The Bank of England said lenders are vulnerable to an abrupt increase in long-term interest rates as it warned confidence in the financial system remains fragile.
The central bank today ordered a review of banks’ exposure to interest-rate risk, which it said is not properly understood. The review will be carried out by the Prudential Regulation Authority, which will report back in September.
Global central banks have cut interest rates to record lows and pumped money into their economies to boost growth. Federal Reserve Chairman Ben S. Bernanke said this month that the U.S. central bank may begin tapering its stimulus program later this year, prompting declines in global stock markets as investors speculated the Fed may raise rates faster than they assumed.
“The violence of the adjustment over the past fortnight underlines the extent of the search for yield and the need for authorities to pin down whether or not there are any vulnerable links,” Paul Tucker, the Bank of England’s deputy governor for financial stability, told reporters in London today. It shows the fragility of markets to “relatively minor” changes in expectations, he said. “In that sense, it’s an amber light.”
The extended period of low interest rates may have led some financial-market participants to become exposed to big increases in interest rates, according to the report. Some investors may also be demanding insufficient compensation for bearing risk, the central bank added, noting reports from some of its contacts that some insurance companies were considering buying residential properties as they sought higher yields.
U.K. households remain “highly indebted” and there is a need to assess the “vulnerability of borrowers and financial institutions to sharp upward movements in interest rates and credit spreads,” the central bank said.
“It’s of course sensible for all households to look ahead and think about what may go wrong” if interest rates rise, Tucker said today. “We as an institution are trying and will bring about an economic recovery.”
In its recommendations published today, the BOE’s Financial Policy Committee said that liquid asset buffers held by U.K. lenders to protect against a credit crunch are above minimum requirements and they have space to reduce holdings by about 70 billion pounds. The Basel Committee on Banking Supervision recommends a liquidity coverage ratio of 100 percent by January 2018 and U.K. banks already meet this, the BOE said.
The central bank, which introduced a program last year to boost lending, said the impact of looser liquidity requirements on credit is uncertain. “But by removing possible impediments to an expansion of credit supply, the committee intends to give the banking system more flexibility to lend,” it said.
In another recommendation, the BOE called for a test of banks’ readiness to deal with a cyber attack on their computer systems. It said that market participants “have increasingly highlighted concerns about operational risk” from hackers.
The BOE said it will assess how banks calculate regulatory capital requirements based on risk models.
The regulator also released for the first time its initial estimate from November that banks could be overstating capital by as much as 80 billion pounds ($123 billion), a figure that was later reduced as banks provided more data on provisioning. Capital could have been depleted by as much as 40 billion pounds from unrecognized expected losses, 20 billion pounds from conduct-related costs and 20 billion pounds from “an imprudent” approach to risk-weighting, the BOE said.
“In the interests of avoiding unnecessary market uncertainty, the committee decided not to include these initial estimates in the record of its November 2012 meeting,” the BOE said today. The regulator said last week that British banks will need to make up an aggregate shortfall of about 13 billion pounds by the end of the year.
The BOE said that part of the fragility of the financial system relates to “a weak and uneven global recovery and imbalances in the euro area.”
Data today showed French gross domestic product fell 0.2 percent in the first quarter, confirming an earlier estimate. Household consumption and capital investment both declined. Elsewhere, South Korea’s manufacturers’ confidence fell to its lowest since March, Singapore’s annual industrial production growth slowed in May, while Thailand’s customs exports dropped.
The U.S. Commerce Department will release its third estimate of first-quarter economic growth later today.