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26 Mar, 2008

Bank of England governor (BoE) Mervyn King has assured market the Bank will continue to pump liquidity into markets in a bid to restore confidence to dwindling sentiment.

Speaking before the Treasury Select Committee (TSC) King said the financial crisis had moved into a new phase.

He said: 'Across the world, confidence in financial markets is fragile. It is not that banks, at least in the United Kingdom, have made loans which are likely to result in unsustainable losses.'

'The heart of the problem is not in the real economy, it is in the financial sector itself. It stems from an 'overhang' on bank's balance sheets of assets in which markets have closed.'

King pointed out that these assets cannot be sold or used to secure funding in the market as they are difficult to finance, which as a result has created uncertainty in the strength of bank's financial positions.

King said action from the BoE was necessary to prevent a major shock to the system. 'I want to assure you that the Bank will provide the liquidity assistance that the system needs in order to restore confidence,' he said.

'Such lending can only be a temporary measure but it can be a useful bridge to a longer-term solution.'

He added: 'It is unrealistic to assume that markets for many asset-back securities are likely to re-open speedily or, when they do, to their previous levels of activity. So we are discussing with the banks how a longer term resolution to the problem might be reached.'

King said it is difficult to assess where the discussions may lead, but highlight two principle roles which would underline the BoE stance. Firstly the risk of losses on lending should remain with banks and secondly a longer-term solution of focusing on the overhang of assets and not subsidise issues of new assets.

'One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks, and hence the true cost, of the securitisation process.'  

Meanwhile King also reiterated the Bank had no intention of following the Federal Reserve's stance on interest rates.

The Fed has embarked on a series of dramatic rate cuts in the US in the last few weeks a bid to stave off the growing threat of a recession in the world's biggest economy. The UK has only made two cuts in this period and last month opted to keep rates on hold at 5.25% at this month's meeting.

King told the TSC the UK is better placed to withstand the problems in markets, hence the difference between the BoE rate policy and that of the Fed's.

'The world economy, particularly the United States, has weakened, but the recent fall in sterling should help to cushion the impact of exports.

'And the official data on retail sales show that spending has this year been surprisingly resilient.'

But short term inflation remains a concern. King told the TSC that the BoE expects high commodity prices across the world to result in a spike in inflation to around 3% in the short term.

But he believes sharp cuts in interest rates will have little impact on short-term inflation trends. 'What is crucial is that the pickup proves to be temporary, just as the rise in inflation was last year was.

'Even if commodity prices remain at their present high levels in the face of a slowing world economy, our central projection is for inflation to fall back towards the 2% target, starting later this year.'

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