BoE Says Banks Are Overstating Losses

Britain's banks may be exaggerating losses due to the current crisis. Bank of England officials warn that could restrict lending and worsen the economy

Britain's banks are overstating losses from the turmoil in the credit markets and the sub-prime lending debacle, the Bank of England says.

Despite frequent official pleas for "transparency" and for the banks to reveal the full scale of potential losses, the practice of "marking to market"—trying to attach a value to unmarketable securities—is creating its own problems, says the Bank. It poses risks to the economy because banks have, as a result of huge writedowns, restricted lending, worsened the credit crunch and held back economic growth and the housing market, creating a vicious circle.

Even so, the Bank cautiously suggests that the cheapness of some mortgage-backed assets, the US Federal Reserve's bold action over Bear Stearns and the Bank's own £50bn Special Liquidity Scheme are beginning to restore confidence in the credit markets, although risks to financial stability remain "high".

The Bank also warns: "Tighter credit conditions mean some rise in financial distress among vulnerable borrowers can be expected, including parts of the commercial real estate sector, some leveraged non-financial companies and some high-risk households... Many high-risk borrowers may find they are unable to refinance expiring fixed-rate mortgage deals... This will result in a jump in their average effective mortgage rate of around 2.5 percentage points." Around 1.4 million borrowers will be affected in this way this year—if they succeed in getting a loan as house prices fall, with a 1 per cent year-on-year fall revealed by Nationwide yesterday.

Some £12bn has been written down by UK banks during the crisis but, in its latest Financial Stability Report, the Bank says that may be too high. "Prices in some credit markets are now likely to overstate the losses that will ultimately be felt by the financial system," it says. The Bank estimates that depressed market prices for sub-prime mortgage-backed securities imply a default rate of 76 per cent, with a loss to the banks of 50 per cent of the loan, both unprecedented. The Bank's analysis would mean a recovery in these prices, as bargain hunters come to swoop on undervalued securities, with a resulting easing in the credit crisis in the coming months.

The Bank's deputy governor for financial stability, Sir John Gieve, said: "The unavoidable correction after the credit boom is proving protracted and difficult. However, the pricing of risk in credit markets seems to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals. So, while there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months."

Yesterday, in evidence to the Treasury Select Committee, the Governor of the Bank, Mervyn King, said "the approach of mark to market is actually a sensible one. Of course, if there is no market and no prices there needs to be something you can use as a substitute... but to go back to something else would be a retrograde step. Where banks have made progress is to be as open as possible about those losses. After all, all the losses we have seen don't correspond to cash losses... It's quite conceivable that in a year's time these prices will have risen, in which case banks will be marking to market and showing significant profits again".

The Bank suggests that the Basel II international banking framework and accounting rules such as marking-to-market should be reviewed to see if they are "pro-cyclical"—that is to ensure they don't encourage reckless lending in booms and artificially restrict credit during downturns.

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