Bank of England accuses UK banks of improper reporting

Peter Lee
Published on:

The Financial Policy Committee wants UK banks to raise more capital to cover future losses from poorly disclosed risks; harping on about these makes investors less likely to supply it.

Like a broken record, the Financial Policy Committee (FPC) of the Bank of England (BoE) repeats its exhortation on UK banks to raise external capital in the BoE’s latest financial stability report, published on Thursday.

At the same time, it rehearses most of the reasons why external investors would be mad to provide it.

The FPC seems to be becoming obsessed with the notion that UK banks are mis-reporting their risks, understating the likely expected losses on their bad loan books by providing forbearance to struggling borrowers while interest rates remain low, while also under-estimating risk-weights on their assets so as to arbitrage capital ratios. On the latter issue, the report states that underestimated risk-weights of banks’ trading books suggest capital ratios for the four largest UK banks, Barclays, HSBC, Lloyds and RBS, could be overstated by between £5 billion and £35 billion.

Piling on the criticisms, the FPC points to banks’ failure to estimate and provide for the full cost of operational risk losses, as exemplified by the much higher-than-expected bill for mis-sold payment protection insurance.

The first sentence of the executive summary of its report damns the UK banks. “The Committee recommends that the Financial Services Authority (FSA) takes action to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights.”

The clear implication of the word “proper” is that what banks are doing now is somehow improper.

The FPC expands on this later in the report. It says that: “One factor which may make stated levels of capital misleading is under recognition of expected future losses on loans. Information from supervisory intelligence and banks’ own public disclosures suggest that expected losses on loans, including those subject to forbearance, are in some cases greater than current provisions and regulatory capital deductions for UK banks’ expected losses.”

Haldane, BoE 
What is this “supervisory intelligence”? The FPC points to a year-old FSA study indicating that around 8% of UK mortgages and up to a third of British commercial real-estate loans by value have been subject to forbearance.

Why would banks provide this forbearance? Perhaps because their regulators have told them to. In a speech delivered shortly after the review was published, Sheila Nicoll, director of conduct policy at the FSA, made it clear that “the FSA remains of the view that, where a consumer is in financial difficulty, firms should look at all appropriate forbearance options before repossessing”.

And, sometimes, forbearance works. Prime property values have recovered in parts of the UK, so justifying it. However, at the press conference accompanying the financial stability report, Andrew Haldane, the BoE’s executive director for financial stability, warned instead of Japanese-style “bad forbearance”, which leaves bad loans “clogging up” UK bank balance sheets.

Enhanced disclosures

The BoE offers no recognition that banks themselves have recently endorsed new enhanced disclosures for reporting on forbearance and models for calculating RWAs, as they were asked to by Mark Carney, head of the Financial Stability Board and soon-to-be BoE governor.

HSBC chief accounting officer Russell Picot co-chaired the committee that thrashed out new disclosure recommendations alongside investors, such as Pimco and BlackRock, rather than regulators.

And while the FPC concentrates on investors’ suspicions over higher-than-disclosed risks on UK banks, it might rather be concern about banks’ capacity to generate returns on capital that reduces their inclination to supply more. The Bank of England seems to be confused itself. While it demands that banks raise more capital immediately, it doesn’t seem to be clear how. Governor Mervyn King confirmed that he does not expect the biggest shareholder in RBS and Lloyds, the UK government, to stump up anymore.

The Committee says banks could improve capital ratios by restructuring their businesses and balance sheets, which can only mean by shedding assets, but then insists they only do so “in ways that do not hinder lending to the real economy”. No wonder Ian Gordon, banks analyst at Investec, throws up his hands at this tosh. He notes: “We find the mixed messages from today’s Financial Policy Committee press conference quite frustrating.”

BoE policymakers have repeatedly rehearsed the Black-Scholes theory that forcing banks to raise more equity should make them less risky, so reducing equity risk premia and even the cost of debt, and therefore having only a neutral impact on weighted average cost of capital.

That’s fine in theory, but it’s not playing out in the real world. Risk premia for banks remain high. And one reason why, that Haldane and colleagues are less keen to discuss than improper valuation of assets, is regulatory uncertainty itself.

UK banks face a deluge of regulatory measures, policy uncertainty, complex new supervisory norms and higher capital requirements relative to peers.

The least impressive part of the stability report comes in tripping over its own criticism that UK banks have been much slower than their continental peers to raise external capital in 2012. Continental banks have only been catching up with the higher capital levels that UK banks have been early adapters to.

As Citi analysts put it: “How can one invest in the sector if there is limited visibility on what it might look like in three to five years’ time?” And they conclude: “A final complete UK regulatory regime, no longer subject to change on a month-by-month basis, needs to be clear-cut, understandable, well disclosed and consistently applied among each and every UK bank ... for banks to become truly investable again on a long-term basis.”