Bank of England calls for "credible threat of closure"

In its latest Financial Stability Report, released today, the Bank of England has emphasised the need for banks to face "a credible threat of closure", and recommended higher capital and liquidity reserves.

"To control risk-taking, financial institutions need to face a credible threat of closure. The establishment of the UK Special Resolution Regime has increased the prospect of orderly failures of deposit-taking institutions. Greater challenges exist in dealing with failures of international financial groups," the report said.

Banks should draw up 'wills' in the form of plans for their own orderly winding up or restructuring, the bank continued - as well as their practical value in times of crisis. This "would force management to contemplate failure in good times and would thus encourage them to prepare better for risks". It could also, the bank added, discourage them from unstated reliance on a government bailout.

The report warned that, despite efforts to improve since the start of the crisis, UK banks were still not secure enough. Leverage rates remained very high, at a median of 30 times in 2008, raising the risk a comparatively small drop in asset values could "significantly erode" capital buffers.

Additionally, UK banks are still heavily reliant on the wholesale markets - the £800 billion gap between customer deposits and loans is met through issuance of securitisations and government-backed debt. This is set to expire soon, leaving a potential shortfall. Banks "conceivably need to shrink their balance sheets or find alternative sources of funding of around £500 billion over the period to 2013, as various forms of public sector financing are progressively withdrawn", the report forecast.

The Bank echoed calls for higher capital levels - saying capital ratios should in future be calculated solely from core Tier 1 capital, in other words common equity - and added banks also need to build up larger liquidity buffers, made up primarily of government bonds. The bank echoed the Financial Services Authority, asserting "banks' liquidity buffers have been too low and must increase substantially once normal conditions in funding markets are restored".

And, as well as having to seek additional funding and increase their capital ratios and liquidity buffers, UK banks may soon face the additional cost of a US-style pre-funded deposit insurance scheme - riskier banks would pay higher rates. "Our previous work suggests this would be a substantial cost to banks in the initial years," commented banking analysts at Credit Suisse in London.

They will also face more detailed reporting requirements - UK banks could have to report every quarter rather than twice a year, and would have to give average, high and low results, as well as period-end figures. The bank pointed to widespread 'window dressing' in the days leading up to the close of each reporting period, with the spread between the bank rate and the Sonia (sterling overnight index average) interbank rate rising dramatically three days before the end of each half, as banks hurried to derisk their balance sheets with very short-term funding in order to conceal risky trading activities.

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