LONDON: British banks need to prepare for the risk of financial market turmoil when central banks end unconventional monetary policy such as asset purchases, the Bank of England said on Thursday.
Don Kohn, a former vice-chairman of the U.S. Federal Reserve who now serves on the BoE's main risk watchdog, told British banks to guard against the risk of defaults, sharp rises in market interest rates and illiquid assets as monetary policy returns to normal after the financial crisis.
British banks should also expect to have to raise more capital, to ensure they can be broken up without cost to taxpayers if they run into difficulty in future, Kohn said.
The remarks from Kohn come as BoE Governor Mark Carney has said that the time for British interest rates to rise is getting nearer, and as the BoE's Financial Policy Committee considers whether to issue new quarterly recommendations to banks on Oct. 2.
The BoE has said it will not start to sell down its 375 billion pounds ($609 billion) of quantitative easing asset purchases until it has raised interest rates well above their current 0.5 percent.
But markets got a taste of the potential turmoil earlier this year when there was speculation that the Fed might slow its purchases, and markets expect the BoE to start to raise interest rates early next year.
Speaking to the British Bankers' Association, which represents high-street lenders, Kohn said the end of unconventional monetary policy should come when the British economy was healthy.
"Exit is likely to be a positive event for the UK economy and financial markets. It will probably occur in the context of continued good gains in output and employment, so your customers will be borrowing more but at the same time better able to repay," he said.
But there could be nasty surprises. "Exit is not without its risks and dangers, especially after a long period of very low interest rates and low market volatility. And exit is likely to occur at different times in different jurisdictions globally, adding to the complexity and potential complications."
Kohn said that interest rate margins were very narrow in some sectors, and that British households were still highly indebted. Market interest rates could also rise sharply once central banks stopped buying or holding government bonds.
"Central bank purchases of longer-term assets, including gilts, have driven down term premia ... suggesting the adjustment at the long end of the curve could be especially sharp," he said.
Some funds invested in bonds might also prove to be illiquid if many investors tried to withdraw their money as bond prices tumbled, he added, touching on a theme previously addressed by BoE Deputy Governor Jon Cunliffe.
Banks also needed to be prepared for the BoE to raise capital requirements further, Kohn said.
"You can expect us to require more capital at every stage of the business cycle - more than you held before the crisis and more than you might hold if left to your own devices and the discipline of the market," he said.
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