Bank of England warns on credit crisis

[Thursday]

From the FT

The UK financial system “remains vulnerable” to new shocks from the global credit squeeze, the Bank of England will warn on Thursday, in an unexpectedly severe assessment of risks still facing banks and financial institutions.

The Bank picks out the commercial property sector, where prices are already falling, for being “particularly prone to further shocks and to rises in the cost of finance”.

There has never been a banking crisis in the UK, such as the one that led to the downfall of Northern Rock last month, without a simultaneous commercial property crisis.

In its latest twice-yearly financial stability review, the Bank adds that equities are also vulnerable to a possible economic slowdown and warns the US dollar might fall sharply “if the change in investor sentiment towards US securities experienced recently were to persist”.

These new concerns, in addition to the credit squeeze, have led the Bank to raise “significantly” its assessment of the chances of a serious increase in the price of credit. Should its fears prove well-founded, it thinks the impact on the economy will be more severe than it would have been six months ago, “given the current fragility of confidence and the continued tightness in wholesale funding markets”.

The report also reveals that the Bank is willing to reconsider its handling of the Northern Rock crisis. In place of the dogged insistence of Mervyn King, the governor, that the blame for the affair lay elsewhere, there is a tentative acknowledgement that the Bank also has some lessons to learn.

A new commitment to “consider carefully” its lending arrangements in the event of a new crisis is included in the report and the Bank also shows some new thinking on the workings of the tripartite arrangements between itself, the Financial Services Authority and the Treasury. While it still thinks it should not take banking supervision back under its wing, the Bank believes it should gather more information about individual banks’ financial circumstances in future to help mitigate a crisis.

The Bank also remains to be convinced by the US “superfund” to prevent a fire sale of assets from banks’ structured investment vehicles. It would support a scheme that established genuine market prices for the asset-backed securities that such a fund would hold but thinks that it would be a bad idea for the so-called Super-SIV to be used to prop-up unjustifiable valuations of assets. The financial stability report makes it clear the Bank does not believe the credit squeeze to be over, since it expects defaults in US subprime mortgages to continue rising; some more ratings downgrades in asset-backed commercial paper; and higher interest rates for risky borrowers in the UK.

But the big new risk it highlights is in commercial real estate where “a sizeable development pipeline has raised the potential for future overcapacity”. Banks’ exposure to commercial property has reached 9 per cent of outstanding loans, more than the previous peak in 1989-90, the report says.

The Bank says the vulnerability to new shocks depends to a large extent on whether banks rein back lending or act as if business has gone back to normal.

The former has worse short-term consequences but would help to reprice risk, while the latter risks a repeat of this summer’s crisis “potentially on an even larger scale”. [Emphasis added.]

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