A sudden drop in house prices and slump in consumer spending poses the greatest threat to the UK economy and stability of its banking system, the Bank of England warned yesterday.
In its twice-yearly review of the risk to financial stability, the Bank said a sudden shift in behaviour might leave it powerless to act to prevent a wider shock.
Overall, the Bank said fears over credit risks had subsided as the outlook for the global economy grew, but it said dangers were still lurking.
Andrew Large, deputy governor in charge of financial stability, said that in countries such as the UK where debt had surged relative to incomes, households' expectations of future income growth and ability to meet debt payments might turn out to be optimistic.
"There are households who are much more vulnerable than average to any rises in debt service payments," he said.
The report, the Financial Stability Review (FSR), warned there was a risk households would suddenly decide to save rather than spend.
"That would have adverse consequences for aggregate demand, to the extent that policymakers were not able to anticipate and counteract the rise quickly enough," it said.
"In such a scenario the credit risks facing lenders would be likely to increase across the board rather than just in relation to their household exposures."
It said there was particular danger from the housing market, where mortgage equity withdrawal - loans to fund spending rather than house purchase - had surged.
"If house prices were to increase less rapidly than households expect, or even fall, thus eroding housing equity, that might trigger a sharp adjustment in spending," it said.
The latest figures from the Bank showed households borrowed a record £10.7bn in both September and October to take the total stock of debt to £916bn, just shy of the annual output of the whole economy.
The report said the surge in debt had left households more vulnerable to an unexpected drop in income or rise in interest rates. The Bank's monetary policy committee has signalled it will move cautiously in raising rates following November's increase, which was the first in almost four years.
The FSR noted there had been a "significant build-up" in hedge fund activity in the past six months, although without any identifiable problems at this stage. It warned there was a danger to financial stability from a more substantial drop in the dollar, but said: "Assessing the risk of a major realignment is difficult."
PROBLEM DEBT 'UNDER CONTROL'
The number of households struggling to cope with debt has not risen despite the record surge in borrowing, the Bank of England said yesterday.
A snapshot survey of around 2,000 adults commissioned by the Bank found that average levels of non-housing debt - overdrafts, loans and plastic - had hardly changed over the past three years.
In October the average unsecured debt was £3,516, close to 2000 levels, and had risen markedly only among those in the highest income group.
Only 6 per cent of those in the lowest income group had outstanding debts compared with a third of the wealthiest.
The share of individuals reporting debt to be a burden was at 42 per cent compared with an average of 39 per cent between 1995 and 2001.
"The rapid growth of unsecured debt in recent years has not, as yet, led to any overall increase in the degree of financial distress," the Bank said. The findings echo the attitude of Mervyn King, the Bank's Governor, who has said debt levels pose a risk to individual households but not to the economy as a whole.Reuse content