Credit, Financial Conditions, and the Quiet Tightening in the UK
Deniz Cicek
Introduction
The past three years have given us the most aggressive monetary tightening cycle in the UK since the early 1980s. This is seen by the contractionary policies of The Bank of England (BoE), increasing the Bank Rate from near the zero lower bound in 2021 to as high as 5.25% mid-2024. Despite this tightening, GDP growth has not seen a significant decrease. However, the UK has been going through what can be a ‘silent credit crunch,’ a gradual but meaningful tightening in credit availability. Different parts of the economy have been impacted differently as well. Lending volumes have declined and standards have become stricter across 2023-24, according to British Business Bank.
This article examines how monetary policy and financial markets influence the growth of UK bank credit. Using quarterly data on policy rate changes and FTSE 100 returns, I establish quantitative methods to estimate an empirical model that underlines how asset-price movements interact with monetary tightening. These results shine light upon the tightening in the credit being persistent but quiet.
Economic Framework
When trying to understand the relation between monetary policy and credit, there are two main arguments that can be used. First, the bank lending channel explained by Bernanke and Blinder in 1988; and the financial accelerator developed by Bernanke and Gertler in 1989.
The bank lending channel emphasises the effect of tightening monetary policy on the supply of credit. This is by the increase in the policy rate increasing banks’ funding costs and lowering their willingness to lend. This mechanism’s most significant evidence comes from analyses on bank-dependent borrowers like SMEs. Though I will attempt to incorporate the ideas put forward in this framework, it will not be the biggest focus.
The financial accelerator tells us how changes in asset prices affect balance sheets of borrowers. A decrease in asset prices lead to falls in net worth and value of collateral, rises in risk premia, and most importantly a contraction in credit supply that is more than proportional. Due to better availability of data and wider applicability of the financial accelerator, it will be this article’s focus. I claim that the credit crunch is more ‘silent’ than abrupt, therefore, a connecting relationship between policy rate and credit is likely. Asset prices may prove to be a fitting connector given the accelerator’s significance in the model.
Data and Methodology
The empirical approach examines how monetary policy and financial conditions jointly influence bank credit growth in the UK.
I use data covering the post-Global Financial Crisis recovery, 2015, until 2025. The dependent variable is the quarterly credit growth rate of banks to non-financial institutions. I use quarterly measures to be in line with analysis of financial markets and aim to capture bank credit using data provided by BoE. Then, I use the change in Bank Rate (ι) and FTSE All Share returns (rFTSE) to capture monetary policy and financial conditions. The policy rate being the central bank’s main instrument, and FTSE returns giving a comprehensive representation of equity markets, they prove to be fitting proxies for monetary policy and asset prices. While the inclusion of the policy rate allows the traditional bank lending channel to be tested, the structure of the regression is designed more towards capturing the nonlinear balance sheets effects highlighted by Bernanke and Gertler, as well as Kiyotaki and Moore. Capturing the nonlinear effects using a quadratic rFTSE proved sensible after seeing its substantial impact on specification seen in the Ramsey RESET Test. I finally add an interaction term between ι and rFTSE. I use an OLS estimation, and the diagnostic tests confirm that the nonlinear model is statistically well-behaved. To be specific, I ran the Breusch-Pagan test for heteroskedasticity, the Breusch-Godfrey test for autocorrelation, Jarque-Bera test for normality of residuals, VIF for multicollinearity and the RESET test for misspecification. Details can be found in the appendix.
Results and Discussion
The regression results provide evidence that the tightening of UK credit conditions since 2015 has been driven mainly by financial market dynamics rather than the direct changes in the Bank Rate. Though the coefficient on ι is negative (-0.0057), it is also statistically insignificant (p=0.258). This indicates that monetary tightening does not explain much of the variation in credit growth directly once the nonlinear effect of financial conditions are controlled for. This seems to be consistent with the post-crisis banking environment in the UK where banks have been liquid and well-capitalised, therefore, rate changes do not directly translate to problems in loan supply.
Nonlinear financial conditions look both economically and statistically strong. The squared FTSE term’s size, sign and significance (0.8553, p<0.001) imply a strong convex relationship between market performance and credit growth. So, sharp declines in equity prices have disproportionate negative effects on credit supply, whereas moderate or positive returns have a lesser impact. The interaction term (-0.1448, p=0.066, significant at the 10% level) further suggests that policy rate hikes have the biggest influence when markets are weak.
Figure 1 - Nonlinear (Quadratic) FTSE Effect on Credit Growth
This implies that the effect of monetary policy is transmitted indirectly, through worsening balance sheets and higher risk premia. This matches well with the financial accelerator framework.
These dynamics explain why the UK has been going through a silent credit crunch and not an abrupt one. There hasn’t been insolvency or liquidity issues with banks but lending growth slows as asset prices fall, amplifying the effects of higher rates. For many firms, tighter credit standards and weaker collateral values together make bank financing harder to obtain. We observe this in the regression as the effects of asset-price movements on bank credit growth. This environment has quietly created the need of alternatives for said firms, especially SMEs as they are more bank-dependent. That alternative seems to be the private credit sector so far. The rise of the sector may bring a reconfiguration of credit markets in high-rate and risk-sensitive periods. More on this later.
Figure 2 - Actual vs Fitted Credit Growth (R2 = 0.549)
Conclusion
This analysis shows that the tightening of UK credit conditions in the past few years has been through a more subtle interaction of monetary policy and financial markets rather than a direct collapse in bank lending similar to the Global Financial Crisis. Although changes in the policy rate alone do not explain much of the variation in credit growth, the nonlinear effects of FTSE returns show that falling asset prices have a major weakening effect on borrower balance sheets and they amplify the impact of higher rates. This combination gives us a silent credit crunch, a gradual but real squeeze. This pattern also helps explain the growing role of private credit providers who step in more and more when traditional banks do not meet the demands of firms during periods characterised by financial stress. Understanding these indirect channels is essential in explaining credit dynamics in the current environment.
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