The Bank of England said rising equity markets don’t reflect the underlying economic situation and warned that investors may be underestimating risks in the financial system.
Gains by equities since mid-2012 “in part reflected exceptionally accommodative monetary policies by many central banks,” the BOE’s Financial Policy Committee said today in London in the minutes of its March 19 meeting. “It was also consistent with a perception among some contacts that the most significant downside risks had attenuated. But market sentiment may be taking too rosy a view of the underlying stresses.”
At the meeting, the FPC recommended that U.K. lenders raise 25 billion pounds ($38 billion) of additional capital to cover bigger potential losses, possible fines for mis-selling and stricter risk models. While banks have strengthened their resilience in recent years, the FPC said today that not all of them may be able to withstand unexpected shocks and maintain lending to companies and households.
The FPC discussed potential threats from the crisis in Cyprus, which agreed on an international bailout last month. While at the time of the March 19 meeting there were “minimal signs” of spillovers to other financial systems, there was “a risk that this situation could change,” the committee said.
The Stoxx Europe 600 Index (SXXP) has risen about 24 percent since the start of June 2012, while the S&P 500 has gained about 22 percent in that period, reaching a record close on April 2. The Stoxx 600 declined for a third day, slipping 0.7 percent as of 10:52 a.m. London time.
The FPC’s comments on the advance in equity markets echo remarks last month by UBS AG Chairman Axel Weber, who said the economy hasn’t kept up with investor sentiment.
“I fear the recent rally in financial markets could be a misleading signal,” Weber, a former European Central Bank Governing Council member, said at an event in London with BOE Governor Mervyn King and Federal Reserve President Ben S. Bernanke. “We’re not really out of the woods yet.”
In making its recommendation, the FPC said that “a line needed to be drawn under doubts about U.K. banks’ capital adequacy.” It said that in light of the latest decree, further recommendations on capital shouldn’t be necessary “in the immediate future.”
The panel, which was operating on an interim basis until the start of this week, recommendated that financial institutions limit payouts such as bonuses and dividends. They should “continue to exercise restraint on distributions and compensation,” it said.
In their discussion, the FPC members noted the potential threats to the financial system from increased risk appetite among investors.
“This was evident in the re-emergence of some elements of behavior in financial markets not seen since before the financial crisis, including a relaxation in some U.S. credit markets of non-price terms and increased issuance of synthetic products,” the committee said. “At this stage, they did not appear indicative of widespread exuberance in markets. But developments would need to be monitored closely.”
The FPC also said that banks’ leverage ratios, a measure of their debt to equity level, would remain “very high” even after the new recommendations were met. It said there would be “little margin for error against a backdrop of low growth in the advanced economies.”
The committee said the Prudential Regulation Authority should take leverage ratios into account when determining individual bank capital requirements. The FPC didn’t name any banks.
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