Bank of England Says Financial System Vulnerable to More Shocks

June 26 — The Bank of England said financial institutions’ losses from the crisis have left them vulnerable to another wave of shocks, including the risk that the economy will stay mired in recession.

“Given their leverage and funding positions, banks in the United Kingdom and internationally will remain sensitive to further shocks for some time,” the central bank said today in London. “If economic recovery were to stall as a result of weak bank lending, losses on assets could rise, further affecting confidence in the banking sector.”

The bank’s biannual financial stability risk assessment follows Governor Mervyn King’s comments that banking problems may make the economy’s escape from recession a “long, hard, slog.” The report today also makes suggestions on regulation changes including greater capital buffers for institutions days before the Treasury unveils its own proposals for a revamp.

“Banks’ balance sheets remain sensitive to any setbacks in recovery in financial markets or real activity,” the bank said. “The economic downturn is still perceived by market participants as the highest risk to financial stability.”

Only 15 percent of banks said they are “very confident” in the financial system’s stability in the next three years, compared with 36 percent in July 2008, a survey of 34 institutions in the report showed. They cited an economic slump and borrower defaults as the biggest risks. Responses were collected from April 27 to May 15.

Bank Losses

U.K. banks’ loan book losses have now reached almost 400 billion pounds ($654 billion), the bank said, without giving a forecast. The European Central Bank said last week that lenders in the 16-nation euro region may lose a further $283 billion by the end of next year.

“While pressures on the major global banks have stabilized over the past few months, their balance sheets remain impaired,” the Bank of England said. “Rising household and corporate distress, and continuing falls in property prices, raise the possibility of further asset impairment.”

More losses risk adding further pressure to banks’ profitability and capital ratios, the bank said.

“Future revenue generation will need to balance the desire to de-leverage with the need to generate new business at profitable spreads,” the bank said in its report.

The global financial system is also vulnerable to shocks from lenders repatriating their financing in foreign countries, the report said. U.K. banks had to weather the withdrawal of about $100 billion of deposits to Russia in the fourth quarter.

Payout Liability

In the “highly unlikely event” that the British government had to pay out on all emergency guarantees and insurance facilities offered to banks, the total liability would be $2.1 trillion, or 88 percent of gross domestic product, the BOE said. That compares with 73 percent in the U.S. and 18 percent in the euro area.

The Bank of England, suggesting changes to financial regulation, said lenders should be required to provide their own insurance from shocks by building up capital buffers with common equity and liquidity buffers with high-quality government bonds. It said they also need plans to obtain funding in times of stress and to wind down their operations in case of failure.

Banks should also boost disclosure of the value of the assets they own and give more details of their stress test and sensitivity analyses, the central bank said.

“Greater resilience will need to be based on a variety of measures,” Paul Tucker, deputy governor for financial stability at the bank, said in a statement. “The policy debate now under way matters enormously if we are to achieve a more stable financial system in the future.”

Global Regulation

The report urged international regulators to cooperate more closely to manage risks posed by global financial institutions, whose cross-border claims have almost doubled in the past decade. Regulators must ensure they can monitor such firms while preventing them from becoming too big or complex, the bank said.

The bank still expressed a note of optimism that the slump may have past its worst after the U.K. economy contracted 1.9 percent in the first quarter, the most since 1979. Banks’ funding conditions are improving as capital markets reopen and interest rates fall, the report said.

“In recent months, market conditions have improved and there are signs that the pace of decline in gross domestic product is easing,” the bank said. “Some markets that had been effectively closed to all but the strongest institutions appear to be reopening.”


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