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Worst of credit crunch may be behind us, suggests Bank of England

01 May 2008 / by Joy Tibbs
Despite a recent statement from Monetary Policy Committee member David Blanchflower suggesting that the credit crisis will continue to damage house prices in the coming years, a new report from the Bank of England implies the effects of the credit crunch may have been overstated in financial sectors.

The Bank's Financial Stability Report suggests that although there may still be risks ahead, the worst of the global credit turmoil could be over.

It begins by explaining the reasons behind the financial struggle that hit the global economy last summer, which has particularly taken its toll on the mortgage and banking sectors. "Rising US sub-prime defaults were the trigger for a broad-based repricing of risk and deleveraging in credit markets," the report explains.

However, the biannual report also offers a glimmer of hope, drawing particular attention to the recently launched Bank of England special liquidity scheme, aimed at bolstering liquidity levels in the financial sector and to encouraging inter-bank lending, which has slumped in recent months.

"Prices in some credit markets are likely to overstate the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include large discounts for illiquidity and uncertainty," it says.

"Conditions should improve as market participants recognise that some assets look cheap relative to credit fundamentals. With sentiment still weak, the Bank has announced a special scheme to improve the liquidity position of the banking system and to increase confidence in financial markets."

It lists the main risks to financial stability as overreaction to market losses which exaggerate the overall costs related to the credit crisis; insufficient information about valuation assumptions and uncertainty about report losses, which raises concerns about risk; tight funding conditions; and narrow lending conditions leading to defaults.

In order to combat these potential hazards, the Bank of England is promoting several confidence-building measures, including its new liquidity scheme; banks raising capital as a signal of strength in volatile markets; transparent disclosure of positions and losses; better governance of risk management within banks; sharper regulatory incentives for banks to control risks; and stronger crisis management arrangements.

The report indicates that complacency within the financial markets prior to the crisis may have exacerbated the situation. It also warns that exaggeration of risk could be equally harmful as it increases the banks' reluctance to lend funds to one another, leading to further tightening of credit conditions.

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