Banking Storm Ahead!

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The European debt crisis is a ‘key risk’ to the UK banking sector and banks should build up their cash reserves in response, the Bank of England warned yesterday.

In its latest Financial Stability Report, the Bank warned UK banks’ exposure to other European lenders made them extremely vulnerable and that some eurozone countries risk defaulting.

The Report called for tighter limits on lending, but at the same time it warned that the European debt crisis could scare the markets, leading to a renewal and tightening of the credit squeeze.

The Report also warned that UK banks are heavily exposed to the danger of a Greek default and that there is an imminent danger of a collapse of corporate bonds, leading to banks having to write down their asset values.

It warned that UK borrowers, notably property developers, have too much debt and are in great danger of default, leading to a collapse of the UK housing market.

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.

The Bank of England warned that the UK’s ‘indirect exposures’ were substantial, for example:

• UK banks have major ‘counterparty’ exposure to 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 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.

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 £750 billion-£800 billion . . . by the end of 2012,’ the Bank of England said, stressing that a ‘credible plan’ of refinancing was needed.