Bank fears financial threat from reckless lending and investing

The Bank of England is growing alarmed at increasingly reckless lending by banks to the commercial property and private equity industries and an unhealthy appetite for riskier investments by borrowers.

Releasing its twice-yearly Financial Stability Review today, the Bank says that a continuing accumulation of debt and an aggressive "search for yield" by investors poses a "significant risk" to the stability of the entire financial system.

It highlights the relaxed lending criteria by banks and increased demand for highly leveraged financial products, such as mortgage-backed securities, that could be storing up trouble if some unforeseen shock hits the financial system. "The UK financial system remains healthy and near-term risks appear limited ... but I believe vigilance is still called for," says Sir Andrew Large, the Bank's deputy governor, responsible for financial stability.

The factors the FSR is highlighting raise "questions about whether, in some areas, standards of procedure, risk appetite and financial discipline have weakened". The Bank holds regular talks with the Financial Services Authority, at which it discusses possible risks to the stability of the British and global financial systems.

"We must remember that the financial environment is now more complex, opaque, interconnected and leveraged, so a wholly benign outcome may not be a foregone conclusion," says Sir Andrew.

The FSR highlights as a potential shock things such as the downgrading of the credit-worthiness of General Motors and Ford earlier this year as well as the filing for protection from creditors by the former GM subsidiary Delphi and the commodities brokerage Refco. These events had only a short-lived impact on resilient credit markets. However, the review says a fresh shock could prompt an investment stampede out of a particular market, destabilising the financial system, as the collapse of the hedge fund Long-Term Capital Management did in the late 1990s.

One area of concern is the marked rise in UK banks' exposure to the commercial property sector which has generated significant returns in recent years. The global mortgage-backed security market has grown rapidly, the review says, allowing greater leveraging up, or borrowing.

"As with leveraged loans and with structured products engineered from instruments that are already leveraged, there are signs that the quality of the underlying asset pool may be deteriorating," it says. "So abrupt swings in financial market sentiment, or a marked deterioration in the economic climate, could create difficulties for firms and lenders."

The Bank remains reasonably relaxed about mortgage lending in Britain, which it thinks is not excessive and presents little danger to the financial system, especially in a more stabilised housing market.