LONDON, ENGLAND - THE Bank of England said that British commercial banks had overestimated their exposure to the collapsed United States subprime home loan sector and the subsequent global squeeze on credit.

The bank did not quantify the overestimation, which it said could be a factor in a loss of confidence that has afflicted certain financial institutions.

A large number of global banks have declared heavy losses from US mortgage-backed securities, which were effectively bets placed on high-risk American borrowers repaying their mortgages.

The credit crunch erupted last August, as many subprime US borrowers failed to keep up with their home loan repayments, forcing major commercial banks to tighten up their lending criteria.

'Estimates of the ultimate losses to the financial system and real economy implied by current market prices are a significant overestimate,' the Bank of England (BoE) said on Thursday in a half-yearly report on financial stability.

'Overpessimism about these losses may itself be denting confidence and may be delaying the return of investor risk appetite and the recovery of asset prices.'

Furthermore, the BoE said that commercial banks were becoming too cautious in their lending criteria.

'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,' said Mr John Gieve, BoE deputy governor for financial stability.

Last week, the central bank had unveiled a US$100-billion (S$140-billion) plan to get banks lending again in the latest attempt to combat the global credit crunch.

Under the plan, the BoE will allow high street banks to swap British mortgage-backed securities for government bonds in a bid to boost their liquidity amid stubborn and widespread fears of subprime exposure.

'Rising US sub-prime defaults were the trigger for a broad-based repricing of risk and deleveraging in credit markets,' the BoE said in its report.

'An adjustment was needed after the credit boom and will inevitably have costs, but it is proving even more prolonged and difficult than anticipated.

'Prices in some credit markets are 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,' said the British central bank.

With some assets undervalued, investment should soon flow back into the financial sector, helping companies' balance sheets, the BoE added.

However it noted that such improvements are likely to be only gradual as uncertainty persists.

'The disruption in markets reflects, in part, structural factors such as information and incentive problems, ... (and) while this adjustment takes place, risks to financial stability remain high,' the BoE warned. -- AFP