Bank liquidity pressure could threaten economic recovery, MPs warn

In a letter to Mervyn King, Governor of the Bank of England, Chairman of the Treasury Committee Andrew Tyrie warned that rules requiring banks to hold more liquid assets were making banks more cautious about lending to businesses.

Liquid assets are assets that banks can easily turn into cash. European banks will be required to hold more liquid assets when the so-called Basel III regulatory regime comes into force. While these changes do not begin to take formal effect before 2015 the financial markets are already starting to monitor banks' performance against this standard, meaning that "tighter liquidity regulation has de facto already begun", Tyrie said.

Emergency liquidity provided by the government and the Bank of England during the original banking crisis in 2008 was also now being withdrawn, he said. This meant that banks were beginning to compete more aggressively for "stable" sources of funding, such as retail deposits.

Pressures on bank lending were also being "compounded" by the current sovereign debt crisis in the eurozone, making it even harder for banks to find stable funding.

"Banks should, in due course, be weaned off extraordinary official liquidity support. But attempting to do it too quickly, in a hostile international economic environment, could risk setting economic recovery back for benefits that are unclear. If that were to happen a second crisis might come to be seen as having been aggravated rather than alleviated by the action of regulators," he said.

Bank credit in the UK shrunk 7% in the year to the end of August, Tyrie said. Continued pressure on bank liquidity risked this contracting further, making economic recovery less likely.

Tyrie added that he hoped the Bank of England's new Financial Policy Committee, set up to monitor and deal with risks to financial stability, was examining the issue.

"This is another instance which highlights the tension between the political pressure on the banks at UK level to increase lending and the current EU reforms which require banks to retain higher levels of capital on their balance sheets – and therefore have less capital available to lend," said Lucy Shurwood, a banking law expert with Pinsent Masons, the law firm behind Out-Law.com.

Earlier this month the Bank of England said it would increase its current programme of quantitative easing by injecting a further £75 billion into the economy. However Tyrie warned that while this was good policy, it would do little to increase the supply of liquid assets to banks.

King will appear before the Treasury Committee to discuss quantitative easing on Tuesday morning.

Tyrie also asked for clarity about which body was responsible for regulating banks' liquidity. A new Bank of England Prudential Regulation Authority (PRA) is to assume responsibility from the Financial Services Authority (FSA), however this will not become operational until the end of 2012, Tyrie said.

"Some concerns have been raised with me about the need to avoid the risk of a regulatory vacuum... We cannot afford the risk of what, at the start of this crisis, became known as a regulatory underlap," he said.

A copy of the letter was also sent to Hector Sants, chief executive of FSA.