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Bank of England should buy UK bank bonds

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.

Sir Mervyn King, governor of the Bank of England (BoE), blamed the downturn in the eurozone for continuing problems at UK banks, speaking at the announcement of the Bank’s Inflation report today. 

King said:

“Our banking system is in a much healthier state than many of the banking systems on the continent, but our banks are inextricably involved with developments in Europe and if there were to be a sharp downturn in the euro area then our banks would be affected by that.”

Warming to his theme of the eurozone as the single biggest risk to the UK, King continued:

“That’s why their [UK banks] funding costs have gone up.”

King says this is not what the Bank of England had expected to happen. 

“We had hoped by now we would be seeing a compression of bank funding costs.”

But it hasn’t materialized and that raises obvious alarm about the potential impact on the UK economy. 

“Higher credit spreads will not help growth in the UK.” 

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 this week “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: 

“The banks demonstrated comprehensively in Q3 11 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 system in 2008-09 has clearly been successful from a financial stability perspective.”  

But 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 disincentivised to lend. The repeated tightening of the screw since 2008 in capital, liquidity and funding has collectively meant that loans extended in, say, 2009 that were expected to offer appealing returns on capital are now sat on the banks' books offering poor returns.

Actual profits are lower because term funding costs have risen, in large part thanks to the structural subordination of bank bonds that has emerged as a cornerstone of regulatory policy. And what profits emerge are typically not available for distribution to shareholders, as dividend payouts are restricted, further disincentivising growth.”

Who’s 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 increasingly 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. 

- Euromoney Skew Blog

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