Page last updated at 09:54 GMT, Saturday, 9 August 2008 10:54 UK

Banks warned of economic worries

BBC Business Editor Robert Peston speaks to FSA chief executive Hector Sants

Banks should make plans based on the assumption the economic downturn could be as bad for them as the recession in the 1990s, the City watchdog has said.

The warning from FSA chief executive Hector Sants comes a year after the credit crunch officially began.

Mr Sants also told the BBC he had put pressure on most of the UK's big banks to raise billions in new capital.

That was so they would be robust enough to withstand the potentially severe financial pressures ahead, he said.

Pressure to raise capital

The recession and property market downturn of the early 1990s saw British banks suffer debilitating losses over an extended period.

On Friday it was reported that repossessions had risen sharply and that one bank, Royal Bank of Scotland, had posted the second-biggest loss in UK banking history.

In an interview with BBC business editor Robert Peston, Mr Sants was asked whether the difficulties for banks could be as bad as they were in the early 1990s, and whether losses on lending would continue to be a problem for up to three years.

He replied that he would expect banks "to plan on that type of assumption".

He said he had expressed his opinions "fairly forcibly" to banks that they needed to raise capital, so that they could be confident of weathering the economic downturn.

Royal Bank of Scotland, Barclays and HBOS have between them raised 20bn of new equity capital.

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The credit crunch began when the banks sharply reduced lending to one another, and to their customers, due to suddenly increased worries about the riskiness of their loans.

This was because for years they had been raising funds to lend to us by selling bonds backed by risky US home loans given to borrowers on low incomes or with poor credit records.

As interest rates in the US rose and these borrowers began to default in record numbers, "the world's investors worked out that sub-prime wasn't pure gold but something a lot nastier and smellier than that", our correspondent said.

"Suddenly the collateral the banks had been offering was not very valuable - in fact many people thought almost valueless, which made it that much harder for banks to raise money," he added.

Bank bonuses blamed

Mr Sants said part of the cause of the economic mess was that bankers had been rewarded for taking foolish risks.

And he warned that if banks continued to reward their employees for doing dangerous deals, the watchdog would make sure that banks and their shareholders would be penalised.

He said there would be "consequences" for banks that pay employees too much for doing imprudent deals.

He also said in future banks must give greater consideration to the downside of the risks they take and make provisions for that to prevent a situation like the current crisis from being repeated.

To make sure banks are less likely to violently react in a downturn, Mr Sants warned consumers would have to accept less access to credit in the boom times.

"We want to create an environment where the right amount of credit is available to consumers, but not too much," he added.

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