Is the BoE’s latest climate risk action all it seems?

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Last week, yours truly complained about the apparent flaccidness of the Network for Greening the Financial System, the club of climate-focused central banks that I believe lacks boldness when it comes to dreaming up ways to speed up the low-carbon transition. The formidable Jean Boissinot put me on blast – and his comments are worth your time.  However, this week another central bank action had me again doubting the energy being brought by these powerful institutions to the climate fight.

I’m talking about the Bank of England’s (BoE) market notice of May 23.  This concerns its Sterling Monetary Framework (SMF), through which banks can access cash loans from the BoE in exchange for eligible collateral.  It’s analogous to the European Central Bank’s collateral framework and kinda-but-kinda-not like the Federal Reserve’s Discount Window (there’s a stigma attached to banks that use this, which doesn’t appear to be the case for the others).

The market notice announced that the bank would no longer accept home loans for certain energy-inefficient properties as SMF-eligible collateral.  Casper Siegert, head of climate risk in the BoE’s markets touted it as “an important step to protect the Bank of England against transition-related risks to its own balance sheet.”

Ok, let’s unpack this.  First of all, what’s actually in scope of the change?  Very little, it turns out. The exclusion applies only to buy-to-let (BTL) mortgages – in other words, those originated for rental properties.  Owner-occupied mortgages are not excluded.  Apparently, the BTL market accounts for just 9% of the UK’s housing stock by number, and 18% of the overall mortgage market by value.

But wait, there’s more.  Remember, only loans for energy inefficient homes are excluded. Specifically, those that have an energy performance certificate (EPC) rated ‘F’ or ‘G’ – the very worst there is.  As of the first quarter of this year, just 2.2% of existing domestic properties in England and Wales had such ratings.  And of course, not all of these are BTL properties. 

Now I haven’t been able to find data on how much BTL loan collateral has been pledged to the BoE in recent years, but I’d bet you anything it’s a tiny, tiny amount, given big banks generally have far more liquid and creditworthy assets to submit to the SMF.

So we know only a tiny fraction of banks’ assets are affected by the change.  Now what about this climate risk the BoE is supposedly guarding against?  In the context of the exclusion notice itself, these risks aren’t enumerated.  However in a following paragraph on collateral haircut adjustments, it says the BoE is adjusting its haircut model to guard against “potential financial losses arising from mortgagors’ exposure to energy price shocks in owner occupied mortgage collateral.”  Presumably, the same argument applies to the BTL exclusion. 

There are two questions to be answered here.  One, could energy price shocks lead to BTL loan defaults of a magnitude that would place the BoE in jeopardy?  And two, would defaults occur over a time horizon material to the SMF?

I can’t provide definitive answers to either. But on the first, the BoE did recently put out a paper on the BTL market and financial stability.  This notes that during the global financial crisis, the delinquency rate for BTL mortgages surged above 3% and the market for new loans “cooled rapidly.”  Clearly, this was a response to credit and macroeconomic conditions rather than energy price shocks, but it does give an idea of what disruption in the BTL market looks like. 

Interestingly, the paper also says that right now “BTL properties are becoming less profitable” because of interest rates and regulatory burdens.  Energy price challenges would presumably compound this issue, and potentially cause distress for some landlords.  However, the note adds that many have low loan-to-value ratios, meaning “lenders are unlikely to experience significant losses relative to their exposures.”  Indeed, renters are the parties most likely to suffer as landlords pass costs onto them.

As for the time horizon question, SMF collateral operations are generally short-dated.  The SMF’s operational standing facility is for overnight lending, its short-term repurchase (repo) operations are 7- to 14-day transactions, and its Indexed Long-Term Repo facility allows borrowings for periods of six months.  

Putting this all together, it's clear that a lot would have to go wrong for the BoE to suffer transition-related losses from BTL loans.  First, an energy price shock would have to occur while a BTL loan is pledged to the BoE as collateral.  Next, this shock would have to be so painful that it exceeds the obligor’s capacity to absorb the costs.  Then, the loan would have to rapidly fall into arrears.  At the same time, the bank holding the loan pledged to the BoE would have to be distressed, and unable to pay back the sterling it borrowed – leaving the central bank stuck with the impaired collateral. 

In other words, it’s very hard to see how a tiny fraction of BTL loans could cause the BoE any meaningful distress.  Hence my catty comment at the top – this is weak sauce, and likely not material to the BoE or mortgage market.

So why has this change been announced?  I think it’s much more to do with the BoE trying to support government policy than managing climate-related risks.  Since 2018, the UK’s Domestic Minimum Energy Efficiency Standard regulations have required rental properties in England and Wales to have an EPC rating of ‘E’ or higher to be let out unless, they have an exemption.  This implies that there are a bundle of BTL mortgages out there for properties that can’t accept renters – assets that have been effectively stranded by transition-related regulation. 

The BoE doesn’t want stranded assets in its collateral pools, obviously.  But perhaps it also wants to deter banks from making loans against energy inefficent properties in the first place.  By barring the below ‘E’ grade loans from its SMF, the BoE is reducing the liquidity value of these assets.  If they can’t be easily traded for cash, then part of their value proposition is removed.  All things being equal, this would make originating such loans less attractive to lenders.

The part of the market notice on collateral haircuts for owner-occupied mortgages should have a similar effect: “Relevant mortgages with no reported EPC ratings will be subject to conservative assumptions, which will tend to increase collateral haircuts relative to a scenario in which counterparties provide EPC data.”

Prima facie, the SMF change being driven by climate risk concerns does not hold water, given the small number of loans affected and the low likelihood that distress in the BTL market would redound to the BoE’s loss.  However, as a tool to support government policy and promote lending to energy-efficient homes, it makes more sense.

It’s a great example of the sleight of hand taken by several central banks in the age of climate distress – take action on risk management grounds while actually supporting the low-carbon transition.  It seems odd and tiresomely convoluted, but it seems to be a popular way for central banks to enact climate-friendly policies under the guise of their “traditional” duties.