(Bloomberg) -- The Bank of England ordered UK lenders to work harder to understand the links between inflation, interest rates and unpaid debts amid continuing concerns that the models banks use to predict loan losses are failing to capture the seismic economic shifts of recent years.
Lenders should “gather data to better understand the relationship between inflation, interest rates and credit losses to inform future enhancements to modelling capabilities,” David Bailey, the Bank of England’s executive director for prudential policy, said in a letter to the chief financial officers of the UK’s biggest banks.
UK banks’ provisions for expected loan losses, as calculated by their risk models, have remained at low levels despite the cost-of-living crisis spurred by inflation and higher interest rates that have weighed on borrowers’ ability to repay loans.
“All firms face challenges assessing the impact of risks that models cannot fully capture due to lack of historical data,” Bailey wrote, arguing that low loan losses made it harder for banks’ models to predict a normalized level of defaults. Lenders need to “compensate for the risk of historical bias where uncertainty exists over recovery outcomes.”
Bailey said some of the limitations of banks’ models could be mitigated by studying the interplay of inflation, interest rates and credit risk. He called out refinancing risk as a particular area for attention, for both retail and corporate borrowers.
“While we saw instances of refinance risk only being considered for the next 12 months, better practice we saw included use of reasonable and supportable information to consider refinance risk over longer terms, such as the next three years,” he said.
In its most recent financial stability update, the Bank of England warned that more than 35% of mortgage holders are still paying interest rates of less than 3%, exposing many to the risk of higher payments when they are forced to refinance as their loans expire.
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