By Christina Fincher Reuters - Thursday, April 26, 2007, LONDON (Reuters)
Banks' growing appetite for risk has made the country's financial system more vulnerable to a downturn in credit conditions, the Bank of England warned on Thursday.
Instead, it pointed to falling credit risk premia, rising sub-investment grade debt issuance and the popularity of complex derivatives as evidence that banks were continuing to take on risk for fear of losing market share.
"Anchored expectations of macroeconomic stability and competitive pressures in the financial sector appear to have encouraged a further increase in risk-taking," the report said.
It noted that increased use of credit risk transfer markets also made it harder for banks and investors to accurately assess risk exposure.
"The trading of credit risk in financial markets enables risk be better diversified across the system as a whole. But recent events in the U.S. sub-prime mortgage markets have illustrated that weaknesses can also emerge," the report said.
"Similar problems in a more significant market, such a corporate credit, could have more serious consequences if credit quality were to deteriorate."
The Bank explored six potential vulnerabilities that could threaten the stability of the financial system.
There are: unusually low risk premia, rising leverage in the corporate sector, distress in the banking sector, infrastructure disruption, global economic imbalances and the high level of household debt.
It judged that only one of these categories -- global economic imbalances -- now posed less of a risk than at its last assessment in July 2006.
The risk from all other categories was either judged to have remained the same or increased.
The Bank noted that several of these categories were interdependent and a shock in one was likely to reverberate in others. It highlighted the credit market as being a potential trigger point.
"An increasingly likely stress scenario would be a sharp unwinding of low risk premia, which then triggered a pickup in corporate defaults as credit conditions tightened," the report said.
"The unwinding of leveraged positions in corporate credit markets could lower market liquidity, amplifying falls in asset prices."
The Bank is urging financial institutions to be aware of this potential domino effect and beef up stress-testing accordingly.