(Adds new comments from BoE's Gieve)
By Matt Falloon
LONDON, Oct 28 (Reuters) - Global intervention should steady the banking system but it will also put big constraints on banks, the Bank of England said on Tuesday, six months after it said it expected confidence to return to financial markets.
In its twice-yearly financial stability report, the BoE also said actual losses may be much less than the $2.8 trillion currently priced into financial markets, reiterating a similar point it made in its April report -- before the credit crunch spiralled into the worst financial crisis in living memory.
"Exceptional interventions by governments and central banks should help stabilise the banking system in the period ahead," the BoE said.
"While there are still risks in the wider financial system, the immediate response to the measures has been positive."
BoE Deputy Governor John Gieve told the British Bankers' Association on Tuesday the financial crisis was not over, and international authorities needed to be ready to act again if necessary.
His speech made no direct reference to the outlook for monetary policy but most analysts expect the BoE to cut interest rates sharply over the next few months, starting with another 50 basis point cut to 4.0 percent in November.
"Authorities worldwide need to remain vigilant and to be ready to step in again if necessary," Gieve said.
In its April stability report, the BoE gave a fairly upbeat assessment of how severely the credit crunch would impact markets and the wider economy, but the central bank's latest report is more cautious.
"The instability of the global financial system in recent weeks has been the most severe in living memory," Gieve said in a statement alongside the October report. "And with a global economic downturn under way, the financial system remains under strain."
"We need a fundamental re-think of how to manage systemic risk internationally. We need to establish stronger restraints on the build-up of risks in the financial system over the cycle with the dangers they bring to the wider economy."
TRILLIONS OF POUNDS
Central banks and governments globally have made as much as five trillion pounds available in support funding since April, but that level of help will have consequences, the BoE said.
"Reducing reliance on the official sector as a source of funds is likely to be a significant constraint on banks' activities over the medium term," the BoE said.
Banks will also need to lower their exposure to short-term wholesale funding and their leverage to improve the quality of their balance sheets, the central bank said.
"Both are consistent with a period of tighter credit conditions for the real economy, compared to the period prior to the turmoil," it said.
The roots of the credit crunch lie in the unwillingness of banks to lend to each other because of fear of what toxic, hard-to-value assets may be lurking behind each others' doors.
That has frozen up markets and cut vital credit lines to businesses, households and would-be homebuyers, helping to drive Britain towards its first recession since the early 1990s.
The BoE said "there are tentative signs that counterparties have become more willing to lend to banks on an unsecured basis" after Britain's recapitalisation package and similar moves by other countries.
The government offered to inject 50 billion pounds into banks and guarantee new short and medium term debt issuance at the start of October. The BoE also extended its Special Liquidity Scheme -- under which banks can swap hard-to-trade mortgage assets for government debt.
Interbank lending rates -- which spiked to unusually high levels at the height of the credit crunch -- have eased as a result of that rescue package, but fears of recession and further market turbulence are hampering a fuller recovery.
"It seems unlikely that these spreads will return to pre-crisis levels, since these reflected an under-appreciation of the risks on banks' balance sheets," the BoE said.
However, as it said earlier this year, the Bank of England believes current market prices are not reflecting the true value of losses from the credit crunch.
"Mark-to-market losses have increased substantially since the April Report across the majority of instruments, roughly doubling for the United Kingdom and the United States, and rising by even more for the euro area," the BoE said, estimating that markets were projecting losses at $2.8 trillion.
"But (the estimated losses) continue to reflect significant premia for uncertainty about future collateral performance and illiquidity in secondary markets. The economic values of these assets lie significantly above their current market values." (Additional reporting by David Milliken, editing by Andy Bruce)