London (MNI) – The current environment is “exceptionally
threatening” with UK banks having significant exposure to the euro
area’s major banking systems, the Bank of England’s Financial Policy
Committee says.

The FPC says with heightened concerns over sovereign debt and banks
and a deterioration in the growth outlook “short-term risks to financial
stability have risen sharply over the past six months,” and there is a
danger weaker banks will not be able to meet their financing needs.

If banks become defensive and rein in lending “this could depress
economic activity and aggravate credit risk that to data have been
contained by forbearance,” the FPC says in the December Financial
Stability Report.

The FPC says while UK banks’ exposure to the sovereign debt of the
most vulnerable economies, the euro area peripherals, is limited they
have greater exposure to those countries’ private sectors and to the
larger euro area banking system. The FPC urges UK banks to strengthen
their balance sheets without cutting back on real economy lending.

While UK banks’ “direct exposures to the sovereign debt of the most
vulnerable economies are limited, they have larger exposures to the
private sectors of some weaker euro area economies. They also have
significant exposures to major European banking systems, which in turn
are highly exposed to weaker euro area countries,” the FPC says.

The report says medium term risks stem from the persistent problems
over relative competitiveness in the euro area, with the peripheral
countries unable to tackle their weaknesses.

The FPC also warns that “the financial crisis could have a
sustained impact on investors’ risk appetite, hindering a recovery in
asset prices and growth” and this would hit banks’ profits “limiting
their capacity to build capital buffers and maintain lending to the real
economy.”

The FPC urges banks to raise external capital if they can’t bolster
their balance sheets through their own earnings.

“Given the current exceptionally threatening environment, the
Committee recommends that, if earnings are insufficient to build capital
levels further, banks should limit distributions and give serious
consideration to raising external capital in coming months,” the FPC
says.

It notes UK banks have substantial refinancing needs at present and
should make their balance sheets more resilient “without exacerbating
market fragility or reducing lending to the real economy.”

While UK banks had made progress since the height of the financial
crisis on improving capital and funding resilience “progress has been
set back recently and they have been affected by strains internationally
in bank funding markets.”

The FPC notes that UK bank credit default swap premia have risen,
reflecting concerns over UK bank solvency. It warns that a high degree
of intra-financial system exposure is amplifying the problems caused by
current strains.

The FPC also says UK banks should disclose their leverage ratios as
part of their regular reporting by the start of 2013 at latest.

The FPC said market participants have “increasingly questioned the
reliability of current regulatory measures of capital adequacy” and this
is adding to concerns over their counterparts’ creditworthiness.

The FPC recommendations were agreed at the committee’s November 23
meeting.

With the BOE getting the lead role in UK financial regulation and
financial stability, the FPC was set up to mirror the work the Monetary
Policy Committee does on the monetary side. It is headed by BOE Governor
Mervyn King.

–London newsroom: tel+44 207 862 7491; email: drobinson@marketnews.com

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