More volatility ahead

The Bank of England has issued a gloomy report on the future of global equity markets, warning there will be continuing volatility.

It also warned that the UK stock market is “particularly vulnerable” to a downturn.

The bank’s Financial Stability Report, which was released in London overnight, noted that the continuing deterioration of the US sub-prime market was exposing vulnerabilities in the valuation and distribution of risk in global markets.

“That has affected banks in all advanced economies, as the risks have flowed back to their balance sheets and funding pressures have intensified,” the report said.

In the UK this led to the cash crisis at Northern Rock building society, which resulted in the Bank of England stepping in to provide liquid support.

The report notes that while there have been some improvements in some financial markets, a return of under-priced risk would be undesirable.

“Periods of tighter credit conditions, especially for higher-risk borrowers, should be expected,” the report said.

“But in the short term, the financial systems in advanced economies remain vulnerable to further adjustments.”

Bank of England deputy governor of financial stability John Gieve said the speed and ferocity of the re-pricing of risk in credit markets had not been anticipated by either firms or the authorities.

“Some markets remain illiquid and the financial system remains vulnerable to shocks,” he said.

“There are some important lessons that need to be learned by financial institutions and the authorities on liquidity risk management, valuation of complex instruments, disclosure of risk positions and crisis management.”

The report said particular issues of weakness in the financial system were underinsurance against closure of key funding markets and investors relying on narrow rating metrics of complex structured products. The report also noted the lack of transparency in off-balance sheet investments and undeveloped practises for managing stress at international institutions.

However, there could be some severe pain before an upturn, with US sub-prime market defaults likely to rise further, which will cause concerns about asset valuations.

The report also noted the impact of the credit crisis may not be apparent in some global financial institutions and this could cause problems in the future.

And the bank warned companies in other sectors are not immune from the credit crisis. “Equity prices, which have risen strongly in industrialised and especially emerging market economies in recent months despite the problems in credit markets, could be vulnerable to any further revision in growth prospects,” the report said.

However, the pain global markets will experience in the next few months will produce a better system for pricing risk, which was overdue, the bank said.