Mervyn King is worried that credit markets are still frozen
Banks have overstated their exposure to mortgage-linked investments and could delay an end to the credit crunch as a result, the Bank of England says.
In its Financial Stability Report, it said fears of financial meltdown may become a self-fulfilling prophecy.
Banks previously over-willing to lend were now too cautious, even with credit-worthy borrowers, it suggested.
The worry is that by being too cautious, banks may deprive consumers and companies of much needed financing.
An increased fear of risk, prompted by a drop in the value of investments linked to mortgages, has undermined confidence in financial institutions and made them reluctant to lend to each other and consumers, the Bank added.
Credit markets "are likely to overstate significantly the losses that will ultimately be felt by the financial system and the economy as a whole", the Bank of England said.
"It will exaggerate to an even greater extent the potential damage to the real economy."
Howard Davies, director of the London School of Economics and the former head of the Financial Services Authority, said the Bank's report was a signal that the worst of the credit crisis could be over.
But he said the economy could still face other problems.
"We now may be just moving into straight forward economic recession where all kinds of other assets begin to deteriorate in quality and in price."
BBC business editor Robert Peston said the report marked a substantial shift in emphasis for the Bank of England.
"Financial institutions are currently assuming that losses on sub-prime will be on a scale without any precedent," he said.
"The Bank of England thinks their fears are exaggerated."
"It now believes that the market price of sub-prime investment products overstates likely future losses on sub-prime lending by about 100%."
The Bank estimates that UK banks still have a potential exposure of $192bn to structured credit products - such as mortgage backed securities - which they are finding difficult to sell.
That is still a higher exposure relative to the size of the economy than among US banks ($490bn) or among European financial institutions ($235bn).
Julian Jessop of Capital Economics agreed with the Bank's assessment that the immediate threat of a full-blown meltdown had been avoided, but said the central bank should not be too optimistic.
"Even if financial conditions do quickly improve, the wider economic fall-out from the credit crisis will persist for many months and, in some cases, years to come," he said.
Confidence to return?
The report said that there was a "significant increase" in the risk that a major bank collapse or reluctance to lend would disrupt the financial system.
And it said the process of adjustment was proving "even more prolonged and difficult" than expected.
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The banks should return to sensible lending policies
Rhys Jaggar, Leeds
The Bank still judges that the most likely outcome is that confidence will gradually return to markets, and does not see that all the exposure will result in losses.
But the size of the problem helps to explain why the Bank was prepared to provide an additional £50bn to help ease the credit crunch facing UK banks.
The Bank of England also warned that there were potentially large exposures that have still not been declared by financial institutions.
It added that the credit crisis demonstrated that banks' risk management systems were weak, and they had not realised that risks could not be easily dispersed around the financial system but would flow back to the banks themselves.
The Bank of England said that there was a risk that "the currently elevated risk premia in some markets will persist".
"This could lead to a self-fulfilling adverse cycle in which persistent market illiquidity and falling asset prices further undermine confidence in banks and results in a sharper tightening of credit conditions," it said.
Lending drying up
The report demonstrates how quickly lending is drying up.
The Bank's quarterly survey of credit conditions shows that lenders are tightening up credit sharply not just on home loans, but also on household lending and commercial loans to companies.
And the sources of future loans in wholesale money markets have also contracted sharply.
The market for "asset-backed securities" such as sub-prime and other mortgages has collapsed - with the value of such assets issued going from $700bn a quarter in the middle of 2007 to just $100bn in the first quarter of 2008.
The Bank of England argues that to rebuild financial confidence, it will continue to allow UK banks to swap illiquid assets with safe UK government securities.
And they say that banks will need to bolster their capital and make further disclosures of their financial position, and explain better how they are valuing complex financial instruments.
In the long term, the Bank of England wants to change the rules under which banks operate, so that they recognise risks, and possibly put aside some extra money in good times to secure against risk in bad times.
And it says that more effective systems are needed so that central banks can respond more quickly in a crisis, such as the run on Northern Rock.