On top of weakening economic conditions, the recent dislocation in the gilt market provided another test for the U.K. banking system. Following the U.K. government's fiscal event on Sept. 23, 2022, the cost and volatility of funding across the U.K. economy rose sharply. The abrupt adjustment in inflation and base-rate expectations comes as markets have become progressively less accommodative through 2022, as rates have lifted and spreads widened, with these conditions likely to persist into next year.

U.K. banks managed the recent period of market volatility from a strong funding and liquidity position, and limited near-term dependence on wholesale markets continues to provide the banks with flexibility. But global funding conditions have turned, and the cheap and abundant liquidity of 2020 and 2021 is unlikely to return in 2023.

Nevertheless, S&P Global Ratings expects that the U.K.'s largest banks can navigate what is likely to be a period of more difficult conditions in domestic and global wholesale funding markets. The U.K.'s major banks have built minimum requirement for own funds and eligible liabilities (MREL) buffers to meet end-state requirements and internal targets, which should help the markets absorb banks' rising funding needs in 2023 and 2024 as they replace central bank borrowings. Together with their access to cheap secured funding markets, this should allow the banks to navigate a choppier unsecured environment.

U.K. Banks Face Tighter Debt Market Conditions With Excess Liquidity

After accommodative funding conditions throughout most of 2020 and 2021, the aftershocks of the U.K. government's fiscal event on Sept. 23, 2022, exacerbated the effects of tighter monetary policy and a broader deterioration in risk sentiment since the beginning of 2022 (see charts 1 and 2). While the combination of gilt-market stabilization measures by the Bank of England and a fiscal policy reversal by the government subsequently contained the volatility in domestic rates, wholesale spreads for U.K. banks and their European peers remain at medium-term highs.

Chart 1

Chart 2

Conditions in the domestic and global funding markets are likely to remain relatively tight. The European Central Bank's recently announced incentives for the early repayment of targeted longer-term refinancing operations (TLTRO) will gradually withdraw liquidity from the eurozone, increasing the prospective supply and potentially the cost of funding through 2023 and beyond. Eurozone banks have already repaid 14% (€296 billion) of the first tranche of TLTRO at the end of November. Closer to home, the Bank of England's quantitative tightening will withdraw a significant amount of liquidity created through prior easing, although this process will be gradual and prolonged. Meanwhile, global central banks continue to tighten financing conditions to reduce demand in the real economy.

Nevertheless, U.K. banks face these less predictable conditions with large buffers of funding and liquidity. Since 2019, and similar to global peers, the U.K.'s four major banking groups' combined core deposits have grown by more than £500 billion due to the monetary expansion through the COVID-19 pandemic, and as yet, there are no signs of outflows as rates have increased. This growth in stable funding has significantly outstripped asset growth and closed the systemwide gap between domestic deposits and loans, shoring up stability in a system already well funded in a global context (see chart 3).

Chart 3

To date, low deposit betas have kept funding costs low against the backdrop of rising interest rates and wholesale spreads. Betas have been close to about 30% to date for the "big four" banks' interest-bearing retail deposits, but they are now increasing, and we expect this trend to continue in 2023. We expect the process to be fastest at challenger banks that will compete aggressively to maintain and increase their deposit balances. In wholesale markets, systemwide liquidity is likely to become tighter and funding costs rise over the coming two years as the Bank of England continues with quantitative tightening and the banks repay central bank borrowings.

Funding Needs Are Set To Accelerate With TFSME Repayments

Highly accommodative conditions in the domestic debt markets throughout the pandemic were partly thanks to the availability of the Bank of England's term funding scheme with additional incentives for small and midsize enterprises (TFSME). Alongside deposit growth, the scheme has significantly limited banks' senior wholesale funding needs since the beginning of the pandemic, and many banks' net wholesale debt activity outside MREL has been negative. After banks' drawings on the central bank funding facility in 2020 and 2021, most of this funding will mature in 2024 and 2025, raising the prospect of increased wholesale issuance and a normalization of currently elevated liquid asset holdings.

Utilization of TFSME varies across the U.K.'s array of lenders. Among the U.K.'s largest banks, the dependence of the mortgage-focused banks outside the big four universal banks stands out (see chart 4). For example, as of June 2022, drawings by Santander UK, Virgin Money, and Nationwide were close to or above 8% of their consolidated balance sheets. Santander UK is the largest user of the central bank funding in relative and absolute terms, with close to £35 billion drawn at the half year. This is more than 10% of its consolidated balance sheet, but more modest in comparison to its Spanish parent's consolidated balance sheet.

Absolute drawings by the four biggest banking groups vary, with HSBC and NatWest having close to £10 billion of TFSME funding outstanding. In contrast, Barclays' and Lloyds' drawings are closer to £30 billion. Nevertheless, each of these banks' reliance is below that of their mortgage-focused peers, and is less than 5% of each group's total assets. This partly reflects the large global balance sheets of Barclays and HSBC, although the dependence of Lloyds and NatWest is also modest relative to their mostly domestic balance sheets. Among groups with ring-fenced operations, drawings by the majority (if not all) have been by the ring-fenced entity. In addition to drawings by their ring-fenced banks, Barclays and Santander UK each have a small amount of TFSME outstanding outside these entities.

Chart 4

We see the big four banking groups as relatively well positioned in this context, considering their use of TFSME and their general dependence on wholesale funding. The combination of their lower use of central bank funding as a share of the balance sheet, their large deposit surpluses, and material liquidity coverage ratio (LCR) headroom provide them with flexibility (see table 1). For these groups in aggregate, excess deposits are more than ample to cover maturing TFSME.

Table 1

In contrast, large mortgage-focused domestic lenders Santander UK, Virgin Money UK, and Nationwide each exhibit greater dependence on wholesale markets to fund customer loans. Taken alongside their high drawings of TFSME compared to their balance sheets, this suggests a larger, but still manageable, funding task ahead. These lenders currently hold excess liquid asset buffers, and so will not need to refinance all their TFSME borrowings. For example, Nationwide's average LCR in the 12 months to Sept. 30, 2022, was 179%, which is significantly above its normalized LCR of 135%-145%. This implies that the lender held an average liquid asset buffer over the past 12 months of close to £10 billion above its normalized level, or close to half of its outstanding £21.7 billion in TFSME drawings.

Overall, we think that while some rated banks' funding tasks are larger than others, the rated lenders are appropriately prepared. In addition, we understand that most banks have agreed on timing and a plan for refinancing the central bank funding. While the funding task appears easily manageable for large rated banks, refinancing in the crowded funding markets could prove more difficult for some smaller, unrated players. Some of these lenders face large refinancing requirements relative to the size of their asset bases and funding franchises. Several have assets of £5 billion or less and outstanding TFSME funding that is more than 10% of their balance sheet. Refinancing could prove challenging as these lenders will compete with the national champions for funding, particularly if conditions remain less than supportive.

Banks Are Likely To Lean More Heavily On Secured Funding Access

With the cost of senior debt likely to remain comparatively high, U.K. banks are likely to prioritize the secured funding markets, most notably covered bonds and residential mortgage-backed securities. Although they have not been particularly active in recent years, the U.K.'s largest banks are established issuers in these markets. In addition, U.K. lenders' low levels of balance-sheet asset encumbrance imply ample headroom for secured bonds. At the half year, gross encumbrance across the U.K.'s largest lenders is slightly above 10% on average, and mostly reflects repo borrowing. The contribution to encumbrance by covered bonds and securitization is very small, particularly for the largest banking groups.

While senior preferred spreads have risen materially, covered bond pricing has been more stable, reflecting the instruments' seniority in the capital structure. The spread between senior operating company debt and covered bonds has gradually trended up throughout 2022, and the most recent data show the spread at close to 80 basis points (see chart 5). This is significantly above the medium-term average (adjusted for the change in the covered bond reference rate in January 2022), and has raised the relative attractiveness of covered bond issuance as a funding option.

Chart 5

Several U.K. banks have issued covered instruments throughout 2022 at attractive pricing. Recent issuance by major U.K. banks includes a £500 million issuance in early November by Barclays Bank UK PLC and a £750 million issuance by Virgin Money UK in September. Further down the capital structure, major U.K. names like Lloyds and NatWest have been in the market for Tier 2 and holding company senior issuance throughout November. Together, bank funding looks to be on a solid footing across the capital stack after September's dislocation.

With European banks seeking to replace TLTRO repayments at least partly with term funding in the coming two years, issuance of euro-denominated covered bonds in 2023 could test the decade-high volumes issued in the year to date. The higher supply could increase the cost of issuance, but with a return to the benign unsecured conditions throughout much of 2020 and 2021 unlikely, secured funding should remain attractive for the banks even if spreads widen marginally.

Last year was the final year of MREL building for many banks, with net issuance of senior holding company debt easily absorbed by accommodative markets. Having built buffers of loss-absorbing capital over the past several years, the major U.K. banks currently meet their end-state 2022 MREL requirements. Consequently, looking forward, net issuance of MREL instruments will largely reflect incremental growth in risk-weighted assets. At the same time, given banks' large gone-concern capital buffers, maturing gross volumes will remain significant.

U.K. Bank Ratings Reflect Banks' Capacity To Manage Changing Conditions

Domestic and global wholesale funding conditions in the coming two years should be more challenging than the benign conditions of the recent past. Wholesale spreads are likely to remain elevated relative to much of 2020 and 2021, and deposit price sensitivity and churn rates are likely to rise. At the same time, domestic rates and spreads have recovered from the one-off, U.K.-specific jump following the September fiscal event.

Large U.K. banks' diversified access to various wholesale instruments across multiple geographies and currencies, together with their strong and stable deposit franchises, support their capacity to negotiate the shift in global funding conditions even as wholesale funding needs rise. Looking to the near future, the U.K.'s biggest banking groups appear comparatively well placed to negotiate potentially volatile funding markets. The U.K.'s other major mortgage-focused banks show a greater reliance on markets and have a larger task ahead, but we think that the task is manageable and consistent with our current assessments of their funding and liquidity profiles, and that they are appropriately prepared. Pressures are likely to be more acute for smaller banks with greater dependence on central bank funding, and weaker and less diverse wholesale funding franchises.