Withdrawal of policy support could spark market volatility and disruption

WEANING the UK economy and the banking sector off policy support risks heightened volatility across asset classes and abrupt portfolio adjustments, according to the Bank of England’s Financial Stability Report (FSR), published today.

In the biannual report, the Bank claims “the enormous scale of public sector intervention means that any withdrawal of support could have a significant impact on investors’ portfolio choices and relative asset prices”.

The Bank estimates that a one percentage point increase in long-term real interest rates or UK equity risk premia would be consistent with a fall in UK equity prices of around 16 per cent.

The rise in asset prices during 2009 has reduced losses of financial wealth since the start of the crisis to $6.3 trillion – less than half the level at the time of the June FSR and just 25 per cent of the expected future losses at the trough of the market.

But the Bank warns that banks’ balance sheet vulnerabilities also expose them to a setback in the asset price rally as well as a slower-than-anticipated recovery and continued concerns about sovereign risk.

Any one of these factors or a combination of all four could pose a risk to the UK’s financial stability and its banking system.