Credit markets have become too pessimistic about the likely scale of defaults even on US subprime mortgages, the Bank of England insists on Thursday in a financial stability report that predicts a recovery in confidence and risk appetite over the coming months.

But the report is careful not to paint a Panglossian view of the world. The situation in four of its six main categories of risks to financial stability is worse than last October, it notes, and the financial system remains dependent on economic conditions.

The main risk highlighted by the report is that current stressed conditions in credit markets continue – what the Bank calls continued “high risk premia”. This would put further pressure on banks and financial institutions, which would be transmitted to households and companies through restrictions on lending, creating a deeper-than-warranted economic slowdown.

If a slowdown turns into something worse, the Bank’s concern is that the banking system would face even greater losses and put even more pressure on lenders, generating a vicious circle of household retrenchment and further banking losses.

It sees “some signs” of a similar vicious circle in the US, saying that experience “underlines the importance of action to insure against that risk playing out in the UK”. But the Bank is clear that it does not think conditions in the UK are yet anywhere near as bad as those in the US.

Wednesday’s figures from the Nationwide Building Society showing the first annual fall in house prices for 12 years are shrugged off by the Bank, which says “most homeowners have substantial net housing equity, boosted by strong house price appreciation over the past decade”.

The Bank’s sanguine attitude, however, does not mean it believes everyone will be secure in a housing downturn. “Highly indebted households, adverse credit borrowers and buy-to-let investors are particularly vulnerable,” it says, noting that many will find it difficult to secure refinancing when fixed rates run out.

Although it notes commercial property is an area of vulnerability, the Bank is relatively relaxed about a 20 to 25 per cent fall in values. Lower prices are not the same as increased defaults, it says, and “a very large increase in default rates would be needed to have a material impact on UK banks’ average profits”.

Of more concern are leveraged loans to companies, where it says default rates are expected to rise.

To guard against instability, the Bank praises its own special liquidity scheme and plans by banks to raise new capital from investors. “Higher capital buffers would improve confidence by increasing banks’ resilience to sudden changes in market sentiment and by strengthening their capacity to handle a potential downturn in the macroeconomy.”

But the report’s main message is one of optimism. John Gieve, deputy governor of the Bank, said: “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

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