Bank of England: the financial system has been significantly more stable over the past six months

The Bank of England is today, October 18, publishing its bi-annual Financial Stability Report (PDF, 74 pages). The Report provides the Bank’s current assessment of conditions affecting financial stability and discusses ways to strengthen the financial system in the future.

Inter alia, the Report identifies that the financial system has been significantly more stable over the past six months.

This was underpinned by the authorities’ sustained support for the banking system and monetary policy measures.

Low risk-free interest rates and reduced uncertainty have led to a rebound in a range of asset prices.

Primary issuance in many capital markets has resumed, reducing financing risks for some borrowers.

The market rally has boosted bank profits, lowered concerns about potential future losses, and has enabled banks to raise further external capital.

Banks have also been able to issue unguaranteed term debt, helping them to reduce their reliance on short-term funding.

At the same time, the Report notes that after such a prolonged period of exuberance earlier in the decade, it is inevitable that some banks around the world have overstretched balance sheets. They will take time to adjust, and in the meantime remain vulnerable to the risk of less rapid than expected economic recovery.

Around the world, a number of borrowers, including in the commercial property sector, have large refinancing needs in the coming years. And while funding costs remain low, there is some risk of market participants accumulating excessively risky positions, which could unwind abruptly when yield curves eventually rise.

Over time, and consistent with maintaining lending into the real economy, many banks will need to reduce leverage further, extend the maturity of their funding and refinance substantial amounts of funding as official sector support is withdrawn.

While their profitability is relatively buoyant and market conditions broadly favourable, banks should take opportunities to strengthen their balance sheets, including by not distributing an excessive amount of profit. That will reduce the risk of disruption to the flow of credit in the future.

In relation to safeguarding financial stability in the future, the Report says that, in the medium term, the root causes of this and previous systemic crises must be tackled – excessive risk-taking in the upswing of the credit cycle and insufficient resilience in the subsequent downturn.

It also says that: An expectation that ‘too important to fail’ firms will receive public assistance, and that unsecured, unsecured wholesale creditors will not share losses, has exacerbated both the boom and the bust.

That calls for a robust, multi-faceted policy response. Regulatory policies should give greater emphasis to systemic risks across the cycle and across institutions, as set out in a recent Bank discussion paper (The role of macroprudential policy, November 2009). They should be complemented by structural measures to contain the spread of risk across the system. And because failures of financial institutions cannot and should not be prevented, the resolution framework will need to be extended to limit the impact on the wider economy.

Technically demanding but interesting read, huh!