UK banks have built up a number of risky investment positions that could trigger a financial crisis if a shock caused a sudden rush to sell up, the Bank of England warned yesterday.
It said the benign economic background had allowed institutions to become complacent about the nature and scale of the risks they had taken on.
However its twice-yearly review of financial stability found that the City of London was sufficiently robust in terms of capital and profits to withstand a shock. It also played down the risk that a crash in the property market would put strains on the banking system.
Sir Andrew Large, the Bank's deputy governor with responsibility for financial stability, said: "In the present benign environment, there is a possibility that lenders, borrowers and investors may be inclined to underestimate long-run vulnerabilities and take on too much risk." The largest concern is a massive increase in investment in less liquid markets as banks have looked to alternative investments for higher yields in the current, relative low interest rate environment.
It also warned that banks had rushed into commercial property, which now made up half of all new corporate loans, and were engaged in a cut-throat price war for unsecured loans.
The Bank said a number of individual banks had admitted they were worried about their exposure to less liquid markets.
Investment in emerging market debt is at an all-time high while speculative positions in commodity futures are close to a record on the back of a surge in bets on copper prices.
Meanwhile cumulative global flows into hedge funds have hit £110bn in the first nine months of the year compared with £70bn in the whole of last year.
"It is perhaps significant that some market participants have expressed misgivings at the scale of investor demand for risky and potentially illiquid assets," the review said. "Unexpected economic developments could trigger the attempted simultaneous unwinding of common positions, possibly leading to strains on market liquidity."
On the purely domestic front the review said there was a contrast between low near-term risks and heightened longer-term vulnerabilities. It said unsecured lending - credit and store cards, hire purchase agreements and overdrafts - was growing at a much faster pace than mortgage loans.
It said the amount of debt write-offs had risen sharply this year even as lenders slashed the interest rates on their products. More than quarter of all issuers offered a zero per cent deal this year - more than double the number two years ago.
The Bank said it was aware the lenders' credit-scoring techniques had not yet been tested in times of stress. "If, in such a period, lenders attempted to lower risk by making it much more difficult or expensive for borrowers to roll over their unsecured lending, wider repayment problems might be precipitated," it said.
The review flagged up a surge in lending to commercial property, which now makes up half of new corporate lending and one-third of the total stock. The Bank hinted there might be a bubble, saying strong investor demand had driven up prices and forced down yields. "In some cases banks may have credit exposures to both real estate companies and corporate borrowers that are tenants," it warned.
However the report was more sanguine about the housing market - perhaps linked to the huge media interest in the fortune of house prices. It said the recent surge in prices had actually strengthened the financial position of many homeowners, giving them a greater cushion against a downturn.
It is understood that the Bank had not carried out a major simulation of a slump in house prices on the financial system for two years.Reuse content