Wheels Spinning, Going Nowhere
17th May 2013
An economic recovery in the UK demands that the incoming Bank of England governor, Mark Carney, (who takes up his post in July) runs a loose monetary policy. This sounds uncontroversial. Indeed, it is what the Bank professes to have been doing since early 2009, when the bank rate was r educed to 0.5 per cent and quantitative easing (QE) was initiated. But a simultaneous and ongoing massive tightening in bank regulation has meant that this official ‘looseness’ has not translated into cheap or available credit for individuals and businesses.
UK lending has been in absolute decline for over four years now. This is historically unprecedented. Loans outstanding are still falling – and this is a key driver of recessionary behaviour among businesses and private individuals: if credit tomorrow will be less available and more expensive than today, why swim against the deflationary tide?
Various Treasury-sponsored schemes have tried to rectify the problem of low official rates being lost in translation to the real economy. Funding for Lending is the most significant, Help to Buy the most recent. But the Bank has been pedalling so furiously in the opposite direction, through its regulator (the Prudential Risk Authority) and its new macro-prudential body (the Financial Policy Committee), that credit conditions have been consistently toughened. Carney will need to call a halt if any unconventional monetary policies are to have a chance of succeeding.
While banking is an inherently risky business, there is one essential question that has not been asked: how safe do banks really need to be? Happily, and contrary to much of the media and political narrative, what needed to be done to make banks less risky was put firmly in train at the peak of the crisis almost five years ago. A narrative of stability that presses on regardless of the costs incurred is exactly the ‘stability of the graveyard’ that the chancellor seeks to avoid.
The UK cannot afford the luxury of chasing a zero-risk banking system. It already has a system that is safer than it has been for decades. Now it has an opportunity, with Carney’s impending arrival, to back out of its current economic dead-end. He will need the political backing to declare victory over banking demons and move on.
That was then: dealing with the banking crisis The last Labour government did not see the banking crisis coming.
What it did do was an excellent job of judging what needed to be done – and what should not be done – in the few short weeks after Lehman Br others collapsed. Management groups were thrown under the proverbial bus; billions of pounds of fresh capital injections into banks were demanded. As a result, the healing process began very quickly.
Importantly, the private sector was kept involved. Nationalising banks completely is not to be done lightly, as is clear from the current government’s drift into attempting to run RBS. Between coalition politics and national debt accounting, the chances of civil servants running a ‘better’ bank are low.
What ailed the banks in 2008 were several interlinked issues. It is worth listing them briefly, as the changes over the past five years are crucial to our case.
- There was little tangible common equity in several of the banks. In early 2008, RBS, Barclays, Lloyds and HBOS had £65 billion between them.
- Assets at these four banks had grown by more than £2.5 trillion in the previous four years, through rapid organic growth and acquisition which brought new and less well-known risks onto balance sheets.
- Several of the banks had very high levels of short-term wholesale funding. Borrowing for a day is the cheapest form of finance, but relying on hundreds of billions of this left the banks exposed to abrupt cash flow issues.
- Most of the banks held very little cash on hand.
- Several of the banks had large concentrations in two areas of risk: complex, structured securities, such as the infamous collaterised debt obligations (CDOs), and commercial property.
This combination of factors meant that as the financial markets deteriorated concern built up that banks could become insolvent – concern which soon expressed itself in the banks becoming illiquid.
Why the response worked
What was done in the wake of the crisis dealt effectively with each of these issues. The Credit Guarantee Scheme provided long-term funding and as a result rapidly improved the market’s confidence in the ability of the banks to access funding. It worked, and was fully repaid in 2012 at a tidy profit to the Treasury.
Huge amounts of equity were required of the banks in short or der – £40 billion was raised from the private sector and £60 billion from the Treasury. Only RBS relied wholly on the state.
And even in the case of RBS, the balance of state versus private action was judged well. Injecting more equity in 2008 would have driven an accelerated sell-down of the bank’s assets – into a terrible market. Full state ownership would likely have required the closure of the investment bank, then a £1 trillion behemoth. Far better to run it down against realised profits over time, which is just what has been done: the assets of this division are now a quarter of what they were, with the run-down paid for by pre-impairment profits of £8 billion and the assets sold for £10 billion over expectations.
Then, in 2009, the banks were aggressively stress-tested. At some level, this merely formalised what Lloyds management was doing as it went through HBOS’s books and was forced to issue five profit warnings in the five months after its takeover was announced. With new management at RBS also going through the books with a fine tooth comb, UK bank impairments spiked massively. But these peaked by the middle of 2009 and have since fallen by four-fifths. Contrast this with the banking system in Spain, which has been allowed to roll over its problems and where, as a result, impairments continued to rise year-on-year through at least to 2012.
The results in the UK were rapid. By late 2009, HSBC and Bar clays had raised over £20 billion and Lloyds was able to raise £8 billion from private investors, mainly British institutions. By the time of the general election in 2010, bank shares were trading above the levels at which the government had invested.