The Bank of England said rapid gains in consumer credit could cause U.K. banks to suffer bigger losses than they’re expecting if the economy weakens.
“Lenders overall are placing too much weight on the recent performance of consumer lending in benign conditions as an indicator or underlying credit quality,” the BOE’s Financial Policy Committee said on Monday. “As a result, they have been underestimating the losses they could incur in a downturn.”
In the event of a recession, losses from defaults in consumer loans would reach 30 billion pounds ($40 billion) within three years, the BOE’s stress tests showed. It will release complete results of that analysis on Nov. 28. The Prudential Regulation Authority will set capital requirements for individual banks to ensure potential losses can be absorbed that will total an additional 10 billion pounds, the FPC said.
The statement comes in the wake of multiple warnings from central bank officials about consumer credit, which has surged about 10 percent in the past year. While some of that relates to car purchases, borrowers are also being enticed by cheap personal loans and incentives on credit cards.
Consumer credit growth poses more of a risk for banks than for the economy overall, the BOE said. Consumer lending accounts for just 11 percent of overall household debt, though defaults on such loans tend to rise faster than others in a downturn, the bank said. The level of consumer debt relative to incomes is in line with historical averages and defaults have fallen from 5 percent to 2 percent in recent years.
To get a handle on potential risks, regulators fast-tracked part of their annual stress tests. That gave the FPC, led by BOE Governor Mark Carney, new information at their latest meeting to analyze the resilience of banks to a sharp jump in defaults.
The BOE reiterated that it plans to raise the countercyclical capital buffer requirements for banks to 1 percent in November.
The BOE’s Monetary Policy Committee said this month that interest rates may need to rise in the next few months if economic growth turns out as expected. Higher borrowing costs would also discourage households from taking on more debt.
For banks, fierce competition has pushed down interest margins and underwriting standards have slackened, according to the PRA. As part of the stress tests, it asked lenders to review their models and consider what a “step-change” in the default rate would mean.
The starkest warning came in July, when Alex Brazier, the BOE’s Executive Director for Financial Stability, said he saw “classic signs” that lenders may be underestimating risks. In his words, they are “dicing with the spiral of complacency.”