The Governor of the Bank of England sought to reassure the City yesterday over fallout from recent market turmoil, but he issued a blunt warning that the Bank would not cut interest rates to bail out any careless lenders hit by loan defaults.

Mervyn King admitted that there were big uncertainties over the scale and future impact of the turbulence in world markets over the past month.

However, he argued that the flight by investors from riskier assets may in practice represent a welcome rethink by financial institutions of the dangers they confront and a recognition that they had become too cavalier.

In a stark message to lenders that may have been caught out by the shift in credit conditions, the Governor made clear that the Bank would respond only if market upheavals had big implications for the economy as a whole.

“Interest rates are not a policy instrument for protecting unwise lenders from the consequences of their past decisions,” he said. “We are certainly not going to protect people from unwise decisions that they have made before.”

Mr King said that the Bank would continue to carefully monitor credit market developments and their impact on the economy.

“We don’t know whether these tremors in financial markets signal a more disruptive movement to come, or constitute a gradual release of pressure on [interest rate] spreads that have built up over some time.

“So it’s impossible at this stage to judge how large and how persistent this tightening of credit conditions is likely to be.”

In an attempt to soothe City nervousness over the market shake-out and the threat of a full-blown credit crunch, the Governor emphasised that market interest rates demanded for mainstream corporate and personal borrowing had not risen dramatically.

He said that interest rate “spreads” – the extra interest premium paid on commercial loans compared with that on ultra-safe government bonds – had not risen sharply.

“There has been a small tick-up in investment grade, but pretty small; a bigger pickup in sub-investment grade, but still those spreads are well below the levels that we have been used to for most of the past six or seven years. I do not think there is any particular evidence here of a fundamental change to the macro-economic outlook.”

That assessment was underlined in the Bank’s quarterly Inflation Report, which noted that “credit spreads for investment grade bonds have so far risen only modestly”.

Beyond the crisis-hit US sub-prime mortgage sector, Mr King said: “I do not think there is much sign of major damage to loan performance in other markets. So far, what we have seen is not a threat to the financial system, either in the United States or Germany, let alone in the United Kingdom. It is not an international financial crisis.”

Mr King suggested that a return to great wariness of risk by financial institutions was likely eventually to prove a positive development that should be welcomed. The Bank has repeatedly given warning over a prolonged period that a global capital glut – fuelled by very low official interest rates in the past – along with an ever-growing “search for yield” by institutions has meant that interest-rate spreads on highly leveraged lending and risky securities were driven to dangerously low levels that did not fully reflect risks involved.

“In terms of financial institutions becoming exposed, many central banks have been concerned about the compression of risk premia,” the Governor said.

“To the extent that these [spreads] are starting to widen, I think that is a welcome development as a more realistic appraisal of risks is being seen.”

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