Banks to ensure borrowers can cope with rate rises, Bank of England says

Amid new worries about sub-prime lending, the Bank of England is looking for banks to tighten up their mortgage requirements to ensure home owners can cope with a potential interest rate rise.

On Tuesday the BoE's Financial Policy Committee revealed it has told banks and other lenders they need to test whether borrowers could still afford their mortgages if interest rates are lifted by the three percentage points.

“This recommendation applies to all lenders which extend residential mortgage lending in excess of £100m per annum,” the central bank said in a statement following its meeting last week.

The changes to the BoE's recommendation on affordability tests are designed to "prevent excessive growth in the number of highly indebted households.

UK households have come under sustained pressure from falling real wages as inflation has risen above earnings growth, with the central bank's warning coming amid growing concerns over reckless lending, notably also in the car finance market.

When assessing affordability, mortgage lenders "should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, their mortgage rate were to be three percentage points higher than the reversion rate specified in the mortgage contract at the time of origination".

In a review of the consumer credit market, the Bank's Prudential Regulation Authority confirmed a September deadline for lenders to show they are adequately protected against consumer credit risks, although it did not outline any new rules.

Amid the growing concerns that consumers and banks have taken on too much at a time when a consumer-driven economy is starting to stutter, the PRA noted risks in the market including poor credit scoring, credit card promotions and the explosion in car finance loans and industry assumptions around vehicle resale values.

The review found: "In an environment of rapid growth in consumer credit, interest margins have fallen and there was evidence of weakness in some aspects of underwriting, so lenders are more vulnerable to losses in stress."

The PRA said UK lenders appeared to be relying too heavily on the assumption that the economy would remain healthy with low levels of arrears.

A week ago the FPC said banks must set aside an extra £11.4bn in the next 18 months to protect themselves against bad loans, increasing the UK countercyclical capital buffer rate to 0.5% from 0% to raise regulatory buffers of common equity Tier 1 capital by £5.7bn. This will provide a buffer of capital that can be released quickly in the event of an adverse shock occurring that threatens to tighten lending conditions.

In its Financial Stability Report on Tuesday, the BoE said there are pockets of risk that warrant vigilance. "Consumer credit has increased rapidly. Lending conditions in the mortgage market are becoming easier. Lenders may be placing undue weight on the recent performance of loans in benign conditions."

The Bank said it expects to increase the rate further to 1% in November, bolstering reserves by another £5.7bn.