UK banks – Safety first

27 March 2013

Michael Symonds

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA

Hopes that a recovery in [productive] bank lending will help kick start the UK’s faltering economy have been dealt a further setback by today’s recommendations from the Financial Policy Committee (FPC), the group charged with overseeing the stability of the UK financial system, that an aggregate capital shortfall in the UK banking sector of at least £25bn is covered by the end of 2013 and a warning that further capital increases will be required for years to come.

The examination of bank balance sheets recommended that around £52bn of additional capital surcharges should be applied across the sector. These were categorised as (i) £30bn of further provisions on higher-risk loans to the UK commercial real estate sector and weak euro area economies; (ii) £10bn to be set aside for future conduct costs such as LIBOR fines and redress payments linked to the mis-selling of interest rate swaps; and (iii) £12bn to reflect the more conservative application of credit risk weights in the banking book.

When judging the resulting impact of these adjustments on banks’ balance sheets as of end-2012, some banks were assessed to already have sufficient buffers to absorb the hit. Those that did not had an aggregate capital shortfall of around £25bn which, according to the FPC’s recommendation, should be addressed by end-2013. Looking to 2014 and beyond, regulatory pressure on UK banks to continue building buffers is unlikely to relent, with the FPC expecting a need for further capital increases to reflect the transition to full Basel III compliance, the introduction of SIFI surcharges and any additional requirements imposed by the implementation of the Independent Commission on Banking’s recommendations.

While individual bank results and the small print on implementation are still to be determined, the short timeframe recommended for making good on the £25bn capital shortfall surely represents the most significant challenge. While the BOE might implore banks to raise fresh capital, dispose of non-core businesses and make further cuts to dividends and remuneration, it is virtually inconceivable there will be no clandestine deleveraging. Certainly, any efforts to raise capital in such a short time will prove tricky for smaller banks and building societies in the current environment. For state-owned banks, meanwhile, where the bulk of the capital shortfall may well be, there is clear resistance from the current government to further injections of taxpayer funds. Furthermore, the FPC’s proclamation also looks set to undermine recent efforts by the UK government to revitalise bank lending (i.e. the Funding for Lending Scheme), highlighting the conflicting messages coming from regulators and politicians.

Overall, the identified sector-wide shortfall of £25bn was within the bounds of our expectations. And the demanding nature of the assessment, including the 7% Basel III capital benchmark, means that we remain relatively sanguine with regard to the capitalisation of UK banks. But it has left us pondering how banks elsewhere in Europe would shape up under a similar forensic assessment. Our guess is that the results of any comparable exercise in the euro area would not be particularly pretty.

 

Michael Symonds
Credit Analyst

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