UK banks 'at risk from financial woes in the eurozone'

Bank of England building The Bank of England has highlighted concerns both in the eurozone and Asia

The continuing financial problems in the eurozone pose a threat to UK banks, the Bank of England has warned.

In its latest half-yearly Financial Stability Report, it called for stringent new tests on the strength of European lenders.

It also called on banks to increase the capital they keep to absorb losses, by paying out less dividends and bonuses.

And the central bank expressed concern about the UK banks' exposure to a further downturn in the housing market.

"It is in banks' collective interest to build resilience gradually through retention of earnings, which would be boosted if banks restrain distribution of profits to equity holders and staff," it said in its latest Financial Stability Report.

UK banks overall have £500bn of debts to refinance in the coming two years - of which £200bn are from the expiring emergency facilities provided by the Treasury and the Bank of England during the financial crisis.

Eurozone hair-raising

The Bank said it wanted a comprehensive solution to the financial situation affecting the eurozone.

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2011 will be a make-or-break year for our banks”

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Its comments came after European Union leaders agreed to set up a permanent mechanism to bail out any member state whose large public deficits threaten the 16-nation eurozone.

Creating such a eurozone stability mechanism will require a change to the EU's Lisbon Treaty - but the wording has now been agreed, diplomats say.

The Bank of England is concerned about the continuing debt situation in the eurozone - the 16 nations that share the euro - because UK banks have substantial investments in many of those countries.

The UK central bank said that claims on the Irish Republic and Spain - the two biggest exposures - represented three-quarters of the total capital set aside by the entire UK banking system to absorb losses, and that this risk was concentrated in a few unnamed UK banks.

And their exposure to other eurozone banks was substantial, raising the risk that the UK would be caught up in any general euro banking crisis.

However, the banks' direct exposure to a default by a crisis-struck eurozone government is relatively limited.

Property prices

The Bank also voiced concern over the risk of a renewed downturn in the UK housing market.

Key Risks to the UK Financial System

  • The eurozone government debt crisis leading to a wider European banking crisis
  • Overheating in some emerging market economies due to international capital inflows
  • A sudden rise in the cost of borrowing in the bond markets, particularly if the Bank starts raising interest rates again
  • Defaults by financially- stretched borrowers, particularly in the commercial property sector, if growth slows or borrowing costs rise
  • Market disruption due to the failure of a systemically important financial firm

Source: Bank of England's Financial Stability Report

"House price to rent ratios in several countries, in particular Ireland, Spain and the United Kingdom, remain well above historical averages," noted the bank.

Most indexes have shown UK house prices gradually declining since the summer.

The Bank of England expressed concerns at the rising burden of unsecured debts - such as credit card debts and personal loans - for some households and worried that a future rise in the interest rates set by the Bank could push many borrowers over the edge.

Another source of angst is company debt, in particular the commercial property market, which represents about a third of all debts in the UK banking system.

The bank said that data from companies' accounts suggested around 30% of companies made insufficient profits to cover their interest payments in 2009.

Although borrowing costs for companies - in the form of corporate bond yields - had fallen significantly in the past year, the Bank worried that the bond market could experience a sudden reversal, similar to what happened in 1994 when the Bank started raising rates again.

The low cost of borrowing may be "masking latent distress among some overextended borrowers, including some households, corporates and sovereigns".

Money flows

The Bank also said "overheating" in emerging markets, such as China and India, could eventually hit UK lenders.

It pointed to stock markets in countries like India and Indonesia being at historically very high levels, and spiralling property prices in China.

The flow of money into these countries was helpful in its opinion, because the developing world represents better investment opportunities and many of the countries have undervalued currencies and large trade surpluses.

But the Bank was critical of some of its central banking counterparts in the emerging markets, saying that their interventions to neutralise the effect of these money inflows and keep their currencies weak was aggravating distortions in the capital markets.

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