Financial Stability Report - December 2025

This section updates on the FPC’s assessment of structural changes in the UK financial system.

The financial system is constantly evolving, and new risks emerging, as technological, economic, geopolitical, and broader societal shifts change the landscape in which it operates. This evolution – and the emergence of new risks – can have material implications for the provision of financial services to households and businesses, and for the FPC’s primary and secondary objectives.

The rapid pace of change under way currently presents a range of opportunities and risks. Technological innovation has the potential to improve the way in which the financial system serves households and businesses, and their resilience to financial and economic shocks, and to reshape the UK economy, boosting productivity and economic growth. But innovation can also present new risks to the stability of the financial system and its contribution to growth. Changes in the economic and geopolitical environment can further expose new vulnerabilities that reduce the resilience of the financial system. Resilience to risks from these structural changes therefore allows the financial sector to make the most of the opportunities they present.

The FPC works to identify new risks, including through horizon scanning, and builds its approach to individual risks over time (as it already has done on operational resilience, cryptoassets, stablecoins, and artificial intelligence (AI)). These opportunities and risks, and the interconnections between them, will remain an enduring focus over the FPC’s policy horizon. And future FSRs will seek to communicate the FPC’s views and actions on these as appropriate.

This section focuses on three areas where there have been developments in recent quarters: operational resilience; climate-related risks; and developments in unbacked cryptoasset and stablecoin markets.

7.1: Operational resilience

Heightened geopolitical tensions and continued advances in technology have underlined the critical importance of operational resilience to the provision of vital services to households and businesses. Against this backdrop of considerably heightened risk, the FPC supports further actions to be taken by firms and financial market infrastructures (FMIs) to build resilience to operational disruption.

In March 2024, the FPC set out its macroprudential approach to operational resilience, which highlighted the growing risks to financial stability from operational issues and the importance of system-wide resilience (in addition to the resilience of individual firms).

Since then, risks to operational resilience have continued to grow.^{footnote [34]} A record share of respondents to the Bank of England’s Systemic Risk Survey cited cyberattacks (86%) and operational risks (36%) in their top five risks to the UK financial system in 2025 H2. In 2025, the National Cyber Security Centre (NCSC) reported over 200 nationally-significant cyber incidents, up from 62 in 2023. The significance of these risks – and their potential to affect activity, revenues and valuations severely – has been highlighted by major incidents affecting national infrastructure, UK retailers and vehicle manufacturers this year.

This increase in risk reflects increased geopolitical tensions and advances in technology. Elevated geopolitical tensions have been associated with an increase in cyberattacks globally. New technologies such as AI and Distributed Ledger Technology (DLT) provide benefits to some firms, and increased automation may reduce operational risks. But they may also introduce new operational risks related to speed, explainability, insufficient controls, and outsourcing including to critical third parties. New technologies may also increase the capabilities of cyberattackers. In future, development of large-scale quantum computing could undermine the security of public key cryptography, upon which many computer systems, including financial software, are dependent. The NCSC has therefore set out recommended timelines to migrate to post-quantum cryptography (PQC). Preparing and planning for PQC migration now – including mapping the software and hardware needed to provide key services, and dependencies between them – will mean firms and FMIs can migrate securely and in an orderly fashion, before quantum-based cyberattacks become widespread.

Together, geopolitical and technological developments further increase the likelihood that operational incidents could affect the provision of vital services such as wholesale and retail payments, clearing and settlement, and other related activity such as custody services. If such services are disrupted, it could affect the ability of financial sector participants, households and businesses to manage risk, transact or access financing. Importantly, disruption to vital service provision could undermine confidence in the financial system, and therefore negatively affect saving, investment, and economic growth.

Therefore, the FPC supports further actions to be taken by firms and FMIs to build resilience to operational disruption, including to emerging risks from AI and quantum computing and as the risk environment continues to evolve.

The appropriate management of high-impact operational risks by critical firms and FMIs is essential for system-wide operational resilience. Therefore, the FPC welcomes work by microprudential regulators to continue to strengthen the regulatory framework for operational resilience.

In line with the heightened risk environment, microprudential regulators including the Bank, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) have continued to strengthen the regulatory framework for operational resilience.

In November 2024, the Bank, PRA and FCA published final policy and rules for Critical Third Parties (CTPs), as well as information on how they will approach CTP oversight. The overall objective of the oversight regime for CTPs is to manage risks to the stability of, or confidence in, the UK financial system that may arise due to a failure in, or disruption to, the services that a CTP provides to regulated firms and FMIs. While no designations have been made to date, preparations are advancing and HM Treasury officials are in the process of gathering the necessary evidence to support decision making on designation. The authorities remain committed to delivering it successfully.

Recent actions taken by the Bank and PRA are set out in the Bank of England’s supervision of financial market infrastructures Annual Report 2025 and the PRA Annual Report 2024/25, as well as the Thematic findings from the 2024 Cyber Stress Test. Since these were published, authorities have continued to engage with firms and FMIs, and published effective practices observed across systemic firms and financial market infrastructures, highlighting the continued evolution of their cyber response and recovery capabilities.

The FPC welcomes these actions. Given the potential severity of operational disruptions, investing in resilience to severe but plausible operational risks, including developing cyber incident response playbooks and testing responses to operational events, provides a net benefit to firms and FMIs as well as their customers. When critical firms, FMIs, third parties, and the wider financial system are resilient, the risk of threats to vital services can be reduced. Firms and FMIs will also be able to respond to and absorb shocks, limiting their transmission across the financial system and to the real economy.

In taking steps to build resilience, firms and FMIs should recognise the role they play in supporting confidence in the financial system, and how disruption to vital services could negatively affect saving, investment and economic growth. For example, FMIs are required to take account of risks to UK financial stability when identifying their important business services – as set out in a recent speech by Sasha Mills – as are some of the largest firms. To support this, the Thematic findings from the 2024 Cyber Stress Test provides tools to facilitate discussion of financial stability issues between subject matter experts from a range of disciplines, as well as illustrative examples of mitigation actions firms and FMIs can take.

Boards of firms and FMIs should work with authorities to use the findings of sector-wide exercises and stress tests such as SIMEX and the Cyber and Operational Resilience Stress Test to improve their understanding of actions they can take to mitigate impacts on financial stability. Given the interconnected nature of the global financial system, the FPC supports further international engagement on operational resilience.

The resilience of individual firms and FMIs alone may not be sufficient to ensure system-wide resilience: some additional vulnerabilities exist at the level of the system. As set out in the FPC’s macroprudential approach to operational resilience, macro vulnerabilities in the financial system arise from structural features, interconnections, concentration, common dependencies, and correlated behaviours, which can amplify operational disruptions and create systemic risks beyond those faced by individual firms or infrastructures.

The Bank continues actively to test resilience to these macro vulnerabilities and transmission channels, including through scenario analysis. For example, staff have conducted a scenario exercise exploring the impacts of a cyberattack on a hypothetical third-party technology provider in core UK markets during a period of financial stress. This demonstrated that cyberattacks have the potential to accelerate and amplify impacts on market confidence, exacerbating risk aversion and liquidity challenges. In the scenario, cross-authority and cross-industry initiatives such as the Authorities’ Response Framework and Sector Response Framework, and guidance on disconnection/reconnection acted as mitigants to the stress’ severity and duration. This emphasises the importance of cross-industry collaboration for building financial system-level operational resilience – as recently highlighted in a speech by Liz Oakes.

System-wide resilience is also supported by cross-industry scenario exercises and stress tests. For example, the Cross Market Operational Resilience Group (CMORG) consists of wholesale and retail banks, FMIs, insurers, authorities and the NCSC, and enables firms to share expertise and build co-ordinated strategies to minimise the impact that incidents can have. CMORG’s programme of sector-wide exercises such as SIMEX allows firms and authorities to prepare for operational disruption by improving collective understanding of how firm-level responses to a given scenario, when taken together, shape outcomes at the market or system level. Similarly, the FPC intends that future Cyber and Operational Resilience Stress Tests (CORSTs) continue to support firms' and FMIs’ understanding of their role as systemic risk managers and the actions they can take to mitigate impacts on financial stability.

Boards of firms and FMIs should use these exercises alongside findings from their own operational resilience testing, sector exercising, and lessons from real incidents to inform their understanding of their role in the wider financial system and so their approach to operational resilience. For example, the Thematic findings from the 2024 Cyber Stress Test highlighted that it is important for FMIs to work with the sector to ensure their members understand the complexity and implications of disconnection and reconnection and can make informed, risk-based decisions which reflect the financial stability implications of these impacts. Boards may also use published effective practices to support conversations about operational resilience including whether firms or FMIs have clear plans for restoring critical data from back-ups following a cyberattack, including whether they can rebuild critical applications and core infrastructure, or how they will fail over to a separate environment. Further, because cyberdefence can be challenging and costly for smaller firms (Box A), Boards, firms and FMIs should consider the appropriate level of assurance that their material third parties – which may be smaller firms – are sufficiently resilient to operational risks.

Given the interconnected nature of the global financial system, the impact of operational incidents in one jurisdiction can quickly spill over into another. The FPC supports the UK financial authorities’ continued engagement internationally through a range of multilateral and bilateral channels such as via the Financial Stability Board and the G7 Cyber Expert Group. The G7 Cyber Expert Group recently issued a statement on artificial intelligence and cybersecurity, encouraging jurisdictions to monitor ongoing developments, promote public-private-academic collaboration, and proactively address the emerging and evolving cybersecurity risks AI may pose. The FPC encourages further multilateral international work to build resilience to operational risks which may affect global financial stability including via globally systemically important markets.

Although it is not a substitute for building appropriate resilience, the availability of appropriate cyberinsurance may mitigate material financial impacts arising from cyber risks, including outages and ransomware attacks.

Several major incidents within the UK this year have demonstrated that cyberincidents can result in material financial as well as operational impacts, particularly where a supply chain is impacted. Although it is not a substitute for building appropriate resilience, cyberinsurance can provide vital financial risk transfer for losses arising from cyberattacks and non-malicious incidents, such as outages. This can include losses sustained due to business interruption, as well as the costs incurred from responding to and recovering from an attack or incident. The availability of appropriate cyberinsurance may act as a financial safety net during incident response and recovery. And guidance by the NCSC suggests that the support cyberinsurers provide to improve policyholders’ operational resilience may aid businesses – in this case firms and FMIs – in responding and recovering during an incident.

Insurance coverage for cyber risks is currently low. According to Munich Re, less than 5% and possibly as little as 1% of cyber risks are currently insured. And only 7% of UK businesses surveyed by the Department for Science, Innovation and Technology (DSIT) had a specific cyber security insurance policy in 2025, although 45% reported being insured against cyber security risks in some way. This low insurance coverage can be driven by a range of factors. On the supply side, factors may include limited appetite from insurers and reinsurers given cyber is complex to model as a systemic and human-driven risk, which evolves as technology and the geopolitical risk environment change. On the demand side, factors include limited awareness of product availability, and difficulties with affordability. For example, a 2025 DSIT report found that for UK small and medium businesses, insurance may be unaffordable, especially for firms with limited security budgets. This relates to broader difficulties small businesses face in building operational resilience – particularly the high technology cost of building and maintaining resilience against cyberthreats (Box A).

As part of wider efforts to improve resilience to cyber risks, there is an opportunity for greater collaboration between insurers and other financial firms to increase the visibility of financial impacts arising from cyber risks and the role of insurance risk transfer. Such collaboration can enable informed decision-making around risk, including where risks are not being insured. This includes where risks may ultimately be insured by governments which often act either explicitly or implicitly as insurers of last resort.

7.2: Developments in unbacked cryptoasset and stablecoin markets

The FPC recognises that DLT and tokenisation have the potential to change how the financial system operates. DLT enables the creation of common shared ledgers which can be updated near-simultaneously across all parties in a financial transaction, while tokenisation enables financial assets to be digitally represented (‘tokenised’) on such shared ledgers and settled near-instantaneously. A range of digital assets utilise this technology, including but not limited to, unbacked crypto, stablecoins, and tokenised deposits and other tokenised assets backed by traditional instruments such as bonds and equities.

These technologies and their associated digital assets could reduce frictions and inefficiencies through 24/7 operations and near-instant settlement, as well as by reducing the number of financial intermediaries and the cost of post-trade processing. Tokenisation of assets and money, combined with smart contracts, allows for greater programmability and fractionalisation of assets, deepening existing markets, potentially unlocking new ones, and changing how capital assets are mobilised within the financial system.

However, without proactive intervention by central banks, there is a risk that the private sector adopts DLT in a way that delivers outcomes that undermine financial stability. Widespread adoption of public permissionless platforms for core functions could result in systemic vulnerabilities if the appropriate governance, risk management, and assurances for settlement finality are not in place to manage these risks. It is therefore important that the efficiency gains offered by this technology are not achieved at the expense of the resilience of the financial system. The Bank is actively engaging on DLT adoption by the private and public sectors and intervening where necessary to support its responsible adoption.

The FPC welcomes work by the Bank to propose a regulatory regime for sterling-denominated systemic stablecoins.

The development of new financial products such as stablecoins and tokenised deposits present both opportunities and risks to the UK financial system. The FPC recognises the transformative potential of technology associated with stablecoins and the importance of ensuring that the public can have the same trust in new forms of money as they do in existing ones. It also notes the potential for growth in funding directly from financial markets and NBFIs to support the provision of credit to UK household and businesses, even if deposits move from the banking system to stablecoins. The FPC therefore takes action to support the responsible adoption of innovative technology by the financial sector, in line with its secondary objective (Section 1 and Box A).

In the UK, the Bank and FCA are developing regimes for systemic and non-systemic stablecoins to ensure appropriate resilience. Other jurisdictions, including the US, are also in the process of designing and finalising their regimes. The FCA consulted on their regime earlier this year, aimed at supporting the sustainable, long-term growth of crypto in the UK while delivering appropriate levels of market integrity and consumer protection.^{footnote [35]} In addition, the Bank has recently published a consultation paper on its proposed regulatory regime for sterling-denominated systemic stablecoins, and an accompanying Financial Stability Paper which sets out the role of holding limits for sterling-denominated systemic stablecoins and a potential digital pound. The FPC welcomes this work, recognising both the transformative potential of technology associated with stablecoins and that there is a risk of reduced lending to businesses and households as the economy adjusts to these new forms of money.

The FPC will also continue to monitor the interactions between stablecoins (including systemic stablecoins) and the wider financial system. Uptake of new stablecoin instruments in the UK could have consequences for other systemically important parts of the financial system. For example:

• Increased demand by stablecoin issuers for the short-dated government debt securities that back the stablecoins they issue could affect the structure and dynamics of that market. Similarly, asset liquidations by stablecoin issuers could have spillover effects on these markets.
• The widespread adoption of stablecoins for retail payments could result in bank disintermediation. This could arise in the transition to steady state – as digital money gains traction, deposits could migrate out of the banking system – with potential consequences for banks’ provision of credit (both the quantity and terms) to the real economy. It could also happen in stress scenarios – for example, by providing another form of perceived ‘safe haven’ for depositors. This could amplify an initial stress, with potential implications for credit availability and resilience.

The Bank’s proposed regime considers potential policy tools to mitigate these risks.

The FPC also supports international efforts to manage the risks posed by stablecoins. These include the FSB’s recommendations on the regulation, supervision and oversight of global stablecoin arrangements, and guidance by the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions. The FPC also supports further international work to understand potential risks from the issuance of multi-jurisdictional stablecoins and how best authorities can mitigate and manage them, including through co-operation in day-to-day supervision and at times of market stress.

The FPC are continuing to monitor developments in the unbacked cryptoasset sector and its interconnectedness with the financial sector and the real economy.

Although DLT has promising potential to increase efficiency and reduce costs in financial markets, unbacked cryptoassets establish no claim on future income streams or collateral, meaning they have no intrinsic value. As set out in the April 2025 FPC Record, they have continued to grow in size and in interconnectedness with the financial system in recent years. For example, total global assets under management in crypto-based exchange traded funds have increased from $40 billion in 2022 to $190 billion in 2024.

Financial firms’ activity in these markets has in part been limited by regulatory uncertainty: for example, global standards on the regulatory approach to banks’ exposures are yet to be implemented. These standards aim to support bank resilience and financial stability. The implementation of regulatory frameworks around unbacked cryptoassets will provide clarity, and could in turn accelerate their adoption, including by banks who play a key role in providing vital services to the real economy.

The FPC will continue to monitor developments in the unbacked cryptoasset sector and its interconnectedness with the financial sector and the real economy.

7.3: Climate-related risks

Climate-related risks to financial stability are becoming more proximate.

In the November 2024 Financial Stability Report, the FPC set out a framework to help identify and assess climate-related risks to UK financial stability. Given the significant uncertainty around the magnitude of future climate-related financial losses and how soon they could crystallise, the FPC committed to further monitoring of climate-related risks and emphasised the importance of scenario analysis, including in the context of stress testing. This was also highlighted in the 2024 and 2025 Remit and recommendations for the Financial Policy Committee.

As set out in a recent speech by Sarah Breeden, there is increasing evidence that climate-related risks could materialise within the time horizons the FPC typically considers. This section considers risks to asset prices and credit quality which could – in a severe but plausible scenario – impact financial stability within the next five years, as well as risks to insurance coverage which are likely to develop over a longer time horizon.

If investors were to reprice financial assets rapidly to reflect climate-related risks, staff estimate that the resulting move in asset prices could be comparable to those moves seen in recent market stress episodes.

Previous Bank work has highlighted that climate-related risks are only partially priced into the value of corporate and sovereign bonds. As set out in Sarah Breeden’s speech, climate-related risks could pose challenges to financial stability in the near term if investors suddenly priced in the costs of transitioning to net zero or the increase in physical risks resulting from persistently high emissions – known as a ‘Climate Minsky Moment’.

Financial assets prices could be affected if investors priced in the expected impacts of physical and transition risk-focused scenarios on corporate and government debt sustainability, as well as the related macroeconomic impacts which could include higher inflation, interest rates, and risk premia.^{footnote [36]} In the transition risk-focused scenario, higher inflation associated with higher carbon prices and other climate policies leads central banks to raise policy rates, pushing down on the price of both corporate and government debt. Higher carbon prices also increase corporate credit risks due to higher costs and lower expected revenues for businesses. In the physical risk-focused scenario, losses are driven by the increased frequency and severity of extreme weather events as global temperatures rise, which would have a severe negative impact on GDP and corporate earnings.

Staff estimates are based on the severe but plausible assumption that markets fully price in one of these two illustrative scenarios within a short period. But it is of course not possible precisely to estimate the likelihood of these scenarios occurring, nor the likelihood that a rapid repricing might occur.

If investors were to price the future impacts of these scenarios into today’s asset prices, the resulting move in asset prices could be comparable to those moves seen in recent market stress episodes (Chart 7.1). For example, a severe macro shock associated with transition risks could lead to a 16% fall in government bond prices. This effect would be larger for countries with a longer-dated maturity profile, shifting more of the interest rate risk from governments to investors.^{footnote [37]} The physical risk-focused scenario leads to a smaller fall in government bond prices of around 8%, largely because there is limited interest rate risk in the scenario used – even though the negative GDP impact of the physical risk-focused scenario is much larger than in the transition risk-focused scenario.

Chart 7.1: If investors were to reprice financial assets rapidly to reflect climate-related risks, the resulting move in asset prices could be comparable to those moves seen in recent market stress episodes

Per cent fall in asset prices relative to baseline under a ‘Net Zero 2050’ and ‘Current Policies’ scenario ^{(a) (b) (c) (d)}

• Sources: Bloomberg Finance L.P., MSCI ESG Research LLC, NGFS Phase V Scenario Explorer, Refinitiv Eikon from LSEG, World Bank and Bank calculations.
• (a) The physical risk scenario is based on the NGFS ‘Current Policies’ scenario. The transition risk scenario is based on the NGFS ‘Net Zero 2050’ scenario. The estimates are based on pricing in the impacts of both scenarios out to 2050. These scenarios are subject to considerable uncertainty not reflected in this chart, and do not capture mechanisms such as environmental tipping points, compound risks, or social impacts such as migration. These mechanisms mean the impact of increases in global temperatures may be underestimated. The estimates of GDP losses associated with physical risk in NGFS scenarios are calibrated based on recent academic research, some of which has been subject to post-publication critique arguing risks are overestimated and is undergoing further peer review. ↩ ↩
• (b) ‘Global sovereign bonds’ is a portfolio of long-dated sovereign bonds of G7 countries. ‘UK corporate bonds’ are the stock of all corporate bonds issued by UK corporates, or those with a UK-based parent. ‘UK equities’ is the constituents of the FTSE All-Share index. ↩ ↩
• (c) The largest historical 10-day fall is the largest 10-day fall in the benchmark index since January 1998. Sovereign bonds are benchmarked against the historical performance of the Bloomberg 10+ Year Total Return Index Value Unhedged, in USD. The benchmark portfolio has a shorter average maturity than the modelled sovereign bond portfolio. UK corporate bonds are benchmarked against the historical performance of the ICE BofA Sterling Corporate High Yield and Investment Grade indexes. UK equities are benchmarked against the historical performance of the FTSE All-Share index. ↩ ↩
• (d) Error bars reflect the 10th and 90th percentile impacts within the relevant portfolio under each scenario. ↩ ↩

Corporate bond and equity prices could also fall as these scenarios are priced in, with UK corporate bond prices falling by 12% and the FTSE All-Share index falling in value by around 24% under the transition risk scenario. These impacts would be particularly large for firms in sectors such as mining and oil and gas, which could be particularly affected by higher carbon prices and other climate policies (Chart 7.2). For example, corporate bonds issued by firms in the transport and mining and quarrying sectors could fall in value by as much as 60% as investors price in lower cash flows and higher costs related to transition policies. By contrast, firms in less energy-intensive sectors such as arts and entertainment and food and accommodation would see smaller falls in bond prices. The scenario would likely benefit other corporates with transition aligned business plans, including those which are not currently listed, or which have not issued corporate bonds.

Chart 7.2: Falls in asset prices related to transition risks would be largest in sectors particularly affected by higher carbon prices and other climate policies

Per cent fall in corporate bond prices under a ‘Net Zero 2050’ scenario, by sector ^{(a) (b)}

• Sources: Bloomberg Finance L.P., MSCI ESG Research LLC, NGFS Phase V Scenario Explorer, Refinitiv Eikon from LSEG and Bank calculations.
• (a) The transition risk scenario is based on the NGFS ‘Net Zero 2050’ scenario. These scenarios are subject to considerable uncertainty not reflected in this chart, and do not capture mechanisms such as environmental tipping points, compound risks, or social impacts such as migration. The physical risk estimates in NGFS scenarios are calibrated based on recent academic research, some of which has been subject to post-publication critique and is undergoing further peer review. ↩ ↩
• (b) Bars reflect weighted average falls of corporate bonds issued by UK corporates or corporates with a UK parent. Error bars reflect the 10th and 90th percentile impacts within the relevant sectors. Price falls shown in this chart capture increases in credit risk and impacts of interest rate paths in the scenario. Price falls are capped at 60%. ↩ ↩

The financial stability impacts of this repricing, and the scale of losses borne by banks and NBFIs, would depend on the speed of adjustment. If the repricing were sudden – such as over the course of 10 days – it could be amplified by the responses of financial market participants, in line with the findings of the Bank’s 2024 system-wide exploratory scenario exercise. For example, institutional investors could be required to sell corporate bonds if they were downgraded from investment grade to high yield or be forced to sell assets to meet liquidity needs from redemptions or margin calls on leveraged exposures. Such actions could increase the corporate bond price impact of the transition-focused scenario by around 4 percentage points.

These scenarios would increase borrowing costs for governments and businesses globally – and as such intensify pressures on sovereign bond markets (Section 2). Unless accompanied by other sources of stress, they would be unlikely to materially disrupt the provision of vital services to UK households and businesses. The likelihood of such a shock materialising could be mitigated if risk managers take actions early to understand and price their exposure to climate-related risks.

In addition, UK banks could face climate-related credit losses over coming years, particularly related to transition risks from sharp increases in energy and carbon prices.

As well as market risks from sudden asset repricing, firms could also face climate-related credit losses on their lending to households and businesses. The Bank’s Climate Biennial Exploratory Scenario, published in 2022, showed that UK banks could face material credit losses from their exposures to physical and transition risks, but there was substantial uncertainty around the magnitude of these risks.

A recent data collection by the Bank and the PRA shows the presence of climate risks in major UK banks’ current wholesale and residential real estate exposures would lead to financial losses. Major UK banks provide substantial financing to agriculture-related activities, transportation including manufacture, and real estate.^{footnote [38]} These climate-sensitive sectors account for close to 23% of major UK banks’ wholesale credit exposures, as measured by risk-weighted assets. And around 13% of major UK banks’ lending to businesses and financial institutions is to sectors currently covered by Emissions Trading Schemes (ETSs). These businesses are vulnerable to increases in carbon prices, which can occur as a result of government policy, but also in response to increases in gas prices. Therefore, they are more highly exposed to transition-related cost headwinds which could adversely affect their ability to repay their debts.

Similarly, around half of banks’ high loan to value (LTV) mortgage lending is to properties with Energy Performance Certificate (EPC) bands D or below. Banks could face losses on their lending secured on buy-to-let properties as an EPC rating of ‘C’ or above could become a minimum requirement for rentability as early as 2028. Further, households in less energy efficient properties are more exposed to sharp increases in energy prices, potentially affecting their ability to repay their mortgage debts. In aggregate, banks’ exposures to losses from physical risks in the residential real estate portfolio appears to be more limited: only 5% of high-LTV mortgage exposures are estimated to be at severe but plausible risk of a flood event. Losses to banks from flooding are also mitigated by the high availability of flood insurance, including due to the presence of Flood Re (more information below).

The credit quality of UK banks’ lending is typically strong. Most UK mortgages have an LTV ratio below 70%, and the FPC’s loan to income (LTI) flow limit provides protection against the UK household sector becoming overly indebted. Further, most bank lending to corporates is investment grade, and ETS allowances mitigate the impact of transition risks on some corporate borrowers. Taken together, these factors would mitigate the impact of any crystallisation of transition risks on banks’ expected losses from these asset classes.

That said, the materiality of banks’ exposures to climate-vulnerable counterparties underscores the need for such risks to be incorporated into banks’ risk assessments and management capabilities, as set out in the PRA’s consultation paper on climate-related risks. This would advance the PRA’s primary objective to promote the safety and soundness of the firms that it regulates and would contribute to the resilience of the UK banking system as a whole. In improving the resilience of the financial system to climate-related risks, these improvements could also lead to a more stable medium-term growth path for the UK economy.

Climate-related risks to household and corporate lending may result in credit losses for banks within a five-year horizon. Bank staff will use the data collected to conduct further analysis on the materiality of transition and physical risks in banks’ commercial real estate lending and trading books, as well as to inform whether and how such risks should be captured in future Bank Capital Stress Tests.

As physical risks from climate change continue to increase over the longer term, lower insurance coverage could transfer risks to households, businesses, banks and governments. Supporting insurability through investments in resilience to physical risks from climate change would be beneficial to UK financial stability.

As set out in the November 2024 Financial Stability Report, the shorter-term financial impact of flooding on households is likely to be limited due to strong flood insurance coverage and affordability relative to other countries. This is in part due to Flood Re – a joint reinsurance initiative between the Government and the insurance industry, which promotes the affordability and availability of insurance for households at high risk of flooding.^{footnote [39]} Credit risks to banks from physical hazards are also currently mitigated by high insurance coverage.

But recent estimates by the Environment Agency suggest that the number of households at risk of flooding could increase from 6.3 million in 2024 to 8 million by 2050. Further, Flood Re is due to end in 2039 and has a statutory objective to manage the insurance market’s transition to a post-Flood Re pricing model. Taken together, these changes could lead to decreases in insurance coverage due to insurers withdrawing from certain regions, or pricing becoming unaffordable for households. This could pose financial stability risks in the long term by negatively affecting:

• Households – through lower house prices due to uninsurability and the costs of repair from physical damages as well as difficulty remortgaging a property if there is a lack of available insurance.
• Businesses – through the destruction of physical goods, capital and infrastructure, as mentioned in a recent speech by James Talbot.
• Economic growth – through the direct impact of floods on consumption and inflation, and the indirect effects of lower insurance coverage on investment.
• Banks – through higher losses on lending to households and businesses affected by flooding. This impact would be particularly large on lower-quality or higher-physical risk portfolios.
• Governments – through the potential need to act as implicit or explicit insurers of last resort more frequently, including to support the economy during periods of stress caused by extreme weather events. The associated added strains on fiscal pressures that this would imply could further weigh on sovereign debt markets (Section 2).

All of these effects could impact the ability of the financial sector to provide financial services UK households and businesses.

Investment in physical resilience and actions to enhance financial resilience could be beneficial to UK financial stability by supporting insurability as physical risks increase. For example, collaboration between businesses, households and governments to facilitate investment in physical resilience – such as the Flood Re Build Back Better scheme – may reduce the financial impacts of extreme weather events. Updates to planning rules and building regulations could further mitigate the impact of increased physical hazards on UK households and businesses.

These risks also present an opportunity for collaboration between insurers, reinsurers and banks to develop innovative financial products to promote the pooling of risks and increase financial resilience – as recently highlighted by the Climate Financial Risk Forum. Actions to improve firms’ climate-related modelling capabilities – such as those mentioned in the PRA’s consultation paper on climate-related risks – should improve their ability to price and manage risks. As with operational resilience, a collaborative approach between authorities and the UK financial sector is essential to ensure resilience to climate-related risks, which is a prerequisite for sustainable economic growth.