LONDON (MNI) – The resilience of UK banks has improved over the
past year, helping them cope with the fallout from the recent Irish
crisis, the Bank of England warns today in its latest Financial
Stability Review.

“In this environment it is important that resilience among UK banks
has improved over the past year, including progress on refinancing debt
and on raising capital buffers”.

But it warns that the UK financial system can only be “partially
insulated” given the “interconnectedness” of EU banking systems.

While contagion effects on the largest EU financial systems has
been “limited”, the BOE states, it warns that “intensification of these
concerns” would pose a risk to financial stability.

UK banks’ holdings of sovereign debt issued by peripheral euro zone
states are “relatively small”, the report states, but total claims
on these economies, including lending to households and businesses, are
larger, it notes.

“Losses on such lending could increase were heightened sovereign
concerns to be accompanied by weakening economic conditions. Credit risk
could also be amplified by the interconnectedness of European banking
systems. UK banks have claims of almost stg300 billion on France and
Germany, whose banking systems are more heavily exposed to the most
affected economies”.

The report points to more concrete risk scenarios which could
unfold if the present contagion were to persist:

“Non-bank financial institutions – such as prime US money market
mutual funds which provide around US$1.3 trillion of funding to banks
globally – could stop rolling over dollar funding to UK and other
European banks…”

And another –

“A broadening of sovereign concerns might also directly restrict
the provision of financial services to the UK economy. Foreign-owned
lenders, which account for around a third of outstanding bank lending to
UK businesses, might restrict lending most in their non-core markets”.

While the BOE notes that recently bond yields have started to
increase – led by concerns over the US fiscal position and inflation –
they remain around historical lows and are therefore susceptible to a
sharp reversal. The latter could be prompted by a “broadening of
concerns about sovereign risk” or by a “further repricing of medium-term
inflation risk,” the bank says.

The current low bond yields have encouraged a search for yield into
some emerging markets, leading to overheating in some Asian and Latin
American economies. But this new search for yield has been “asset
specific and not generalised”, the BOE says.

The BOE also warns that any ‘snap-back’ in yields could also expose
‘latent distress’ among some overextended borrowers in the household and
corporate sectors, the BOE warns.

On the regulatory reform agenda, the BOE continues to lay stress on
a “gradual transition by banks to greater resilience by retaining
earnings, avoiding rapid adjustment via tightening credit conditions”.

“From a system-wide perspective, a desirable adjustment path to
tighter prudential standards would be for banks to build capital by
retaining earnings. That is why authorities internationally
agreed the extended transition to tighter standards; they should
maintain this commitment”.

The BOE urges bank boards to exercise restraint in distributing
profits to shareholders and staff.

“Distributions to staff in a form such as contingent capital or
subordinated debt would boost loss-absorbency, at the same time as
better aligning risk incentives,” the report says.

–London newsroom: 44207 862 7492; email:

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