LONDON (Reuters) - The Bank of England urged banks on Thursday to consider the risk of future spikes in interest rates when they approve mortgages, and prepared tools to rein back potentially dangerous lending.
British house prices have risen by around 10 percent over the past year, and the central bank said mortgages were higher as a share of home-buyers' income than at any point since 2005, although other indicators remained weaker than average.
Some commentators argue that parts of Britain's housing market are already in a bubble and the BoE's Financial Policy Committee, which monitors risks to the financial system, said it was keeping a close eye on the sector.
"Given the increasing momentum, the FPC will remain vigilant to emerging vulnerabilities, will continue to monitor conditions closely and will take further proportionate and graduated actions if warranted," the Bank said.
From next month the body that regulates how British banks lend to consumers, the Financial Conduct Authority, will introduce tougher home loan underwriting standards.
The BoE said in a report of a quarterly meeting of its risk watchdog, the Financial Policy Committee, that from June it hoped to have the power to set the interest rate scenarios that lenders would have to consider when granting loans.
The central bank also said that when it conducts its part of European Union-wide stress tests for banks this year, it would also make them consider the risk of a sharp rise in interest rates and a big fall in house prices.
"The scenario was not intended to be the FPC's expectation of what would happen, but a coherent tail risk event against which banks' resilience could be tested," the BoE said.
The FPC made no new formal recommendations, but it said that concern about financial markets' readiness for a rise in interest rates was "now at the heart of the FPC's risk and vulnerability assessments".
This extended to emerging markets. While financial markets had been little affected by turmoil in Ukraine and parts of China's financial markets, investors may have a false sense of security that interest rates will not return to more normal levels, the BoE said.
The BoE added that British banks' financial health had improved since its last report in November, but that uncertainty about the cost of past misconduct had increased.
Lenders are also paying huge sums in compensation for mis-selling loan insurance and allegations are emerging that banks have manipulated the foreign exchange market.
Separately, the Bank published its terms of reference for an assessment of leverage ratios at banks, which it said would report back in November. However it will not set a numerical value for a leverage ratio until later.
The FPC is likely to get power in future to raise leverage ratios at British banks to above international minimum levels.
Under the global accord known as Basel III, banks across the world must hold capital equivalent to at least 3 percent of their total assets on a non risk-weighted basis from the start of 2018. The aim of this so-called leverage ratio is to serve as a backstop to a bank's core capital buffer, which is based on risk-weighted assets.
Policymakers in Britain, Switzerland and the United States have put more emphasis on the leverage ratio, saying banks can too easily game risk-weightings in their core buffers and that a higher ratio is required. Analysts expect them to set levels of 4 to 4.5 percent.
The FPC also said it was minded to require big banks to add up risks on their books using the same standardized model as smaller lenders.
Policymakers have become skeptical about how large lenders use in-house computer models to tot up risks, a calculation which determines how much capital they must hold.
The FPC said banks who use in-house models may have to report figures under the standardized approach as well following a review due in the first half of next year.
Finally, the watchdog said it will set out "concrete and specific action plans" for banks this year to improve their resilience to cyber attacks.
Editing by Catherine Evans