UPDATE 2-BoE says banks would be vulnerable to abrupt rise in global rates

* Regulators to quantify risks from rate by September

* Banks allowed to draw on their cash buffers

* Banks face using standard method to add up risks

* Stress tests of top banks yearly, some results published

By Huw Jones and David Milliken

LONDON, June 26 (Reuters) - The Bank of England warned banksand borrowers on Wednesday they may be vulnerable if there is anabrupt rise in global interest rates which could require lendersto bolster their capital cushions again.

Global bond yields have jumped since U.S. Federal ReserveChairman Ben Bernanke said last week that the U.S. central bankmay start to scale back bond purchases later this year.

"The violence of the adjustment over the past fortnightunderlined the extent of the search for yield over the pastmonths and the need for the authorities ... to pin down whetheror not there are any vulnerable links in the financial systemthat could jeopardise stability," BoE Deputy Governor PaulTucker told reporters.

The BoE ordered an investigation into the vulnerability ofBritain's financial institutions and a "cohort" of borrowers tohigher interest rates, and the findings would be given to itsnew risk watchdog, the Financial Policy Committee, by September.

"Financial institutions and markets are also vulnerable toan abrupt rise in global interest rates. And some UK borrowersremain highly indebted, which could result in losses for UKbanks," the FPC said in a half-yearly report on Britain'sbanking system.

"Capital can provide some protection from interest raterisks," it said.

As well as causing loans to go sour, higher interest ratescould bump up banks' own borrowing costs, the FPC said, addingthat around 40 percent of banks' assets would have to beimmediately revalued if rates rose abruptly.

The BoE itself is a long way from tightening monetarypolicy. Tucker reiterated comments made by outgoing GovernorMervyn King on Tuesday that an interest rate hike was notimminent, saying it would only occur once the British economyhad reached "escape velocity."

Indeed, a minority of the Bank of England's rate-setters,including King, have been pushing for more bond-buying due tothe weak state of Britain's economy.

Jaime Caruana, general manager of the Bank for InternationalSettlements, a forum for central bankers, said banks shouldprepare themselves for interest rate risks, market volatilityand drops in asset prices.

"If they prepare themselves then, when the time comes, thenormalisation process would be smoother and easiers," he said.

Also on Wednesday, the British central bank said banks couldscale back some of the short-term cash they hold against shocksto encourage more lending to the economy, a change which couldrelease as much as 70 billion pounds in new credit depending ondemand, Tucker said.

The 11-member FPC gained legal powers to set capitalrequirements for banks in April after operating on an interimbasis for the previous two years.

Just a week ago it ordered five banks to raise 13 billionpounds ($20 billion) of extra capital.

Privately, bankers complain that higher capital requirementsand limits on leverage are hampering their ability to lend, anargument which has been strongly disputed by the BoE.

In its report on Wednesday, the FPC said it saw nocontradiction between its calls for higher capital and financeminister George Osborne's request that it heed the impact of itsactions on short-term economic growth.

King steps down as governor at the end of this week and willbe replaced by former Canadian central bank chief Mark Carney,who many economists expect to advocate a long-term commitment tolow interest rates as a way to keep down bond yields.

The FPC said there will be an annual stress test of banksstarting in 2014 and it will issue a discussion paper later thisyear on what test results will be published each time.

The FPC fleshed out on Wednesday how far banks can go inscaling back their cash-like buffers to free up money that canbe lent to the economy.

Banks already hold amounts that exceed the new global Baselrules and the FPC said the buffers can be reduced to 80 percentof the Basel minimum until January 2015, and then rise back tofull compliance by January 2018.

Separately, the FPC requested the central bank's PrudentialRegulation Authority, Britain's day-to-day banking supervisor,to report by the final quarter on whether banks should be forcedto use a standard model for totting up their risky assets.

Banks use bespoke models to quantify the risks which in turndetermine the size of their capital buffers but some FPC membersworry banks are underestimating risks.