen Blake

Artificial intelligence (AI) is an increasingly important feature of the financial system with firms expecting the use of AI and machine learning to increase by 3.5 times over the next three years. The impact of bias, fairness, and other ethical considerations are principally associated with conduct and consumer protection. But as set out in DP5/22, AI may create or amplify financial stability and monetary stability risks. I argue that biased data or unethical algorithms could exacerbate financial stability risks, as well as conduct risks.

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Unifying monetary and macroprudential policy

Julia Giese, Michael McLeay, David Aikman and Sujit Kapadia

Central banks have been using a range of monetary policy and macroprudential tools to maintain monetary and financial stability. But when should monetary versus macroprudential tools be used and how should they be combined? Our recent paper develops a macroeconomic model to answer these questions. We find that two instruments are better than one. Used alone, interest rates can control inflation, but are ineffective for financial stability. Policymakers can do better by also deploying the countercyclical capital buffer, a tool that varies the amount of additional capital banks must set aside. The appropriate combination of tools can vary: both should tighten to counter a joint expansion of credit and activity, but move in opposite directions during an exuberance-driven credit boom.

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Central clearing and the functioning of government bond markets

Yuliya Baranova, Eleanor Holbrook, David MacDonald, William Rawstorne, Nicholas Vause and Georgia Waddington

The functioning of major government bond and related repo markets has deteriorated on several occasions in recent years as trading demand has overwhelmed dealers’ intermediation capacity. Seeking a remedy, Duffie (2020) proposes a study of the costs and benefits of a clearing mandate in these markets. Such a policy could boost dealers’ intermediation capacity by allowing more of their trades to be netted, thereby reducing their balance sheet exposures and capital requirements. In a recent staff working paper, we estimate the effects of comprehensive central clearing of cash gilt and gilt repo trades on UK dealer balance sheets during one particular stress episode. This post summarises those quantitative results and discusses qualitatively other costs and benefits of broader central clearing.

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The transmission of macroprudential policy in the tails

Álvaro Fernández-Gallardo, Simon Lloyd and Ed Manuel

Since the 2007–09 Global Financial Crisis, central banks have developed a range of macroprudential policies (‘macropru’) to address fault lines in the financial system. A key aim of macropru is to reduce ‘left-tail risks‘ – ie, minimise the probability and severity of future economic crises. However, building this resilience could influence other parts of the GDP-growth distribution and so may not always be costless. In our Working Paper, we gauge these potential costs and benefits by estimating the effects of macropru on the entire GDP-growth distribution, and explore its transmission channels. We find that macropru is effective at reducing the variance of GDP growth, and that it does so by reducing the probability and severity of excessive credit booms.

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Leveraged and inverse ETFs – the exotic side of exchange-traded funds

Julian Oakland

Exchange-traded funds (ETFs) are supposed to be simple and straightforward, and for the most part they are, but one group punches well above its weight when it comes to market impact. In this post, I show that leveraged and inverse (L&I) ETFs generate rebalancing flows that: (1) are always in the same direction of the underlying market move; (2) grow significantly with both increasing and inverse leverage; and (3) must be transacted towards the end of the trading day. These features give rebalancing flows the potential to amplify market moves when markets are at their most vulnerable. L&I ETFs do not currently pose a risk to UK financial stability, but this could change if they grow in popularity.

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