The Bank of England suggests banks may be

4th December 2012

 

The Governor of the Bank of England Mervyn King has suggested that banks in the UK could have a £60bn hole in their books. Since the onset of the financial crisis, there has been a tradition of central bankers and finance ministers telling banks that they were in much worse shape than they thought they were or that they were prepared to admit to.

But King's remarks come just as some experts were hoping that we were reaching at least the end of the beginning of the crisis or at least the part to do with banks. Perhaps those hopes are going to be dashed. Here Mindful Money outlines some of the big questions now hanging over UK banks once again.

What's happened?

The most recent Financial Stability Report from the Bank of England put out a warning shot on British banks. It said that a combination of bad loans, regulatory pressures, customer compensation and exposure to European banks might knock a £60bn hole in the banks' balance sheets. It warned that this, in turn, could damage their ability to supply credit effectively. Here is the link to the Bank of England for those who wish to read the full report.

Bank of England Governor Mervyn King concluded: "In judging whether banks are adequately capitalised, we need to ensure that reported capital ratios do in fact provide an accurate picture of banks' health. At present there are good reasons to think that they do not. That uncertainty around capital adequacy is in part responsible for low investor confidence in banks… Investors need confidence that banks have adequate buffers against stress in order to be willing to fund them at the low rates necessary to support a recovery."

Is it important?

The headline figure of £60bn is a worst-case scenario. Putting it into perspective, some measures have continued to improve, such as the aggregate Tier 1 capital ratio (a measure of the bank's capital strength). Equally, some banks have made provision for compensation claims, either from Libor manipulation or consumer mis-selling. Equally, the market is well-aware of the problems of the UK banks. The share price of RBS, for example, dipped dramatically on the release of the report, but recovered speedily as investors digested the news. There have long been fears of black holes in banks and the fact that the report had little impact on share prices shows that it held few surprises for investors.   

However, the Bank of England believes that any provision for compensation is currently inadequate and banks continue to underestimate the potential for bad debts. It also believes that the banks may be interpreting legislation too optimistically, which may force them to improve their capitalisation at a later date.

Either way, the problem is that investors still do not have sufficient confidence in the asset base of banks to invest, hence their low share prices. The Bank of England has made no mention of any public bail-out, but it remains the elephant in the room.

Who's said what?

Management Today said that banks were 'on the scrounge'.  "If the banks were the country's teenage son, this is them returning to the parents after borrowing a ton for a Friday night out, going: ‘Can I have £2k? I reckon that's what it's going to cost to get your car fixed. Plus I'll need £500 for the speeding fine."

The Huffington Post quoted Company Watch's Nick Hood saying that since the capital adequacy of banks was driven by so many factors, nobody could hope to put an accurate number on their current deficits: ""A blindfolded monkey with a pin has as good a chance of getting the figure right as any hypothetical financial model," he said.

 

Why does it matter for investors?

The black holes in the banking system matter because of what it means for access to funding. SMEs are seen to be the engine of the UK economy; they need access to capital to grow and the weakness in the banks threatens that. However, SMEs have been struggling to gain access to financing from banks since the credit crisis, so much so that a number of alternative funding mechanisms have emerged. This would seem to diminish the reliance of SMEs on the banks.

However, just days after the release of the Financial Stability Report, the Bank of England also revealed the early results from the 'Fund for Lending' (FLS) scheme. "In the quarter ending 30 September 2012, net lending by FLS participants was +£0.5bn and total FLS drawdowns from the Bank were £4.4bn. There are now 35 groups participating in the Scheme, which cover just over 80% of the stock of lending to the real economy." This was generally seen as a little lower than expectations – the Guardian calls it a 'White Elephant' –

. The scheme also still relies on the participation of the banks, who may be less willing to take part if their balance sheets come under pressure.

The bond market has been the other main alternative. Small and medium sized businesses have used capital markets to diversify their debt exposure away from banks. In fact liquidity in the bond markets has started to dry up as companies increasingly decide that they don't require further borrowing as FtAdviser.com reports.

At the moment, as Richard Buxton of Schroders points out, net new business creation is still running at double digit growth rates. In the end, the banks are still an important source of funding for UK companies and, as such, it is vital to monitor their ability to lend, but there are alternatives so it may not be catastrophic.

The other question is what it means for the share prices of the banks. It has been a good year for bank shares, with RBS up around 36% over the past 12 months. However, many investors bought because the shares were very cheap and the market seemed to be assuming the banks would go bust. They have proved less keen to buy at this higher share price and this report will do little to muster additional demand.

Likely outcome?

As with many of the scare stories about banks, the ultimate deficit is unlikely to be as bad as the headlines would suggest. They have muddled on so far and can muddle on further. The lending situation is weak, but companies are starting to adapt. The bad news, if it comes, is likely to come out in drips, rather than as an economic vortex down which the economy will disappear. But, even if the risks have been over-stated, it still doesn't make banks a compelling investment opportunity except perhaps as a very long term recovery play.  And that be a decision best left to to a specialist fund manager.

3 thoughts on “The Bank of England suggests banks may be”

  1. Anonymous says:

    When I referenced the emerging E7 countries, Wikipedia indicated that it originally referred to China, India, Russia, Brazil, Mexico, Indonesia and Turkey, but that some people replace Turkey with South Korea. For the most recent year available, according to the IMF, South Korea had a higher GDP on a PPP basis than either Indonesia or Turkey. Which definition does Mr. Ward favour? Andrew Baldwin

    1. Noo 2 Economics says:

      If you want an answer Andrew you’ll have to frame your question here http://www.henderson.com/sites/henderson/media_centre/ExpertDetails.aspx?xprefid=163 although Simon isn’t noted for replying he does sometimes.

      1. Anonymous says:

        Thank you, Noo 2 Economics, you’re a buddy.

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