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Financial System at Risk of Further Shocks, BoE Says

The trouble in financial markets is not over yet and stocks, commercial property and credit markets in the rich world could suffer a further hit, the Bank of England said on Thursday.

The ferocity with which the crisis took hold was a shock and the authorities need to beef up their management arrangements in the wake of the Northern Rock debacle, Britain's first bank run in more than a century, the central bank said in its twice-yearly Financial Stability Report.

Things are starting to look better, the BoE said, and the strength of the British economy and banking sector should help the financial system ride out the current storm, but further shocks are possible whether at home or abroad.

"In the short run, the financial system in the advanced economies remains vulnerable to further adjustments, whether in the credit markets ... or, for example, in the equity or commercial property markets."

Equity markets are trading near multi-year highs, although the FTSE-100 index ended Wednesday's session down 0.5 percent at 6,482.

The BoE said that while there had been signs of recovery, returning to earlier conditions of under-priced risk would, in any case, be undesirable.

"A period of tighter credit conditions, especially for higher-risk borrowers, should be expected," it said. First-time home buyers were also finding it difficult to enter the property market, potentially removing a key source of housing demand.

Hard Lessons

The BoE has taken a lot of flak in recent weeks over its reluctance to pump cheap cash into the money markets to relieve a squeeze on interbank lending rates -- which is what led to problems for Northern Rock.

BoE Deputy Governor for Financial Stability John Gieve said all parties concerned had much to learn from the episode.

"Some important lessons need to be learned by both financial institutions and authorities on liquidity risk management, valuation of complex instruments, disclosures of risk positions and on crisis management," Gieve said.

On liquidity risks, the report said financial firms needed to plan better for the possibility of a prolonged shutdown in markets, while reglators should ensure that banks had sufficient contingency funds to cover a liquidity shock.

Britain's tripartite supervision authorities, made up of the BoE, Treasury and Financial Services Authority must also look into improving the way they work together to handle crises.

The central bank noted the stigma attached to any commercial bank seen having to borrow from it and said it would "consider carefully" the design of its lending facilities in times of stress to maximise the chances of these being effective.

It was news the BoE provided emergency funding to Northern Rock that triggered the run on the bank. And subsequent offers of 3-month cash loans fell flat, probably because banks feared that bidding for money would be taken as a sign they were in difficulty.

The report also recommended amending the insolvency arrangements for banks and improving the guarantees provided to savers.

And it said more transparency was needed in the composition and valuation of structured products and banks' exposures to off balance sheet vehicles.