UK banks’ £25bn shortfall: positive for banks, negative for BoE credibility

Sid Verma
Published on:

Capital-shortfall estimate comes as a relief but Bank of England's methodology implicitly damns perfectly legitimate bank-accounting procedures.

It’s all too easy to be seduced into fear over the capital positions of UK banks, which are faced with chronic deleveraging pressures, distressed asset values, a raft of misconduct claims, a high cost of capital and besieged business models. All against the backdrop of a possible triple-dip UK recession.

As a result, the charge by the Bank of England’s Financial Policy Committee (FPC) that UK banks face a lower-than-expected £25 billion shortfall has been greeted largely with relief by analysts. Simon Adamson of CreditSights says: “The eagerly awaited press release by the Bank of England’s Financial Policy Committee (FPC) on UK banks’ capital has identified a substantial shortfall, but one that is well below the potential number identified in November 2012.. We think banks will mainly focus on balance sheet restructuring, as appears already to be the case in 1Q13 at RBS and Lloyds.”

In November, the FPC accused UK banks of inadequate reporting and ignited investor fears over UK banks’ capital cushions. It argued that UK banks’ expected losses on high-risk loan portfolios might exceed current loan-loss reserves, that misgovernance costs, e.g. swap mis-selling provisions, would be higher-than-expected, and that banks had taken a cavalier approach to risk-weights.

But analysts at Investec were upbeat, arguing the £25 billion aggregate shortfall estimate would have a “very limited” impact on the banks’ existing capital plans. “Importantly, there is no trigger for any fresh equity issuance, with a new recommended end-2013 capital target of “7% of RWAs”, albeit AFTER making higher allowance for future credit and redress costs and “a more prudent calculation of risk weights””.

The Bank of England charges that UK banks’ capital position is overstated by around £50 billion: £30 billion on mispriced asset valuations, £10 billion in misconduct costs and £12 billion addressing risk-weights. After adjusting for the current pool of excess capital, relative to a target of 7% Basel III common equity Tier 1 ratio, this shortfall stands at £25 billion.

The oft-touted compliant that the BoE has sent out mixed messages is summed by Adamson: “The FPC is also treading an uncomfortable path between prudence and political expedience. It is encouraging banks to expand their lending to the real economy at a time of economic weakness in the UK (and despite the banks’ view that demand is very weak), and it is hard to reconcile this with the image of a prudent central bank. It seems to us that the drive to increase UK banks’ capital is as much about giving them more lending capacity as about covering unrecognised risks.”

More profoundly, as Euromoney has reported, the BoE’s credibility to reprimand UK banks’  is at risk by its lack of recognition that IFRS accounting standards and new enhanced disclosure requirements for banks all suggest financial institutions are legitimately accounting for their assets. IFRS, for example, does not permit banks to calculate provisions on possible, rather than incurred, losses. As Adamson says: “It is in effect making an implicit criticism of IFRS accounting guidelines for loan impairments and of the RWA models agreed by the Basel Committee.” As one UK banks analyst put it: “it (the implicit criticism of IFRS) is weird, perhaps, but it's consistent with past FPC comments.”

For equity investors, the FPC comments highlight that, in this climate, bank dividends are political suicide, Justin Cooper, chief executive of Capita Registrars, the share-registration service provider, says. “£25 billion extra capital for the banks is bad for income investors. It will push back the time when the state banks will begin to pay dividends again, and may even restrict growth of dividends from those banks still in private hands. Since 2007 banking dividends have halved their share of the total since the peak of the boom, and it seems unlikely that their pre-eminent position will be restored anytime soon.””