Tuesday, October 28, 2008

BoE Financial Stability Report: Further instability possible

(FT) Britain’s financial system faces the possibility of further instability, with the health of insurers and hedge funds among the current areas of concern, the Bank of England warned on Tuesday.

In its twice-yearly Financial Stability Report, the Bank talked not only of significant risks remaining for the banking system – in spite of the £50bn bail-out that in recent weeks has shown signs of bringing some stability – but it also highlighted other potential worries.

Describing the instability in the global financial system as “the most severe in living memory”, Sir John Gieve, deputy governor for financial stability, said: “With a global economic downturn under way, the financial system remains under strain.”

Looking beyond the banks to other risks, the report said: “One risk is that leveraged investors, like hedge funds, may be forced to liquidate asset holdings due to tight credit conditions.”

It added that hedge funds have recently faced “additional funding pressures due to redemption requests and a risk is that these could increase”.

Meanwhile, insurance companies, while not overleveraged, offered other potential problems, not least if their investments fell below capital adequacy rules. Another risk would be credit ratings agencies downgrading insurance companies, which would undermine their liquidity because counterparties to any derivative trade would demand more collateral or higher charges.

The picture painted by the report is a far cry from that just six months ago, when recent events were portrayed as unlikely ever to occur.

Meanwhile, the report also warned that in the long term, banks must cut back their lending sharply and that recent infusions of government money are only a temporary measure aimed at making that process easier.

“For example, even after accounting for recently announced capital-raisings, which the UK government will help underwrite, the largest UK banks would need to shed around one-sixth of total assets to reduce leverage back to, say, 2003 levels,” the report said.

That implies a significant reduction in lending to homes and businesses, which could have painful effects on the wider economy. If banks try to do that within the next year, it will result in a sharp contraction of credit, the report showed.

Sir John called for a “fundamental rethink” of how regulators deal with risks in the global financial system and talked about the need to restrict banks’ ability to increase lending.

The report said the fragile state of banking worldwide is a reflection of the fact that neither regulators nor banks themselves understood fully the “potent interconnections between firms in the global financial system”.

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