Bank of England Governor Mervyn King urged banks to enhance efforts to bolster their defences against the euro area’s debt turmoil, which now looks like a “systemic crisis”.
“An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts,” threatening banks’ balance sheets, King told reporters in London.
“This spiral is characteristic of a systemic crisis.”
The US Federal Reserve cut the cost of dollar funding for European financial institutions yesterday in a coordinated move with other central banks. That measure came two days after King said there are “early signs” of a credit crunch in the euro region, where leaders face increasing pressure to resolve intensifying turmoil.
“Sovereign and banking risks emanating from the euro area have intensified and remain the most significant and immediate threat to UK financial stability,” the central bank said in its Financial Stability Report. It said that if banks’ earnings aren’t enough to build capital, they should limit payments of bonuses and dividends and “give serious consideration” to raising external capital.
Credit squeeze
The central bank’s Monetary Policy Committee restarted bond purchases in October to aid the recovery and cut its growth forecasts this month. Officials warned today that the strains in interbank markets could threaten economic growth.
“Against a backdrop of slowing global growth prospects, concerns about the sustainability of government debt positions of smaller economies have broadened to larger euro-area economies,” the central bank said. “The current funding pressures facing banks could lead to a renewed tightening in credit conditions for real economy borrowers.”
The central bank also published the recommendations of its Financial Policy Committee, which met on November 23. The panel said the Financial Services Authority should encourage banks to disclose leverage ratios to investors by the start of 2013, two years earlier than Basel rules originally required.
The Bank of England said in the FSR that UK banks have 140 billion pounds ($215 billion) of term funding due to mature in 2012, concentrated in the first half of the year. It said short-term money market funding conditions have “been fragile over the past few months, with banks finding it harder to roll over all of their maturing funding and tenors shortening.”
Contingency plans
UK authorities are working on “a wide range of contingency plans” to deal with a further intensification of the crisis, including a possible breakup of the euro, King said. The central bank is working with the Financial Services Authority and the government on plans, he said.
After a series of stop-gap accords failed to protect Italy and Spain from surging bond yields, Europe is under growing pressure from US leaders and international financial markets. European leaders will meet next week to discuss the next steps in resolving the debt crisis.
The cost for European banks to borrow in dollars fell for a second day after the coordinated central bank action. The three-month cross-currency basis swap, the rate banks pay to convert euro payments into dollars, was 118 basis points below the euro interbank offered rate in London. The gap had widened to 162.5 below Euribor yesterday, the most in three years, before the Fed move.
Underlying problems
King said the central bank measure was “designed to deal with clear evidence that there were problems in banks around the world finding difficulty in accessing dollar funding in particular.” Still, he added it can only provide “temporary relief” and is not a “solution to the underlying problems.”
He also said that said resolving the wider problems of global financial imbalances are beyond the UK authorities to deal with on their own and “only the governments directly involved can find a way out of this crisis,” referring to the euro-area debt turmoil.
“The crisis in the euro area is one of solvency and not liquidity,” he said. “Here in the UK we must try and find a way to bolster the resilience” of the financial system.
While Britain’s banks have 15 billion pounds of exposure to sovereign debt in the most vulnerable euro-area economies, they have “significant” exposures to the private sectors of Ireland, Spain and Italy, the Bank of England said. This amounts to about 160 billion pounds, or 80 per cent of their core Tier 1 capital.
“UK banks have made significant progress in improving their capital and funding resilience,” the bank said. “But progress has been set back recently and they have been affected by strains in bank funding markets.”
Bloomberg