Bank of England wary of increased risk-taking

The Bank of England’s monthly financial stability report has warned that the recent meltdown in the US sub-prime mortgage sector could be repeated in the UK, as leveraged lenders exploit the benign economic conditions to increase their risk-taking.

The Bank of England has warned of the dangers to the UK financial system posed by increased risk-taking by institutions, particularly in the area of leveraged corporate lending – a key component of the recent private equity boom.

In its monthly Financial Stability Report, the UK’s central bank said that favourable economic conditions had encouraged financial institutions to extend their risk-taking, taking on increased credit risk at low cost. Innovations like the growing credit transfer market have increased the system’s risk-bearing potential, but this still leaves the market vulnerable to a sudden change in conditions, the bank said.

The bank cited the US sub-prime mortgage market as recent example where credit risk assessment had been impaired and participants ended up being badly hit by a sudden reduction in liquidity. “Similar problems in a more significant market, such as corporate credit, could have more serious consequences,” the bank said.

Growing demand from buyout firms has driven leveraged loan issuance to greater heights every year, with the global total hitting $321 billion in 2006, according to ratings agency Standard & Poor’s. But although the market appears to be booming, the bank is worried that institutions are under-valuing the risk they are assuming.

It believes the growing use of risk transfer markets, which allow leveraged lenders to sell on their risk at low cost, is making these lenders less careful about assessing and monitoring credit risk. This could cause problems if a systemic shock causes market liquidity to dry up, leaving them with no buyers for this risk.

The report identified six key vulnerabilities in the UK system that could cause such a shock: increased leverage in the corporate sector; the potential impact of a big financial institution falling into distress; dependence on infrastructure supporting the markets; financial imbalances between the major economies; and high levels of consumer debt.

However despite this, the bank said that the UK financial system remains “highly resilient” and stressed that “conditions are likely to remain favourable”.

In a recent report, the European Central Bank also downplayed the risk posed by private equity to the stability of the overall market. The ECB said that although banks were a major player in the buyout industry, “(their) relatively low proportion of LBO linked assets compared with total balance sheet sizes (or even own funds) seems to show that the potential for a severe market downturn to have a material impact on their financial accounts is still rather limited.”

However, the ECB did agree that the greatest danger would be if a bank was caught with a large exposure during a sharp and unexpected downturn.