Saturday, 22 March 2008

Banks go begging

Earlier this week, the UK’s leading banks went to see Mervyn King. At the time, the visit made me so angry I could barely speak. I needed a few days to calm down before I posted anything about the meeting.

According to the press, the banks were there to look for help with the credit crisis. In particular, the banks begged the BoE to provide "much needed liquidity".

Do the banks need any help from the BoE? I don't think so. To see why, let us start with a couple of simple but revealing questions. First, why weren’t the banks looking for help last July? Presumably, back then were was plenty of liquidity.

So where did this liquidity go? The answer; it is still there. Some banks have spare cash, but are not prepared to lend it to those banks that need it. The interbank market has all but collapsed. The implication here is obvious, if the banks trusted each other more, they would not need any help from the BoE.

Since the meeting was not about a lack of market liquidity, what did the banks really want? The request for BoE assistance is about two things; shifting risk and and finding ways to avoid a much needed restructuring of bank balance sheets to make them more prudent, less risky but also less profitable. It was about making the public sector pay for banking sector mistakes and avoiding change.

Since the banks are not prepared to lend to each other, they want the public sector to come along and help. The banks would like the BoE to take the place of the interbank market, providing liquidity in return for dodgy collateral from cash-strapped banks. This is what bankers do best; shift the risk. Banks holding surplus cash could provide liquidity and accept this dodgy collateral, but why should they when the fool of Threadneedle street is there to soak up the risk.

The simple fact is that several banks have far too much of their liabilities in the form of wholesale lending. This form of high leverage banking has had its day. Banks need to sort themselves out.

Take, for example, Bradford and Bingley's balance sheet. According to their website, in 2006 the B&B had liabilities amount to ₤44 billion, of which almost ₤22 billion were: a) debt securities, b) deposits from other banks, c) subordinated liabilities, d) derivatives or e) other capital instruments.

In other words, the B&B generated about half its balance sheet by borrowing from other institutions. Their customer deposit base was just ₤22 billion. Turning to the B&B's capital; it has shareholder equity of about ₤1.4 billion. Since it has assets of about ₤45 billion, one pound of capital generates ₤32 of assets, of which about 80 percent are loans and advances to customers.

Concerns are only heightened when potential lenders take a closer look at recent UK banking activity. Many smaller banks pushed out too much money into the housing markets, with the now crumbling buy-to-let business being a special favourite. Is it any surprise that potential interbank market lenders say, “thank you, but we will pass”

These liquidity difficulties also raise the issue of bank capital. For years, the FSA had one answer to any questions about the increasingly bizarre lending activities of UK banks. The UK banks were supposedly “well capitalized”. If banks are as well capitalized as the FSA told us, then it should be able to ride out these ongoing credit difficulties.

Banks seeking cash could offer to pay higher interest rates. In the short run, these funding rates might be higher than their rates on loans. The banks will accumulate some losses, but the capital is there to absorb the problem. In the meantime, problem banks can restructure their liabilities, reduce their dependence on short term lending, sell off some assets to other banks and soon everything will be sorted out. To help the process along, banks could cut dividends, look for more capital, and eliminate bonuses to senior staff. Of course, this would mean that banking sector profitability would fall somewhat, but that is the price that banks need to pay for reducing excessive risk. Understandably, banks are reluctant.

Again, taking the B&B as an example, it needs to raise capital, de-leverage, increase customer deposits, diversify its asset base and above all reduce its funding risks. Moreover, it does not need any help from the BoE to undertake these difficult measures. It does, however, have to understand that it must return to a more prudent, less risky form of banking. This means, for example, no more lending to buy-to-let speculators taking a punt on continued housing market price appreciation.

These measures are all about internalizing the pain of past mistakes. However, bank do not like to internalize, they prefer to pass the problem onto others. This week’s meeting with the BoE was all about passing the pain of adjustment onto the public sector. Hopefully, the BoE said no.

(Disclaimer: I wouldn't want to be accused of spreading rumours. The B&B information is publicly available information. I am not saying anything about the current health of the B&B or making any suggestion that it suffering from liquidity difficulties.)


Anonymous said...

ukhb: ¨The simple fact is that several banks have far too much of their liabilities in the form of wholesale lending..¨

I believe your are right. Many banks are too highly geared, leveradged, call it what you will. Because it was the faddy fashionable thing to do.

The result in a downturn is, not so much they cannot get a credit line, but that their liabilities are too great.

The FSA, of course is on top of the issue.

Josh said...

Oh yeah, the FSA are on top of it.

Anonymous said...
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Anonymous said...

Just to say I've been reading this blog for a while and am very impressed with the quality of understanding and expression on this subject.

Bill (Economist)

Anonymous said...


Another great post and I share your feelings - I too sometimes almost shake with rage when I see the captains of capitalism become communists the moment losses hit.

What would really interest me is if you had an analysis of which banks could fail and be bailed out and which couldn't, based on the as yet uncommoted part of the BoE balance sheet.

I notice the HBOS-influenced disclaimer. Funny how lying to say a bank is fine (e.g. Bear Stearns) goes unpunished but possibly lying, and possibly not, that a bank is in trouble is market abuse. Hmmn. Funny that.


Alice Cook said...


This whole business is full of sad ironies. One may lie about a bank, but if the truth is bad, then one might get investigated. Unlike the UK banking system, I choose prudence.

As for the BoE balance sheet, I am amazed that no one has given it any serious examination. In my own limited way, I gave it a go, but for some strange reason, this blog is the only place where such matters are discussed. Even there, it is only with a handful of people.

That is also somewhat ironic, the BoE pledges billions of pounds of taxpayers money, and virtually no one has followed the money and watched how they did it.

Thanks for the comments and the kind words.