Bank of England orders lenders to strengthen reserves amid ‘deteriorating’ economy

The Bank of England yesterday ordered lenders to fortify their defences in preparation for the looming economic downturn, warning the City against “excessive” cuts in lending to households and businesses.

The central bank, which oversees Britain’s banking sector and the country’s monetary policy, doubled the proportion of money lenders need to keep in reserve to two per cent.

The change takes the rate back to its pre-pandemic level and will come into effect on 5 July next year.

The Bank has forced the sector to exercise greater caution to ensure capital buffers are “large enough to create capacity for banks to absorb shocks, so they are able to continue to lend through downturns,” it said in its financial stability report.

Governor Andrew Bailey said “the UK banking system remains strong” and that the likes of HSBC, Lloyds and Barclays can support the economy through turbulence.

The change in capital reserve rules sent FTSE 100-listed banks tumbling. HSBC, Barclays and Lloyds all shed more than two per cent. 

Rampant inflation triggered by global supply shocks and Russia’s invasion of Ukraine are eroding households’ budgets and weakening businesses’ balance sheets.

Upward price pressures, alongside the Bank’s five successive rate rises, are raising the risk of loans souring, intensifying stress in the UK’s financial system.

The UK and global economic outlook “has deteriorated materially” as a consequence of the cost of living crisis, the Bank warned.

The glum forecast “largely reflects steep rises in energy and other commodity prices that have exacerbated inflationary pressures arising from the pandemic, and further disruption of supply chains. Household real incomes and the profit margins of some businesses have fallen as a result,” Threadneedle Street said.

Living costs have soared 9.1 per cent over the last year, the fastest acceleration in four decades. Inflation is expected to top 11 per cent in the autumn, more than five times the Bank’s two per cent target.

Threadneedle Street urged banks to avoid reining in credit like they did in response to the global economic reversal after the financial crisis. 

​​”Restricting lending solely to defend capital ratios or capital buffers would be counterproductive and could prevent credit-worthy businesses and households from accessing funding. Such excessive tightening would harm the broader economy and ultimately the banks themselves,” it said.

Capital buffers are intended to help lenders cushion loan losses so they can keep lending to households and businesses during economic downturns. 

However, forcing banks to save a greater amount of their capital can prompt them to turn down prospective borrowers to comply with regulatory requirements.