Regulation: BoE accuses UK banks of improper reporting
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Regulation: BoE accuses UK banks of improper reporting

FPC wants UK banks to raise more capital; Frustrations over ‘mixed messages’

Like a broken record, the Financial Policy Committee (FPC) of the Bank of England (BoE) repeated its exhortation to UK banks to raise external capital in the BoE’s last financial stability report of 2012.

At the same time, it rehearsed 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 ($56.7 billion).

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."

Inadequate provision

The FPC expands on this later in the report. It says: "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."

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. However, is this more credible than the banks’ own disclosures?

Alastair Ryan and John-Paul Crutchley, analysts at UBS, point out: "Lloyds, for example, shows that mortgages in forbearance account for only 1.1% of its portfolio. Given that Lloyds has a representative portfolio of regulated UK residential mortgages and accounts for almost 30% of the market, we struggle with the implied idea that some other banks have such high loans in forbearance that the 8% figure becomes realistic."

It could be that the FSA analysis is loaded with unregulated sub-prime mortgages of pre-2008 vintage. Now the FPC says that the incurred loss accounting model, by delaying recognition of expected losses, might overstate UK bank’s asset values by £13.8 billion. However, Andrew Coombs and Ronit Ghose, banks analysts at Citi, note: "Under Basle III a deduction for shortfall to expected loss is already included. We estimate that around 80% of the FPC’s £13.8 billion estimate is therefore already captured within the banks own Basle III capital projections. Any additional hit to capital from full recognition of expected loss may only be around 4bp to 19bp per bank."

Andrew Haldane, the BoE’s executive director for financial stability

Meanwhile, let’s not forget that one big reason banks provide forbearance in the first place is because their regulators have told them to. In a speech delivered shortly after the forbearance 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, banks should look at all appropriate forbearance options before repossessing".

And, sometimes, sticking with struggling borrowers through cyclical downturns works. Prime commercial property values have recovered in parts of the UK, so justifying forbearance. 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.

Buffers rebuilt

But the capital buffers on those balance sheets have already been substantially rebuilt. The FPC criticizes UK banks for raising less external capital than European banks in 2012, seemingly ignoring the fact that European banks were catching up with their UK counterparts last year.

Amid all the sound and fury over mis-stated risk-weighted assets from banks’ proprietary models, let’s remember that the Basle Committee and the Financial Stability Board are due to release preliminary conclusions on a coordinated response to this early this year.

Coombs and Ghose point out: "RWA floors are a possibility, but greater prominence on a leverage ratio may offer a simpler solution. The UK banks screen well on this metric versus Euro peers."

Who is the BoE criticizing here: the banks or their regulators at the FSA? What a mess Mark Carney is due to inherit later this year. Ryan and Crutchley are quietly scathing: "The Financial Policy Committee may have just reminded us why macro-prudential regulators are so rare globally. They don’t remain relevant for long."

And while the FPC concentrates shareholders’ suspicions on higher-than-disclosed risks at UK banks, it might rather be concern about banks’ capacity to generate returns on capital that reduces investors’ inclination to supply more.

The BoE seems to be confused itself. While it demanded that UK banks raise more capital immediately, it seemed to be the only market participant unaware that HSBC was selling a big stake in Chinese insurer Ping An.

That well-flagged disposal was announced days after the report, triggering a $2.6 billion post-tax gain, raising HSBC’s September 30 2012, pro-forma core tier 1 ratio to an eye-popping 12.2%.

Barclays has just expanded its capital buffers with a contingent write-down debt offering. So which banks does that leave to raise capital? Governor Mervyn King confirmed he does not expect the biggest shareholder in RBS and Lloyds, the UK government, to stump up anymore.

Mixed messages

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". Ian Gordon, banks analyst at Investec, throws up his hands at all this. He notes: "We find the mixed messages from the Financial Policy Committee press conference quite frustrating."

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

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."


Ryan and Crutchley see light ahead for UK banks because loan spreads are up and funding costs are heading down. "The views of the Bank of England may now be of diminishing significance to bank shareholders, having dominated performance over much of the last two years," they state. "The disappointment is that the time spent on excessive regulation may have been time wasted for the economy. If the banks are left alone, they will restart lending." They cite Lloyds as a good example. After mortgage volumes plunged in 2009, one would reasonably have expected a recapitalized Lloyds to begin to grow loans again as house prices stabilized and it became clear that losses on this portfolio would be modest. Instead, volumes kept falling. In the first half of 2012, lending was down 30% on an already depressed 2009 level.

"We ascribe this to the early closure of the SLS; the demands to build liquidity, funding and capital; and the effective withdrawal by the Bank of England of liquidity insurance – other than as part of a full-scale bank failure – from end-2008 to mid-2012," the analysts say.