King warns of more turbulence for banks

The Governor of the Bank of England warned yesterday of further pain for the banking sector and said this week's action by central banks would probably not be enough to unfreeze the inter-bank lending market.

Mervyn King said it would take at least until March before banks stopped being afraid to lend to each other and inter-bank rates started to return to normal. Central banks are making three-month liquidity available in December and January to try to stop the lending blockage tipping the world into recession, he added.

"A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets," Mr King told the House of Commons Treasury Committee. "Central banks are working together to try to forestall any prospective sharp tightening of credit conditions that might lead to a downturn in the world economy." But, he added: "There is no easy way through. Even the operation we have put in place is unlikely to bring a significant reduction in spreads [between inter-bank and base rates]."

Mr King also admitted the authorities had realised a year ago that there was an "urgent" need to beef up measures to deal with a failing bank. Asked why he had not specifically pressed the matter with the Chancellor, Mr King said he could not have known the Northern Rock crisis would happen so quickly: "Urgent does not mean rushing it," he told Michael Fallon, the committee's deputy chairman.

Mr King said the Bank and the FSA would ensure that banks were tested for liquidity and called for powers to "get hold of" a lender that was in danger of running out of liquidity.

The Bank of England sold 10bn of three-month loans to banks yesterday in the first of two planned auctions to relieve money market interest rates. It received requests for 10.85bn at an average interest rate of 5.949 per cent.

The lowest rate accepted was 5.36 per cent, well below the Bank's 5.5 per cent base rate. The highest bid was for 6.6 per cent, though a bank that made that bid could have put in a lower one, too.

Central banks are making more than 50bn in three-month money available over the crucial year-end period. The European Central Bank also injected €348bn (248bn) in two-week funds into the financial system yesterday.

Mr King has been accused by banks of being too hardline on providing liquidity compared with the ECB and the US Federal Reserve. John McFall, the chairman of the committee, accused him of "a perfect U-turn" by auctioning the loans for a wider range of collateral without the penalty rate he had imposed before.

Mr King said conditions had changed in the past month and that yesterday's auction, and another planned for January, were to reassure them about the security of lending to other banks. A continued freeze in banks' lending could cause a "feedback" effect by putting borrowers under further pressure and more loan defaults, he warned. The Bank hopes that the relatively low bids will calm nerves about other lenders' need for funds.

Mr King said the Bank of England had injected more, not less, liquidity into the market than the ECB or the Fed. He admitted he should have spoken out in August to explain how the Bank's money market operations work and said many bankers do not understand now.

Sir John Gieve, his deputy for financial stability, said the authorities did not do enough to reassure retail depositors when Northern Rock's emergency funding was announced.