LONDON (Reuters) - Banks look in better shape than six months ago but are still vulnerable to economic shocks, the Bank of England said on Friday as it set out a raft of proposals to toughen up financial regulation.
Banks are finding it slightly easier to raise money and have benefited from rising asset prices over the past three months, but are still heavily indebted and lack secure long-term funding, the Bank said in its twice-yearly Financial Stability Report.
“Banks in the United Kingdom and internationally will remain sensitive to further shocks for some time. And 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 said.
The Bank also set out in detail its call for global action against banks currently deemed too big to be allowed to fail — just days before the government is expected to publish regulatory proposals on which Bank Governor Mervyn King pointedly noted on Wednesday that he had not yet been consulted on.
“Regulators should ensure that banks’ resilience is commensurate with the costs that failure could impose on the financial system as a whole. This would mark a step change from the current approach, which has been largely orientated towards protecting depositors,” the report said.
Britain’s once-vaunted financial regulation has lost its shine since financial malaise which started in the U.S. housing sector spread across the Atlantic and required multibillion pound government bailouts of leading banks late last year.
In terms of the immediate health of banks, the Bank said they were vulnerable to falls in asset prices — with commercial property being a key area of concern alongside the generally higher rate of loan defaults in a recession.
The arrears rate on residential mortgages was expected to more than double from 1.3 percent in the first three months of 2009 to just under 3 percent by mid-2011, though the Bank said it expected government aid to homeowners would limit the ultimate cost to banks.
Further afield, banks were exposed to potential losses in emerging markets, particularly in central and eastern Europe via their links to euro zone banks.
Turmoil overseas or a sovereign debt rating downgrade could also push up investors’ risk aversion, making it once again harder for banks to get funding.
Moreover, banks needed to start making plans to raise finance for when they would have to repay government aid in 2011 and 2012, and ultimately boost reserves to make themselves less reliant on government in a future crisis, the Bank said.
Repeated public-sector bailouts of the financial system would not be sustainable, as ultimately they would push up the government’s own financing costs and thereby those for banks, the Bank warned banks.
For the first time the Bank also made public the results of its survey of financial markets’ own worries.
Compared with last year, the economic downturn and funding pressures remained high on the agenda, while worries of borrower defaults and regulatory changes and replaced property prices and the failure of other financial institutions as top concerns.
REGULATING FOR SELF-RELIANCE
Reducing banks’ reliance on the state in the event of a crisis was the main theme for the Bank’s recommendations for supervisory reform.
Banks should have to hold higher levels of capital — consisting of shareholder funds — especially during apparently good times when default rates looked low.
Those that were essential to the financial system would have to hold extra-high capital reserves, and all financial institutions should hold higher liquidity reserves made up of government bonds.
Ratings agencies’ judgements should no longer be allowed to substitute for banks’ internal risk assessments, and banks had to make it easier for regulators to disentangle their businesses if they got into a mess.
Steps towards this last goal would include limiting the number of legal entities — currently numbering in the thousands — that make up some banks and forcing banks to draw up plans of how they would wind down their business if needed.
“To control risk-taking, banks need to face a credible risk of closure,” the Bank said. “The current size and structure of financial systems may be incompatible with maintaining financial stability and containing calls on public resources.”
The Bank said regulators should consider limiting key banks’ businesses to low-risk areas or to require even higher capital reserves to compensate for opaque businesses.
All this would require international cooperation — as too would tackling the global trade and savings imbalances that had helped fuel the boom that had led to the current crisis.
“Ideally, mechanisms should be found to impose symmetric obligations on countries that run persistent current account surpluses and deficits — a problem identified but not solved at the Bretton Woods conference in 1944,” the Bank said.
Reporting by David Milliken; Editing by Victoria Main