The Bank of England has published its bi-annual Financial Stability Report.

Since the December 2009 Report, markets have focused increasingly on strains placed on sovereign balance sheets. In April, concerns over Greek sovereign risk spilled over to other European countries and developed rapidly into a generalised retreat from risk-taking. Inadequate transparency about sovereign exposures led to counterparty concerns and renewed strains in bank funding markets. In response, the IMF and European authorities put in place a substantial package of support. While these measures helped to stabilise conditions, market pressures have not yet abated. EU leaders also recently announced plans to publish the results of stress tests conducted on the largest European banks; this will be another important step.

UK banks have raised their capital and liquidity buffers substantially, which has helped them weather recent tensions. But, in common with their peers, they face a number of challenges in the period ahead. UK banks need to maintain resilience in a difficult environment, while refinancing substantial sums of funding; they have a collective interest in providing sufficient lending to support economic recovery; and they will need over time to build larger buffers of capital and liquidity to meet more demanding future regulatory requirements. The new Basel regulatory regime will be agreed in the autumn. An extended transition to this new regime would enable banks to build resilience through greater retention of earnings, while sustaining lending.

Key risks to the UK financial system:

• Counterparty risks among European banks that have direct exposures to countries facing increased sovereign risks (pages 21–22).
• A sustained reversal in investor risk appetite, increasing the challenge for banks internationally in refinancing maturing funding (pages 42–43) and reducing the value of banks’ assets (pages 38–39).
• A shift in investor portfolios geographically and across the risk spectrum. That could weigh on growth prospects in Europe, heightening credit risk (page 21). It could also fuel a slow-burn risk of overheating in some Asian EMEs (pages 28–29).
• Payment difficulties for some UK borrowers with overextended balance sheets, including in the commercial property sector, particularly if growth proves weaker than anticipated or market interest rates rose by much more than expected (pages 30–31).
• Downside risks to the UK and US housing markets could increase losses on household lending (pages 25–27).
• Banks reining in lending to meet future regulatory requirements and to alleviate funding pressures could undermine economic growth and raise credit risk for all banks (pages 53–54).

Policy measures required:

• Banks should build up higher buffers of loss-absorbing capital and resiliently liquid assets when economic conditions improve (pages 55–56).
• An extended transition to the new international regulatory regime would help banks to build resilience through greater retention of earnings, while sustaining lending.
• Policies should ensure that the banking system is resilient through the credit cycle and that structural distortions caused by banks that are ‘too important to fail’ are reduced. Potential changes include:
  
  • Usable capital buffers, above a hard minimum (pages 56–57).
  • Improved market discipline via enhanced disclosure, including on intraperiod exposures (pages 63–64).
  • Consideration of restrictions on banks’ ability to engage in certain activities and measures to reduce dependence on the banking system, through the Independent Commission on Banking (page 66).
  • Measures to ensure that banks’ uninsured creditors face a credible threat of loss (page 67).
  • Strengthened risk management standards for central counterparties (pages 68–70)

Source:  Bank of England, Financial Stability Report Summary