UPDATE 2-Bank of England readies tools to rein in risky mortgage lending

* BoE says will be vigilant about rise in UK house prices

* Risk of interest rate spikes "at heart" of FPC monitoring

* UK faces extra house price crash scenario in EU bank tests

* Review of leverage ratio will not set actual figure

* Analysts say FPC tone points to more action on housing (Adds analysts' comment)

By Huw Jones and David Milliken

LONDON, March 27 (Reuters) - The Bank of England urged bankson Thursday to consider the risk of future spikes in interestrates when they approve mortgages, and prepared tools to rein inpotentially dangerous lending.

British house prices have risen by around 10 percent overthe past year, and the central bank said mortgages were higheras 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 housingmarket are already in a bubble and the BoE's Financial PolicyCommittee, which monitors risks to the financial system, said itwas keeping a close eye on the sector.

"Given the increasing momentum, the FPC will remain vigilantto emerging vulnerabilities, will continue to monitor conditionsclosely and will take further proportionate and graduatedactions if warranted," the Bank said.

From next month the body that regulates how British bankslend to consumers, the Financial Conduct Authority, willintroduce tougher home loan underwriting standards.

The BoE said in a report of a quarterly meeting of its riskwatchdog, the Financial Policy Committee, that from June ithoped to have the power to set the interest rate scenarios thatlenders would have to consider when granting loans.

The central bank also said that when it conducts its part ofEuropean Union-wide stress tests for banks this year, it wouldalso make them consider the risk of a sharp rise in interestrates and a big fall in house prices.

JPMorgan bank said it expects stricter mortgage stress testsfor borrowers and lenders as a minimum step by the FPC.

"But a continued rise in transaction levels together withdouble-digit house price inflation would probably push the FPCinto taking further steps," JPMorgan said in a research note.

Banks could be forced to hold more capital against mortgagesand there was a "high chance" the FPC will recommend scalingback the second phase of a government scheme to help homebuyers,JPMorgan said.

The FPC made no new formal recommendations, but it said thatconcern about financial markets' readiness for a rise ininterest rates was "now at the heart of the FPC's risk andvulnerability assessments".

MISCONDUCT COSTS

The BoE added that British banks' financial health hadimproved since its last report in November but that uncertaintyabout the cost of past misconduct had increased.

Banks like Barclays and Royal Bank of Scotland have been fined millions of pounds for rigging theLondon Interbank Offered Rate, or Libor, an interest ratebenchmark.

Lenders are also paying huge sums in compensation formis-selling loan insurance and allegations are emerging thatbanks have manipulated the foreign exchange market.

Separately, the Bank published its terms of reference for anassessment of leverage ratios at banks, which it said wouldreport back in November. However it will not set a numericalvalue for a leverage ratio until later.

The FPC is likely to get power in future to raise leverageratios at British banks to above international minimum levels.

Under the global accord known as Basel III, banks across theworld must hold capital equivalent to at least 3 percent oftheir total assets on a non risk-weighted basis from the startof 2018. The aim of this so-called leverage ratio is to serve asa backstop to a bank's core capital buffer, which is based onrisk-weighted assets.

Policymakers in Britain, Switzerland and the United Stateshave put more emphasis on the leverage ratio, saying banks cantoo easily game risk-weightings in their core buffers and that ahigher ratio is required. Analysts expect them to set higherlevels than Basel III.

"We expect the UK regulator will eventually settle on a4-4.5 percent hurdle rate, to be achieved by end-2017. Barclayslooks most at risk," Citi bank said in a research note.

The FPC also said it was minded to require big banks to addup risks on their books using the same standardised model assmaller lenders.

Policymakers have become sceptical about how large lendersuse in-house computer models to tot up risks, a calculationwhich determines how much capital they must hold.

The FPC said banks who use in-house models may have toreport figures under the standardised approach as well followinga review due in the first half of next year.

"On a standardized basis we estimate Lloyds would see thegreatest risk-weighted assets inflation," Citi bank said.

Finally, the watchdog said it will set out "concrete andspecific action plans" for banks this year to improve theirresilience to cyber attacks. (Editing by Catherine Evans and Hugh Lawson)