Bank of England Governor Mervyn King stood firm against bailing out struggling banks on Wednesday, but hinted that interest rates had reached their peak as he made his first comments since the credit crisis swept global markets.
King said that the mispricing of risk in the financial system, rather than the state of the world economy, was the source of ongoing market problems.
"If risk continues to be underpriced, the next period of turmoil will be on an even bigger scale," he said in written testimony to the British Parliament's Treasury Committee.
However, King said that the financial crisis sparked by the U.S. subprime mortgage market collapse "should not threaten our long-run economic stability" -- as long as the bank maintained its hardline approach.
He rejected calls to provide banks with more longer-term cash to reduce borrowing costs, which have soared amid fears of depleting credit liquidity.
"The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior," said King. "That encourages excessive risk-taking, and sows the seeds of a future financial crisis."
The Bank of England has been more reluctant than its counterparts in Europe, the United States and Asia to provide funds to support financial markets.
While the European Central Bank has injected 253.5 billion euros ($352 billion) in the past several weeks, the British central bank made no move until last week when it offered to pump an extra 4.4 billion pounds ($8.9 billion; 6.4 billion euros) into the banking system to ease high short-term borrowing costs. The ECB on Tuesday drained 60 billion euros ($82.7 billion) from money markets to absorb excess liquidity.
King said there were moral hazards inherent in providing retrospective insurance to those who had engaged in risky or reckless lending.
"The provision of large liquidity facilities penalizes those financial institutions that sat out the dance, encourages herd behavior and increases the intensity of future crises," King said.
Shrinking credit levels started with rising defaults in U.S. subprime mortgages, or home loans made to people with weak credit histories. The crisis has spread because banks have repackaged risky loans with the more reliable, and sold them to a wide range of investors, including several European banks.
In Britain, the key three-month interbank lending rate, or LIBOR, now sits at 6.9% -- more than a full percentage point above the 5.75% base rate and just above the Bank of England's emergency lending rate of 6.75% -- as banks grow increasingly wary of lending to rivals and becoming more exposed to the crisis.
King also indicated that the current crisis could rule out further interest rate rises.
He noted that the sharp increase in borrowing costs over the past month was likely to have a knock-on effect on consumer demand -- the bank's own figures showed Tuesday that lenders are starting to pass on those costs to their customers by raising mortgage rates.
"If, in the wake of a shock to the financial system, the terms on which the financial system extends credit to the private sector become less favorable, then borrowing and overall demand would weaken," he said. "Other things being equal, that would lower the inflation outlook."
He added that rates could be "adjusted quickly when necessary," raising the possibility of a cut if the crisis deepens.
"The committee is monitoring credit conditions intensively," he said. "It's too soon to tell how persistent and how large any change in credit conditions for household and corporate borrowers will prove to be."