Mounting fear among banks over lending to each other threatens to prolong and deepen the global credit squeeze and add to the severity of its toll on economies, Mervyn King warned MPs yesterday.

Predicting that intense strains in the markets for lending between banks will persist well into next year, the Bank of England Governor said it was now fear over new losses on complex debt securities that are yet to emerge, rather than shortages of funds, that was fuelling these financial stresses.

“The problems in the financial sector remain with us,” Mr King told the Commons Treasury Committee. “A painful adjustment is facing the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets.”

Because anxiety over unknown losses faced by rivals — rather than scarce liquidity— was now behind unwillingness by the banks to lend to each other, the Governor said that interest rates in interbank markets were unlikely to return to normal for at least several months.

Nor could there be any guarantee that substantial new injections of extra funding by the Bank of England, the European Central Bank and the US Federal Reserve would help, he added. He emphasised that banks were “awash with cash”.

“In the last four to five weeks, there has been a palpable sense of fear,” he said. “The difficulty we face is that even operations we put in place cannot be guaranteed [to], and are indeed unlikely to, bring about a significant reduction in spreads.”

Mr King sounded a warning over the risk that tighter credit conditions could spell a more severe economic downturn in the United States and elsewhere, leading to yet steeper losses for banks, adding to their reluctance to lend, and then fuelling still worse economic fallout in a vicious downward spiral. “That concern is a serious one because it does hold out the prospect that there will be a self- reinforcing downturn in credit and activity.”

The Governor offered some grains of comfort, however, when he predicted that market stresses could ease by spring. By then, he suggested that “provided we can help to dispel that sense of fear ... conditions will return to a more sustainable position”.

In hard-hitting comments, Mr King predicted greatly reduced demand in future for complex financial instruments.

He blamed “hubris” by institutions, the “collective madness” of their belief that they could all secure above-average returns, and pressure on them to do so for fuelling the risk-taking that sparked the present market crisis. “The experience of the last few months has been a chastening one,” he said.

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