Looming Bank Losses Threaten BoE's Credit Easing Plans

Big British banks still face the prospect of more significant losses because of their exposure to private sector borrowers in the ailing eurozone, according to the Bank of England's Financial Policy Committee (FPC), as well as indirect losses from their EU counterparts exposed to struggling countries in the single currency area.

Unless the macroeconomic picture improves soon, which includes slowing growth picking back up in emerging markets as well as stability in the eurozone, looming losses for banks threaten the Bank of England's attempts to increase lending into the UK economy and pull it out of recession and into recovery.

"If contagion were to spread, there would likely be significant disruption through secondary channels, such as increased counterparty risk and stresses in funding markets, with adverse feedbacks to the macroeconomy," said the minutes from a 22 June FPC meeting released Friday.

The FPC cited the rapid credit growth in emerging economies and "signs of overvaluation in Asian property markets" as of particular risk concern to UK banks.

"A disorderly unwinding of asset prices could result in direct losses on UK-owned banks' exposures to the region, which for some banks were significant," the FPC minutes warned.

There were also warnings over slowing progress in banks building up their capital buffers to insulate them from the eurozone crisis.

This has been impacted by constrains on earning stemming from "structural balance sheet changes, redress for mis-selling of financial products and squeezed net interest margins due to elevated funding costs."

"These factors were likely to provide a drag on future earnings for some time," said the minutes.

"None of the large UK banks had issued equity, except for the purpose of paying dividends or bonuses."

All of this pressure on banks' finances is likely to impact on their appetite for lending, even despite two new Treasury-backed credit easing schemes launched by the Bank of England.

Under the Extended Collateral Term Repo and "funding for lending", banks will have access to cheap loans from the Bank of England.

This should offer a "significant financial incentive" for banks to lend at an affordable rate, said the Bank's governor Mervyn King.

Access to the cheap loans will be directly linked to how much banks are lending.

However King has warned that there are "no guarantees" that the schemes will work.

He said that their success may have to be measured in how they limit a contraction in lending should the economic picture deteriorate, rather than any expansion in access to credit.

Since the 22 June FPC meeting, official GDP figures for the UK were revised down to put the country deeper in recession than thought.

Private industry data has shown a marked slowdown in service sector growth, as well as continued contraction in manufacturing sector output, and a collapse in construction sector activity.

Many economists expect the UK recession, its second in four years and the first double-dip since the 1970s, to extend into another quarter.

The Bank of England increased its quantitative easing programme by an extra £50bn on 5 July.