Rising US sub-prime mortgage defaults were the trigger for an inevitable and broad-based repricing of risk and deleveraging by banks and other financial market participants. This process is proving even more prolonged and difficult than anticipated. Banks have been unable to sell or secure funding on assets in which markets have closed. That has increased uncertainty about banks’ financial positions, contributing to continued stress in money markets and tighter credit availability.

In these conditions, adverse news and rumours can lead to a sudden loss of market confidence, as was shown by the collapse of Bear Stearns in mid-March.

An adjustment in both the price and quantity of risk-taking was clearly needed after an extended credit boom and was bound to have costs. But estimates implied by prices in some credit markets are likely to overstate significantly the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include unusually large discounts for illiquidity and uncertainty. In effect, risk premia in some markets have swung from being unusually low to temporarily too high relative to credit fundamentals. That may be contributing to the delay in the return of confidence and risk-taking.

The most likely path ahead is that confidence and risk appetite turn gradually as market participants recognise that some assets look cheap on a fundamentals basis. But with sentiment still weak and deleveraging continuing, downside risks remain. Actions are needed to bolster confidence and ensure that risk appetite returns. Central bank measures to address liquidity problems, such as that announced recently by the Bank of England (Box A), are an important component. Banks can further boost confidence in their resilience through more informative disclosures and by raising capital as a signal of strength in turbulent market conditions, as some are already doing.

Further ahead, it is important that banks and the official sector also tackle the underlying sources of the overextension of credit in recent years.

Conclusion

A necessary repricing of risk and deleveraging is taking place, which will inevitably have costs for some market participants and borrowers. But this adjustment is being hampered by poorly functioning markets. Confidence among market participants has been dented by falls in credit market prices and large mark-to-market losses which are likely to reflect large, and temporary, discounts for illiquidity and uncertainty, as well as expected future credit losses. In effect, risk premia have swung from being unusually low to temporarily too high relative to credit fundamentals. That is leading to heightened concerns about banks’ resilience, continued strains in money markets and reductions in credit availability. That in turn is retarding the return of confidence and risk appetite in financial markets.

The most likely path ahead is that confidence and risk appetite gradually turn as market participants recognise that some assets look cheap on a fundamentals basis. That could generate a virtuous cycle of rising asset prices and improving bank balance sheets, reversing the cycle of the past six months. But there is still a possibility that high risk premia in some markets could persist, undermining confidence and potentially setting in train a further adverse cycle. The Bank’s recently announced Special Liquidity Scheme is intended to help reduce that risk. But banks can also bolster confidence in their resilience by improving their disclosure and by raising capital as a signal of strength in turbulent market conditions.

Further ahead, it is important that banks and the official sector respond not just to problems that have surfaced in the current episode, but also tackle the underlying sources of the overextension of credit in recent years.

Download Bank of England Financial Stability Report, April 2008

PDF format, 7.3MB, 77Pages.

Financial Stability Report
April 2008 | Issue No. 23

The Bank of England has two core purposes — monetary stability and financial stability. The two are connected because serious disruption in the financial system would affect the implementation and effectiveness of monetary policy, while macroeconomic stability helps reduce risks to financial stability.

The Bank’s responsibilities for monetary stability are set out in the Bank of England Act 1998. Responsibility for financial stability in the United Kingdom is shared between the tripartite authorities — HM Treasury (HMT), the Financial Services Authority (FSA) and the Bank of England. Their roles are set out in a Memorandum of Understanding (MoU).

The Bank’s responsibility for contributing to the maintenance of the stability of the financial system as a whole derives from its responsibility for setting and implementing monetary policy, its role in respect of payment systems in the United Kingdom and its operational role as banker to the banking system. The Bank aims to bring its expertise in economic analysis and its experience as a participant in financial markets to the assessment and mitigation of risks to the UK financial system including, if necessary, helping to manage and resolve financial crises. In so doing, the Bank works closely with authorities domestically and overseas on issues relevant to the stability of the UK financial system, including the international financial architecture and regulatory frameworks.

The Financial Stability Report aims to identify the major downside risks to the UK financial system and thereby to help financial firms, authorities overseas and the wider public manage and prepare for these risks. The Report is produced half-yearly by Bank staff under the guidance of the Bank’s Financial Stability Board, whose best collective judgement it represents.

The Financial Stability Board:
John Gieve, Chair
Martin Andersson
Andrew Bailey
Charles Bean
Nigel Jenkinson
Mervyn King
Rachel Lomax
Paul Tucker

Visit Bank of England Financial Stability Report Website

Glossary and Other Information

Glossary of selected data and instruments
ABCP – asset-backed commercial paper.
ABS – asset-backed security.
ABX – a set of indices linked to credit default swaps on US sub-prime home equity loans of specific vintage and rating.
Alt-A – a classification of mortgages where the risk profile falls between prime and sub-prime.
CDO – collateralised debt obligation.
CDS – credit default swap.
CDX – a family of indices offering credit default protection against groups of North American and emerging market companies of various quality and over a range of maturities.
CLO – collateralised loan obligation.
CMBS – commercial mortgage-backed security.
CMBX.NA – a set of indices linked to credit default swaps on
US commercial mortgages of specific vintage and rating.
ERI – exchange rate index.
GDP – gross domestic product.
iTraxx – a family of indices offering credit default protection against groups of European and Asian companies of various quality and over a range of maturities.
Libor – London interbank offered rate.
MBS – mortgage-backed security.
RMBS – residential mortgage-backed security.
SIV – structured investment vehicles.
TB – Treasury bill.
VIX index – a measure of the 30-day option-implied volatility of S&P 500 index.

Abbreviations
BBA – British Bankers’ Association.
BCBS – Basel Committee on Banking Supervision.
BTL – buy to let.
CEE – Central and Eastern Europe.
CESR – Committee of European Securities Regulators.
CFP – contingency funding plan.
CHAPS – Clearing House Automated Payment System.
CLS – Continuous Linked Settlement.
ECB – European Central Bank.
ELA – emergency liquidity assistance.
EME – emerging market economy.
EOD – event of default.
EU – European Union.
FRBNY – Federal Reserve Bank of New York.
FSA – Financial Services Authority.
FSCS – Financial Services Compensation Scheme.
FSF – Financial Stability Forum.
FTSE – Financial Times Stock Exchange.
FVA – fair-value accounting.
G7 – Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
G10 – Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.
HBF – Home Builders Federation.
HEL – home equity loan.
HM Treasury – Her Majesty’s Treasury.
IMF – International Monetary Fund.
IoD – Institute of Directors.
IOSCO – International Organisation of Securities Commissions.
IPD – Investment Property Databank.
IRB – internal ratings based.
LCFI – large complex financial institution.
LGD – loss given default.
LTV – loan to value.
MoU – Memorandum of Understanding.
MSCI – Morgan Stanley Capital International Inc.
OIS – overnight indexed swap.
OMO – open market operation.
ONS – Office for National Statistics.
PD – probability of default.
PIT – point in time.
PNFC – private non-financial corporations.
RICS – Royal Institute of Chartered Surveyors.
RoE – return on equity.
S&P – Standard and Poor’s.
SEC – US Securities and Exchange Commission.
SLR – sterling stock liquidity.
SWF – sovereign wealth fund.
TAF – Term Auction Facility.
TSLF – Term Securities Lending Facility.
TTC – through-the-cycle.
VaR – Value-at-Risk.

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