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Opinion

Bank recapitalization: BofE should buy UK bank bonds

The UK banking system is reasonably well fixed, but relentless regulatory pressure renders it useless to the real economy.

Sir Mervyn King, governor of the Bank of England, blamed the downturn in the eurozone for continuing problems at UK banks, speaking at the announcement of the Bank’s inflation report last month.

King said the UK banking system was in a much healthier state than many of the banking systems on the continent, but if there were to be a sharp downturn in the euro area, then UK banks would be badly affected. Warming to his theme of the eurozone as the single biggest risk to the UK, King argued that is why their funding costs have gone up. This is not what the Bank of England had expected to happen. Rather, it had hoped by now to be seeing a compression of bank funding costs. That it hasn’t materialized now raises obvious alarm about the potential impact on the UK economy.

It’s an interesting analysis. Alastair Ryan and John-Paul Crutchley, banks analysts at UBS, develop an alternative narrative with a different villain in a report released earlier last month – Enough, already.

The UBS analysts agree that UK banks have done much to increase their financial strength in the past three years, but blame key regulators, including the Bank of England, for failing to recognize this, tilting the regulatory burden in ways that prevent banks from providing decent returns to shareholders, increasing risk aversion among bank bond investors and so increasing risks to the UK economy.

They argue that UK banks demonstrated comprehensively with third-quarter results their ability to weather difficult markets: all reported improving loan/deposit ratios, stable or higher capital, and stable or increased primary liquid assets. The reconstruction of the UK banking system in 2008-09 has clearly been successful from a financial stability perspective.

However, regulators are still forcing banks to shrink to the detriment of the UK economy.

The UBS analysts point to continuing pressure from the Bank of England on banks to retain earnings, increase capital and boost liquidity buffers in low-return investments. All this, they say, is inimical to growing lending. The banks have been disincentivized to lend. There is no point amassing more and more capital and liquidity to further protect against tail risk in the banking system if that means it stops working.

Regulators’ insistence that a greater portion of banks’ balance-sheet assets comprise those famously risk-free and highly liquid government bonds has hugely reduced the balance sheet available to lend to the real economy. Those loans that banks do hold on balance sheet no longer offer much prospect of returns when banks’ funding costs have soared thanks to the structural subordination of bank bonds that has emerged as a cornerstone of regulatory policy.

An investor in bank bonds used to feel strongly confident in getting back 100% of his money even in tough times for the bank. Now, ranking below depositors and secured creditors, bond investors are worrying about 100% loss given default, not zero. As bond investors abandon banks, so too do equity investors. With shares trading at steep discounts – even around 50% of book value, banks are incentivized to shrink if every pound they earn becomes worth 50 pence if they retain it.

Whose story is more believable: the Bank of England’s or the UBS analysts’? If you spent as much time as Euromoney talking to investors in bank debt and equity, you would find regulators being cast as the villains of the piece.

Is there a way for bank regulators to recast themselves as the good guys? The UBS analysts point to the ineffectiveness of quantitative easing in boosting lending to the UK economy. Meanwhile, the stock of UK bank bonds outstanding is roughly comparable in size to the gilt market.

If the Bank of England wants to help bring down UK banks’ funding costs, so as to ease credit to the economy, maybe it should start buying UK bank bonds.

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