In this issue:

Bank of England Warns of Systemic Risks

BIS Warns Against Banks' Risky Loans, Investments


From Volume 3, Issue Number 27 of Electronic Intelligence Weekly, Published July 6, 2004

World Economic News

Bank of England Warns of Systemic Risks

In its semi-annual "Financial Stability Review," the Bank of England (BOE) points to "considerable challenges" for maintaining "financial stability," in particular, in "an environment of rising global interest rates and, for many borrowers, historically high levels of debt." These "high debt levels, notably in the UK household sector but also still for many corporate borrowers at home and abroad, mean that the impact of any increases in interest rates will be the greater." And while corporate debt levels are "high by historical standards," corporations are in addition now suffering "significant pressures" from higher oil and other commodity prices.

"Some credit risks merit especially close monitoring because of the size or the concentration of exposures. For UK banks, secured lending to UK households is substantial. The relative importance of domestic mortgages has increased in recent years, and they now account for around 20% of the on-balance-sheet assets of the large U.K.-owned banking sector." Lenders, in general believe, says the BOE, that default rates will not go up sharply once interest rates rise. However, "given the size of the exposures, stress testing for the implications of various low-probability but high-impact scenarios—for example, sharp house price falls coinciding with a significant deterioration in the employment outlook—remains important."

Another risk factor the BOE highlighted, is the "search for yield," which is being reflected by various kinds of "carry trades" and the overall growth of hedge fund operations. Some "carry traders" were suffering problems recently as bond prices started to fall. "Further price changes could trigger other sharp asset price movements or market liquidity problems were investors simultaneously to try to unwind common positions, leading to 'one-way' trading.... Those risks may have been exacerbated by the rapid growth and proliferation of hedge funds over the past year, possibly bringing in less experienced fund managers. There have also been some reports of increased use of leverage amongst hedge funds," even if leverage appears to be lower than in 1998.

In conclusion, there are a number of "downside risks" that need careful evaluation: "As well as the possibility of house price falls and weaker income growth, there may be larger-than-usual interest rate and other market risks; increased liquidity and concentration risks in the markets used to manage market risk and raise wholesale funding; and possible weaknesses, in changing macroeconomic circumstances, of increasingly complex credit and market risk models based on limited historical experience. Some of these risks may be linked."

BIS Warns Against Banks' Risky Loans, Investments

The Bank for International Settlements (BIS) released its 74th Annual Report June 28 focussing on the fact that banks in Europe and U.S. have been taking on "tenuous" risks on loans and trading. As well, it warns about the U.S. current account deficit, and the capital flows needed to finance it.

In a review of the financial sector, the BIS states, "Some institutions may have undertaken investments premised on tenuous assumptions regarding the outlook for growth and the level of interest rates." Among the problems that the BIS finds are, that based on alleged increased economic growth, lowered interest rates/increased liquidity, and greater bank "capitalization," banks have been encouraged to undertake "greater risk-taking." For example: Investment banks have come to rely increasingly on proprietary trading—buying and selling securities using the banks' own money—which increases these banks' "value-at-risk." The "value-at-risk" is simultaneously a measure of how much a bank can lose in a single day. These banks' "value-at-risk" had jumped 20% by end of 2003 over the year before. The BIS reported: "Large losses on these activities could affect a number of players if market liquidity were to dry up," or interest rates to shift.

The report also warns about the escalating of home mortgage debt: "If [home] prices were to fall, this would be likely to trigger mortgage defaults and financial stress."

However, while recognizing real problems, what the BIS recommends, would intensify the problem. The BIS reports that German banks' distressed loans are a very high 9.5% of total loans, but praises them for "restructuring the loans," which often involves the risky process of securitizing them. The report continues, "Moreover, the restructuring of problem loans, destined eventually to be sold to international investors, provided a boost to capital adequacy." The BIS also said, "Trading in mortgage-backed securities was an additional important source of revenue." It praised banks for laying off workers, and the mergers and acquisitions in the world banking sector—i.e., banks producing mega-banks—and said, "The resilience of the financial sector to the recent economic downturn represents in part the fruit of these efforts."

Finally, the BIS praised to the skies its new report from June 26, entitled, "International Convergence of Capital Management and Capital Standards: A Revised Framework," which argues that if only banks put aside higher levels of Tier 1 bank capital, the banks would be stable, in a dying global banking-financial system penetrated by $400 trillion in speculative derivatives and other obligations.

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