The European debt crisis is a key risk to the UK's banking sector and banks should build up their cash reserves in response, the Bank of England has warned. In its latest financial stability report, the central bank welcomed recent measures taken by the EU to stem the crisis.
But it said UK banks' exposure to other European lenders made them vulnerable. Investors remain concerned that some eurozone countries risk defaulting.
Market expectations of a default by Greece hit an all-time high on Thursday, as the cost of insuring against the country rose sharply.
Sovereign debt concerns have raised doubts about the strength of some European banks, the Bank of England said, which could have a knock-on effect on the UK financial sector.
UK banks have relatively little direct exposure to Greece and other crisis-hit European governments. However, the Bank of England indicated that indirect exposures were substantial. For example:
• UK banks have major counterparty exposure to its fellow European banks, and a default by Greece and other sovereign borrowers could lead to the collapse of these European banks.
• The European debt crisis could scare markets, making them less willing to lend to anyone they consider risky, including to UK banks.
• Greater market fear could also lead to falling prices for risky assets like corporate bonds, forcing UK banks to write down the value of their loans and other assets, causing them heavy losses.
The report also warned of the potential risks posed to banks by the UK economy.
A weaker-than-expected economy or a rise in interest rates could see large numbers of mortgage-holders default on their loans, it said.
Interest rates have been held at historic lows of 0.5% since March 2009, while earlier this month the Office for Budget Responsibility said it expected the economy to grow at a slower rate than previously forecast by the Treasury.
But low interest rates do not appear to have deterred savers, according to figures in the report. The amount saved in UK banks in 2009 outweighed the amount borrowed for the first time since the Bank of England's records began, with £24bn saved compared with £20bn borrowed.
The banks themselves remain saddled with significant debts, according to the report.
The banking sector faces a substantial refinancing challenge over the coming years, the report said, as loans mature and emergency loans from the government are paid back.
In the UK, the largest banks will need to refinance or replace around £750bn -£800bn... by the end of 2012, the Bank of England said, stressing that a credible plan of refinancing was needed.
UK banks have already raised the amounts of capital they hold to protect themselves against future problems in the financial sector, the Bank added, but further increases would be necessary.
However, it conceded that measures to increase the financial strength of the banking sector should only happen over several years. The stability report called for an extended transition to new international rules that would raise capital and tighten limits on lending.
It said a rush to impose bank reforms could risk the economic recovery.
Central banks throughout the world are hammering out a new set of international rules.
The updated Basel rules - named after the Swiss town where the central bankers meet - will require banks to raise a lot more money from shareholders to hold as capital against possible losses on their loans.
However, the rules may have the effect of limiting lending, at least in the short-term, as most banks - particularly those in Europe - have far too little capital.
The Bank of England fears that a rush to impose these new rules could force banks to rein in their lending, which in turn would undermine the recovery. (BBC).