Bank of England warns of risks to property and stock markets

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The world's financial system remains "vulnerable" to new shocks, with shares, commercial property and parts of the residential housing sector especially exposed, according to the Bank of England.

In its Financial Stability Report, published today, the Bank has joined the chorus of calls for improvements in the UK's regulatory regime, stating that "the authorities need to strengthen their crisis management arrangements" after the Northern Rock debacle, especially the "stigma" that attaches to banks approaching the Bank of England for help. This may make their position more precarious and a panic more severe if it is seen as an admission of failure.

More broadly, the Bank also identifies "underdeveloped practical arrangements for managing stress at an international institution".

On the outlook for the real economy, the Bank cautions that "a period of tighter credit conditions, especially for high-risk borrowers, should be expected".

As banks are building up their liquid assets to insure themselves against losses in their so-called special investment vehicles, or SIVs, and to insulate themselves from other risks, so less money will be available to credit markets. Thus the squeeze is set to continue, albeit not necessarily to the same degree and with market interest rates perhaps lower than recent peaks. Equity prices are seen as vulnerable to further downgrades on economic growth, and the weak US dollar is an another cause for concern for the Bank.

According to the Bank, there is a "tail of vulnerable UK households" who will find themselves hard pushed to get credit as the banks tighten lending criteria. "This tail includes 'adverse credit' households, recent first-time buyers and some buy-to-let investors" where "buy-to-let yields continue to be squeezed, with rental growth remaining weak and net rental yields remain negative. Recent investors are relying on continued house price appreciation to earn positive returns".

A renewed squeeze "could expose fragilities among a small, but growing, cohort of more vulnerable borrowers, such as UK 'sub-prime' borrowers and highly leveraged companies, including those that have been the subject of recent buyouts". That weakness in turn indicates a "potential underpricing of, and underprovision for, household sector credit risk" on the part of banks and building societies.

The Bank has not explicitly endorsed suggestions from the IMF and elsewhere that UK property is overpriced, but muses that "anecdotal evidence suggests first-time buyers are now feeling priced out of the market, which suggests that an important source of housing demand may drop out of the market", and notes the exposure of some investors to foreign property, which has passed its peak.

On commercial property, however, the Bank does raise the alarm: "Problems could mount in the commercial real-estate sector where price inflation has weakened and a sizeable development pipeline has raised the potential for future overcapacity", a situation made worse by the high value of property relative to rents, on a 20-year high.

Although the Financial Stability Report did not mention the so-called super SIV, organised by Citigroup and other US banks to deal with their off-balance sheet vehicles, the usefulness of this new conduit will crucially depend on precisely what assets the new SIV will buy and at what price. In any case, the Bank sees a return to the position before the credit crunch as "undesirable" and wants the banks to be more robust and transparent. "The structure of institutions' balance sheets and, in particular, their funding is more fragile than previously... Losses will need to be distributed and disclosed across the financial system."

Northern Rock : What lessons need to be learnt?

The Bank of England is keen to defend its record, turn the debate to the future and sound as optimistic as possible in its Financial Stability Report.

"Action and the continuing strong capital position of the UK banking system should anchor confidence as risk is repriced," it says.

The Bank stresses that "most of the individual ingredients of recent stress in the UK financial sector had been highlighted in advance, including by the Bank... But few had predicted that these ingredients would combine in such a way and with such force".

This is the Bank's agenda for reform:

* Liquidity: Northern Rock highlighted the lack of regulatory attention to liquidity (as opposed to capital adequacy). Northern Rock's business model saw the funding of its activities swung radically away from retail deposits to the wholesale money markets: "Enhanced stress testing is the key tool" to deal with this.

* Valuation of complex instruments: The bank urges investors to place less "mechanical" reliance on what credit agencies tell them about securities.

* Crisis management: The Bank wants a special insolvency procedure for banks to keep them running in a crisis, and to counter "the danger that support from the central bank may stigmatise a bank and reinforce a loss of confidence rather than allay it".

* International: How would the authorities globally deal with a problem at a vastlylarger global investment bank than Northern Rock? This is "apriority for the Financial Stability Forumand EU authorities".