The ability of big financial groups to “farm out” risks on their loans to other institutions through derivatives is leading them to be increasingly cavalier over corporate borrowing, fuelling the present explosion in leverage, the Bank of England will tell the City today.

In the latest caution to the financial industry over a boom in leveraged buy-outs, coupled with escalating risk-taking by lenders, the Bank raises concern that credit transfer markets, which allow bad loan risks to be diversified through the financial system, might be creating dangerous complacency.

It suggests that this trend is being compounded by a long run of benign economic conditions. “Some market participants appear to be extrapolating the stable past environment and high asset market liquidity into the future. Greater use of risk transfer markets may have encouraged this process,” the Bank says in its latest Financial Stability Report.

The report highlights worries that the outsourcing of risk on loans by lenders “is affecting the depth and quality of risk assessment” and concern over less careful scrutiny of lending practices alongside “high and rising leverage in parts of the corporate sector”.

The Bank raises the spectre that if the sort of careless lending behaviour that led to the recent turmoil in the American sub-prime mortgage sector is repeated in the more significant market for corporate lending, this “could have serious consequences if credit quality were to deteriorate”.

Striking an ominous note, it adds: “If corporate credit quality weakened sharply, a growing tail of risky corporate debt could be exposed.”

Sir John Gieve, the Bank’s Deputy Governor, urged institutions to manage risk with more care. “Risk-taking is increasing, including through higher leverage, lower margin requirements and relaxation of covenants,” he said. It was important for lenders to be “alert to these risks and that firms’ stress-testing takes them into account”, he said.

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