By Steve Schifferes
Economics reporter, BBC News
The Bank of England has warned that banks' fears of a financial meltdown may become a self-fulfilling prophecy.
Banks previously over-willing to lend are now too reluctant, even with credit-worthy borrowers, it suggests.
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Its financial stability report suggests the credit exposure not declared by UK banks may be near to Ј100bn.
The twice-yearly report says that there is a "significant increase" in the risk that a major bank collapse or reluctance to lend will disrupt the financial system.
And it says the process of adjustment is proving "even more prolonged and difficult" than expected.
The Bank still judges that the most likely outcome is that confidence will gradually return to markets, and does not see that all the exposure will result in losses.
But the size of the problem helps explain why the Bank was prepared to provide an additional Ј50bn to help ease the credit crunch facing UK banks.
In its Financial Stability Report, the Bank of England warns that there are potentially large exposures that have still not been declared by financial institutions.
Massive losses
The report estimates the total potential losses in "structured credit and monoline-related write-downs and exposures" at $914bn overall.
It says UK banks could lose $192bn (Ј96bn), compared to $232bn for European large financial institutions, and nearly $500bn for the US banks and investment houses.
However, the Bank points out that the freezing up of markets has meant that these estimated losses may be inflated because of the difficulty of pricing the complex securities which are now very difficult to value.
It says that "credit losses from the turmoil are unlikely ever to rise to levels implied by current market prices unless there is a significant deterioration in fundamentals."
And it estimates that total sub-prime losses could be reduced from $400bn to $200bn once market conditions return to normal.
Self-fulfilling prophecy
But it says that the crisis has led to the pendulum swinging too far, with risk premia in some markets "swinging from being unusually low to temporarily too high relative to credit fundamentals".
It says the crisis demonstrated that banks' risk management systems were weak, and they had not realised that risks could not be easily dispersed around the financial system but would flow back to the banks themselves.
The Bank of England judges that there is a risk that "the currently elevated risk premia in some markets will persist".
"This could lead to a self-fulfilling adverse cycle in which persistent market illiquidity and falling asset prices further undermine confidence in banks and results in a sharper tightening of credit conditions."
Lending drying up
The report demonstrates how quickly lending is drying up.
The Bank's quarterly survey of credit conditions shows that lenders are tightening up credit sharply not just on home loans, but also on household lending and commercial loans to companies.
And the sources of future loans in wholesale money markets have also contracted sharply.
The market for "asset-backed securities" such as sub-prime and other mortgages has collapsed - with the value of such assets issued going from $700bn a quarter in the middle of 2007 to just $100bn in the first quarter of 2008.
What can be done
The Bank of England argues that to rebuild financial confidence, it will continue to allow UK banks to swap illiquid assets with safe UK government securities.
And they say that banks will need to bolster their capital and make further disclosures of their financial position, and explain better how they are valuing complex financial instruments.
In the long term, the Bank of England wants to change the rules under which banks operate, so that they recognise risks, and possibly put aside some extra money in good times to secure against risk in bad times.
And it says that more effective systems are needed so that central banks can respond more quickly in a crisis, such as the run on the Northern Rock.
(BBC)
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