Britain’s financial system is vulnerable to new shocks in the wake of its most severe challenge for decades, and banks and authorities must learn the lessons of the crisis, the Bank of England says today.

In its first detailed analysis of the squeeze that has engulfed credit markets since the summer, the Bank says that financial institutions have become more fragile and that the availability of credit may tighten. In turn, it sounds a warning that tighter lending conditions could spell serious fallout for the economy, with sub-prime borrowers and highly-leveraged companies particularly exposed.

The Bank’s unexpectedly gloomy report goes on to warn investors that share prices in Britain and the US could prove “vulnerable to any further revision in growth prospects”. A further danger is that the dollar could fall sharply if adverse sentiment towards US securities persists, it says.

Sir John Gieve, the Bank Deputy Governor, admitted that although it had expected some of the problems, “the speed and ferocity” of the global disruptions “had not been anticipated by firms or authorities”.

The Bank’s half-yearly Financial Stability Review, published today, says that the turmoil “has proved to be the most severe challenge to the UK financial system for several decades” and calls for the UK’s crisis management tools to be strengthened. It says that “serious fragilities” have been exposed within the so-called originate and distribute business model used by many financial firms to parcel up debt.

British banks are especially vulnerable. They face a bill of almost £150 billion, hitting their profitability, if the credit crisis forces them to set aside capital against their exposure to structured investment vehicles (SIVs), leveraged loans and mortgage-backed securities, the Bank says.

The banks have promised liquidity lines worth about £109 billion to their SIVs and other off-balance sheet vehicles. If these provisions have to be drawn down and become an on-balance sheet exposure, the full amount in risk capital could have to be put aside. This could come on top of £15.5 billion for leveraged loan risks that have been kept on the banks’ books, and £22.8 billion against exposure to mortgage-backed securities. The Bank points out that the £109 billion bill alone was equal to 35 per cent of the banks’ on-balance sheet loans to British nonfinancial companies.

If banks now fail to adapt their business models and carry on as before, confidence will return but at the risk of a repeat of the market turbulence “potentially on an even larger scale”, the Bank says. It adds that there is evidence that some banks are already loosening their standards once again.

In a shot across the bows of the private equity industry, the report says firms subject to leveraged buyouts will be particularly sensitive to the rise in the cost of debt. The likelihood of a sharp rise in corporate distress in this area has risen, the Bank says.

The report singles out commercial property as “particularly prone to shocks and to rises in the cost of finance”, noting the high levels of borrowing by the sector.

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