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LONDON (Reuters) - Rising interest rates after years of loose monetary policy will pose a fresh risk to banks' ability to absorb losses using capital buffers, the Bank for International Settlements said in its annual report on Sunday.
A prolonged period of ultra-low rates would further weaken the financial sector and squeeze banks' profitability, but a "normalization" of borrowing costs would reverse the debt-fueled inflation of asset prices and hit banks' own loss-absorbing equity capital, the BIS said.
"Just as falling yields have supported asset valuation gains in recent years, an eventual normalization would generate losses ... Banks' equity capital would shrink."
The banking sector has made progress in building up capital buffers since the 2008 crisis, which sounded alarm bells over leverage in the financial industry. Big international banks' core capital levels have risen over the past three years while assets adjusted for riskiness have fallen, the BIS said.
But the report said an impending turn in monetary policy underscored the need for extra regulatory safeguards. Global banking regulators earlier this month set out two such possible measures to force banks to set aside more money to cover interest-rate risk.
The BIS also warned that banks might have an "incentive" to opt for more lax risk adjustments to flatter capital ratios. "Supervisors need to be in a position to regularly, transparently and convincingly validate risk estimates," it said.
Some investors and analysts see strong retail banks as better able to pass on the cost of rising rates to clients than investment banks or trading houses more exposed to a potential squeeze on credit trading.
Insurers and pension funds are however seen as clearer beneficiaries of rising rates as investment yields rise too. Ultra-low rates have spurred a search for yield that the BIS described as "aggressive".
Pension funds, for example, had a 25 percent exposure to alternative investments such as real estate, hedge funds, private equity and commodities in 2014 versus only 5 percent in 2001.
The BIS report said asset managers faced their own set of risks in the face of market shocks. Restrictions on investment portfolio shifts or leverage could be one way to contain market volatility or big price swings, the report said.
Reporting by Lionel Laurent; Editing by Ruth Pitchford