BoE's Furse - markets more vulnerable to shocks as liquidity shrinks

By Huw Jones

LONDON (Reuters) - Markets are less active and therefore less able to absorb shocks and fund growth now that tougher capital rules have forced banks to cut back on trading, a senior Bank of England policymaker said on Wednesday.

Clara Furse, a member of the BoE's Financial Policy Committee (FPC) and former chief executive of the London Stock Exchange , said the risk from shrinking liquidity is not fully priced in, making them vulnerable to sharp corrections.

Her comments echo concerns from other policymakers that capital adequacy rules may need revisiting as they could be making it harder for banks to make markets in securities and raise funds for companies to expand.

The rules have increased resilience in banks but they have also "acted as an additional disincentive to such activities, especially those related to low-margin market-making activities", Furse said in speech in Birmingham.

Banks have to hold far more capital on their inventory of securities used for market making, prompting some to pull out.

Furse said British banks have cut trading inventories by nearly a third since the 2007-09 financial crisis to levels last seen in the early 2000s while the actual markets themselves have grown in size.

"As a consequence the financial system has less capacity to absorb market shifts and periods of higher volatility are more likely," Furse said.

Europe's capital markets already lack the depth of their U.S. counterparts at a time when policymakers are looking to them even more to plug funding gaps for companies.

Banks, traditionally the source of 75 percent of corporate funds in Europe, have scaled back on lending to focus on building up their capital levels.

Furse said that as the post-crisis regulatory reform agenda beds down, it will be important to take stock of the cumulative impact and interaction of all the recent rule changes.

"The goal is to achieve the right calibration for a financial system that is able to work towards a sound and strong economic future," said Furse.

The FPC has powers to alter how much capital banks must hold but many of the requirements are set at the European Union and global level.

The structure of the market is changing with big investors, pension and hedge funds seen as the true providers of liquidity rather than banks in a transition that could be bumpy, she said.

The G20's Financial Stability Board, headed by BoE Governor Mark Carney, is already looking at the cumulative impact of new banking rules and the possible unintended consequences.

(Editing by Louise Ireland)