UK banks might have overstated their profits by not taking sufficient provisions for loans that have gone sour, the Bank of England's new financial watchdog has warned.
In its first public statement the bank’s financial policy committee (FPC) highlighted the risks posed to UK banks by the European sovereign debt crisis and said a new breed of complex products could pose a risk to the banking system.
It also called on banks to hold back on bonus and dividend payouts and use earnings to build strong capital buffers.
The FPC, which will not get its full powers until 2013, has asked the Financial Services Authority to examine forbearance of loans where lenders waive covenants, allow borrowers to take payment holidays or move to interest-only arrangements if they are struggling to repay.
Bank governor Sir Mervyn King said the result meant that banks’ reported profits and capital levels “may provide a misleading picture of their financial health”.
The worry is that banks have not put enough money aside to absorb future losses if, for example, base rates rise sharply, putting more pressure on borrowers.
Sir Mervyn added: “The key thing is commercial property. That is where we think the problems are likely to be most severe.”
The FPC did not name any institutions that they were concerned about although Royal Bank of Scotland and Bank of Scotland, now part of Lloyds Banking Group, were both significant lenders to the property sector before the credit crunch.
FSA chief executive Hector Sants, who serves on the FPC, said: “We are not comfortable that their systems and controls are adequate; that they are addressing this in the consistent way they should.”
The Bank estimates that as many as 12% of UK residential mortgages and a third of commercial property loans are receiving some kind of forbearance.
Forbearance may also have been significant in the smaller companies sector.
The Bank said in its financial stability report: “Much of the improvement in banks’ profits since 2009 has been the result of a fall in provisions made against bad loans.
“If the scale of forbearance is significant as the data suggest, banks’ total provisions may not be sufficient to cover losses on these loans. This may heighten uncertainty among bank creditors about profit and capital positions.”
The FPC said: “The most serious and immediate risk to the UK financial system stems from the worsening sovereign debt crisis in several euro-area countries.”
It acknowledged that UK banks have limited direct exposure to sovereign debt but warned of “contagion”.
Sir Mervyn said: “A UK bank could have lent to a bank that could itself have lent to a bank that is itself exposed to a sovereign risk.”
UK banks should disclose more information about their sovereign and banking sector exposure, the committee said.
The FPC warned that exchange traded funds (ETFs) posed a risk to the banking system. It said these had become increasingly complex with some funds using synthetic strategies instead of owning the securities they track.
The assets of ETFs are increasingly being used as a source of funding for banks, the committee said, and called on the FSA to monitor closely the risks of the sector.
Mr Sants said: “There are question marks about whether synthetic ETFs are appropriate for all parts of the retail market.
The committee also issued a cautious warning to banks that they should prioritise building their capital cushions over paying high bonuses or dividends.
Sir Mervyn said: “When times are good, that is no moment to be complacent about the need to build up capital.”
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