Finance: The Bank of England says UK banks have fundamentally misjudged the quality of British consumer debt and might be heading into a £30 billion hole

The warning comes after the BoE recently expressed worries about the sustainability of the "PCP" car loan business.

LONDON — UK banks have misjudged the quality of the £145 billion ($200 billion) in outstanding consumer debt they hold on their books, and this might cost them losses of £30 billion ($40 billion) in a severe recession, the Bank of England said yesterday.

The warning comes after the BoE recently expressed worries about the sustainability of the "PCP" car loan business, in which drivers pay less than the value of the vehicle they're buying. The credit rating service Moody's also recently downgraded its outlook for UK consumer debt vehicles because debt is growing faster than incomes.

The BoE's latest statement is unusual because it unambiguously says UK banks are making a fundamental error in how they judge the quality of consumer credit they hold on their books.

The banks believe their consumer credit assets are high quality because the default rate is currently low, the BoE says. The default rate — the percentage of consumers who can't make their monthly payments — fell from 5% in 2011 to 2% in 2016. The declining level of defaults has led the banks to incorrectly conclude that the credit quality of their customers must be improving, the BoE says.

In reality, the default rate is low because interest rates are low and unemployment is low, making it easier for low-quality borrowers to keep rolling over their debts without defaulting. The BoE specifically mentions the "growth of interest-free credit card balance transfer offers" as one way that consumers are fooling banks into believing they are capable of paying back their debt — people are simply juggling credit cards with zero-interest offers. That won't last forever, especially if interest rates go up.

Here is what the BoE's Financial Policy Committee said yesterday:

"The FPC judges that lenders overall have been attributing too much of the improvement in consumer credit performance in recent years to underlying improvement in credit quality and too little to the macroeconomic environment. As a result, they have been underestimating the losses they could incur in a downturn.

"... Submissions by major banks in this year’s stress test process confirm banks have been underestimating losses in a severe stress."

"There is a pocket of risk in the rapid growth of consumer credit," the BoE added. "It is a risk to banks’ ability to withstand severe economic downturns, because this asset class is disproportionately more likely to default" than mortgages.

The BoE's 2017 "stress test" for banks' balance sheets assumes a recession with interest rates at 4% and unemployment at 9.5%. That's a more severe recession than the 2008 crisis, but Britain has hit both those rates before. In that scenario, "the UK banking system would, in aggregate, incur UK consumer credit losses of around £30 billion, or 20% of UK consumer credit loans," the BoE says.

"Banks have been underestimating losses in a severe stress," the BoE added.

The good news is that even if banks took a £30 billion hit, that's not on its own a "material risk to economic growth." Consumer credit is only one-eighth the size of mortgage debt, so defaults would not be on the scale of 2008. Of course, these things don't happen in isolation, and the BoE statement doesn't discuss what type of contagion might occur of losses occurred in other asset classes simultaneously.

The warning comes after the BoE recently expressed worries about the sustainability of the "PCP" car loan business. Read Full Story