Banks and the FSR

Posted by Neil Hume on Dec 18 10:35.

The Bank of England’s Financial Stability Report (FSR) was released overnight and the focus, as one would expect, is on capital and liquidity.

But Jonathan Pierce, Credit Suisse’s banking analyst, says the most interesting thing is the suggestion (repeated several times in the 74-page report) that banks should use stable markets to issue more, non-guaranteed wholesale funding and to raise capital externally.

From the FSR:

Banks should take advantage of favourable market conditions.

Despite inevitable short-term costs, there is a strong case for banks acting now to improve balance sheet positions while conditions are favourable. Retaining a higher share of current buoyant earnings could significantly increase banks’ resilience and ability to lend. If discretionary distributions had been 20% lower per year between 2000 and 2008, banks would have generated around £75 billion of additional capital — more than provided by the public sector during the crisis.

It is also an opportune time for banks to raise capital externally, extend the maturity of their funding, and develop and implement plans for refinancing substantial sums as official sector support is withdrawn.

Taking advantage of current favourable conditions would help to repair balance sheets and thereby insure banks against future adverse developments. Given their balance sheet vulnerabilities, banks remain exposed to any future deterioration in macroeconomic and market conditions, which could substantially raise the cost of funding and capital raising in the future.

Coming hot on the heels of Thursday’s report from the Basel Committee on Banking Supervision, this means the capital debate will continue, says Pierce, who has also done some quick maths on the Basel III consultation paper.

Applying the new Basel definitions, he thinks Barclays’ equity Tier 1 capital could fall by 300 basis points, Lloyds by 360bps and RBS 450bps.

Which leads Pierce to conclude:

Capital and liquidity remain big challenges and shareholders are likely to be subordinated in the interests of stability for quite some time, in our view. Indeed, we think that the various papers from the FSA, BIS and BOE in recent weeks support our view that, structurally, the UK banks will struggle to generate ROTE much above 10-12% in the medium term.

Small wonder then, that UK banks stocks are under pressure this morning.

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Other highlights from the FSR:

• Banks will face higher capital requirements on trading assets and securitisations from 2011 — of around £33bn for financial institutions in the United Kingdom.
• Over the next five years, UK banks also need to refinance over £1 trillion of wholesale funding, including funding that has been supported by the public sector.
• Improving balance sheet structures may be costly. In retail markets, competition for funding has raised retail bond rates to around 200 basis points above risk-free rates, compared with a spread below zero in 2005. And, in wholesale markets, longer-term interest rates are well above short-term rates. Based on those rates, the cost to the industry of increasing the maturity of funding, while replacing Special Liquidity Scheme (SLS) and Credit Guarantee Scheme (CGS) support and acquiring low-yielding assets to meet regulatory requirements, could be significant.
• Outstanding loans to the commercial property sector were over £250bn at end-September 2009, nearly six times their level a decade earlier. The major UK banks have lent around £200bn to the sector and have additional contingent exposures of over £30bn in the form of undrawn credit facilities. In addition, the largest UK banks have gross exposures of over £18bn to securities backed by domestic and foreign commercial real estate loans.
• In the United Kingdom, past falls in commercial property prices have raised average loan to value (LTV) ratios above 100 per cent, according to industry estimates. Around £160bn of loans are scheduled to be refinanced between 2009 and 2013

Related links:
Bank calls City’s bluff on regulation – FT
Digesting the Basel reforms – FT Alphaville
Strengthening the resilience of the banking sector – BIS
International framework for liquidity risk measurement, standards and monitoring – BIS