July Financial Stability Report introduces cost of living adjusted DSRs

The Bank of England's Financial Policy Committee (FPC) introduced a new measure of household debt affordability in its Financial Stability Report published on 5 July 2022, according to an account given by FPC external member Colette Bowe in a speech on 7 September 2022¹. The cost of living adjusted debt service ratios (DSRs) deduct taxes and an estimate of essential spending from household income, rather than using pre-tax income as the earlier gross DSR measure did¹.

Bowe said the gross DSR measures the FPC generally reports "are not well suited to account for the increases in the cost of living"¹. The adjusted measure is built on disposable household income after taxes and an estimate of essential spending, including utility and energy bills, food and transport, with debt servicing consisting of regular debt repayments¹. Bowe said the new measure better captures the effect of higher essential spending, possible interest rate rises, possible higher unemployment, and offsets from nominal wage growth and fiscal policy¹.

The speech set out the scale of UK household debt. The total stock of UK household debt excluding student loans was just under £2 trillion in 2022 Q1, equivalent to around 124.5% of total household income, below the 2008 peak of 146%¹. Average annual household debt growth slowed from around 9% before the global financial crisis to around 2.4% over the last decade, while annual income growth slowed by less, from an average of 4.6% to 3%¹.

On the older gross measure, households with a mortgage DSR at or above 40% were more likely to experience repayment difficulties during the financial crisis¹. In 2022 H1 the share of such households increased to around 1 ¾%, broadly in line with pre-crisis averages¹. On the cost of living adjusted measure, the share of households with high DSRs was expected to remain at around 1.7% over the course of 2022, below the pre-2008 level of 2.8%¹. Bowe said the equivalent threshold at which households are likely to struggle with repayments is 70% of disposable income¹.

The speech also covered the FPC's withdrawal of its mortgage affordability test, which had specified that lenders should assess whether borrowers could still afford their mortgages if rates rose by 3 percentage points¹. That test sat alongside FCA rules introduced in 2014 requiring lenders to verify income and account for other debt and spending commitments, and a flow limit restricting loans above 4.5 times income to at most 15% of new lending¹. Bowe said the FPC "has recently withdrawn its affordability test, although the underlying FCA framework remains in place"¹.

Why it matters for households

The adjusted measure changes how the Bank of England gauges which households are under pressure, by counting taxes and essential bills before debt repayments rather than looking at debt against pre-tax income¹. That matters most for households on lower incomes, who Bowe said are disproportionately affected by rises in the cost of essential items¹. The Bank estimated the share of households with high adjusted DSRs would stay at around 1.7% through 2022, below the 2.8% seen before 2008, but Bowe said there may still be an increase in defaults or households making sharp cuts to spending¹. She also noted that the August 2022 Monetary Policy Report showed a further deterioration in the outlook, making conditions more challenging for UK households than at the time of the July report¹. The withdrawal of the affordability test removes one check on new mortgage lending, though the FCA's affordability framework and the flow limit remain¹.

What happens next

The 2022 annual cyclical scenario stress test was to be launched later in September 2022, assessing the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, real income shocks, large falls in asset prices and higher global interest rates¹. The FPC said it will continue to monitor UK household debt vulnerabilities¹.