The State of UK Banks & The Long Haul to Recovery

Opposition politicians are very fond of telling us that the UK government’s economic strategy isn’t working and that it is time for Plan B. The tacit assumption behind this assertion is that there exists a set of policies which if correctly identified and implemented would lift us out of our current state of economic stagnation and return us to the halcyon days of robust growth we enjoyed just five years ago. What this fails to take into account, however, is that much of the finance upon which our former growth was based no longer exists: a fact which becomes very quickly apparent if one compares the balance sheets of the UK’s four leading banks in the year before and then in the three years following the financial crash of 2008.

 Table 1: UK Bank Financial Profiles 2007-11

In Table 1, I have picked out what I believe to be the four most salient balance sheet items for these banks during this very dramatic five year period: their overall profitability; their levels of assets and stockholder funds; and the ratios between these latter two measures. For simplicity, I have aggregated the figures for Lloyds TSB and HBOS for the years 2007 and 2008, even though the two banks didn’t actually merge until the beginning of 2009. I also have some concerns over the reliability of the figures for RBS, which, although taken from the bank’s own annual reports, don’t, on the surface, appear to make a lot of sense. I suspect that the apparent mismatch between the declared losses and their effect – or lack thereof – on stockholder funds during 2008 and 2009 has something to do with the timing of the various tranches of the UK government’s bailout package. What caused the massive drop in stockholder funds in 2010, however, a year in which the bank only recorded a loss of £0.67b, is far less easy to explain. If anyone can do so, I should therefore be very happy to hear from them.

Looking at the figures overall, however, the most surprising fact to emerge is almost certainly just how small the losses for 2008 actually were – at least, according to the banks’ own reports. Indeed, it appears that only RBS and the HBOS half of Lloyds Banking Group lost any money at all. Admittedly, HSBC’s profits were down and, at various points, both HSBC and Barclays were forced to raise more capital. But neither had to turn to the government for this and, in terms of profitability, Barclays seems to have sailed through the troubles more or less unscathed. The most significant effect on all the banks, in fact, had very little to do with actual losses. It was rather the effect it had on their assets: the mortgages and other loans extended to businesses and individuals on which a bank’s profits are made. For, as can be seen in Figure 1, over a period of just twelve months, these four banks were collectively forced to reduce the overall value of their assets – which is to say the volume of money they were lending – by £1,813 billion.

Figure 1: Bank Assets 2007-2011

One of the main reasons for this very rapid contraction is the way in which, over the last twenty-five years, most banking assets have been funded. For since lighter regulation was introduced in the 1980s, progressively less and less bank lending has been financed out the banks’ own ‘Stockholder Funds’: that part of their capital made up of equity and retained profits. The vast majority of the funding has come from customer deposits and loans from other banks.

Not that there is anything wrong with this in principle, of course. Lending other people’s money to third party borrowers is the main way in which banks make money for their shareholders. It is what allows them to multiply the earning power of their own capital. At present, for instance, the average net return on the assets held by the four banks listed above – the difference between the interest they earn on the money they lend and the interest they pay on the money they borrow, plus the cost of their own operations – is just 0.25%. By leveraging their own funds with those of their depositors and other lenders, however, they effectively multiply this to produce a return on investment for their shareholders commensurate with, and sometimes significantly better than other similarly priced equities.

In 2007, for instance, only 2% of the assets held by Lloyds TSB were financed out of stockholder funds: a gearing ratio of 50:1. This meant that their 0.25% return on assets was actually turned into a 12.50% return on stockholder capital, nearly all of which was distributed as dividends to these self-same stockholders, of whom, during that year, I happened to be one. Indeed, I remember staring in pleasurable disbelief at the dividend slips that came through my door at the time, wondering how the management at Lloyds were able to conjure such a trick. For it almost seemed too good to be true. Which, in a sense, of course, it was. For when, in 2008, it started to be recognised that a good many of the assets held by UK banks were worth considerably less than the value the banks, themselves, placed on them, those banks with highest gearing ratios were seen as particularly vulnerable. After all, it would only have required a 2% write-down in the book value of Lloyds’ asset register for the stockholder capital on its balance sheet to have been wiped out completely, at which point the bank would have been technically insolvent.

Fortunately for me, I sold all my banking stocks at the beginning of 2008. Not that I can claim any significant degree of prescience in this. I sold the shares to invest in a new business start-up which I thought was going to make an even bigger return. Unfortunately, with the financial crash, the market for this new company’s products and installation service effectively collapsed, and I lost more or less the same amount of money as I would have lost anyway. In the immortal words of Kurt Vonnegut: So it goes.

The real problem for the banking industry, however, was that, although those banks with the highest gearing ratios were clearly the most vulnerable, no one knew where the bad debts in the system actually were. They knew that they were mostly bundled up in mortgage based derivatives called Collateralised Debt Obligations or CDOs, but no one actually knew which CDOs were toxic, and which, if any, were perfectly sound. As a result, no bank could be entirely trusted. As a further result, therefore, inter-bank lending, on which the vast majority of banks relied to fund the vast majority of their assets, simply dried up. No one wanted to lend money to a bank which, like Lehman Brothers, could fail at any moment, virtually without warning. More to the point, starved of new borrowing, they were now hard pressed to meet existing obligations. When the loans they had made to existing customers were repaid, therefore, instead of re-lending this money to new customers, they had no choice but to use it to pay off their debts to other banks. Thus, in this merry-go-round of reduced lending, followed by reduced borrowing, followed by reduced lending, and so on ad infinitum, the combined balance sheets of the UK’s four largest banks were reduced by £1.8trillion.

Indeed, it was as much to put an end to this cycle of contraction as to prevent insolvencies that national governments throughout the world – though more particularly in the UK and the United States – intervened to support the banking system. This, thankfully, stopped the rot; but even today the asset registers of our four largest banks are still £1.6trillion smaller than they were in 2008. 

Not, of course, that all of this missing finance is money that, were it still available, could now be used to lend to UK businesses and would-be home-owners. All four of our largest banks are international in their operations. Thus some of this money would now be being lent in other countries. Particularly in the case of Lloyds and RBS, however, there is still a strong emphasis on the home market; and looking at all four banks’ divisional analyses I estimate that the pool of available finance for potential borrowers in the UK is still around £700-800billion lower than it was four years ago. 

Nor is it likely to grow back to its former size any time soon. 

Part of the reason for this is that in order to avoid another such banking collapse in future, under prospective new banking legislation, following the latest Basel Accord, all UK banks will soon be required to hold a minimum amount of stockholder capital as a percentage of their assets, and are already preparing for this, even though the question as to what the required percentage holding should be has yet to be decided. For while implementation of the Basel Accord is mandatory for all G20 members, its interpretation within the structures and codes of practice of a particular banking culture is the responsibility of national governments. Thus while some member states are arguing strongly for the minimum requirement of 7%, as recommended by the Basel Committee itself, others, including the UK, are proposing an even higher figure. In fact in May of this year, George Osborne astounded EU Finance Ministers – and effectively prevented Basel III from being enshrined in EU law – by insisting that the UK be allowed to impose an ‘own capital’ requirement of 10% on its banks, thus actually placing them at a disadvantage with respect to the banks of other countries, and potentially making a UK economic recovery even more difficult to achieve than is currently the case.

Why the UK government should be taking this strong line, in fact, has got many commentators rather baffled. One financial journalist has attributed it to the ghost of bailouts all too recently past. Others suggest that it is mere political posturing: George Osborne and David Cameron showing us how ‘tough’ they can be on fat-cat bankers. To appreciate the damage it could inflict on the British banking industry, however, one only has to go back to the reasons for bank gearing in the first place. For if UK banks are required to hold stockholder funds equivalent to 10% of their assets, the 0.25% return on assets they are currently enjoying would produce a mere 2.5% on investment for their shareholders. In contrast, the lower requirement of 7%, would produce a return on investment of 3.57%, which may not seem a lot, but in today’s market is a very significant differential, and would make investment in British banks inherently less attractive.

Of course, it is also intended that by denying banks the option of boosting their profits by increasing their gearing, they will be forced to become more efficient, increasing their return on assets by cutting costs, including the inflated salaries and bonuses they currently pay their senior staff. And in the long term, I do in fact believe that this will do more than any other measure to curtail the excessive bonus culture endemic within the banking industry. In the short term, however, most banks are currently cutting costs by simply closing branches and reducing staff altogether, while at the same time increasing their interests rates on loans and mortgages to customers to levels well beyond what a Bank of England’s base rate of 0.5% would seem to justify, all of which is having a negative effect on the UK’s economic performance.

Worse still is the effect these measures are likely to have on the rate at which banks are going to be able to increase their lending in the near future. For given that the requirement with respect to stockholder funds is defined in terms of a percentage of their assets, one obvious way for banks to meet this requirement is simply to shrink their asset registers still further. Indeed, in the case of three of our four biggest banks, this may be the only way.

 Table 2: Increases in Stockholder Funding Required Under Different Scenarios

One can see this in Table 2, which presents two sets of data. The first set includes the asset levels for each of the four banks at the end of both 2008 and 2011 and shows how much additional lending each bank would have to undertake in order to return to its 2008 level. The second presents the level of stockholder funds held by each bank at the end of 2011 and calculates how much additional capital they would need to retain or acquire in order to meet the required levels of stockholder funds, firstly at their 2011 levels of lending, and then at the 2008 levels. As you can see, even at the 2011 levels, Barclays, Lloyds and RBS would all need significant injections of capital even to meet the lower, 7% level of stockholder funding. 

The question arises, therefore, as to where this additional capital is going to come from.

Of course, all three banks could try to raise the money through new share issues. There are, however, a number of factors that would make this very difficult, particularly at present. As already pointed out, depending on the level of stockholding funding the UK government decides to impose on its banks, future returns on investment are likely to be considerably less than in the past. More importantly, the current level of uncertainty makes it very difficult for any potential investor to calculate what later returns are likely to be. There are also a number of skeletons still rattling around in some of our banks’ cupboards. In addition to the LIBOR scandal, of which we have not heard the last, according to the shareholder advisory group, PIRC, UK banks are still sitting on around £40billon of undeclared losses, £18billion of this total being hidden at RBS. Finally, to complicate matters further, both RBS and Lloyds Banking Group are still substantially owned by the UK taxpayer. Before putting any money into either of these banks, therefore, most potential investors would want to know what role, if any, the UK government intends to play in their management and direction, and what its medium term strategy is, particularly with respect to its own exit. New share issues, as a consequence, are a very unlikely prospect in anything like the near future.

The obvious alternative, of course, is for each of these banks to grow their balance sheets organically, using retained profits to swell their stockholder funds. As can be seen from Table 2, however, HSBC is probably the only one of these banks for which the organic solution is a realistic option. In fact, I calculate that if HSBC continues to grow its assets at no more than 2011 rates, and retains 75% of its after-tax profits for 2012 and 2013, it will already cross the 7% stockholder funding threshold by the end of 2013. In contrast, even if Barclays stopped growing its assets altogether and retained 100% of its after-tax profits, distributing no dividends at all for the rest of this decade, it still wouldn’t cross the 7% threshold until 2020. As for RBS and Lloyds, in 2011 they didn’t actually have any profits to retain.

That’s not to say, of course, that Barclays, Lloyds and RBS won’t find a way forward. In all three cases, however, I suspect that it will involve a significant amount of restructuring. One possible solution for RBS, for instance, would be to sell Nat West, a bank with a very strong brand, which, even in the current state of the market, would almost certainly attract a potential buyer, probably from one of the emerging economies. It would then become the responsibility of this new owner to meet the 7% own capital requirement, while RBS, having divested itself of Nat West’s asset register, and therefore reduced its own aggregated lending, would be able to add the proceeds of the sale to its stockholder funds, thereby very probably achieving its own 7% stockholder capital requirement in one fell swoop.

I’m not saying this is definitely going to happen, of course. The RBS board will be looking at all the options. The point is that some such restructuring is almost certainly going to be necessary before any of these banks can start growing their asset registers with any alacrity. Anyone who thinks that, with the exception of HSBC, any of our top four banks will be able to start lending money again at 2008 levels in anything like the near future is therefore simply deluding themselves. Politicians can go on television and admonish the banks to lend more all they like; but even if there were willing borrowers out there – enough to make a difference – the banks can’t lend what they don’t have and what they will soon be prevented by law from borrowing. Moreover, the fact is that even if the banks still had the additional £700-800billion of available finance they had in 2008, the world has changed since then, and there are now far fewer people willing to borrow money for speculative investments than there were four years ago, whether it be on property or on new business start-ups. If the supply of finance has dried up, the demand for it has also taken a bit of a hit. And when you put these two things together, it’s going to take more than an Olympic Games and a cut in VAT to overcome the inertia that has now firmly taken hold of the UK economy.

To understand just how difficult it is going to be break free of our present stagnation, however, one first needs to understand that what has happened since 2008 is not just a temporary local difficulty, and that just as the issues surrounding the banks are far more complicated and far-reaching than most people appreciate – as I hope I have now demonstrated – so too the change that has overtaken the demand side of the equation is far more profound and long-term than most politicians are willing to admit. To demonstrate this clearly, however, will require at least as much space as I have devoted the problems of our banking industry, and will therefore have to wait until my next blog.