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 12 May 2008 16:02 BST

Credit crunch could get worse, Bank of England warns

Thursday, 01 May 2008 19:54
Bank of England warns credit crisis could worsen
The Bank of England (BoE) has warned the reluctance of banks to take on risk by refusing to extend credit could fuel the credit crisis.

In its Financial Stability report, the central bank said although a return to the loose credit conditions before the crisis last summer would not be desirable, the perception of risk is now overstated.

"If risk premia in these markets remain elevated for a prolonged period, banks’ profitability, capital and funding could be adversely affected, potentially leading to a more severe tightening of credit conditions in the wider economy," the BoE said.

As long as financial institutions overrate risk and refuse to lend, the markets will not be able to return to normal, "undermining confidence and potentially setting in train a further adverse cycle," the bank added in its report.

Banks could do more to avoid this risk and return the markets to normalcy, the BoE said.

Increasing capitalisation – possibly through rights issues as HBOS and Royal Bank of Scotland have done – will help restore confidence in banks, as will being more upfront about write-downs, the BoE said.

The BoE said its special liquidity scheme, which allows banks to swap mortgage-backed assets for government bonds, should help the market to recover.

But it also listed several measures it wants banks to take to restore confidence in the system.

Higher capital buffers would improve confidence, the BoE said, by increasing banks' resilience to sudden changes in market sentiment.

Raising capital through rights issues or attracting investment would be better than reducing lending growth – which could increase losses across the system as a whole, the central bank said.

Better and more frequent disclosure of banks' financial positions would also improve confidence, as would better information on complex instruments, the bank added.End of story

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