Default risks keep cost of lending high

AN INCREASE in financial institutions’ perceived riskiness and their need to shore up balance sheets in the wake of the credit crisis has kept the cost of borrowing high despite the Monetary Policy Committee (MPC) slashing headline interest rates to historic lows, the Bank of England will say today in its latest quarterly bulletin.

Despite improvements in their capital and liquidity positions, lenders are struggling to raise funds in the long-term wholesale debt market at pre-crisis rates because market participants are still demanding significantly greater compensation for the credit risk associated with long-term exposures to lenders, the report said.

The end result is that interest rates charged on mortgages have fallen much less than cuts in the Bank’s key policy rate to 0.5 per cent.

The recession and associated increase in unemployment has also caused an increase in the number of borrowers missing interest payments, requiring banks to raise their estimates of the number of defaults and hike their lending rates accordingly.

The Bank’s analysts Richard Button, Silvia Pezzini and Neil Rossiter think it likely that lenders have increased their mark-up to improve the profitability of extending loans and increase institutions’ capital. Such an increase could improve lenders’ profitability and – if those profits were retained – enable them to increase capital, they said.

They argued that an increase in capital is desirable providing “it does not unduly constrain the supply of credit to households and businesses”. Both households and small and medium enterprises have found access to credit extremely difficult since the onset of the financial crisis.

However, an improvement in lenders’ capital positions should eventually reduce the price of lending: “Building up higher levels of capital in the banking sector reduces the likelihood that lenders will default. This should lower market participants' perceived riskiness of the lenders and corresponding lenders’ marginal funding costs, enabling them to reduce the price of new lending to households,” they added.

Elsewhere, the Bank said the recent recovery in world trade suggests the financial crisis has not inflicted permanent damage on the links connecting the global marketplace.