The Bank of England warned that financial institutions are taking increasing risks.

The Bank’s report says that the British financial system remains highly resilient. “But strong and stable macroeconomic and financial conditions have encouraged financial institutions to expand further their business activities and to extend their risk-taking, including through leveraged corporate lending, and the compensation for bearing credit risk is at very low levels,” it warned. “That has increased the vulnerability of the system as a whole to an abrupt change in conditions.

“Financial innovation and the growing use of credit risk transfer markets have increased the risk-bearing capacity of the system – but also bring some risks,” the Bank added. “Recent developments in the US sub-prime mortgage market have highlighted how credit risk assessment can be impaired in these markets and how participants can be hit by sharp reductions in market liquidity.”

It says that similar problems in a more significant market, such as corporate credit, could have more serious consequences if credit quality were to deteriorate. “It is important that participants in these markets are alert to these risks and that firms’ stress testing takes them into account.”

“Financial markets have continued to be vibrant, core institutions are highly profitable and the economic outlook is favourable. But risk-taking is increasing including through higher leverage, lower margin requirements and relaxation of covenants. The rapid growth in credit risk transfer markets is also making more participants dependent on continuous market liquidity and could amplify the impact of shocks like a sharp reversal in credit spreads from their current low levels,” said John Gieve, deputy governor for Financial Stability. “Risk managers need to further develop ways of measuring and managing these new forms of risk.”