The Bank of England warned banks and borrowers on Wednesday about risks from a potential abrupt rise in global interest rates, and said banks might need to further bolster their capital cushions to protect against this.
The past week has seen a sharp rise in global bond yields since U.S. Federal Reserve Chairman Ben Bernanke said that the U.S. central bank may scale back bond purchases later this year.
BoE Governor Mervyn King said on Tuesday that markets had "jumped the gun" in their sharp reaction to Bernanke's comments, but the BoE's half-yearly Financial Stability Report said more bond yield rises could hurt UK banks, insurers and borrowers.
The BoE said that it had ordered an investigation into the vulnerability of Britain's financial institutions and borrowers to higher interest rates, to report back by September to its new risk watchdog, the Financial Policy Committee.
"Financial institutions and markets are also vulnerable to an abrupt rise in global interest rates. And some UK borrowers remain highly indebted, which could result in losses for UK banks," the FPC said.
The 11-member FPC gained legal powers to set capital requirements for banks in April after operating on an interim basis for the previous two years, and just a week ago it ordered five banks to raise 13 billion pounds ($20 billion) of extra capital.
Privately bankers complain that higher capital requirements and limits on leverage are hampering their ability to lend, but this is strongly disputed by the BoE, which says healthier long-term capital levels make it cheaper for banks to borrow.
Wednesday also saw the BoE allow banks to scale back some of the short-term cash they hold against shocks to encourage more lending to the economy.
Nonetheless, on Tuesday, BoE Governor Mervyn King, making probably his final public comments before retiring, accused British banks of lobbying senior politicians to undermine a new system of financial regulation.
In its first formal response to the remit given to it by finance minister George Osborne, the FPC said it saw no contradiction between its calls for higher capital and Osborne's request that it paid heed to the impact of its actions on short-term economic growth.
"Capital can provide some protection from interest rate risks," the FPC said, adding that as well as causing loans to go sour, higher interest rates could bump up banks' own borrowing costs. Around 40 percent of banks' assets would have to be immediately revalued if rates rose abruptly, the FPC said.
The BoE itself is a long way from tightening monetary policy, and a minority of BoE rate-setters have been voting for more stimulus efforts for the past few months due to the weak state of Britain's economic recovery.
King steps down at the end of this month, to be replaced by former Canadian central bank chief Mark Carney, who many economists expect to advocate a long-term commitment to low interest rates as a way to keep down bond yields.
The FPC also fleshed out how far banks can go in scaling back their cash-like buffers to free up money that can be lent to the economy.
Banks already hold amounts that exceed the new global Basel rules and the FPC said the buffers can be reduced to 80 percent of the Basel minimum until January 2015, and then rise back to full compliance by January 2018.
The FPC also requested the central bank's Prudential Regulation Authority, Britain's day-to-day banking supervisor, to report by the final quarter on whether banks should be forced to use a standard model for totting up their risky assets.
Banks use bespoke models to quantify the risks which in turn determine the size of their capital buffers but some FPC members worry banks are underestimating risks.
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