18 March 2009

Bank of England warns tensions in banking system at fever pitch

Investors have restrained the amount they are willing to lend, banks have grown reluctant to entrust their cash to each other and levels of stress in the system have hit new peaks, according to the Bank's Quarterly Bulletin.

The Bank's chief economist, Spencer Dale, warns in the report, published today, that: "Against the background of a significant and synchronised weakening in international economic activity, market conditions generally remained strained. In particular, bank funding markets became more difficult again reflecting renewed concerns about the scale of potential credit losses and write-downs facing banks."

The report lays bare the fears investors currently have about the creditworthiness of Britain's biggest banks. It reveals that a key measure of interbank health - the spread between the London Interbank Offered Rate (Libor) and expected interest rate levels had "started to widen again" while "contacts reported some increased reluctance to lend to banks beyond very short maturities."

The main worry haunting investors is the threat that banks could be nationalised and that financial institutions are harbouring "ongoing balance sheet constraints".

However, most worryingly, it warns that the credit default swap spread rates on large banks - a key measure of concerns about their possibly insolvency - picked up to their highest level since just before the collapse of Lehman.

The Bulletin says: "With a number of banks reporting large credit losses and write-downs for 2008 Q4, perceptions about bank counterparty risk appeared to pick up again. Consistent with that, premia on UK banks' credit default swaps rose, and approached levels reached in October 2008 when fears about system-wide failure were intense."


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