Bank of England Warns Private Equity on Risk Management

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The Bank of England (BoE) emphasized the need for improved risk management in the private equity sector, particularly as the period of low interest rates transitions to higher financing costs in this highly leveraged industry. This assertion was made in the BoE’s twice-yearly Financial Stability Report released on Thursday. The report highlighted that the sector is currently facing significant challenges due to increasing borrowing costs.

The BoE stated, “Improved transparency over valuation practices and overall levels of leverage would help reduce the vulnerabilities in the sector. Risk management practices in some parts of the sector need to improve, including among lenders to the sector such as banks.” The Financial Policy Committee (FPC) of the BoE indicated that it would consider the outcomes of ongoing internal work and efforts by the Financial Conduct Authority to address these issues.

In addition to the focus on the private equity sector, the report also assessed stock market valuations of British lenders. This assessment followed concerns from the UK’s Conservative government about the lag in valuations compared to U.S. counterparts. The BoE found that the valuations of British banks were aligned with those of eurozone peers and were beginning to close the gap with U.S. banks. The report noted, “The difference in banking sector equity valuation in the UK relative to the U.S. is similar to that of other economic sectors.” It attributed the valuation differences to market-wide factors, such as variations in economic outlooks and market depth.

The BoE assured that the FPC would continue to monitor developments in UK banks’ market valuations, comparing them with international peers. It also announced plans for a “desk-based” stress test of Britain’s major banks this year. Unlike traditional stress tests, this approach will use the BoE’s own models instead of requesting data from lenders, with aggregate results expected in the fourth quarter of this year. A standard stress test, with individual results, is anticipated in 2025.

The Financial Stability Report also noted that the UK banking sector has the capacity to support households and businesses, even if economic and financial conditions deteriorate significantly. The countercyclical capital buffer (CcyB), which serves as a “rainy day” reserve of capital for banks, remains at its neutral setting of 2%.

Furthermore, the BoE provided initial findings from its first system-wide exploratory scenario (SWES), designed to test the impact of theoretical shocks on different market participants within the UK government bond market. The test revealed that liquidity needs rose significantly as margins for backing positions increased, leading to a rise in corporate bond selling. Following the near-meltdown in the UK government bond market in September 2022, the liquidity buffers of market participants are now well above regulatory minimum levels. A second phase of this test is currently being rolled out, with overall results to be published in the fourth quarter.