Bank of England Warns Lenders of ‘Elevated’ Risk in Loan Loss Models Amid High Inflation

(CTN News) – The Bank of England has cautioned financial institutions about the “elevated” risk inherent in the models they use to predict loan losses and has scolded them for failing to adequately account for the effects of high inflation and interest rates on borrowers.

Despite rising interest rates contributing to a cost of living crisis that has left families owing roughly £22 billion in critical expenditures, UK banks have maintained comparatively low loan loss charges this year.

Bank of England head of prudential regulation Vicky Saporta wrote a letter to the CFOs of nine major banks on Friday, warning that 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.”

Since 2018, when banks enacted an accounting adjustment that required them to set aside money for potential defaults, loan loss costs have been based on “expected” losses rather than those suffered.

Bank supervisors want loss prediction algorithms to factor in both the current economic climate and the institutions’ historical performance in times of crisis.

Saporta suggested that financial institutions modify the results of their models to account for a wider range of 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 continued.

Banks, according to the Bank of Englands instructions, should “challenge whether models capture risks associated with affordability,” such as the impact of price increases and high-interest rates on the most financially precarious borrowers.

After almost two years of rate hikes, the Bank of England kept rates steady at 5.25 percent this month to slow inflation.

The Office of National Statistics reported that inflation in the United Kingdom was 6.7% in August. Saporta brought up specific worries about the bank’s assumptions regarding the amount of money that may be recovered from bad loans, usually through the sale of the underlying asset.

Banks were also urged to assess the vulnerable parts of their operations. Regarding the impact of rising inflation and interest rates, “we encourage all firms to consider additional, more severe but plausible economic scenarios,” Saporta stated.

However, experts on financial stability at the Bank of England have repeatedly warned of the “vulnerabilities” affecting consumers and companies due to rising indebtedness, even while actual defaults remained low in 2023.

In 2022, the Bank of England also checked in on how well banks evaluated climate threats. The report concluded that progress had been achieved but that significant challenges remained.

Saporta elaborated, saying, “Availability and quality of data remain pervasive challenges,” adding that there is a justification for centralizing data collecting because of the “fragmented” techniques to analysing climate data.