Finance

In its latest Financial Stability Report, the Bank argues that the market’s ability to price risk has gone from one extreme to the other – whereas last summer it was ‘unsustainably low’, now it’s too high. Last year the banks were treating all these dodgy sub-prime borrowers as cast-iron bets – now it’s expecting pretty much all of them to hand over the keys to their trailer park homes any day now.

This means – according to the BoE – that banks’ estimates of potential losses are way too high. ‘Estimates implied by prices in some credit markets are likely to overstate significantly the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include unusually large discounts for illiquidity and uncertainty,’ the report claims. In other words, because the banks are nervous, they’re over-estimating how much money they’ll lose – the Banks reckons actual losses will be less than half of the estimated $400bn (meaning that someone could make a pile of money if they hold their nerve…)  

The problem, of course (as the Bank recognises), is that this could become a self-fulfilling prophecy. Sellers are worried that prices are unrealistically low so they don’t want to sell; buyers are nervous about pricing (and possibly suffering from funding constraints if they borrow a lot of their money) so they don’t want to buy. With no buyers or sellers, the markets stays gummed up and prices keep sinking – creating a downward spiral. The Bank thinks some parts of the economy are particularly at risk here: it picked out the commercial property sector, private-equity backed companies, emerging markets in Eastern Europe and (you guessed it) households that have mortgaged themselves up to the eyeballs.

The long-term answer, says the Bank, is better risk management and a better crisis response system. But in the short-term the key is to get the markets moving again – which is why it’s just pumped in an extra £50bn that banks can borrow in exchange for mortgage-backed securities. At the same time, it wants the banks to bolster their cash piles (like RBS and HBOS are doing) and come clean about their exposure to all this stuff, to start rebuilding confidence.

Some are suggesting today’s report signals that the worst of the credit crunch is over, and the Bank certainly seems keen to cheer people up a bit – it suggests that things are starting to look up and argues that: ‘The most likely path ahead is that confidence and risk appetite will return gradually in the coming months’. Since Mervyn King doesn't tend to be the glass-half-full type, let’s hope that’s a good sign...