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Stressed out: banks and the regulators

Stressed out: banks and the regulators

If the last ten years have taught us anything, it is the lesson that banks remain leveraged to the economies in which they do business. Their lending and deposits are leveraged upon their regulatory capital and any diminution of the quality of this lending, or these deposits, adds further layers of risks to that leverage.

The first, and highest, quality tranche of this capital is Equity Tier 1 Capital – in essence equity and retained profits. This exists primarily as the buffer to protect depositors. It wasn’t that long ago that shareholders were imploring banks to run down this buffer in order to increase returns on equity. The net result was indeed high (apparent) returns on equity - but unsafe institutions. The real-life stress test provided by the financial crisis showed, painfully, how unsafe these institutions were and how illusory were the high returns that shareholders earned.

The balance between a “fair” return for shareholders and the safety of the institution…was now the focus of the debate.

However, the crisis also highlighted the many “stakeholders” that had, and have, an interest in our banks. No longer was the debate about the split of rewards between management and shareholders. In the aftermath of the crisis, shareholders drifted well down the pecking order behind depositors, bond holders, regulators, politicians and the public at large. The balance between a “fair” return for shareholders and the safety of the institution, given the important place in the economy that these businesses held, was now the focus of the debate. Since those dark days of 2007/8 and in the light of this new debate, the banks have been gradually rebuilding their capital bases, while reducing the volume but improving the quality of the lending supported by them.

Stiff tests

In the light of the banking industry’s evolutionary journey over the past decade, last week’s publication of the Bank of England’s annual stress tests made for interesting reading.

The tests were stiff ones, predicated on world GDP down 2.4%, UK GDP down almost 5%, real estate prices falling by a third and sterling falling by another 27%. A gloomy scenario certainly, and one that would result in stress for the banks greater than what was experienced in the financial crisis.

The Bank estimates that the losses induced by these stresses would be of the order of £70 billion. Despite these forecast losses, all UK banks passed the test. Ten years of rights issues, bond issues and retained profits have left the banks with more than three times the amount of capital they had available amidst the crisis of 2008. However, while the banks passed the test, they only did so with the inclusion of a passing of the sector’s dividends and a 95% fall in variable remuneration to management. Clearly, should this scenario play out, it would result in another painful period for shareholders.

The other interesting element of the stress tests is the increase in the ‘countercyclical buffer’. This compels banks to set aside capital in good times, in order that they should be better prepared for the bad times. The Bank of England’s Financial Policy Committee, which is charged with focusing on the macro-economic and financial issues that may threaten long term growth prospects, had noted some concerns about the performance of credit assets in the stress tests. These concerns led the Committee to insist that 0.5% was added to banks’ capital. This additional capital will again dilute return on equity, but will further enhance the quality of that return.

Still too big to fail

There remains considerable debate as to what the “right” level of capital is for banking institutions, but many remain too big to fail. The regulators (at least in the UK) obviously are alert to the dangers, both for the banks and for the wider economy. Hence the tightening of the regulatory screw.

However, this is also an environment where many investors and some managements see only good economic times ahead and continue to have a considerable appetite for risk. The existence of valid concerns surrounding the consumer credit markets – and, in particular, the auto and credit card markets in the UK – surely demonstrates huge divergence in risk appetite between the regulators and those they regulate. In the housing market, too, we see similar divergence in views. Here, an enthusiastic lending market has had to be tempered by macro prudential regulation from the regulators.

Investors, too, have a heightened appetite for risk - with synchronised global growth, stock markets at all time high and risk free rates towards all-time lows.

It does feel that we are at an important juncture in the relationship between regulators and those regulated in both the UK and the global banking sector. Perhaps not surprisingly, regulators continue to favour a safety-first approach. Their actions, in requiring higher levels of capital and in trying to put a macro-prudential brake on some of the more exuberant areas of bank lending, would suggest that they have some concerns about the quality of banks’ returns.

We head into the new year with a lot of leverage around, animal spirits at their greatest for a decade and with some considerable economic and political uncertainty ahead of us. It feels like a time for safe banks.

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