The Bank of England has made two significant announcements that could reshape the UK’s financial landscape. First, in August 2024, the Bank of England released its second assessment under the Resolvability Assessment Framework emphasising the need for banks to strengthen their crisis preparedness to avoid taxpayer bailouts and ensure financial stability for the economy. Then, in September 2024, the Bank signalled potential interest rate cuts, marking a shift from its current monetary tightening stance. This announcement came amidst concerns about the UK’s economic stability, inflation control and the global financial environment. 

For banks, the twin forces of impending interest rate cuts and regulatory demands mean that preparation is critical to avoiding regulatory and compliance risks.

Key takeaways from the 2024 Resolvability Assessment Framework 

The 2024 Resolvability Assessment Framework (RAF) report offered insights into how well UK banks are prepared for potential financial crises. The RAF was introduced to assess the ability of large UK banks to manage their own resolution (i.e., closure) without relying on public funds. The August 2024 report found that major banks have made significant progress, but that gaps remain. 

A key component of the RAF assessment is a bank’s ability to assess their liquidity needs under stress. Banks were required to prove they could evaluate their liquidity within 24 hours, to ensure enough funds were available to meet depositor demands during a crisis. The report identified that Barclays, HSBC and Standard Chartered could “further enhance” how quickly they were able to provide asset assessments, and shortcomings on behalf of Standard Chartered in relation to the execution of restructuring plans.

The RAF places ongoing pressure on banks to continually improve their crisis management, and mandates that resolvability is included into their business practices. Interest rate cuts could complicate banks’ liquidity management and financial stability.

Preparing for changes in interest rates

The Bank of England’s indication that interest rates may soon be cut marks a turning point in its monetary policy. With inflation stabilising, the focus may shift toward supporting economic recovery. Lower interest rates would reduce borrowing costs, potentially stimulating investment and consumer spending. However, it could also compress margins for banks, especially those dependent on income from interest. This could challenge banks in meeting liquidity needs or other financial obligations. 

Compliance and regulatory risks: failing to prepare for interest rate cuts

Banks that fail to prepare for rate cuts face compliance and regulatory risks. The Bank of England, along with the Prudential Regulation Authority (PRA), expects banks to demonstrate sound risk management and compliance with liquidity and capital requirements, particularly in volatile economic conditions. Banks unprepared for rate cuts, i.e. by failing to adjust their financial models, may struggle to meet those regulatory requirements. 

Reduced interest rates are likely to squeeze banks' interest margins, especially those that rely on interest income from loans and other financial products. This drop in revenue could strain liquidity, increase credit risks and impair profitability, particularly if the cuts coincide with an economic downturn or a financial crisis.

Strengthening liquidity management is essential to maintain sufficient cash reserves and access to alternative funding sources. The 2024 RAF report emphasises the need for quick liquidity assessments. The ability to quickly assess liquidity becomes even more critical when interest rates drop, as banks will likely face higher withdrawal rates and lower returns on their assets. If banks cannot manage this effectively, they risk breaching regulatory liquidity thresholds, and face penalties or increased scrutiny from regulators. 

As interest rate cuts typically encourage borrowing, banks could see a risk of increased credit exposure, especially if the economic outlook remains uncertain. Banks should closely monitor market trends and customer behaviour to anticipate shifts in loan demand and savings patterns, and adjust their portfolios accordingly. 

Banks must also stress test their balance sheets under various interest rate scenarios, particularly in low-rate environments where margins could shrink considerably. Shrinking margins could destabilise balance sheets, requiring banks to have contingency plans. 

Legal and regulatory consequences 

In addition to compliance risks, if banks are unable to properly manage liquidity or execute restructuring plans during times of stress, they may face regulatory enforcement actions. Banks that fail to demonstrate crisis planning can face regulatory fines, penalties, or restrictions on operations. Legal risks may also arise, as customers, shareholders or investors could bring claims against the bank for mismanagement if the institution fails to follow the Bank of England’s recommendations.

Banks should also prepare for potential rate hikes. A sharp increase in rates could destabilise markets, lead to higher default rates on loans and raise operational risks. Banks need to be agile, and have contingency plans in place to handle both interest rate cuts and unexpected rate hikes.

Balancing crisis preparedness with interest rate announcements

The Bank of England’s interest rate announcements and its ongoing focus on crisis preparedness highlight the need for banks to be agile, resilient and proactive in managing risks. The RAF report serves as a reminder for banks to continuously enhance their crisis management capabilities, while the prospect of interest rate cuts adds another layer of complexity to the challenges banks face.

Banks that fail to prepare for either scenario – interest rate cuts or financial crises – risk exposure to regulatory sanctions and financial instability. By adhering to the Bank of England’s guidance and refining their liquidity management and restructuring plans, financial institutions can better navigate the challenges of a changing economic environment.

Natalie Todd is a commercial litigation partner and Anna-Rose Davies is an associate at Cooke Young & Keidan.