"Bad news for financial markets isn't over"

Mervyn King

London (Reuters) - Bad news for financial markets isn't over yet and joint central bank action to ease the credit crunch may not be enough to stop a big slowdown in the world economy, Bank of England Governor Mervyn King said on Tuesday.

Under fire for his handling of the crisis gripping markets, King painted a gloomy economic picture when he appeared before parliament's Treasury Committee, and blamed the problems on investors' greed and ignorance.

"The problems in the financial sector remain with us," King told the committee. "A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets."

While he spoke, the BoE offered banks 3-month loans totalling 10 billion pounds as part of a global drive to kickstart interbank lending. This has all but dried up as banks fear lending to fellow financial institutions in case they run into trouble.

But the take-up in the auction was not as strong as some people had expected. Many banks were able to get the money at the lowest bid rate of 5.36 percent, below the BoE's main lending rate of 5.5 percent.

King pointed out that the problem with markets was not a lack of money but a lack of trust. The big banks, he said, were awash with cash. It was confidence that had to come back.

That was the reason for last week's announcement by the BoE, the ECB, the U.S. Federal Reserve, Bank of Canada and Swiss National Bank of a range of measures to aimed at getting markets to flow freely again.

Interbank lending rates have come down since then but they are still trading at a considerable premium over official lending rates, and few people expect a return to normality at least until the new year.

"The difficulty we face is that even the operations we put in place cannot be guaranteed and are indeed unlikely to bring about a significant reduction in spreads," King said.

"In the last four weeks, banks themselves have been worried that the impact of their reluctance to lend will lead to a sharper slowdown in the United States," he said. "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."

GREED ISN'T GOOD

Asked what the cause of the current crisis was and how it had led to the run on Northern Rock bank, King said he had been warning for some years of the excessive risks being taken in financial markets in the constant search for yield.

"The real cause lies with human nature and the wish to get higher returns," he said, describing the idea that everyone could get above-average returns as "collective madness".

"What we have to try to do is to make sure that people responsible for investment decisions, whether it's pension fund managers or others, say to themselves: 'I am not going to be seduced into investing in something I don't understand.'"

Still, there were lessons to be learnt from the last few months, he said, admitting it had been a chastening experience.

Chief among these lessons was the need to get legislation in place to help the authorities rescue failing banks covertly.

September's Northern Rock debacle, Britain's first bank run in more than a 100 years, happened because savers panicked when they heard the lender had to seek emergency funding from the BoE as a result of the credit squeeze.

But on his own future, King, whose term as governor ends in June 2008, was silent and rejected accusations in some newspapers that the BoE had been briefing journalists against the government.

Deputy Governor John Gieve, who has been taking even more flak than King because his remit is financial stability, said he considered he had done a "reasonable job".