LONDON The Bank of England warned banks and borrowers on Wednesday they may be vulnerable if there is an abrupt rise in global interest rates which could require lenders to bolster their capital cushions again.
Global bond yields have jumped since U.S. Federal Reserve Chairman Ben Bernanke said last week that the U.S. central bank may start to scale back bond purchases later this year.
"The violence of the adjustment over the past fortnight underlined the extent of the search for yield over the past months and the need for the authorities ... to pin down whether or not there are any vulnerable links in the financial system that could jeopardise stability," The Bank Deputy Governor Paul Tucker told reporters.
The Bank ordered an investigation into the vulnerability of Britain's financial institutions and a "cohort" of borrowers to higher interest rates, and the findings would be given to its new risk watchdog, the Financial Policy Committee, by September.
"Financial institutions and markets are also vulnerable to an abrupt rise in global interest rates. And some UK borrowers remain highly indebted, which could result in losses for UK banks," the FPC said in a half-yearly report on Britain's banking system.
"Capital can provide some protection from interest rate risks," it said.
As well as causing loans to go sour, higher interest rates could bump up banks' own borrowing costs, the FPC said, adding that around 40 percent of banks' assets would have to be immediately revalued if rates rose abruptly.
The Bank itself is a long way from tightening monetary policy. Tucker reiterated comments made by outgoing Governor Mervyn King on Tuesday that an interest rate hike was not imminent, saying it would only occur once the British economy had reached "escape velocity."
Indeed, a minority of the Bank of England's rate-setters, including King, have been pushing for more bond-buying due to the weak state of Britain's economy.
Jaime Caruana, general manager of the Bank for International Settlements, a forum for central bankers, said banks should prepare themselves for interest rate risks, market volatility and drops in asset prices.
"If they prepare themselves then, when the time comes, the normalisation process would be smoother and easier," he said.
Also on Wednesday, the British central bank said banks could scale back some of the short-term cash they hold against shocks to encourage more lending to the economy, a change which could release as much as 70 billion pounds in new credit depending on demand, Tucker said.
The 11-member FPC gained legal powers to set capital requirements for banks in April after operating on an interim basis for the previous two years.
Just a week ago it ordered five banks to raise 13 billion pounds ($20 billion) of extra capital.
Privately, bankers complain that higher capital requirements and limits on leverage are hampering their ability to lend, an argument which has been strongly disputed by the Bank.
In its report on Wednesday, the FPC said it saw no contradiction between its calls for higher capital and finance minister George Osborne's request that it heed the impact of its actions on short-term economic growth.
King steps down as governor at the end of this week and will be replaced by former Canadian central bank chief Mark Carney, who many economists expect to advocate a long-term commitment to low interest rates as a way to keep down bond yields.
The FPC said there will be an annual stress test of banks starting in 2014 and it will issue a discussion paper later this year on what test results will be published each time.
The FPC fleshed out on Wednesday how far banks can go in scaling back their cash-like buffers to free up money that can be lent to the economy.
Banks already hold amounts that exceed the new global Basel rules and the FPC said the buffers can be reduced to 80 percent of the Basel minimum until January 2015, and then rise back to full compliance by January 2018.
Separately, the FPC requested the central bank's Prudential Regulation Authority, Britain's day-to-day banking supervisor, to report by the final quarter on whether banks should be forced to use a standard model for totting up their risky assets.
Banks use bespoke models to quantify the risks which in turn determine the size of their capital buffers but some FPC members worry banks are underestimating risks.
(Additional reporting by Matt Scuffham and Clare Hutchison, Editing by Jeremy Gaunt.)