The Bank of England today publishes its Financial Stability Report and signals that the worst of the credit crisis is over.  It says the credit markets “overstate the losses that will ultimately be felt by the financial system and the economy as a whole”.

The Bank says that rising US subprime defaults have triggered a broad-based repricing of risk and deleveraging in credit markets. An adjustment was needed after the credit boom and was bound to have costs, but it is proving even more prolonged and difficult than anticipated. Prices in some credit markets are now likely to overstate the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include large discounts for illiquidity and uncertainty. Conditions should improve as market participants recognise that some assets look cheap relative to credit fundamentals. But with sentiment still weak, the Bank has announced a special scheme to improve the liquidity position of the banking system and to increase confidence in financial markets.

The Report sets out:

• The reasons for the repricing of credit risk and deleveraging being so protracted.

• Why market-based estimates of the costs of the crisis are likely to overstate ultimate losses.

• Prospects for financial stability.

• Measures to help contain the length and costs of the turmoil and to prevent its recurrence.

Introducing the report, John Gieve, Deputy Governor for Financial Stability, said:

“The unavoidable correction after the credit boom is proving protracted and difficult. However the pricing of risk in credit markets seems to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals. So, while there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

“To reinforce those prospects of recovery, we need to restore confidence in the banking system. That is why we have launched the Special Liquidity Scheme and why I welcome the steps taken by some banks to strengthen their capital positions.”

Last month, the International Monetary Fund (IMF) estimated that financial sector losses so far had mounted to $945bn, a figure the Bank of England terms “misleading” because it “confuse[d] true credit losses and losses implied by market prices”.

The report says that if current market prices are to be believed, they imply “unprecedented” levels of default on mortgage-backed assets. Some 76 per cent of US subprime mortgages sold in the first half of 2007 would default with a loss of 50 per cent on each of these impaired mortgages if market prices were correct, the bank calculated.