Page last updated at 11:04 GMT, Friday, 18 December 2009

UK banking sector 'significantly more stable'

Bank of England building
The Bank is pumping 200bn of newly created money into the economy

The UK's financial system has become "significantly more stable over the past six months", the Bank of England has reported.

It said the situation had improved on the back of its efforts to assist the sector, such as its quantitative easing (QE) programme and 0.5% interest rates.

However, it said the commercial banks still had to do more to improve their long-term stability.

The Bank is spending £200bn under QE to boost lending in the banking sector.

The Bank is using new money to buy assets from banks and other companies, in order to stimulate both bank lending and the wider economy in general.

Increased profits

The Bank's comments have come in the latest edition of its bi-annual Financial Stability Report, which puts across its current assessment of the strength of the financial sector and ways to improve it in the future.

Interest rates

It said that over the past six months, banks had been able to increase their profits, reduce concerns about potential future losses and raise further external capital - thereby reducing their reliance upon short-term funding.

However, it cautioned that the banks would still need further time to recover from the crisis in the financial system, and that in the meantime, they "remain vulnerable to the risk of less than expected economic recovery".

With banking sector profits now "relatively buoyant" again, the Bank said the commercial lenders should "take opportunities to strengthen their balance sheets, including by not distributing an excessive amount of profit".

Some of the downsides of carrying around a big financial system are now evident to all
Andy Haldane, Bank of England

It added that the root cause of the crisis in the global financial sector over the past year had been "excessive risk-taking in the upswing of the credit cycle and insufficient resilience in the subsequent downturn".

The Bank said these two factors had to be tackled to prevent a similar crisis happening again in the future.

Tighter regulation

Its comments come as the government's Financial Services Bill is making its way through parliament.

The bill's aim is to give the City watchdog, the Financial Services Authority, more powers to regulate banks, such as the authority to stop bankers from receiving excessive bonuses, and to cancel any pay packages which appear to reward undue risk-taking.

Quantitative Easing

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First, with the permission of the Treasury, the Bank of England creates lots of money. It does this by just crediting its own bank account.

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The Bank of England wants to use that cash to increase spending and boost the economy so it spends it, mainly on buying government bonds from financial firms such as banks, insurance companies and pension funds.
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The Bank buying bonds makes them more expensive, so they are a less attractive investment. That means companies that have sold bonds may use the proceeds to invest in other companies or lend to individuals.
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If banks, pension funds and insurance companies are more enthusiastic about lending to companies and individuals, the interest rates they charge should fall, so more money is spent and the economy is boosted.
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Theoretically, when the economy has recovered, the Bank of England sells the bonds it has bought and destroys the cash it receives. That means in the long term there has been no extra cash created.
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The bill also calls for a new Council for Financial Stability, which is intended to consist of Treasury, Bank of England and FSA officials.

It would have the job of analysing risks in the financial sector, to ensure that the recent financial crisis is not repeated.

Bonus limits

The Financial Services Bill also requires major banks and other important financial firms to hold larger capital reserves and to prepare so-called "living wills" to ensure they could be wound up in the case of failure, without putting the entire financial system at risk.

The bill will also include the FSA's new regulations covering banks, which were unveiled in August.

A nice ice age just arrived for banks and bankers
Robert Peston, BBC business editor

Under the code - due to take effect from January - bonuses should not be guaranteed for more than a year.

Senior employees should have their bonuses spread over three years under the code.

The rules are aimed at linking pay more closely with the long-term profitability of banks, as well as addressing concerns that big bonuses led to excessive risk-taking which contributed to the financial crisis.

The new bill adds to these rules by giving the FSA the power to stop excessive payments and to cancel any pay packages which appear to reward undue risk-taking.

The government has also introduced a new one-off 50% tax on bank bonuses over £25,000 to apply to bonuses paid between now and April 2010.

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