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Bank of England launches immediate review of consumer loans amid rapid rise in household indebtedness

The Bank of England (BOE) will test the risks associated with sterling dropping by a further 32 percent from today's level to languish at a low of 85 cents by year-end.

This scenario will form part of the stress tests the central bank is set to run in 2017, the inputs for which were revealed on Monday morning.

The bank's Financial Policy Committee (FPC) simultaneously announced that a review of consumer credit is to be launched immediately. This review will focus specifically on the credit quality standards being applied to new consumer loans given concerns over the rapid rise in levels of household indebtedness.

"U.K. household indebtedness remains high by historical standards and has begun to rise relative to incomes. This could principally represent a risk to lenders if accompanied by weaker underwriting standards. The FPC judges that these standards should be monitored closely," read the BOE's press release.

Yet there are signs that the pace of consumer credit growth has begun tailing off in recent months, according to a U.K. consumer monthly report issued by Capital Economics last Thursday.

"Following a weak December for consumer credit growth, both credit card and personal loan/overdraft borrowing showed a stronger monthly increase in January, although the rise in credit card borrowing was still subdued relative to the latter half of 2016," said the note.

Unveiling the parameters for both a "cyclical" and an "exploratory" test, the BOE said that while it perceives the overall risk to U.K. financial stability as broadly similar to last year, its assessment of the level of global risks has increased.

The bank specifically highlighted increased global concerns over risks coming from higher U.S. equity valuations and the growing gap between credit and gross domestic product (GDP) in China.

While total domestic risks are considered to be on par with those assessed in 2016, the relative weightings given to the risks have shifted slightly.

The HSBC Holdings Plc headquarters sits in the Canary Wharf business, financial and shopping district of London.
Simon Dawson | Bloomberg | Getty Images
The HSBC Holdings Plc headquarters sits in the Canary Wharf business, financial and shopping district of London.

Namely, risks over the Brexit referendum result have ceded ground to risks surrounding the actual process of the U.K. exiting the European Union (EU) while risks to commercial property are seen as slightly less severe given the small drop in valuations since the vote last June.

On the other hand, as U.K. house prices have continued to rise over the past year, the BOE is now assigning a 33 percent downside stress test scenario versus last year's 31 percent test input.

The central bank has also introduced a longer-term (up to 7 years) stress test called the "exploratory" test which looks specifically at the risk that banks' profitability remains persistently low.

"While some of the recent weakness in profitability is due to legacy issues, such as past misconduct, or cyclical factors, there is a risk that some of the pressures weighing on profitability may prove to be longer lasting," read the press release, explaining why the BOE had selected this scenario above all other trends to probe in additional detail.

While many welcome the capital strengthening evident since the BOE held its first annual stress test in 2014, there are concerns that the increasing detail required each year from the tests is placing an ever greater burden on stretched banks, according to Lee Thorpe, business solutions manager at analytics outfit SAS U.K. and Ireland.

"Stress testing is always an all-consuming activity for the banking community. The scenarios that banks face as part of annual stress testing exercises are becoming more exploratory which means the variety and complexity of modelling is increasing," Thorpe said in an email to clients on Monday.