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The Bank of England said lenders should use improved funding conditions to buffer themselves against further shocks and brace for 1 trillion pounds ($1.6 trillion) in liabilities maturing in the next five years.

“Banks remain exposed to any future deterioration in macroeconomic and market conditions, which could substantially raise the cost of funding and capital raising,” the central bank said in its semi-annual financial stability report published today in London. “Taking advantage of current favorable conditions would help to repair balance sheets and thereby insure banks against future adverse developments.”

Threats include the unwinding of dollar-funded trades because of the withdrawal of emergency policy measures, sovereign risks, a prolonged economic recovery or a drop in asset prices, the central bank said. Policy maker Kate Barker said this week the U.K. faces a “bumpy and uneven” pickup and a quarter of contraction is possible in 2010.

“The financial system has been significantly more stable over the past six months, underpinned by the authorities’ sustained support for the banking system and monetary policy measures,” the report said. “But globally some household, corporate and national balance sheets remain stretched. And with access to bank lending still impaired, some borrowers face significant refinancing challenges.”

The U.K.’s six-quarter recession may be ending after unprecedented emergency policy measures. The central bank is buying 200 billion pounds of bonds with newly created money to aid economic growth, while Prime Minister Gordon Brown has bailed out banks, cut sales tax and helped carmakers.

Asset Prices

Asset prices have since increased. The FTSE 100 share index is up more than 50 percent from the low for the year reached in March. House prices rose 1.8 percent in November from a year earlier, the first annual increase since February 2008, Lloyds Banking Group Plc’s Halifax division said Dec. 8.

“There has been a strong, synchronized rise in asset prices internationally, underpinned by substantial interventions to support banking systems,” the central bank said. “Improved market conditions have boosted bank profitability.”

Recent U.K. bank earnings have been mixed. HSBC Holdings Plc, Europe’s biggest bank, said Nov high risk personal loans. 10 third-quarter pretax profit was “significantly higher” as bad loans declined, while Barclays Plc posted a 54 percent drop in earnings.

Banks’ mark-to-market losses from the financial crisis on selected assets have also dropped, falling to $6.3 trillion this month from $24.3 trillion in March in the U.K., U.S. and euro area, the Bank of England said.

Bank Liabilities

Financial institutions need to prepare themselves for the end of government support and the withdrawal of emergency measures, the central bank said. Three-quarters of bank liabilities maturing by the end of 2014 are “unguaranteed” market funding, the bank said.

The central bank also called for lenders to curb payouts to investors and employees and hoard capital instead. That echoes the tone of the Basel Committee on Banking Supervision, which yesterday urged national authorities to limit bonus and dividend payments by banks with weakened capital safety nets.

“Retaining a higher share of current buoyant earnings could significantly increase banks’ resilience and ability to lend,” the U.K. central bank said. A 20 percent cut in “discretionary distributions” each year between 2000 and 2008 would have boosted capital by 75 billion pounds, more than the public sector provided in the crisis, the bank said.

Volatility Threat

Among the risks to the financial industry, the bank said that the unwinding of government support could create volatility across all asset prices and produce losses in investments funded with low-yielding assets such as the dollar. Credit-rating downgrades for sovereign debtors could produce a capital flight that would strain access to funding, the bank said.

While a slower-than-expected recovery could also place strains on access to credit and pose a risk to financial stability, so could higher interest rates, the bank said. Rate increases would strain the finances of indebted consumers, the report said.

“The availability of credit to households will be an important determinant of the pace of economic recovery and a driver of prospective losses for banks,” the report said.

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