Bank warns of increased risks to the UK's financial system

By Jane Padgham

Published: 26 April 2007

The Bank of England issued a stark warning today that the dangers surrounding the UK's financial system have risen over the past nine months. It said benign economic conditions had made banks complacent about risk-taking, some companies were loading themselves up with worryingly high levels of debt, complex credit derivatives were untested in times of turbulence and some debt-laden households were showing "signs of stress". It said the recent US sub-prime mortgage crisis was a salutary reminder of how credit risk assessment can go disastrously wrong, and how participants can be hit by sharp reductions in market liquidity.

In its twice-yearly Financial Stability Report, the Bank said the financial system remained "highly resilient". But it urged banks to be alert to the growing risks and take them into account. It singled out the corporate bond market and its associated derivatives market, which has exploded in size in recent years, as particularly vulnerable.

The six key danger areas identified by the report are: unusually low premia for bearing risk, especially in credit markets; high and rising leverage in parts of the corporate sector; rising systemic importance of large complex financial institutions, ie. the big investment banks and securities houses; dependence of UK financial institutions on market infrastructures and utilities, for example the smooth running of the London Stock Exchange and the BACS clearing system; large financial imbalances among the major economies; high UK household sector indebtedness.

Sir John Gieve, the Bank's deputy governor for financial stability, said: "Financial markets have continued to be vibrant, core institutions are highly profitable and the economic outlook is favourable. But risk-taking is increasing, including through higher leverage, lower margin requirements and relaxation of covenants. The rapid growth in credit risk transfer markets [such as collateralised debt obligations] is also making more participants dependent on continuous market liquidity and could amplify the impact of shocks like a sharp reversal in credit spreads from their current low levels."

Sir John, a member of the Bank's Monetary Policy Committee, said there were few signs that America's sub-prime mortgage crisis would cross the Atlantic. He also played down fears that rising insolvencies and home repossessions could spark a housing crash and undermine financial stability. "We watch the housing market at the MPC every month and there are some signs of easing off," he said. "I don't see this [rising household debt] as likely to precipitate a financial crisis."