Low rates may slow banks' balance sheet clean-up

BASEL, Switzerland (Reuters) - Low official interest rates may slow banks' progress towards cleaning up balance sheets and make the financial sector vulnerable when monetary policy is tightened, the Bank for International Settlements said on Monday.

In its annual report, the BIS said major economies' very low or even negative interest rates once adjusted for inflation were pushing up longer-term rates and boosting bank earnings.

Low rates also encouraged banks to allow borrowers to roll over non-viable loans, as happened in Japan in the 1990s, allowing borrowers to keep up very low interest payments and avoiding banks having to write off bad loans.

"The currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets," the report said.

"Central banks' commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency."

U.S. banks are forecast to total about $885 billion (588 billion pounds) in writedowns and losses as a result of the financial crisis and Europe's banks are seen losing nearly $1.3 trillion in the 2007-10 period, according to International Monetary Fund forecasts in May.

The BIS said an unexpected rise in policy rates could trigger a rise in yields and a fall in prices, making it harder for banks to roll over short-term debt, and cause "serious repercussions" in the banking sector.

Central banks in major industrialised economies are keeping rates at record lows and the U.S. Federal Reserve promised last week to keep rates ultra-low for an extended period.

Low rates also give governments little incentive to cut debt, as borrowing short-term is very cheap, and can prompt a potentially destabilising influx of capital and carry trades in emerging market countries with higher interest rates.

The rapid recovery in global stocks and house prices in many countries since spring 2009 may reflect the build-up of another asset bubble similar to that which led to the financial crisis, the BIS warned.

(Reporting by Krista Hughes; Editing by Toby Chopra)