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Financial Policy Committee says banks might need to eat into capital cushions to keep credit flowing The Bank of England has warned of “severe strains” in financial markets and appeared to concede that banks might need to eat into their capital cushions to keep credit flowing into the stagnating economy. The second report by the new Financial Policy Committee – set up by the coalition inside the Bank to be responsible for financial stability – indicated that it had considered the need for “short-term measures” to try to prevent a re-run of the 2007 credit crunch. In a two-page update of its latest meeting – which took place on 20 September – the FPC said: “The committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term.” Even so, the committee said it was recommending banks take “any opportunity” to strengthen their capital and stock of liquid assets to “absorb flexibly any future shocks without constraining lending to the wider economy”. This could be done by raising long-term funds on the markets and reducing dividends and bonuses in line with any fall in profits. The Bank’s quarterly credit conditions survey , issued alongside the committee’s report, said lenders were warning that the shaky state of financial markets could constrain credit in the coming months. The FPC, which is chaired by Bank governor Sir Mervyn King, also advised the Financial Services Authority to encourage banks “to manage their balance sheets in such a way that would not exacerbate market or economic fragility”. “For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided. Moreover, the committee recognised that, in the event that severe risks crystallised, it would be natural for banks’ capital and liquidity ratios to be run down to ensure that lending to the non-financial economy was not impaired,” the committee said. After its first meeting in June , King described the eurozone as posing the “most serious and immediate” single threat to financial stability and the committee acknowledged that since then there had been “severe strains” in financial markets. But given the scale of current risks, the committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system. “The committee recognised that dealing with the problems facing the international financial system as a whole would require long-term reforms to tackle unsustainable debt positions and the cumulative and persistent loss of competitiveness in a number of euro-area countries. But given the scale of current risks, the committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system.” The credit conditions survey showed that the supply of loans to households increased modestly in the third quarter of the year, while the availability of lending to businesses was flat; but, “lenders pointed to adverse wholesale funding conditions as a key factor which might constrain future lending”. Some banks are heavily reliant on funding in the wholesale money markets, which are at risk of drying up as the eurozone crisis rocks confidence. The Bank added: “More recent discussions with some of the major lenders suggested that although these factors had not yet led to reduced credit availability, a period of sustained tight funding conditions could act to constrain their ability to extend loans going forward.” Lenders also told the Bank that many of their business customers are reluctant to take on new borrowing against the background of a deteriorating economic outlook. “Lenders expected a fall in demand across firms of all sizes in Q4. Lenders commented that companies are reluctant to hold increased levels of debt against a backdrop of a more uncertain economic outlook and a fall in consumer confidence,” the Bank said. The FPC does not yet have powers to intervene in markets but is calling for powers that allow it to intervene on bank balance sheets, the terms of market transactions and trading systems to help spot and tackle potential financial crises. Financial policy committee Banking Bank of England Banking reform Financial sector Jill Treanor Heather Stewart guardian.co.uk