In its biannual Financial Stability Report, the Bank of England says that policy measures have shored up the financial system in the short term, but that risks remain. It also calls for a fundamental rethink of systemic risk.

The report explains that after a year of exceptional stress in the banking system, the failure of Lehman Brothers triggered a severe loss of confidence. To reverse that, significant measures were announced in the UK and many other countries to provide banks with new capital and guarantees for borrowing, and further to enhance liquidity. It sees “early signs that these measures have helped to underpin confidence in the banking system. They have increased banks’ capacity to withstand future losses and lowered the perceived risk of default significantly.”

That said, the report notes that risks remain in the financial system. “While these early signs of stabilization in bank funding conditions are encouraging, risks remain in the broader financial system. One risk is that leveraged investors, like hedge funds, may be forced to liquidate asset holdings due to tighter credit conditions,” it warns. Also, it says that risks could arise for insurance companies if the value of their investments were to fall below regulatory capital requirements. And, it says that adverse developments in emerging market economies could put fresh strains on financial systems in developed countries.

Additionally, over the medium-term, there will be transition risks as banks adjust their balance sheets and funding models, weaning themselves off current high levels of official sector support.

The report also discusses the “need for a fundamental rethink of how to safeguard against systemic risk, for example through the development of new countercyclical tools to dampen the financial cycle and though stronger capital and liquidity requirements.”

“The instability of the global financial system in recent weeks has been the most severe in living memory. And with a global economic downturn underway, the financial system remains under strain,”said Sir John Gieve, deputy governor at the Bank. “But it is better placed as a result of the exceptional package of capital, guaranteed funding and liquidity support. That is helping to underpin the banking system both directly and by demonstrating the authorities’ determination to do whatever is needed to restore confidence.”

“Looking further ahead, we need a fundamental re-think of how to manage systemic risk internationally,” he added. “We need to establish stronger restraints on the build-up of risks in the financial system over the cycle with the dangers they bring to the wider economy. That means not just increasing capital and liquidity requirements for individual institutions but relating them to the cyclical growth of risk in the system more broadly. Counter cyclical policy of that sort should complement regulation of companies and broader macroeconomic policy.”