The Bank warns of tighter credit

The Bank of England has warned that British subprime borrowers and highly-leveraged companies could be hit by tighter credit conditions. While it was upbeat on the British economy, the Bank expects higher costs of interbank borrowing to continue.

The warnings came in the Bank’s half-yearly Financial Stability Report, published last week. The report, which aims to identify the major downside risks to Britain’s financial system, highlights a number of concerns.

In particular, it points to weaker credit risk assessment, with investors increasingly searching for higher yields in a relatively low-interestrate environment. This, it says, has “stimulated a wave of innovation, creating often opaque and complex financial instruments with high embedded leverage.”

However, tighter credit conditions and uncertainty over such instruments have left British markets in a “transitional state”, as liquidity and credit risks are assessed and managed more carefully. The Bank warns that, while the overall economy remains “robust”, this transition will take time and may not be smooth.

The Bank notes signs of a short-term recovery in the asset-backed commercial paper (ABCP) market, but predicts that interbank lending rates will remain high or even increase further towards the end of the year.

Continuing uncertainty over the valuation and location of exposures to debt leave the financial markets vulnerable to further shocks, it adds. These may include weaker commercial property prices, falling share prices in the face of lower growth and a downward correction of the dollar.

Richard Batty, global investment strategist at Standard Life Investments, says the primary money market is still “fairly well jammed-up”, with the three-month London Interbank Offered Rate (Libor) running at about 6.3%. However, he adds that most institutions are still able to raise capital.

Batty says: “Even the lower-graded names are not having problems getting funding. Bradford & Bingley and Alliance & Leicester have been issuing two and three-year bonds. At the moment, investors are giving institutions the benefit of the doubt.”

However, Batty says the Bank is right to right to highlight risks in the credit markets. He adds that British subprime lending is “struggling”, and points to lower returns from the retail property sector.