LONDON Bank of England Governor Mervyn King warned on Tuesday that investors appeared to be making worryingly risky bets at a time when Britain's economy was weak and its banks had not yet recovered from the financial crisis.
Speaking before a committee of British legislators, King also said Britain's banks would have to raise large amounts of capital as fines for rigging the Libor benchmark and compensation to investors for mis-sold loan insurance, hit reserves.
"The economy is operating well below full capacity, the banking system is in a stretched position and we are clearly struggling to find instruments to ensure an economic recovery," King told the committee.
"A combination of a weak recovery, and ... people searching for yield in ways that suggest that risk isn't fully priced (in), is a disturbing position. It's one that we will have to monitor very carefully," he continued.
British share prices have rallied to near their highest level since early 2008, bolstered by an easing in the euro zone debt crisis and a U.S. budget deal.
But King said the dangers were not over, despite European Central Bank efforts and a deal on bank supervision. Figures earlier on Tuesday showed that Germany's economy shrank at the end of 2012, and Britain's is forecast to do the same.
"The actions of the ECB have been successful in calming markets and in buying time. What it can't do, because no central bank can do this, is to resolve the underlying real challenges. And in that sense, banking union is certainly not a magic answer," King said.
He was presenting his latest assessment of the health of Britain's financial system, and he and his colleagues repeated warnings that British banks needed to raise more capital and may have underestimated future fines for bad behaviour.
He also condemned as "depressing" plans by U.S. investment bank Goldman Sachs (GS.N) to enable its staff to avoid Britain's temporary 50 percent rate of income tax.
From April the central bank's Financial Policy Committee (FPC), which King chairs, will have powers to force banks to increase their cushions against future losses - something many banks and analysts say would be costly and of little benefit.
The committee expects regulators to report back by March on how much capital banks need to raise in the short term, and on Monday it set out details of how it would curb booms in bank lending in future.
At the same time, the central bank is trying to encourage banks to increase lending to home buyers and businesses through its Funding for Lending Scheme (FLS) and resolve a more immediate source of weakness in the British economy.
Andrew Bailey, a Bank official who is also a top regulator at the Financial Services Authority, said the FLS appeared to have increased mortgage availability, but that the jury was still out on how much it would increase net lending.
Another FPC member, Michael Cohrs, forecast that the body would face strong criticism from banks, politicians and the public as soon as it acted to curb lending.
"If the party ever gets started again and we try and take the punch bowl away there will be a huge row, and only if we are seen as being highly accountable ... will it be acceptable to you and your constituents," Cohrs told legislators.
King made it clear that Britain's banks would have to raise large amounts of capital as fines for rigging the Libor benchmark, compensation for mis-selling loan insurance and a rethink of how banks tot up risks, hurt reserves.
Royal Bank of Scotland (RBS.L), majority owned by the UK government, is braced for fines of between 400 million and 500 million pounds for Libor rigging as soon as next week, sources told Reuters on Tuesday.
"The real threat to taxpayers comes from banks that are inadequately capitalised," King said. "There is a prima facie case for believing the problem is sufficiently big ... for action to be required."
Legislators pressed FPC members to give an estimate of how much capital would be needed, but they all said it would be premature to do so.
"We do think there is a shortfall of capital in the system. It's a big number," Cohrs told the committee.
The FSA's Bailey said restructuring and more capital would be needed before the government could sell its stakes in RBS and Lloyds (LLOY.L).
"If you want to sell the government shareholding, you have to sell it in an institution that has a balance sheet and business model that has a stable future," Bailey said.
(Additional reporting by Olesya Dmitracova, Patrick Graham and Brenda Goh; Editing by Susan Fenton)