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The Bank of England has warned lenders over the “elevated” risk in the models they use to predict loan losses and criticised them for failing to fully recognise the impact of high inflation and interest rates on borrowers.
UK banks have posted relatively low loan loss charges this year, even as soaring interest rates have fuelled a cost of living crisis that has seen households owing about £22bn in essential bills.
But in a letter to the chief financial officers of nine large lenders on Friday, BoE prudential regulation head Vicky Saporta said the model risk was “elevated” and that some calculations “were not calibrated to capture the impact of higher inflation and interest rates on borrowers’ ability to repay”.
Loan loss charges have been based on “expected” losses since 2018 — when banks implemented an accounting change that forced them to set money aside for likely defaults — rather than those incurred.
Loss prediction models, which are approved and monitored by banking regulators, are supposed to take economic conditions into account alongside the experience of banks during past downturns.
Saporta recommended that lenders tweak their models’ output to capture additional economic risks. “We consider it crucial that firms challenge the completeness of post model adjustments to ensure provision cover reflects actual expectations of credit losses,” she added.
The BoE also said it wanted banks to “challenge whether models capture risks associated with affordability”, including the effect of rising prices and high interest rates on vulnerable borrowers.
The BoE held interest rates at 5.25 per cent this month after almost two years of rate rises in an effort to curb price rises. UK inflation stood at 6.7 per cent in August, according to the Office for National Statistics.
Saporta highlighted particular concerns over banks’ assumptions around how much money could be recovered from bad loans, typically through selling the underlying asset.
Lenders were also pressed to examine the areas of their business that were most at risk. “We encourage all firms to consider additional, more severe but plausible, economic scenarios that encompass shocks affecting those sectors or segments most vulnerable to higher inflation and interest rates,” Saporta wrote.
Actual defaults remained low in 2023 but BoE financial stability experts have repeatedly warned of the “vulnerabilities” facing households and businesses as indebtedness continues to rise.
The BoE also reviewed the progress of banks in 2022 on assessing climate risks. It found that while improvements had been made, big obstacles remained, including identifying which loans are most exposed.
“Availability and quality of data remain pervasive challenges,” Saporta added, noting that approaches to assessing climate data were “fragmented” and that there was a case for centralising data collection.
