The Factors Affecting the Financial Stability in the Uk

1. Introduction

This paper attempts to find out the factors affecting the financial stability in the UK and its key risks. The financial stability in the United Kingdom has been adversely affected by recent global developments in advanced countries especially Europe, while it has been stabilized by strong growth in emerging economies and generally healthy domestic financial conditions. However, key risks from abroad remains, given the high exposure of the UK banks in the affected areas, which will be explored in detail. This paper also attempts to map out the effect of the Euro zone crisis on the UK financial system - the UK's financial sensitivity is no doubt the highest due to its geographical proximity and financial integration.

2. Recent Global Financial Developments

Europe

The global recession have strained sovereign and banking funds in parts of Europe - Portugal, Greece and Ireland resorted in seeking financial support from European authorities and the International Monetary Fund. In the event where these countries default, this would pressurize the countries in the European Union. This contagion is amplified by uncertainties in debt restructuring, shaking the UK banks' financial stability due to their financial interconnectivity with these countries.

Middle East, Japan and the United States

Beyond Europe, shocks originating from the Middle East, Japan and the United States have further tested the stability of UK banks. The Middle East and North Africa have experienced major political unrest, ranging from the toppling of rulers in Egypt to Libya. This resulted in a higher oil price, threatening increased inflation which devalues the bank asset values. Furthermore, the downgrades on Japan and the US sovereign ratings further destabilized the global markets and with it the UK banks. The drop was attributed to Japan's reconstruction needs following the March earthquake and the "lack of clarity over US fiscal policy towards tackling the size of the US budget deficit and rising government indebtness".

Emerging Economies

China and Latin America have experienced relatively strong growth over the past few years. Strong growth rates, albeit lower than pre-crisis levels have been maintained throughout the financial crisis. However, there's a fear that this growth rate is unsustainable since most emerging markets are exporters to advanced economies. Time is needed for these countries to adapt towards domestic consumption instead. On the other hand, there are fears that it may grow too fast - overheating due to inflation may serve to be the stumbling blocks of emerging economies.

3. Domestic Financial Conditions

Despite fears of financial contagion from external sources, financial markets in UK have been stable since December . Assets price, equity price have both increased; corporate bond spreads generally narrowed; changes in CDS premia also suggested improved sentiment for higher-yielding debt relative to investment-grade debt. Despite these improvements, market risk appetite did not strengthen. Market volatility fell even during significant price movements in the commodity markets in the spring period , showing signs of increased financial stability within the UK.

4. Impact on the UK's Financial Stability

Effect of Capital Flows

In view of the current global financial situation, capital inflows have generally increased. Flows into advanced countries picked up following outflows during 2010, mainly due to the reassessment of economic prospects. Inflows into emerging economies have also resumed given high long-term growth prospects and the current small share in major investors' overall portfolio. This resumption and continuation of capital inflows proved encouraging for the stability in the UK. However, cross-border bank lending had been unstable due to high sovereign risks. This is only limited to intra-EU; lending to emerging, advanced economies have strengthened and rebounded respectively .

The pattern and balance of capital inflows may however, shift over the medium term. The US capital inflows in particular are highly dependent on current account surpluses. Capital inflows may be affected by various geo-political factors such as oil price. The economic decisions and situations in emerging economies could also affect global capital flows. China has been the main buyers of US treasury bonds - an overheating in the economy may adversely affect capital flows, proving a source of potential destabilization of the UK financial system albeit in the middle term.

General Impact

Financial shocks within the European Union, political shocks in the Middle East and the downgrades of Japan and US sovereign debt rating have destabilized the UK financial stability somewhat. However, the UK financial system is still relatively stable - improved monetary conditions , improved global economic outlook, improved capital inflows globally have been sources of stabilization.

5. Key Risks

UK banks' exposures are evenly split between the United Kingdom and abroad . Key risks arising from abroad include macroeconomic, emerging market and political risks, while key risks arising within the UK are mainly credit risks on an inter-banking, corporate and personal household level.

Macroeconomic Risks

Internationally, the banks are exposed directly in holdings of government debt. Indirectly, the banks are exposed through inter-banking system transactions and foreign non-bank private sectors. The claims in France and Germany represent about 130% of the UK banks' core Tier 1 capital, with banks representing half of it. The non-bank private sector in Ireland and Spain represents about 50% of the major UK banks' core Tier 1 capital.

Hence, global macroeconomic risks are a major risk factor in the UK financial system. Worries over the debt sustainability of Greece, Ireland and Portugal have not been sufficiently allayed. The United States, Japan and some euro-area sovereigns have negative credit rating outlooks due to their large refinancing needs in the next two years. The average debt to GDP for advanced economies is expected by IMF to breach 100% for the first time since World War II. Possible shocks to GDP growth and funding costs would further threaten these economies and hence, the UK financial systems. These have further impacts on the banking sector risks and corporate credit risks in these countries respectively.

Emerging Market Risks

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